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Stephen Harper vowed to fix Canada's growing innovation gap, and the budget delivered.

The Prime Minister and Finance Minister Jim Flaherty laid out a major shift Thursday in how the federal government funds business research and development – one that will dole out more grants and fewer tax refunds – in a bid to tackle chronically lagging R&D investment.

The government is cutting what it gives to businesses via its popular R&D tax credit program by roughly half a billion dollars a year and plowing some of the savings back into direct grants to companies.

The shift to subsidies and away from tax breaks doesn't sit well with many business groups.

"They seem to be taking the subsidy approach of winner-picking by bureaucrats," said Catherine Swift, chief executive of the Canadian Federation of Independent Business. "That's always been a fiasco. We throw money down the toilet."

David Hearn of Scitax Advisory Partners in Toronto said the changes to the Scientific Research and Experimental Development (SR&ED) tax credit program won't make it simpler, and in some ways may make it more complex. But he added the cuts to the SR&ED program are less significant than he expected.

The government counters that what it's doing now isn't working. Mr. Flaherty said in his budget speech to Parliament that Canada offers some of the most generous tax incentives in the world, but business investment in R&D is actually falling. "Canada is not keeping up with other advanced economies on this crucial front," Mr. Flaherty said.

The new approach will "position Canada in the knowledge economy of the 21st century" and help "build globally competitive companies," Mr. Flaherty said.

The budget's innovation plan roughly mirrors findings in a recent federal task force report, headed by Tom Jenkins, chairman of software maker Open Text Corp. The report concluded that R&D by Canadian companies has been falling in recent years – both in total and as a percentage of gross domestic product.

The report also pointed out that Canada invests proportionately more in tax credits (about $3.6-billion in 2011) versus direct grants than virtually all other developed countries.

The most significant move is an overhaul of SR&ED will save the government $520-million a year. The changes include a cut in 2014 to 15 per cent from 20 per in the tax credit rate and a restriction on which expenditures count toward the credit.

For example, capital expenditures – buildings, equipment and product prototypes – will no longer be eligible. The amount of eligible overhead expenses and subcontracted R&D will also be reduced.

That's bad news, said Teledyne Dalsa Inc. chief executive Brian Doody. He said capital-intensive companies such as his Waterloo, Ont.-based electronics firm would lose out.

"I'm quite disappointed," Mr. Doody said. "By excluding capital expenditures as an eligible R&D expense, the government decided that technology companies have no place in Canada unless they are software based, where essentially all expenses are in labour."

This change will remove "one of the key instruments that allowed us to grow," he said.

The government also said it would move to address complaints about administration of the credits and study abuses by consultants working on contingency fees.

Some, but not all the savings will be reinvested in direct grants. The changes will save the Tories an estimated $520-million a year, but they plan to reinvest only about $225-million.

"The government will be hard pressed to show how outcomes will be improved in business R&D if they're spending less money," said Jayson Myers, chief executive of the Canadian Manufacturers and Exporters.

The new innovation initiatives include a near-doubling of the National Research Council's Industrial Research Assistance Program, which doles out cash and advice to R&D projects mainly by smaller businesses. The government is putting an extra $110-million a year into the program.

The government is also giving the NRC, which runs a network of specialized labs across the country, a one-time injection of $67-million to help it concentrate on "business-driven, industry-relevant applied research" and away from the pure research that made the 96-year-old institution famous.

The budget said the government would make $400-million available for venture capital "activities." But it provided no detail on how the money will be spent, or through which government agency. "In the coming months, the government will consider how to structure its support," according to the budget.

Not in the budget is any new money for Ottawa's highly regarded green technology fund, Sustainable Development Technology Canada, which has helped spawn a generation of successful home-grown companies.

The $590-million fund, set up by Ottawa in 2001 with some of the cash from the sale of Petro-Canada, will run out of new money to invest by year-end without a fresh cash infusion.

With files from Sean Silcoff and Richard Blackwell