How can the feds support innovation?

Asks David Crane in today’s Toronto Star. Between the lines I read that the feds need to stop listening to whining corporate elites, whose cries inevitably come back to tax cuts, deregulation, more “free trade” (investor rights) deals and reduced public services as the means to “competitiveness”. Crane suggests a federal approach based on a little thing we used to call industrial policy, back when the term meant doing something active.

Crane draws on a now-canceled federal program, Technology Partnerships Canada, for inspiration of what has worked in the past. One reason why TPC was canceled probably had to do with finger-pointing from the Canadian Taxpayers Federation, who ripped TPC a few years back based on some FOI documents they got. There is some merit to the CTF critique of TPC, but a lot of it is just the knee-jerk libertarianism. Here is Crane’s article, followed by some unpublished observations I made about the CTF and TPC a few years back.

Ottawa must do more to promote business innovation
May 28, 2007

David Crane

While Canada’s manufacturers continue to close factories and shed workers, the federal government is moving too slowly to create new opportunities.

Science and technology are vital for future jobs in Canada. Yet as the federal government’s new science and technology strategy – Mobilizing Science and Technology to Canada’s Advantage – acknowledges, Canada’s business community invests far too little in the science and technology that can generate new products and services that lead to new jobs. They rank 15th in R&D spending.

It is not clear why Canadian companies are so reluctant to spend on R&D. That’s why Ottawa has asked the Council of Canadian Academies, Canada’s national institute for the advancement of science, to work with business and academic experts to find out why.

To get the right answers, the council will investigate each industry separately, because reasons for underinvestment in the chemicals industry, for example, will be quite different from reasons in the auto industry. This will take time.

But there is more Ottawa can do to promote innovation. One huge gap in its new strategy is the lack of direct support to business to share the risk in developing new technologies. For example, Research in Motion’s BlackBerry, held up in the government’s new report as a model for Canadian innovation, benefited twice from a federal program, Technology Partnerships Canada, which the Harper government has since abolished.

That program provided up-front funding, repayable on commercial success, and helped many companies develop new technologies.

In a recent report, the Economist Intelligence Unit emphasized that innovations are not a simple matter of, say, a company signing up for a university patent, as Ottawa seems to think. Rather, “innovations are the result of a chain of events that starts with an original idea, invention or discovery, and then proceeds through prototype construction, financing, customer demonstration, field trials, engineering, production, marketing and finally sales.”

As it points out, “an invention that costs $1,000 to make can easily cost $10 million to turn into an innovation.” The new federal strategy addresses only the earliest part of this process.

Canada relies heavily on tax credits to encourage business R&D, and they are important. But many smaller companies cannot take advantage because they have no profits against which to deduct the tax benefit. One solution would be to permit them to sell these tax benefits to other companies, generating cash they urgently need to get new products to market. Mining companies are allowed to do this, but not high-tech companies.

This disadvantage can force burgeoning Canadian high-tech companies to sell out to foreign multinationals, creating what Tundra Semiconductor chairman Adam Chowaniec has called “R&D branch plants.” The R&D team in Canada is sustained but the job-creating commercial production from their work will likely be carried out in another country.

What comes through in the federal government’s new report is a limited view of government’s role. “The most important role for the Government of Canada is to ensure a competitive marketplace and foster an investment climate that encourages the private sector to innovate,” says Industry Minister Maxine Bernier.

There’s no doubt that competition encourages innovation. But as Harvard Business School competitiveness guru Michael Porter stresses, while such framework conditions matter, they are not enough. This is the great weakness of the Harper government’s approach. Thus, Canada will miss opportunities for new businesses and be handicapped in creating new jobs to replace lost ones.

Full disclosure: in my days as Industry Canada bureaucrat, I was one of the low-level folks who worked on putting together ideas for the information technology side of the TPC program, when it was being created to fill the gap made by then-Finance Minister Paul Martin’s cancellation of the DIPP (Defence Industries Productivity Program). It was widely seen inside the bureaucracy as a quick response to corporate blackmail on the part of Pratt and Whitney, who claimed they were going to pack up their Montreal-based toys and go home to the US unless federal funding was restored, and they did so in the lead-up to the last Quebec referendum. In my info tech branch, we saw the new program as an opportunity to do some real industrial policy work, though we got a pretty thin slice of the pie when it finally came out.

My overall assessment is that TPC was a sound program in spite of some shortcomings, like a tendency towards defence-industry pork. So I am neither a blind supporter or critic. I accept that industrial policy is an important area for government to engage in, but am cautious of the pitfalls that it does not become “corporate welfare” as claimed by the Canadian Taxpayers’ Federation. Here’s an excerpt of what I wrote back in 2002, in a paper presented at the Canadian Economics Association meetings:

The CTF’s 2002 report on Technology Partnerships Canada is used here to examine the elements of their critique. TPC was established in March 1996, and is a program based on sharing risk with private sector ventures, with repayments based on successful commercialization of technology. In the five years ending March 2001, total allocations have amounted to $1.8 billion.

The CTF report begins by indicting the Defense Industries Productivity Program (DIPP), TPC’s forerunner that was ended in the 1995 federal budget, citing a repayment rate of only 18.24% on contributions from April 1982 to December 2001. To be fair, the DIPP program was based on both loans and grants, and much of its history appears before repayment was made a significant factor in the design of industrial policy programs. Repayment streams from DIPP are expected into the future, but the CTF rightly asks for some degree of accounting by the federal government about expected future repayments.

In its analysis of TPC, the CTF critique boils down to four key points (most of the report’s points are variations on the same ideas): a lack of transparency and accountability in TPC’s functioning; a poor track record with regard to repayment; over-concentration of spending in Ontario and Quebec; and, excessive cost per job created or maintained. The latter two points are highly subjective, so no further analysis is provided here.

The first point—lack of accountability and transparency—has been documented by Canada’s Auditor General. The AG has flagged a number of concerns applicable to TPC and to other industrial development programs. The AG notes that: program design has failed to cite the specific results expected from the spending of public money; delivering programs in a cost-effective way remains a concern; program evaluations are often limited in scope and do not provide a clear overview of whether the programs are achieving value for money; and, Parliament, receives limited information on program performance. [2001 Report of the Auditor-General of Canada, Chapter 5]

The second issue—repayment—is core to all CTF critiques of industrial policy. From the inception of the program in April 1996 to December 2001, the TPC program had received repayments of only 2.58% on close to $1 billion in outlays. Some wiggle room is appropriate in this instance, as the program is relatively new. Repayments should be expected to increase into the future, and as some projects may not be commercially successful, there will be instances of non-payment. In addition, repayments may be a poor indicator of overall performance, because its use is too narrow to capture the objectives of the program. Nonetheless, repayment issues also have an accountability dimension, and the low level of existing repayments, read with weaknesses in reporting and monitoring, suggest more than a passing hint of corporate welfare.

Concerns about corporate welfare are implicit in the data presented by the CTF that show a disproportionate amount of TPC funding allocated to the aerospace and defense industries in Canada. These industries have been major recipients of public funds in the past and have been successful in exerting political pressure to keep the spigot flowing. Indeed, such manoevres are connected to the establishment of TPC in the first instance. After the cancellation of DIPP in 1995, a US-owned jet engine manufacturer, Pratt and Whitney, sought $100 million in financing from the Canadian government, threatening to close its Montreal plant. The demand came in the lead-up to the 1995 Quebec referendum on sovereignty, which made the government highly susceptible to this corporate blackmail.

While the program covers other areas of innovative activity, including green technologies and “enabling” technologies, some 55% of TPC funding between 1996 and 2001—almost $1billion—went to aerospace and defence. Pratt and Whitney has been the premier recipient of government largesse. Over the 1996 to 2001 period, Pratt and Whitney went to the trough four times, emerging with $385 million in total funds. This amounts to three times the value of allocations granted for the environmental technologies section of TPC (and one-third of the aerospace and defence budget). Ironically, while such expenditures are premised on the notion of creating or at least maintaining jobs, Pratt and Whitney actually laid off 900 workers in 1999. Even outside aerospace and defence, the list of recipients of public money contains many very large and profitable corporations, such as IBM, Rolls Royce, BF Goodrich, and CAE Electronics.

This does not mean that TPC should be entirely dismissed as corporate welfare. There are many smaller companies that received funds under the program, and such funding may or may not have had commercial success as a result. Here again, however, TPC runs aground on accountability issues, where existing practices make it difficult to properly assess whether TPC is indeed performing this function (a full audit is well beyond the scope of this paper, and remains the purview of the Auditor-General). But the presence of companies on the list that could easily raise funds in the private market for new investments is troublesome.

The TPC case also raises issues about what extent programs should be provided to keep jobs in Canada, whether in politically sensitive regions or not. A counter-argument from federal bureaucrats is that such programs are necessary for sectors like aerospace and defence in order to keep high paying jobs in Canada, that this represents the public cost of being “in the game”. This is a recognition that increased capital mobility enhances the bargaining position of foreign investors. Competing jurisdictions are prone to offering up subsidies, tax breaks and other freebees of various sorts to influence location decisions of large corporations. This is a dangerous game for governments to play that has enormous benefits for foreign-owned corporations that are considering investments in a nation or region, or that already have an investment that they can threaten to pull. As the Pratt and Whitney case suggests, companies can also lever political fault lines to their bottom line advantage.