Encouraging Long-Range Industrial Research

Article excerpt

Tax credits will not stimulate industry to fund the high-risk R&D that is necessary for the long-term health of the economy.

The debate over tax incentives vs. direct government funding of research and development (R&D) has once again arisen, and once again this debate is based on an imperfect understanding of the underlying economics. For the past 15 years, the United States has had a tax credit for R&D, and for the past five years, it has operated a direct funding program for specific categories of technology research through the Advanced Technology Program (ATP) at the Commerce Department's National Institute of Standards and Technology (NIST).

Some members of Congress and some industry leaders have recently declared their preference for an R&D tax credit over direct funding of R&D for the general purpose of stimulating investment in R&D, implying that the two mechanisms are alternatives. In fact, tax credits and direct funding of technology research are not good substitutes. Rather, they are responses to different market failures and should therefore be viewed as complementary policy tools.

Since 1981, Congress has provided a tax credit for industry-funded research and experimentation (R&E). Its coverage is very similar to the National Science Foundation definition of R&D. The R&E tax credit is calculated as 20 percent of the increase in R&D over a base R&D number, where the base is calculated by multiplying the firm's average R&D-to-sales ratio for the years 1984-88 by the average sales of the four years prior to the year for which the credit is being calculated. The important point for policy analysis is that it tends to leverage investment in R&D generally and therefore implies a market failure in the category of general risk aversion.

On the other hand, direct government funding of civilian technology research is a policy mechanism used primarily to increase investment in early-phase generic technology research. This phase of industrial technology development is associated with a specific set of risks and therefore results in a different and more specific set of market failures. In response, ATP has provided funding to U.S.-based firms on a cost-shared basis since 1991 for research projects pursuing emerging technologies with significant economic potential that do not fit industry's current risk, time, or market-strategy profiles. ATP does not fund later-phase applied R&D, which is more effectively performed by the private sector. Generic technology research typically enables later-phase applied R&D, which, in turn, enables multiple market applications. The ultimate result is frequently high aggregate economic returns on the original generic technology investment.

However, the character of such enabling technology makes the investment-decision process subject to potentially severe market failures, thereby creating substantial underinvestment in critical technologies. Specifically, direct funding is intended to compensate for:

* industry's aversion to the higher risk that characterizes R&D aimed at major technological advances;

* excessive time-discounting of expected economic returns from longer-term R&D; and

* uncertainty about how an emerging technology suits a potential market.

Underinvestment in the early phases of the R&D process results in critical delays in reducing technological risk and thereby reaching the point in the technology life cycle at which the private sector can make follow-on investment decisions. In highly competitive global markets, such delays can mean losing market participation opportunities completely. Consequently, effective growth policy requires a response that targets this generic technology research phase, and this is ATP's mission.

The right tool

The economic term for cooperative technology research such as that supported by ATP is "risk-pooling. …