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John Lester is a senior research associate at the Centre for the Study of Living Standards. He is a former federal government economist who writes on public-policy issues.

The federal government’s recent innovation policy report dissects Canada’s innovation performance and finds it wanting in many dimensions. Among other issues, the report draws attention to Canada’s difficulties in commercializing inventions and scaling up innovative companies. One strand of the policy response is to increase support for all firms but weight the increase in favour of larger firms in order to redress a small-firm bias in existing innovation programs.

Reducing the bias toward small companies is good public policy, but the federal government could do more than what was announced in the innovation report.

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In a remarkable omission, the report does not explicitly mention the Scientific Research and Experimental Development (SR&ED) investment tax incentive, the largest innovation support program. The federal SR&ED program subsidizes research and development (R&D) performed by small companies at a 35-per-cent rate, compared with 15 per cent for large firms.

Provincial SR&ED programs reinforce this bias, raising the average small and medium-sized enterprise (SME) subsidy rate to almost 43 per cent and the large-firm rate to about 20 per cent. In addition, about 2,000 SMEs top up the SR&ED incentive, which is available to all firms performing R&D in Canada, with targeted assistance from the Industrial Research Assistance Program (IRAP), raising the subsidy rate to around 60 per cent on average for these firms.

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Why do governments subsidize R&D? The short answer: because its benefits are not confined to the firm performing the R&D. Some of the knowledge created while performing R&D inevitably leaks out or spills over to other firms, which allows them to reduce production costs or to improve their products and services. Companies do not consider these spillover benefits when deciding how much to invest in R&D, so a subsidy to encourage more R&D is the right policy response.

Why are the high subsidy rates a problem? By lowering the hurdle rate for a profitable investment, subsidies allow R&D projects with less commercial potential to go ahead, which reduces the value of output. Since the commercial rate of return on R&D performed falls as the subsidy rate rises while the spillover benefit is a constant share of the additional R&D induced by the subsidy, increases in the subsidy rate eventually cause the net benefit to become negative. The sweet spot – the maximum net benefit to society – for the subsidy rate occurs when it is equal to the spillover rate.

Recent research I have undertaken with my colleague Myeongwan Kim indicates that the subsidy rate on R&D performed by small companies is well above the sweet spot while the large firm subsidy rate is below it. In fact, our research finds that small companies generate fewer spillovers than larger firms. The high subsidy rate for small companies may be contributing to this outcome: Projects with low commercial value to the performing firm may not provide much useful knowledge to other firms either.

The lower spillovers generated by small companies suggest that R&D performed by small firms should be subsidized less than R&D performed by larger firms. However, the development of small companies is impeded by several factors, including more burdensome costs of filing tax returns and applying for R&D support programs, barriers to entry erected by larger firms and tax policies that unintentionally hinder entrepreneurs. Perhaps more important, a few small companies are the source of innovations that have big effects on living standards that are not captured in the spillover analysis. As a result, it would not be prudent to consider only the spillover rate when deciding how much to subsidize R&D performed by small companies.

Our research indicates that the all-firm average spillover rate is approximately 30 per cent, which is about 10 percentage points above the small company spillover rate. Adopting this as a common federal-provincial SR&ED subsidy rate would raise real income in Canada by lowering the small-company rate and increasing the large-firm rate closer to their optimal levels.

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Rebalancing the rate would mean fewer small companies performing R&D, but since the average quality of R&D would be higher, the commercialization rate would rise. The conclusion to draw is that subsidizing R&D performed by small companies at a high rate is contributing to the problems of commercializing inventions and scaling up companies identified in the innovation report.

The federal government could achieve the target combined rate on its own by reducing the SR&ED small-company rate to 20 per cent and raising the large-firm rate to 25 per cent. Thousands of small companies would continue to top up the SR&ED benefits with subsidies from IRAP, which could raise the subsidy rate slightly above 40 per cent for these particularly promising companies.

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