Industrial R and D: determinants and consequences.

Hall, Bronwyn H.

In modern industrial economies, technical change and innovation are considered to be a major impetus behind economic growth and improvements in the standard of living. Although many "actors" are important in creating a climate in which innovation can flourish, in a market economy it is primarily private firms that deliver the benefits of scientific research and technological innovation to consumers. For this reason, I and other economists have focused on understanding and measuring the forces that determine individual firm performance in this area, and on evaluating the effectiveness and direction of industrial research.

Economic analysis of industrial R and D has led many to question whether private firms have an incentive to undertake the amount of R and D that is optimal for society as a whole.(1) This causes us to ask by how much the private returns to R and D fall below the social returns; whether our capital market and corporate governance systems do a good job of encouraging R and D investment and innovation; how effective such government policies as the R and D tax credit are; and how our performance and policies compare to those of other large developed economies. My own recent research has examined: the consequences of U.S. capital market structure and the corporate restructuring wave of the 1980s for the performance of R and D; the effectiveness of the R and D tax credit in inducing firms to increase their R and D spending; the contribution of industrial R and D both to productivity growth and to the private returns of individual firms during the recent past; and comparisons of U.S. firm performance in this area with that of France and other countries.

The Market for Corporate Capital and Industrial R and D

During the past decade many observers viewed the wave of restructuring and downsizing in the U.S. manufacturing sector as inimical to investment in R and D in that sector. Some went so far as to argue that the market for corporate control had a serious negative impact on companies' long-term investment, which in turn contributed to the decline of the United States in global competitiveness. Beginning with a study for a 1987 NBER Conference on Corporate Takeovers, I have investigated the evidence behind this argument in a series of papers, and reached the conclusion that the picture has been greatly overdrawn. Still, there is no doubt that a variety of external forces led simultaneously to an increase in leverage and a reduction in R and D investment in certain sectors.(2)

The financial restructuring of U.S. public corporations can be divided loosely into three classes of activity: ordinary merger or acquisition activity; leveraged buyout or going private transactions; and large shifts in the balance sheet toward debt without going private. During the 1980s, the relationship among these three activities and the R and D activities of the firm varied substantially, with only the third being clearly associated with declines in R and D spending. Ordinary merger activity unaccompanied by changes in leverage seems to have gone on throughout the period without having much impact on firms' R and D policies. After a merger, the typical firm had an R and D-to-sales ratio that was equal to a size-weighted average of the intensities of the two merging firms.(3) Not only does this imply that mergers are not necessarily negative for R and D investment, but it also indicates that cost-saving on R and D was probably not the primary motive for these mergers.

Leveraged buyouts and going private transactions increased dramatically during the 1980s, but the potential impact on R and D spending was minuscule, for the simple reason that most of these took place in sectors where R and D investment historically had not been an important part of business strategy (food, textiles, auto parts, tires, fabricated metals, and miscellaneous manufacturing). In ten years, the total amount of annual R and D investment involved was less than 0.5 percent of annual industrial R and D spending during the period.

However, leveraged restructurings in which the firm was not taken private also increased during the 1980s, and these transactions often were followed by substantial declines in R and D investment throughout the period and particularly in the latter half: for example, the decline in R and D intensity for such firms was about 0.8 percent (from 3.4 to 2.6) for 1982 to 1987. The firms involved were primarily in sectors with relatively stable long-horizon technologies (petrochemical, steel, autos) that have been under pressure from foreign competition. Case study evidence does not generally support the view that these foregone investments would have been highly productive for the firms in question. The aim of these restructurings seems to have been shrinking excess capacity in these industries.(4)

Thus, rather than interpreting the corporate restructuring wave as negative for R and D and other long-term investments, it makes more sense to view the two phenomena, increases in leverage and declines in investment, as joint consequences of the higher overall cost of capital during this period and changes in the relative price of debt to equity.(5)

The Returns to R and D During the 1980s

To provide another perspective on the factors affecting changes in R and D investment strategy in U.S. manufacturing during the 1980s one needs to take a closer look at the ex ante and ex post returns to these investments. Ex ante, the stock market signals its expectations of the future profitability of investment in particular firms and sectors via the discrepancy between the market value of existing capital and the book value of the underlying assets (albeit with considerable random error). During the 1980s, the ratio between the market value of ordinary capital and the book value of that capital for the average firm rose from somewhat less than one toward one in most manufacturing sectors.(6) The implication of this finding is that the wave of restructuring and downsizing that we experienced during the period had the effect of removing less productive firms and capital from the sector.

In contrast, changes in the ratio between the market value and the book value of capitalized R and D expenditure varied widely across sectors in ways consistent with the restructuring scenario: in the traditional medium technology sectors of nonpharmaceutical chemicals and petrochemicals, metals, transportation equipment, and machinery, the value of R and D rose from below one to close to one during the period, as the sectors shrank. In pharmaceuticals it has remained above unity throughout most of the past 20 years (through 1991). However, in the electrical, scientific instruments, electronics, and computing sectors, the value of capitalized R and D fell precipitously, becoming close to zero at the end of the 1980s in the electronics and computing sectors. This result admits of two (related) interpretations: either the expected return to future investments in these industries is very low, or the past investments have experienced a much faster depreciation of economic returns than the rate at which they are traditionally capitalized (15 percent).

Ex post results on the contribution of R and D investment to firm revenue support this interpretation. They show that the contribution of R and D to sales growth was low during the 1970s and the first half of the 1980s but has increased recently, except in the electrical industry and in the large-firm part of the computing, machinery, metals, and motor vehicle industries. The overall explanation for these findings is that the very substantial restructuring of the manufacturing sector during the 1980s raised the valuation of ordinary capital (and of R and D capital in the medium-technology sectors). At the same time entry by smaller firms and new technology coupled with a speedup in product cycles eroded the profits in the electrical and computing sectors, leading to a substantial decline in the valuation of their investments.(7) It is noteworthy that although the private returns in these sectors have been low, the benefits that have spilled over to consumers have been large: almost all of the productivity gains in the computing and electronics sectors have gone to the purchasers of their products rather than to the industry itself. This is another piece of evidence of the gap between the private and social returns to R and D.(8)

Market Myopia Toward R and D

The argument that a liquid market for corporate capital such as the United States experienced during the 1980s is not a market that encourages investment in innovation often goes hand-in-hand with complaints about short-termism in U.S. equity markets. That is, analysts are focused on short-term earnings rather than on the potential payoff from long-term investments, and this discourages firms from undertaking them. One way to examine this claim is to measure the discount rate that investors implicitly are applying to the cash dividend streams they expect to receive from holding the shares in a company. Do they penalize firms that have low current earnings and high R and D investment rates?

The answer to this question is no.(9) Although it is perfectly true that the average discount rate that investors apply to the future cash dividends of firms is somewhat higher than the rate at which they discount Treasury bills and bonds (as earlier researchers have found), it is lower than average for firms with either higher R and D investment or higher capital spending, and higher than average for firms with high current earnings.(10) In addition, this discount rate seems to have fallen somewhat during the 1980s, suggesting that investors have become less myopic, if anything. In some respects, this finding is the mirror image of the findings discussed earlier: if anything, investors in the late 1970s and early 1980s were overly optimistic about the future profits to be earned from R and D investments in some sectors, leading to a tendency to discount such investments at a low rate.

R and D Tax Policy and the Cost of Capital

The potential for market failure in the allocation of resources for industrial research has led to a desire for further understanding of the cost of capital faced by firms undertaking R and D and of the effects of corporate tax provisions on that cost of capital. Recent research has addressed both these questions. In addition to the normal considerations that apply to the cost of any type of investment, two features of R and D require special consideration: first, the very fact that it typically creates an intangible, highly idiosyncratic and risky asset will tend to increase the effective cost faced by firms. Second, the U.S. tax system contains several features intended to reduce this cost for R and D-performing firms, among them the expensing of most R and D, the rules on the allocation of R and D spending to foreign source income, and most importantly, the incremental Research and Experimentation Tax Credit.(11)

The asset created by R and D is to a great extent intangible knowledge, embodied only in scientists and engineers. Its value is typically difficult to signal to the market ex ante (even if it is known). Therefore we might expect firms to find internal funds much cheaper than external, and equity cheaper than debt (because of the lack of a securable asset) when financing this investment. Whether or not this is true matters, both because many innovative firms find it difficult to generate the earnings necessary for investment and because our tax system has an implicit subsidy for debt financing relative to equity.

It is easy to find evidence for the preference of R and D-intensive firms for equity over debt, but somewhat more difficult to evaluate the importance of the "liquidity" constraint for these firms.(12) There are two reasons for this difficulty: first, in general, finding that investment of any kind is sensitive to cash flow always admits of two interpretations. Either the firm is responding to positive or negative demand shocks that appear as changes in cash flow, or the firm indeed finds internal funds a cheaper source of capital, and so it increases investments when these increase. Second, for R and D investment in particular, adjustment costs are high, and firms have incentives to smooth their investment paths. This fact will moderate any year-to-year responsiveness to liquidity, although at the same time it implies that firms will underinvest even more.(13) In spite of these problems, a series of studies has documented the importance of liquidity constraints for R and D investment by U.S. firms.(14)

Evidence that firms are not able to capture all the returns to R and D investments, in spite of the legal mechanisms available, including patenting and trade secret protection, implies that society as a whole would be better off if we could induce firms to perform more R and D. The R and D tax credit, which has been a feature of the U.S. tax system since 1981, is the most prominent and wide-ranging of the government policies designed for this purpose.(15) Before 1985, most researchers found relatively weak evidence that firms responded to the tax credit by increasing their R and D spending.(16) Most attributed this to the fact that the effective tax credit faced by most firms amounted to a reduction of 5 percent in the marginal cost of R and D, rather than the statutory rate of 25 percent.

New results suggest that by 1990 the tax credit has become more effective, in that the amount of additional R and D spending induced by the credit has been greater than the cost in foregone tax revenue.(17) This has occurred in spite of the fact that the effective credit rate is small, because the average tax price elasticity for R and D spending is around one in the short run, and also because it has taken firms some time to adjust to the continuing presence of the tax credit in our corporate tax system.(18)

International Comparisons

Many questions about the role of the government and institutional environment in promoting innovation are difficult to answer by studying the experience of a single country. The conclusion that U.S. firms probably were investing and disinvesting "correctly" on average during the 1980s, given the behavior of the stock market, real interest rates, and other macroeconomic factors does not really answer the question of whether other environments might elicit a more socially productive level of investment. To explore such questions as these, we have begun a collaboration with colleagues in several European countries that differ in various ways from the United States.

The initial results of this project are described in a comparative study using about 1000 manufacturing firms each from France and the United States.(19) We find that the contribution of R and D to sales productivity growth declined during the 1980s in France as well as in the United States. The simultaneity among sales growth and both Rand D and ordinary investment is somewhat higher in the United States than in France, possibly reflecting the greater importance of liquidity constraints for investment in the United States. Future work will incorporate comparisons to the United Kingdom, Germany, and Japan.

1 See R. R. Nelson, "The Simple Economics of Basic Scientific Research," Journal of Political Economy (1959), pp. 297-306; and K. Arrow, "Economic Welfare and the Allocation of Resources for Invention," in The Rate and Direction of Inventive Activity, R. R. Nelson, ed. Princeton: Princeton University Press, 1962, pp. 609-625. Empirical evidence on the topic has been surveyed by Z. Griliches, "The Search for R and D Spillovers," NBER Reprint No. 1758, November 1992, and Scandinavian Journal of Economics, (1992).

2 See B. H. Hall, "The Effect of Takeover Activity on Corporate Research and Development," NBER Reprint No. 1091, December 1988, and in The Economic Effects of Takeover Activity, A. J. Auerbach, ed. Chicago: University of Chicago Press, 1988; and "The Impact of Corporate Restructuring on Industrial Research and Development," Brookings Papers on Economic Activity (1990:1), pp. 85-136; and "Corporate Restructuring and Investment Horizons, "Business History Review 68 (Spring 1994), pp. 110-143.

3 See B. H. Hall, "The Effect of Takeover Activity . . ." and "The Impact of Corporate Restructuring . . .," ops. cit.

4 See the evidence reviewed in B. H. Hall, "Corporate Restructuring . . .," op. cit. For a different way of looking at the same phenomenon, see M. C. Jensen, "The Modern Industrial Revolution, Exit, and the Failure of Internal Control Systems," Journal of Finance 48 (1993), pp. 831-850.

5 This point also has been made by M. M. Blair and R. E. Litan, "Corporate Leverage and Leveraged Buyouts in the Eighties," in Debt, Taxes, and Corporate Restructuring, J. B. Shoven and J. Waldfogel, eds. Washington, DC. Brookings Institution, 1990.

6 See B. H. Hall, "Industrial Research During the 1980s: Did the Rate of Return Fall?" NBER Reprint No. 1858, March 1994, and Brookings Papers on Economic Activity: Microeconomics 2 (1993), pp. 289-344; and "The Stock Market Valuation of Research and Development Investment During the 1980s," American Economic Review 83 (may 1993), pp. 259-264, for the evidence discussed here.

7 See B. H. Hall, "The Stock Market Valuation . . .," op. cit.

8 See B. H. Hall, "The Private and Social Returns to Research and Development: What Have We Learned?" paper presented to the American Enterprise Institute/Brookings Institution Conference on the Contributions of Research to Economic Growth and Society, Washington, DC, October 1994 (forthcoming in the conference volume); and Z. Griliches, "Productivity and the Data Constraint," American Economic Review 84 (1994), pp. 1-43 for more detailed discussion.

9 See B. H. Hall and R. E. Hall, "The Value and Performance of U.S. Corporations," Brookings Papers on Economic Activity (1993:1), pp. 1-50.

10 See, for example, R. Mehra and E. C. Prescott, "The Equity Premium: A Puzzle," Journal of Monetary Economics 19 (1985), pp. 145-161.

11 For a review of the foreign source income allocation rules for R and D intensity in the cross section, see J. R. Hines, Jr., "International Taxation," NBER Reporter, Fall 1994, pp. 10-15.

12 For evidence that leverage is inversely correlated with R and D intensity in the cross section, see M. S. Long and I. B. Malitz, "Investment Patterns and Financial Leverage," in Corporate Capital Structures in the United States, B. M. Friedman, ed. Chicago: University of Chicago Press, 1985; and B. H. Hall, "Research and Development Investment at the Firm Level: Does the Source of Financing Matter?" NBER Working Paper No. 4096, June 1992.

13 See B. H. Hall and F. Hayashi, "Research and Development as an Investment," NBER Working Paper No. 2973, May 1989; Z. Griliches, B. H. Hall, and A. Pakes, "R&D, Patents, and Market Value Revisited: Is There a Second (Technological Opportunity) Factor?" Economics of Innovation and New Technology 1 (1991), pp. 183-202; S. Lach and M. Schankerman, "Dynamics of R&D and Investment in the Scientific Sector," Journal of Political Economy 97 (1988), pp. 880-904. and J. L. Bernstein and M. I. Nadiri, "Financing and Investment in Plant and Equipment and Research and Development," in Prices, Competition, and Equilibrium, M. H. Peston and R. E. Quandt, eds. Oxford, England: Philip Allan, 1986, pp. 233-248, for evidence that R and D spending is relatively smooth within firms and displays high adjustment costs.

14 See B. H. Hall, "Research and Development Investment at the Firm Level . . .," op. cit., and C. P. Himmelberg and B. C. Peterson, "R&D and Internal Finance: A Panel Study of Small Firms in High Tech Industries," Review of Economics and Statistics (1994), pp. 38-51.

15 Many countries have similar measures, including Canada, France, and Japan among the G-7 countries.

16 See R. Altshuler, "A Dynamic Analysis of the Research and Experimentation Credit," National Tax Journal 41 (1988), pp. 453-466; R. Eisner, S. H. Albert, and M. A. Sullivan, "The New Incremental Tax Credit for R&D: Incentive or Disincentive?" National Tax Journal 37 (1984), pp. 171-183; and E. Mansfield, "The R&D Tax Credit and Other Technology Policy Issues, "American Economic Review 76, pp. 190-194. 17 See B. H. Hall, "R and D Tax Policy During the Eighties: Success or Failure?" in Tax Policy and the Economy, Volume 7, J. M. Poterba, ed., Cambridge: MIT Press, 1993, pp. 1-36; M. N. Baily and R. Z. Lawrence, "Tax Incentives for R&D: What Do the Data Tell Us?" study commissioned by the Council on Research and Technology, Washington, DC (1992); and "Fiscal Policy Towards R&D in the United States: Recent Experience," paper presented to the OECD Meeting on Fiscal Policy and Innovation, Paris, France, January 19, 1995, Paris: OECD, forthcoming.

18 See B. H. Hall, "R and D Tax Policy During the Eighties . . .," op. cit., and J. R. Hines, Jr., "On the Sensitivity of R and D to Delicate Tax Changes: The Case of U.S. Multinationals," in International Taxation, A. Giovannini, R. G. Hubbard, and J. B. Slemrod, eds., Chicago: University of Chicago Press, 1994. For estimation of an R and D price elasticity that does not rely on the tax treatment, see J. I. Bernstein and M. I. Nadiri, "Interindustry R&D Spillovers, Rates of Return, and Production in High Tech Industries," American Economic Review 78 (1988), pp. 429-434.

19 See B. H. Hall and J. Mairesse, "Exploring the Relationship Between R and D and Productivity in French Manufacturing Firms," NBER Reprint No. 1962, April 1995, and Journal of Econometrics 65 (1995), pp. 263-293; and "Estimating the Productivity of Research and Development: An Exploration of GMM Methods Using Data on French and United States Manufacturing Firms," in International Productivity Comparisons, Wagner, Karin, and van Ark, eds., Amsterdam: Elsevier-North Holland, forthcoming.