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Donít neglect innovation

By Nicholas Gruen - posted Wednesday, 19 January 2011

Economic reform isn’t just about economics. It’s also a political project. Reform requires political leadership because electoral pain is inflicted now for benefits that can take many years - and more to the point, more than one electoral cycle - to materialise. Alongside the removal of dysfunctional economic institutions, reform also involves building new institutions. Just as we’ve removed industry assistance that wasn’t justified, we’ve increased assistance where the economic textbook said we should. Thus for instance, because others can see and copy others’ new knowledge, governments should assist research and development (R&D).

And politicians wouldn’t fund the billions that go into them without a long line of vice chancellors, researchers and businesspeople on their seasonal migrations to the lobbies of Canberra. If this looks like rent seeking, it is. It’s a dirty job. Its sole justification is that someone has to do it. In contrast to most other rent seeking, it’s justified. However if keeping the rent seekers’ snouts out of the public trough is what gets you up in the morning - and it does if you’re an economic reformer - you’re bound to feel diffident about capitulating to the rent seekers, however justified their case might be.

And that’s a pity, because building a political economy focused on the future is every bit as much of a challenge as dismantling the culture of protecting the losers. The new must force its way into the world in a hostile environment. As thinkers since Adam Smith have observed, incumbent business interests are typically well represented in the political process whereas emerging possibilities can be fragile. They have minimal political visibility let alone support. That’s why in the last federal election the ALP scrapped its own policy to fund innovative government IT programs and the Libs junked the entire budget for e-health to fund spending on more familiar, (read: “more vote winning”) issues.


The Productivity Commission (PC) exemplifies reformers’ diffidence. It emphasises the importance of innovation and supports the textbook case for assisting R&D. Yet somehow it just can’t bring itself to propose increased assistance. The big calls in the PC’s 2007 mega-report on science and innovation amounted largely to hand wringing. “Australia’s public support of science and innovation is not in the ‘danger zone’ of demonstrable over or under-funding.” Yet its own research suggested that the economy wide rate of return to Australian business R&D was around 50 per cent!

It’s possible that all the cherries have been picked - that the average return is 50 per cent but the return of the next marginal project of the rank is below par. But how many industries do you know with an average return of 50 per cent that aren’t expanding? But somehow the idea of increasing government support for R&D just didn’t rate. Indeed, the Commission couched some ideas for improving the efficiency of the R&D tax concession as opportunities for savings. But the tax concession it was proposing to economise on provided less than half the rate of assistance it did in 1996 when the Commission last reviewed it. Back then it said the rate was well … not in the danger zone of over or under funding.

When there are disparities of assistance - for instance industry funded agricultural R&D is usually funded at higher rates than business R&D - the PC has a problem. It can’t evaluate what level of assistance business R&D should receive (I can sympathise, we really don’t know enough to be at all precise). But it somehow it always seems to back levelling out assistance by lowering higher rates rather than raising lower rates.

The closest we ever got to a controlled experiment between the reformers’ inclinations towards the “positive” and “negative” aspects of reform occurred when the early Howard government turned the clock back on reform to reduce the budget deficit. It introduced a temporary 3 per cent revenue duty on duty free imports and permanently halved the (then) 150 per cent R&D tax concession. On the backsliding from the “negative” reform policies of cutting tariffs, the PC’s next Annual report was as critical as a government agency can be commenting on “perceptions of confusion and inconsistency in the approaches of governments to industry assistance” with the new import levy singled out as an instance. By contrast its reaction to the backsliding on the positive reform agenda - the reduction in the R&D tax concession was platitudinous, calling for greater continuity of innovation policy “notwithstanding a change of government”.

Now we have a chance to get some of this right. The Review into Australia’s Innovation System on which I sat found that the 125 per cent R&D tax concession was too small to influence firms’ decision making and also highly capricious in its incidence. R&D by profitable firms gets a little help (which varies depending on their dividend policies), whilst loss making start ups often get nothing. The review recommended substantially higher and more evenly distributed assistance together with some narrowing of eligibility to prevent “whole of mine” claims where the bulk of money spent building a huge mine in the face of novel geological challenges qualifies for the concession.

With some of those rent-seekers lobbying for the legislation enabling the new scheme to pass and others wanting it stopped, the Australian Business Foundation has asked Lateral Economics to investigate and report on the best way forward, a report we’ll be delivering in March. We begin the project with an open mind about whether the new legislation truly reflects the Innovation Report’s recommendations and whether, even if it does, it can be improved.


And we also respect the importance of avoiding waste and poor design in assistance programs. In this regard, many of the PC’s proposals to redirect the energies of R&D programs often make a helpful contribution. But we also know that the economy of the future must push its way through the economy of the present. Improving competition in the economy is an important contributor to that vision. I salute the Commission’s vigilance on that score. But given the increasing importance of innovation in meeting the challenges we face - most particularly in climate change - and the declining importance of traditional assistance like tariffs, our current micro-economic priorities seem strangely inverted - somehow lacking in imagination and confidence.

Finding our way to a world in which firms focus on investing in the new knowledge necessary to address the problems we face is surely a bigger prize.

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A shortened version of this article was first published as ďDonít neglect innovationĒ in the Australian Financial Review on January 10, 2011.

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About the Author

Dr Nicholas Gruen is CEO of Lateral Economics and Chairman of Peach Refund Mortgage Broker. He is working on a book entitled Reimagining Economic Reform.

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