New Zealand and hoe it may prosper.

In considering the proposition that national economic prosperity is directly linked to public sector R&D investment, two separate issues must be addressed. Firstly, is investment in R&D a material driver of national prosperity, and secondly, is prosperity best served by R&D investment being publically or privately funded? This paper will discuss both these issues, and will argue that while it is imperative investment in R&D in New Zealand is growing; increased investment by the NZ government is important, but not necessarily imperative.

Historically, prosperity has been defined as a state of economic growth, with rising incomes and high employment levels. Simply, social well-being is enhanced by economic growth. More recently, prosperity has been defined to include advancement in a number of areas, including economic fundamentals, entrepreneurship, democracy, education, health, safety, freedom and social capital (The Legatum Prosperity Index, 2009). In considering all of these factors, it is evident that long run economic growth on its own does not necessarily deliver prosperity, and furthermore, a nation’s prosperity could well increase with improvements in other factors, excluding economic growth. While this may be the case for nations where economic prosperity far outweighs social prosperity, in the case of New Zealand, long run economic growth will continue to be a major driver of prosperity (ref).

New Zealand presently ranks tenth on the Legatum Prosperity Index, an index which ranks countries based on all of the factors which are encompassed in prosperity’s modern definition. Considering each of the individual sub-indexes, a clear pattern emerges. While New Zealand ranks highly in social areas such as democracy, freedom and social capital, it sadly lacks in economic fundamentals, with a ranking of just 27th (The Legatum Prosperity Index, 2009). This appears largely due to New Zealand’s less than optimal export performance, and high reliance on natural resources and the industries which consume them, together with a relatively slow growth in national productivity. This can be improved though economic diversification and growth, adding value to existing output, improving overall productivity (economic output per unit of labour and capital employed).

Investment in R&D is a major factor in building the human and physical capital needed to drive economic growth. The value of physical and human capital can either be directly increased through investment, or indirectly increased through investment in R&D, which drives improvements in technology. As resources are scarce, maximum economic growth can only be achieved through efficient allocation of resources in a way which will provide maximum benefits. According to Tassey, author of the economics of R&D policy, economic studies have shown that technology is the single most important factor in increasing economic growth, generating marginal social benefits which greatly exceed that of investment in other areas. This is because, in addition to creating new market opportunities, technology is essential in quality and productivity improvements, the drivers of sustained increases in wages and profits. These increased in wages and profits are in turn the drivers for savings and investment, which drive continued economic growth (Tassey, 2010).

Over the past few decades, investment in R&D in New Zealand, by both private and public sectors has constantly been lower than that of other developed nations. According to the ministerial report on the OECD innovation strategy, New Zealand’s investment in R&D accounts for a mere 1% of GDP, under half of that of the average investment for OECD countries, which ranges from 2 to 5.4% (OECD Innovation Strategy, 2010). Consequently, New Zealand’s economic growth has also lagged behind the OECD average. Considering the clear correlation between economic growth and national levels of R&D spend, this would suggest that investment in R&D in New Zealand should increase, in order to catch up with the rest of the world.

What is not evident from the basic statistics is whether and to what extent the value of R&D investment is a matter of quality or quantity. The fact that New Zealand’s investment in R&D is relatively low compared with its international peers does not in itself prove that investment in R&D needs to grow. As described earlier, investment in R&D is only one form of investment, and to claim that R&D is the key to our future prosperity may be overstating its importance relative to these other forms. Furthermore, investment in R&D which does not result value creation may actually reduce overall productivity.

Economic growth requires the efficient allocation of resources, to achieve the best possible outcome. The fact that R&D in New Zealand is underrepresented in our national accounts may simply be due to a difference in nature of our economy, making our investment in physical or human capital more efficient relative to other economies. The statistics however do not support this argument. According to Winsley, overall investment in R&D produces a risk adjusted marginal social rate of return ranging between 50-70%, almost twice that of physical capital and three times that of human capital, which directly attests to the conclusion that increased investment in R&D would be an efficient use of resources (Winsley, 1996).

The fact that New Zealand’s economy is much smaller than that of other OECD countries could provide an explanation of why investment in R&D is underrepresented, and may also provide an argument that increased investment in R&D is not required. Investment in R&D is highly influenced by economies of scale, meaning it is much more efficient and cost effective when undertaken on a large scale (Rowe, 2005). This could mean that New Zealand’s underinvestment in R&D is warranted, based on the fact that it would be inefficient due its scale. As the benefits of R&D are not entirely limited to the country in which they are produced, New Zealand could “piggyback” off the R&D of larger nations, leaving resources to be invested in other areas. This argument falls short however in that prosperity as a country requires a rate of increase relative to other nations, and simply ‘piggybacking’ off ideas and developments will only cause New Zealand to fall behind. Even if a policy of ‘piggybacking’ was adopted, it could be likely New Zealand needs to increase investment in R&D regardless, as a means adapting other countries R&D investment (Tassey, 2010).

Based on these arguments, it can reasonably be established that in order for New Zealand to prosper, investment in R&D needs to grow, firstly to meet that of other developed nations, and eventually to outpace them.

Whether or not investment in R&D needs to increase however, is only half the issue. What is more important is who is best placed to fund and perform R&D functions in New Zealand. Simply suggesting that the government should throw more tax payers money into R&D, would be largely understating the complexity of this issue, and as such, the rest of this paper will be dedicated to addressing where this funding should come from.

Presently, investment in R&D in New Zealand is largely publicly funded, with public funding accounting for 51% of R&D, much higher than the OECD average of 30% (OECD Innovation Strategy, 2010). As well as this, direct public funding, rather than indirect, accounts for nearly 100% of all public R&D expenditure. The reason for this mix in funding is that rather than being an entirely private or entirely public good, the classification of R&D as an investment is largely mixed. This is due to the broadness of scope of R&D as an investment, which encompasses all forms of research such as basic science and research into generic and proprietary technologies, and all forms of development from conceptualisation to commercialisation. It is well accepted that the development of basic scientific knowledge is a public good function, and is therefore primarily the responsibility of the government. It is not so clear whether the development to commercialisation of knowledge and technology into assets for economic activity should be a public sector responsibility, or driven by the private sector (Tassey, 2010)

In considering New Zealand’s underinvestment in R&D, increased government funding may at first glance appear to be an obvious solution. This would be based on the premise that R&D will increase long run growth, it is currently underrepresented, and therefore it is something the government should be investing in. New Zealand’s economy is about the same size as an average S&P company. Therefore it could make intuitive sense that the central government replaces private sector funds in R&D, as pooling resources would allow for a more substantial research base. In addition, the government’s access to taxation revenue is more mobile than private funding for investment, allowing it to easily and quickly be redistributed (Jacobsen, 1991). While this solution may have merit, for scale reasons the real issue is not the volume of spending, rather it is the value of spending. While there is clear evidence that increased investment in R&D will increase long run economic growth, all other factors held constant, the real factor that needs to be considered is whether or not the government will make the most efficient use of resources.

As stated earlier, many studies have shown that investment increases long run economic growth, however whether or not direct public investment increases economic growth is an entirely different matter. Frank Lichtenberg, who conducted an extensive investigation into R&D investment, and its relation to international productivity differences, found that while privately funded investment has significant positive effects on productivity, the effects of public investment was insignificantly different from zero, or in some cases negative (Lichtenberg, 1992). This points to the conclusion that the government, as an investor, is unable to make efficient use of the resources which it extracts from the economy. This inefficient use of resources can be explained by a number of factors, most import of which is that government expenditure essentially has little to no accountability, other than the party in power being accountable to voters. This leads policy and spending to focus on politically popular funding options, rather than those which are economically efficient. Therefore, in order for New Zealand to prosper, it would seem that the required increase in investment in R&D would need to be met by private industry.

In theory private funding for R&D, will drive resources to be allocated efficiently. In the market, price and profit act as a language that communicates the wants of consumers to those who produce goods. Economic agents respond to changing relative price signals, and their response to this language of price shifts resources to their highest value in use, thus achieving efficiency. In contrast public spending tends to be characterised by resources being allocated on the basis popular public policy, often providing what the market will not pay for. Private business which at times will have the existence of their business at stake, will tend to pursue R&D with a high probability of commercial return or avoid altogether higher risk programs with very uncertain payback. Private sector R&D has very strong commercial drivers to be successful, increasing productivity and profitability, in turn creating wealth and prosperity (Tassey, 2010).

But if the market acts to correctly allocate resources, then why is investment in R&D so underrepresented, considering marginal rates of return are so high?

The theory that the market will effectively allocate resources is based on the premise that all the characteristics of a well functioning market are upheld, such as perfect information, zero barriers to entry, and most importantly, the non-existence of externalities or “spill over” effects (Cellini, Lambertini, 2008). The underinvestment in R&D can be described by the failure to meet these requirements. Market failure results from a dysfunction in the private sectors capabilities for assessing the economic potential of an R&D project i.e. imperfect information, and a limited pool of high risk capital. Technical risk is often too high, meaning risk cannot be reliably estimated, time to completion is often outside the strategic scope of management. Co-ordination problems also exist, as the nature of evolving markets requires investment in combinations of technologies. Significant positive externalities or “spill over” effects are prominent in the R&D industry. These externalities are often unable to be internalised to the producer, meaning the full potential benefit of R&D is often not rewarded to the producer (Jacobsen, 1991).

The existence of market failure is an important justification for government intervention. As market failure results in a sub-optimal level of R&D investment, public policy is required to address this issue. This does not necessarily mean however that government’s direct investment must increase (although this may well be the case) rather it means that the causes of market failure need to be identified, and properly addressed through effective measures (Jacobsen, 1991). Therefore in order to increase investment in R&D, the government should properly consider the causes of underlying underinvestment, and formulate appropriate cost effective policies which encourage investment to occur. This conceptualisation leads to a policy view that the government’s role is best served funding scientific research in universities and crown-owned research institutes. While it is theoretically possible to break down certain aspects of R&D into purely private and public good, the boundaries of these aspects are often too vague to be effectively established in practice (Tassey, 2010). It is this mixed nature of R&D’s classification as a good which causes this funding conundrum, as, if R&D was purely a private good, private funding would be most efficient and vice-versa.

To stimulate and facilitate private investment, it is likely that direct government funding will have to increase, not because government funded R&D stimulates growth, but because it may required to facilitate and increase private investment. While government funded R&D may itself be relatively unproductive, any spending which stimulates private investment, will provide significant benefits for New Zealand, by facilitating increases in productivity, and with this, economic growth. Rather than simply pouring money into politically popular areas of R&D, the government can use resources effectively by increasing funding in New Zealand’s generic technology base, and investing in technology infrastructure which supports domestic industries. An example of this would be increased funding to scientific research in universities. Broad-based underinvestment in R&D could be reduced by sufficiently lowering the cost of R&D, through indirect funding such as tax credits. This would partly address the loss of reward caused by positive externalities, somewhat correcting market failure.

In conclusion, in order for New Zealand to prosper, it is likely, but not imperative that the government’s investment in R&D should grow. While overall prosperity encompasses many factors other than economic growth, it cannot be achieved without it. Efficient investment into physical, human and technological capital is a pre-requisite. New Zealand is currently underinvesting in R&D, an area which has been shown to produce significant marginal social benefit. What is imperative is that effective policy is established to facilitate private investment. Public investment, where required, should be targeted specifically in areas which act to strengthen New Zealand’s fundamental research base, such as research universities and generic technologies. Increased investment in R&D is essential for long run growth, and if private investment is able to be significantly increased, it will become a lasting foundation of greater prosperity.

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