Don't underinvest in research!

Laurent Probst, Partner, and Mycola Goncharenko, Senior Adviser at PricewaterhouseCoopers Luxembourg
Lëtzebuerger Land, December 2008

What is the return on investment for research?
Is it 10, 20, 50, or perhaps 100 percent? More than you may think…

Many discussions as to the relevance of research, its large financial requirements, its benefits for the economy and the society have been held lately
in the political and business circles in Europe and Luxembourg. But what does all this actually mean?
Why is research so vitally important for companies, industries and for a country? In this article we will try to shed light on this underlying complex economic phenomenon.

Accumulation of knowledge as a result of research, supported by the build-up of financial capital is driving long-term economic growth.
To the business community, research often means risk: R&D requires large financial investments, and many companies think that they will never get a direct return in terms of Euros.
For this reason market tends to underinvest in research, as companies believe that they cannot benefit from all the created knowledge.
But what companies tend to forget is that by putting money into research, they are able to convert it into innovative products and new services, thus securing their enduring competitiveness,
and consequently, future revenue streams. Moreover, by bearing infrastructural and technological costs, investing into human capital and so forth, businesses also support the overall economy.
For the government, to compare, research means above all innovations, and therefore, value for the society. These innovations feed the economy through new products and services, forming the basis for economic competitiveness of the country as a whole. However, in the conditions of insufficient industrial funding of research, there are no alternatives for public actors but to support it through investments, often also providing tax incentives for those commercial organisations that carry out R&D.

In finance, the term “return on investment” (ROI), also known as rate of return, is the ratio of money gained or lost on an investment relative to the amount of money invested.
ROI does not indicate how long an investment is held, but it is often expressed as an annual rate of return. The concept of ROI in R&D is at the core of what is called the “economic benefits of research”. Much evidence on this matter comes from the academic studies performed on US, OECD and EU economic activities. These studies measured the total economic benefits of research taking into account both the cost of R&D of successful projects, as well as those that failed 1 . Different economic studies have tried to estimate private and social rates of return on R&D.
They suggest that the annual rates of return for R&D expenditures on the public/private company level are anywhere between 3% and 54%, and between 4% and 86% – on the industry level 2 .
Due to methods used in these studies the estimates vary considerably, but the real gross rates of return at firm level are thought to be around 25%, whilst at the industry level they are higher – up to 40%. Such surprisingly high rates of return for the industries are the result of spillovers taking place between firms. This means that firms benefit from the research results conducted by other companies in diverse industries, inspiring multiple industrial sectors. Finally, these spillovers favour society as a whole (see table).

	Investment in Physical Capital	Investment in R&D
	Private Returns	Private Returns	Social Returns
Chemical Products	20%	22%	46%
Fabricated Metal	21%	21%	21%
Non-electrical Machinery	24%	25%	40%
Electrical Products	18%	27%	31%
Transport Equipment	26%	23%	35%
Scientific Instruments	28%	28%	86%

Private and Social Marginal Rates of Return on Investment in US Manufacturing Industries (before tax, net of depreciation)
Adapted from: Dowrick, S (2003).
Shows that there is little difference in terms of private returns, if investing into physical capital or into R&D, however, large social returns are fostered. Private returns on R&D are known to arise from long-term sustained competitiveness.

At this point many might have a question of what these spillovers are, and how they happen. Spillovers are a “give-and-take” experience: every time people from different companies exchange ideas, or every time an employee moves from one organisation to another one, a spillover occurs. Thus, knowledge is spread, as it is a “public good”.

So, if investment into R&D is so beneficial to the companies, then which companies benefit most from investing into R&D? Internal R&D is of particular importance for larger firms,
which have enough capacity to run their own research. In contrast, smaller companies benefit most from university-based public research conducted in the labs close-by.
Firstly, research and inventions promote new companies being spun-off from the university, thus creating jobs. Secondly, having closer ties with the university, smaller companies can acquire knowledge spillovers more efficiently, rapidly transforming them into product innovations. Therefore, investing in research fosters innovations.

There are also some additional benefits of research that should not be forgotten: they include training of skilled workforce, inventing new equipment and new methods, and forming social interaction networks. Macroeconomic studies of R&D benefits are of particular interest to the government, as they capture a unified picture of ROI from the industry, the full extent of inter-firm and inter-industry knowledge spillovers, as well as some of the above mentioned additional benefits. These studies show very high rates of social return for R&D, usually above 50%.
However, even such measures of returns on R&D ignore other aims of research – such as national security, economic sustainability, environmental protection, improvement of public health,
or social cohesion etc.

Thus, should a small country like Luxembourg invest in research? Or should it merely lay back and watch other larger nations perform their R&D, and then simply appropriate the resulting innovations?
This would, of course, make perfect sense, but knowledge flow as a result of spillovers, has a time-lag: it may take years for the innovations to arrive from other countries to Luxembourg; and in terms of international competitiveness this would mean a very long time. Like every developed country, Luxembourg has no alternative but to invest in its own R&D activities, to prioritise the areas of national interest, and to engage with international partners. During the last year one could watch a number of new important collaborations (both academic and industrial) in diverse fields of research being established in Luxembourg. These were mediated and launched by organisations such as the “Centres de Recherche Public” and the University of Luxembourg, supported by Luxinnovation. In the long run these collaborations aim not only at diversifying the economy but more importantly – at creating additional value for the companies, for industries, and after all for Luxembourg. Such R&D collaborations are also an important milestone on Luxembourg’s way towards a competitive, dynamic, knowledge-based economy, as aimed for in the Lisbon strategy of the EU. This type of economy will guarantee international competitiveness of the region in the future, as production sites will continue shifting to the low-cost locations outside of Europe.

But some questions remain: How to allocate these R&D investments, and how to transform this knowledge into value for all? The answers to these questions are complex, and will require an array of support mechanisms to be developed. They will need to address diverse issues such as legal and intellectual property rights, to set-up special dedicated financial structures, technology transfer agencies and science parks, and to make the public grasp this need for R&D.

1. Reviewed in Dowrick, 2003.
2. Nadiri, 1993.
3. « Centre de recherche public de la santé », « Centre de recherche public Gabriel Lippmann », « Centre de recherche public Henri Tudor » .