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Summary

This policy brief explores the type of interventions that developing countries can use to increase local technology-generating efforts in production enterprises. It focuses in particular on two financial instruments (tax incentives and grants), and on two non-financial incentives (human resources development and industrial standards).

Introduction

Technology is central to many of the changes now taking place in the manufacturing and service sectors of countries across the world. In a number of developing countries, however, much creation of new knowledge is still confined to government research institutes and universities, and these tend to be isolated from the production system. As a result, businesses remain peripheral to the production of knowledge, limiting both their competitiveness and economic development.

To change this situation, policy makers and researchers in developing countries increasingly believe that companies in both the private and public sectors must be encouraged to commit more resources to generating new technology, for example through research and development (R&D) or through other engineering activities.

This process, however, can be hampered by the threat of severe market failures in the financing of R&D — in other words, by the fact that the likely financial return may be insufficient in itself to attract the required investment. As a result, governments need to intervene by providing enterprises with financial and non-financial incentives that can help avoid or reduce the chance of underinvestment in R&D.

This policy brief explores the type of interventions that developing countries can use to increase local technology-generating efforts in production enterprises. It outlines various financial and non-financial instruments that can achieve this, focussing in particular on two financial instruments (tax incentives and grants), and on two non-financial incentives (human resources development and industrial standards).

Developing countries and technology generation

There are significant differences in the technological capacity of developing countries. One of the best indicators of this comes from the patent record, based on a growing consensus that, although they have limitations as a measure of local efforts, patents are a reasonable indicator of a country's potential for generating new technology.

A brief analysis of the distribution of patents granted in the United States appears to show that the proportion granted to developing countries is increasing. Based on this, one might also claim that the potential for developing countries to generate new technologies has also been growing (see Table 1).

But a closer analysis of the data shows that just 11 developing countries — Argentina, Brazil and Mexico from Latin America, South Africa from the whole of the African continent, and India, China, Hong Kong, Singapore, Malaysia, Taiwan and South Korea from Asia — have managed to make major efforts in patentable innovations. And even within these better-performing countries (with the possible exception of South Korea and Taiwan), these efforts are restricted to a handful of domestic firms.

These 11 countries can be broken down into three groups. At the top end are the traditional Asian 'Tigers' — South Korea and Taiwan. Next are the two Asian 'cubs', Singapore and Hong Kong. Finally, there are the remaining seven, that is, China, India, Brazil, South Africa, Argentina and Malaysia. Although still small when compared to the overall number of patents, the number of patents granted to inventors from countries in these three groups has increased tremendously, and they are slowly emerging as potential creators of new technologies.

Many other developing countries, however, remain primarily involved with incremental technology-generating efforts, concentrating on the adoption, use, assimilation and modification of imported technologies. Shifting from this state to becoming a creator of new technologies demands a deliberate investment in technological learning — that is, in accumulating the capability to introduce increasingly complex changes in technologies

This is important because even to assimilate imported technologies effectively, firms in developing countries need to invest in local R&D and other local technology-generating efforts. And to encourage them to do so, governments have designed a variety of financial and non-financial instruments.

Click here to open Table 1: Developing countries and the creation of new technologies in a new window.

Notes: 1. Two Asian countries are South Korea and Taiwan; 2. Two Asian Cubs are Singapore and Hong Kong, SAR; 3. Asian NICS are South Korea, Taiwan, Singapore and Hong Kong; 4. Other developing countries are China, India, South Africa, Brazil, Mexico, Argentina, and Malaysia. 5. The data is based on the number of US patents granted to inventors from these countries. Source: United States Patent and Trade Mark Office, http://www.uspto.org/

Public innovation policies to promote business R&D

In relation to business, the basic rationale behind public support for innovation is to address private underinvestment in R&D.

Such policies generally cover two main areas [1]:

• The creation and maintenance of a legal environment — through measures such as patents and the relaxation of antitrust activity — that increase the likelihood of generating an acceptable return from investment in innovation, and thus encourages such investment by the private sector.
• The provision of grants, contracts, targeted tax incentives and other mechanisms intended to encourage private agents to look beyond their private benefits when assessing whether to get involved in innovative activity.

Public innovation policies vary significantly among countries [2], and governments have created a range of R&D incentives. Table 2 summarizes the major types of financial and non-financial instruments.

Table 2: Components of innovation policies
Relationship with the market	Type of measure
	Financial measures	Non-financial measures
Public provision of goods and services	Subsidizing exchange of R&D personnel between public and private sectors	Policies aimed at diffusion of technology Human resources development policy University and government R&D Industrial standards
Modification of market incentives	Tax incentives for R&D Direct funding through grants, soft loans, loan guarantees for R&D projects Promotion of national R&D projects Joint cooperative R&D projects between government and the private sector	Public procurement [3] particularly in defence The intellectual property right (IPR) regime Industrial and trade policies
Support of the improvement of market mechanism	Creation or improvement of specialized financial market mechanisms (such as venture capital)

Of these, it is the financial measures — and particularly tax incentives — that have attracted the most attention and analysis. This is because policymakers sometimes narrowly equate public innovation policies solely with tax incentives and other financial measures.

But non-financial measures, such as human resources development and industrial standards, are equally important, particularly for developing countries. Indeed financial incentives are only likely to be successful in stimulating domestic innovation if governments give equal weight to non-financial incentives. Research grants, for example, only work effectively when there is a critical mass of scientists and engineers to undertake the R&D.

Another factor that needs to be taken into account in choosing mechanisms to support business innovation is that developing countries are not a homogeneous group, particularly when it comes to technological capability. Furthermore, innovation policies need to be adapted to the needs of a country at its particular stage of technological development. Policies also need to change as a country progresses technologically.

As we have seen, some developing countries in East Asia and Latin America already make substantial R&D investment, and are potential creators of new technologies. For these — which may be referred to as Type 1 countries — financial measures should be given more weight, since these can be an effective way to expand innovative activities.

In contrast, other countries in sub-Saharan Africa, South Asia, Latin America and the Middle East, are mainly users and adapters of imported technologies. For such countries, referred to as Type 2 countries, the emphasis should be on non-financial measures; these must precede financial measures if the latter are to be effective.

Financial measures supporting business R&D

Grants and tax incentives are the two financial instruments most widely used to support business R&D both in industrialised [4] and, increasingly, developing [5] countries.

When governments fund business R&D directly, they generally do so by awarding grants. By contrast, tax incentives represent an indirect form of support to business R&D by providing tax relief that lowers the costs to the company of R&D activities. Each of these mechanisms has advantages and disadvantages that need to be taken into account by developing countries when devising their R&D policies (see Table 3).

Table 3: Financial instruments to promote innovation
Types	Advantages	Disadvantages
Research grants	Allows governments to target areas with high social returns Could prompt potentially higher increase in business R&D Reward on a 'case-by-case' basis Selective incentive systems.	High interference in the market Dependent on annual budget reviews Temporary and unstable Require complex bureaucratic mechanisms.
Tax incentives	Low interference in the market Higher potential innovation outcomes Higher political feasibility Less bureaucratic and more predictable Stability of R&D incentive policy.	A blunt instrument which does not allow targeting of R&D to specific areas Can be perceived as entitlement Insufficient return from finished projects.

As Table 3 shows, tax incentives involve less interference in the market than grants, as they provide more discretion to private agents. This is because the market, not the government, decides on the allocation of resources to R&D investments. In other words, tax incentives allow firms to retain autonomy in devising their R&D strategies in response to market signals, and to select which R&D projects to carry out.

Research grants, by contrast, are inherently discretionary. Through them, a government defines who gets how much, and for what specific purpose.

In comparison to grants, tax incentives are blunt instruments. A tax incentive such as a tax credit cannot be targeted at R&D projects with large external benefits. In contrast, by offering to support particular types of R&D projects, grants allow governments to orient business R&D efforts towards projects with high social returns.

Furthermore, in terms of total increase in R&D spending, grants tends to be more efficient than tax incentives in enlarging the overall stock of knowledge available to domestic firms. This is because direct funding is likely to raise total spending on R&D by more than the amount spent by the government, as additional funds may be provided by the firm itself.

In contrast, one unit of tax incentives is likely to yield significantly less than one unit of additional spending on R&D because of its relatively large spillover effects. 

But if the main aim of government policy is to boost a country's rate of commercialisation of new products, processes or services, tax incentives offer several advantages over grants.

For example, success in commercialisation hinges on a sound understanding of the market, and tax incentives leave decisions on which projects to fund in the hands of private firms — which will have such knowledge — rather than government agencies.

Even with tax subsidies, firms will still be providing most of the money for projects they pursue out of their own financial resources, ensuring that they, not the taxpayers, will bear most of the risks of failure. In contrast, direct funding of commercial R&D through grants can lead to a misallocation of resources among major sectors of the economy, as governments do not react as sensitively as companies to market signals.

Finally, tax incentives are easier to administer and less discretionary than grants. The latter are often allocated on a case-by-case basis, demanding a substantial amount of administration. They are also subject to yearly review and budget allocations, making them less predictable in the long run.

Yet tax incentives also have a number of limitations in relation to their administration. For example, R&D tax subsidies tend to operate as entitlement — that is, all firms that qualify may claim a subsidy, whether they actually need that subsidy or not.

Tax credits are also easy to abuse: routine expenditures, such as those incurred in quality control and routine testing, may be classified as R&D expenditure, and claimed as a tax credit accordingly.

Non-financial measures supporting business R&D

As mentioned above, non-financial incentives are also important factors influencing business R&D investments. Two such measures are particularly crucial: policies on human resources development, and policies on industrial standards.

Policies on human resources development

A steady stream of highly trained personnel is, of course, necessary if business R&D is to thrive. Without it, no amount of fiscal incentives can spur innovation. All successful countries — including the Asian Tigers and 'cubs' — have efficient policies for increasing both the quality and quantity of technically trained personnel [6].

Most developing countries, however, face serious shortcomings in human resources development. This is illustrated by the relatively low density of tertiary students in their populations (see Table 4), or of research scientists and engineers (RSE) in their labour force (see Table 5).

As Table 4 shows, there is consistently very low enrolment in tertiary education in the least developed countries. This represents a huge obstacle to technological development in these countries, and is a key policy challenge for them, as the availability (or lack) of university graduates obviously influences the potential number of research scientists and engineers entering the labour force.

Furthermore, as seen in Table 5, a very strong positive correlation exists between the number of research scientists and engineers in a country's labour force and that country's level of R&D activity.

Table 4: Density of tertiary students (per 10, 000 inhabitants)
	Brazil	China	South Korea	Malaysia	Singapore	India	Tanzania	Uganda	Zambia	Nigeria
1980	1,158	166	1,698	419	963	515	22	45	128	229
1985	no data	328	3,568	595	1,474	582	22	69	181	352
1990	1,082	331	3,946	680	1,846	582	26	107	212	no data
1991	1,077	313	4,071	753	1,956	No data	28	126	no data	no data
1992	1,042	313	4,375	856	2,080	No data	29	124	no data	no data
1993	1,067	377	4,420	886	2,273	No data	33	135	no data	410
1994	1,092	437	4,637	973	2,328	538	36	150	238	no data
1995	no data	461	4,950	1,048	2,527	610	43	160	no data	no data
1996	1,424	473	5,605	no data	2,730	638	48	179	no data	no data
1997	no data	488	6,106	no data	no data	no data	57	no data	no data	no data

Source: Centre for Human Capacity Development (2000)

Other key issues need to be considered in designing human resources policies. In most developing countries, for example, only about 15 to 20 per cent of students enrolled at the tertiary level study science and engineering. Policy choices that emphasise a technology-oriented curriculum can go some way towards addressing this gap.

Official thinking also needs to go beyond simply supplying technically trained personnel. Governments need to ensure that their education policies lead to a match between the requirements of industry and the output of universities. A failure to recognise this can result in the loss of important markets and have other significant consequences.

Table 5: Density of research scientists and engineers and R&D intensity (per 1 million labour force)
Country	Year	Researchers per 1 million labour force	R&D intensity (R&D/GNP*100)
US	1993	3676	2.63
Germany	1995	2831	2.41
UK	1996	2448	1.95
Singapore	1995	2318	1.13
South Korea	1996	2193	2.82
South Africa	1993	1031	0.70
China	1996	454	0.66
Brazil	1995	168	0.84
India	1994	149	0.73
Malaysia	1996	93	0.24
Uganda	1997	21	-

Source: UNESCO (1999)

Policies on industrial standards

Such policies are an integral component of public innovation policies [7], and confer both direct and indirect benefits.

The immediate impact of standardisation in industry, for example, is to reduce the costs of doing business by providing clearly specified interface requirements for products, ensuring that certain characteristics of the physical boundaries between such devices are well defined.

In this way, standardisation can both lower barriers to market entry and speed up competition, and thus the demand for new technologies. It also functions as quality certification, which is especially important for industrial components.

Standardisation also has indirect benefits. For example, both the preparation of new standards and the review of existing ones provide an important forum for the exchange of technical information about products and processes, both within an industry and between users and suppliers. In this way, standardisation can function as a means of placing continuous pressure on firms to upgrade their products, while providing them with the technical information required to do so [8].

Industrial standards are also important for developing countries that want to produce and export manufactured goods, especially to markets in industrialised countries. For instance, manufacturing and service sector firms that are keen to establish a credible presence in international markets have found certification under ISO 9000 standards — technical standards defining requirements for quality management in production — to be increasingly important [9].

Finally, under the Technical Barriers to Trade (TBT) Agreement, part of the World Trade Organization (WTO) Treaty that was signed in 1994, all signatory governments must give preference to international — rather than national — standards as a basis for their technical regulations. 

Despite the many advantages of industrial standards, however, many developing countries continue to pay little attention to them. Although there has been an increase in developing countries gaining the ISO 9000 certification, the biggest concentration of certified companies has been in East Asia (namely the Asian Tigers and cubs plus China, Malaysia, Indonesia, Thailand and the Philippines). By contrast, the number of certified firms in the rest of the developing world has risen only very slowly in recent years, and their share of the total remains small (see Figure 1).

The implementation of industrial standards in developing countries cannot be left to private sector institutions alone. The governments of these countries have an important role to play in introducing standards, and in persuading firms to comply with them.

A high policy priority for these countries is the development of standards institutions to provide the certification. Such institutions can also contribute to the diffusion of best practice in industry, to helping firms to obtain certification, and to the development of programmes that guarantee quality standards in the business sector.

Click here to open Figure 1: Trends in ISO 9000 certification worldwide, 1993—2002 in a new window.

Source: International Organization for Standardisation, http://www.iso.ch/iso/en/iso9000-14000/pdf/survey12thcycle.pdf (accessed on 9 February 2005)

Conclusions

Business R&D activities are an important input to a country's scientific and technological development, and thus contribute directly to increased domestic productivity and growth. But if R&D financing is left entirely to the private sector, a lack of market incentive can lead to underinvestment. So governments often need intervene in order to support those activities. 

The role of public policies in supporting business R&D is particularly important for developing countries. This is because most firms in those countries rely primarily on the acquisition and adaptation of foreign technologies, while most complex technology-generating activities take place in public research institutions and universities.

The latter only have limited links to the production system. But as even foreign technologies need to be adapted to local conditions, firms in developing countries need to undertake some R&D activity. That means that governments must provide both financial and non-financial incentives to promote R&D in the business sector.   

To be most effective, those two sets of incentives need to be treated as complementary. For instance, governments can stress both financial incentives — such as tax incentives and research grants — and essential non-financial measures, such as policies on human resources development and the implementation of industrial standards.

Further reading

Centre for Human Capacity Development (1999), Global Education Database 2000, Washington, DC: United States Agency for International Aid.

Ergas, H. (1987) 'The Importance of Technology Policy' in Dasgupta, P. and Stoneman, P. (Eds.) Economic Policy and Technological Performance, Cambridge: Cambridge University Press, pp. 51-96.

Kim, Linsu (1997), Imitation to Innovation: Dynamics of Korea's Technological Learning, Boston, Massachusetts: Harvard Business School Press.

Lall, Sanjaya (2001), Competitiveness, Technology and Skills, Cheltenham, UK and Northampton, US: Edward Elgar.

Leyden, Dennis Patrick, Link, Albert N.  (1992), Government's Role in Innovation, Berlin: Springer.

Mani, Sunil (2002), Government, Innovation and Technology Policy: An International Comparative Analysis, Cheltenham, UK., and Northampton, US: Edward Elgar.

OECD (1996a), Fiscal Measures to Promote R&D and Innovation, OECD/GAD/(96)165, Paris: OECD.

OECD (1996b), Public Support to Industry, Report by the Industry Committee to the council at the ministerial level, OECD/GAD/(96)82, Paris: OECD.

UNESCO (1999) Statistical Yearbook 1999, Paris: UNESCO.

Viner, Neil, Philip Powell and Rod Green (2004), 'Institutionalized Biases in the Award of Research Grants: A preliminary Analysis Revisiting the Principle of Accumulative Advantage' (2004), Research Policy, Vol. 33, pp. 443-454. 

World Bank (1998), Knowledge for Development, World Development Report 1998, Washington, DC: The World Bank.