NZ Economic Papers 34(1), June 2000, pp.129-147.

Crowding out and resulting trends in research fund allocation in New Zealand 1991-2000

by

Robin Johnson

This is a revised version of a paper presented to the Annual Conference
of the New Zealand Association of Economists, Wellington, September, 1998.
Comments of two referees have been incorporated.

Since 1991, the New Zealand Government has allocated public Research and Development funds through a pool system - called the public good research fund - through which research providers (universities, research institutes etc) must bid for funding on a project by project basis. This system was to counteract a previous tendency for public funding through departmental structures to discourage private sector investment - crowding out. The funding administrators were enjoined to take account of the private appropriability of the projects submitted and direct public funds to complementary projects or projects which would otherwise be under-funded. This paper finds evidence of increased private sector participation in research funding, and a declining share going to research provision over the last 9 years. The Crown Research Institutes appear to be the main beneficiaries.

1. Introduction

The administrative reforms of research organisations in New Zealand in the last fifteen years have been propelled by fiscal conservatism on the part of the governments of the time and a perception that publicly provided funds should be accounted for in a more open and efficient way. In that framework, it was thought that the dominance of public funding in the science sector had tended to discourage private investment in research and development - the so-called phenomena of crowding-out (Bollard et al 1987, p.67;Jardine 1989, p.8). Part of the reform was therefore to change the set of incentives that faced research funders and providers in order to bring about greater accountability, efficiency and private participation. It is now fifteen years since the start of the reforms and responses/reactions to the changes are starting to emerge. This paper discusses the reasons behind the reforms as demonstrated in government documents of the time and developments in funding and provision since.

In the early 1980s government funded about half, business about a third and the universities about a sixth of annual research expenditure in New Zealand. Taking the public sector and the universities together, public investment was 64 per cent of the total funded and private investment 36 per cent. The pre-reform organisation of public science providing activities was strongly hierarchical and controlled and funded by central government. Prior to the reforms, the Ministry of Agriculture (MAF) and the Department of Scientific and Industrial Research (DSIR) spent 73 per cent of the total government budget on science.

The 1980s reforms changed the funding basis of public research as well as the organisational structures. Central government funds were placed in a pool (the public good science fund) and made available to all research providers through a bidding process - the universities were included at a later stage of the reforms when they could identify what they would contribute to the pool. The old departmental structures were replaced by subject-based, self-financed and governed research institutes, that would compete with other providers for the public funds available, and seek private funding as well.

In the aggregate, the share of funding carried by the public and private sectors in the 1990s has not changed greatly - private sector funding has risen to 40 per cent and the total public sector funding has declined accordingly. But within these changes, there has been a more pronounced shift in the conduct of research - the private sector (which includes industry research associations) is contracting out more of its research, mainly to the benefit of the universities. Government provision of research (mainly the CRIs) has increased marginally.

The post-reform response to the organisational and funding reforms has therefore been a shift toward private sector funding and direction of research (as envisaged by the planners) and a contrary shift toward public conduct of research (including the universities). Most significant has been the movement of new funds into the university research sector - from government, from university general funds, and from business. The flow of private funds into the research institutes has also increased, thus reducing their dependence on public funds from their previously high levels. These changes suggest that private investment was crowded out in earlier years, but closer investigation reveals that the private sector was not positioned to carry out a greater role in funding and conduct of research at the time.

This paper discusses the policy climate surrounding public fund allocation during the reforms of the science sector in the late 1980s and early 1990s, and the trends in organisation, funding and research provision that have emerged since.(1)

2. The reform of public good research funding

The public good science fund (PGSF) system pooled the available government funds for research and development (Research and Development) and instituted a bidding process, administered by the Foundation for Research, Science and Technology (FRST), in which research providers competed for public sponsorship. (2)

The newly formed crown research institutes (CRIs), other providers, and later the universities, were able to draw on these funds provided they met the administrative criteria for public good research.

The administrative test is specified as [investment in goods] that may be of benefit to New Zealand, but are unlikely to be funded, or adequately funded, from non-government sources (MoRST 1992b, p.16). This [assumes] that the reason for under-investment is non-appropriability of the results. It is a wide definition that could encompass any research where the benefits are spread across a large number of beneficiaries and cannot be captured at all by a single entity. The addition of a test of inadequate funding suggests private market failure as economists understand the term, and allows some degree of compensation or subsidisation to be taken into account in making grants.

The title of the fund was borrowed from economics but the definition of public good science is fraught with difficulties in practice. The main criteria appears to be whether under-investment will result from the removal of public funds when it has been identified that a proposed piece of research would be in the national interest. This implies that a matrix of social benefits can be identified that will reward the taxpayer in some way. The award of contracts is actually decided not by some social cost-benefit analysis but by the defining of a research agenda and utilising the resulting rules accordingly (MoRST 1992b, p.78). There are thus real difficulties in turning broad objectives into practical rules for public good research funding and allocation.

The search for allocation rules

The 1992 review of long term science priorities raised concerns about the balance of research funding between research directly impacting on economic performance, and research underpinning areas on which economic activity depends indirectly (infrastructure research, and the social and natural sciences)(MoRST 1992c, p.11). The report noted that 68 per cent of PGSF funding in 1991-92 was allocated to the directly `wealth creating' classes 1 to 19 (of the first list of output classes). They stated that this class of outputs was already well funded, but output classes 20 to 35 were more difficult to assess because the benefits they create are less direct and can be longer term. The report recommended a shift in emphasis from both the natural sciences and the production groups to what they called the infrastructural group (output areas 20 to 28). The implication is that underpinning research is more of a public good than wealth creating research goods.

The report recommended a productive partnership between the public and private sector to ensure successful commercialisation of PGSF research results. It stated that PGSF research is more likely to be successfully adopted if the research is planned with strong user involvement and is likely to have the greatest chance of producing benefits to New Zealand where users have well-established market linkages and were performing their own research. The implication here is that greater co-operation and co-ordination between sectors would compensate for the low level of private sector sponsorship of research (BERL 1995, p.46).

The 1992 report's authors believed there was an imbalance between different output classes. They noted the low spending of the private sector in primary production compared with primary processing. This allocation of funds by the different providers has been consistent through all the surveys conducted by the Ministry of Research, Science and Technology (MoRST)(Table 1). Government spending dominates in primary production and in environmental research; `business' investment dominates in processing primary products, manufacturing, construction, transport and energy; the universities dominate in social science, health and fundamental research. Since 1995-96, the private sector share as a whole has not changed much but there has been a shift away from government to the universities.

The report recommended that the PGSF should complement successful private research activities where funds are used to promote strategic and generic research and where there is a demonstrated need for such research. Such complementarity should not displace private research funding, the report states, or support appropriable research. The panel therefore recommended that using the PGSF to complement private funding should be conditional on a continuation or enhancement of funding from the private sector.

In the MoRST instructions to FRST dated July 1997, these objectives do not appear to have changed (MoRST 1997b). The Minister noted that the organisational gains made have resulted in a strong focus on small-scale purchasing of outputs, over relatively short time frames, and within a rather rigid framework of rules and procedures. FRST needed to develop a strategic, far-sighted, and pro-active strategy for focusing on the achievement of outcomes. It will be crucial to foster interactive relationships....... in publicly funded organisations and in the private sector, that together underpin a vibrant and thriving knowledge-based society. With respect to encouragement of the private sector, funding allocations should be managed in a way ........that does not diminish the incentives for, or displace investment by other funders.....

3. Would re-allocation between output classes work?

The STEP report (MoRST 1992b) suggested that redistribution of the PGSF from output classes where there is low private funding, such as agricultural production, to output classes where there is a high level of private funding, such as secondary processing and manufacturing, will reduce the possibilities of crowding out, or funding appropriable research. The report noted that there were applied research programmes in output areas where there was also low private sector funding. PGSF funding should be withdrawn in such an area. The report recommended a strategy for five year priorities that supported strategic and generic research in outputs which have high private sector funding, and withdrew funding from the more applied research programmes in outputs where there was low private sector funding (MoRST 1992c, p.15).

This observation does not surface in later literature. I would suggest that the state could complement private sector activity without specifying whether business was a big spender in that output or not. I believe the panel got a bit off the track at this point and got carried away with their complementarity idea. Re-allocating investment away from one set of outputs (see Table 1) would leave them worse off, and the gap will not be filled by private enterprise without greater incentives. In addition, the high so-called private investment in some sectors was due to the fact that the industry research associations were arbitrarily classified as business rather than government even though they were all established with DSIR seed money! The key issue is whether public investment can be used to trigger further private investment in a complementary way, as well as to create conditions where the up-take of the results of all science investment is enhanced.

4. Involving the private sector

The role of the private sector needs to be looked at from two different points of view. By international standards, the level of own investment in research by private New Zealand entities is low.(3) This suggests a search for reasons for firm behaviour in terms of incentives to invest, and rates of return expected from in-house and industry organisation research. Second, the level of public research is relatively high but its up-take by the private sector is perceived to be too low. This suggests an evaluation of the transfer mechanisms for the up-take of public good research.

The low participation rate of private sector research in New Zealand may well be explained by institutional features of the public and private research markets and not reflect an absence of incentives per se. In the case of the relatively low rate of private investment in intra-mural research [Research and Development activity carried out by an organisation on its own behalf or the behalf others], the impediments to greater investment have been identified by various authors as:

1. the cost of own research is too high in terms of scale and the results sought;
2. the returns on investment are too low;
3. the benefits are too slow in coming in from an initial investment;
4. the system of property rights is inadequate;
5. most companies are too small and dispersed and have an inadequate skill base; and
6. the research results are too lumpy or uncertain in their application.(4)

One answer to these institutional features would be to provide tax incentives to encourage the entry of new firms as well as increase the investment of existing firms (see Bollard et al 1987, p.67). Such measures could be designed to lower the cost of entry to the market for research goods, to lower the costs of technology transfer, and to lower the costs of intra-mural research. Such measures have not been tried extensively in New Zealand hence it is difficult to make a judgement about their efficacy. But given the history of low participation in the past, it seems unlikely they would be very effective in making a significant change in the private rate of Research and Development investment. In view of the low status of the TBG programme (see below), which subsidises very similar objectives, it would appear to me that the small size of the private research market and its dispersion are fundamental problems which can only be changed slowly, and which will not respond to incentives of either sort.(5)

Secondly, the private sector can draw upon the pool of research results derived from public investment in research as well as carrying out its own research. Prior to 1991, the departmental sector was the main supplier of public research goods. Since then, the PGSF system has provided research results as a free or nearly free good. The characteristics of non-rival consumption of such public goods means that private firms have some of the initial work done for them with few restrictions on access. Yet in practice, there appear to be all sorts of impediments to the up-take of these research goods by enterprise. There is not, apparently, a smooth-running market that transforms such free goods into practical uses. There appear to be transaction costs of some magnitude (see for example Bollard et al 1987, p.36). The institutional imperfections, in this case, which prevent higher utilisation of the knowledge already available, have been identified as:

1. the [goods] are not in readily usable form;
2. the costs of further development are considerable;
3. the stock of research is not easily understood nor immediately transparent;
4. agents who can explain what is available are absent;
5. enterprises are too small to take on further development;
6. the rate of recovery of development costs is too low;
7. property rights or patents prevent greater access; and
8. the discovery and development process takes too long.(6)

5. Policy responses

It states that government research will be unproductive if it not able to be utilised by enterprises. Enterprises should transform the results of research and technology into tangible economic benefits. There is a role for government in assisting the enterprise sector to achieve effective uptake of technology, particularly if there are transitional problems or barriers preventing this from happening through market processes - a possible co-operative approach. The 2010 Report refers to historically developed attitudes and behaviours which have been slow to change, such as many enterprises do not have a technology strategy, technically qualified staff, or any investment in research. Part of the reasons for this is the small scale of firms, the high degree of risk aversion, and the high cost of accessing information.

MoRST suggests that a major policy target should be assistance to firms making the transition to greater technological awareness. Access to information could be best assisted by improved networking, with Government taking a role in sectors which are highly disaggregated or where there are insufficient firms to make networking possible (ibid, p.28). In its 2010 Action Agenda, MoRST planned to strengthen the Technology for Business Growth scheme (TBG) administered by the Foundation for Research, Science and Technology (FRST), explore possible funding of `near market' research outside the PGSF, expand Joint Action Groups established by Tradenz, and evaluate the effectiveness of the tax system in achieving investment in innovation, research and technology (ibid, p.32).(8)

Co-operative research arrangements with the private sector

In 1996, the TBG had three grant programmes, the Co-operative Research programme, supporting joint research programmes between research institutions and companies; the Technology Transfer programme, encouraging the uptake of existing knowledge; and the In-House Research and Development programme, encouraging the expansion of effective technological capacity within enterprises. The programme financed up to 50 per cent of Research and Development costs for an agreed project. Total funding was $15m per year. In May 1997, FRST was concerned with the lack of applicants to join the programme [which it administers] and put it down to companies not having enough technically and scientifically trained staff to work on the technological directions they should be moving into (NBR, May 9, 1997). It was noted that only the electronics and software companies initiated their own Research and Development projects and led the private sector in employment of research scientists.

The Technology New Zealand programme was introduced in mid 1997 and consisted of the original TBG scheme, the Techlink scheme, and the Graduates in Industry Fellowships (GRIF) scheme. Through Techlink, business were able to get support for assessment of technology needs for small and medium businesses; Research and Development strategy development; assessing information on overseas technologies and technological innovations; and evaluation and acquisition of overseas technologies and technological innovations. The GRIF programme supports undergraduate, masterate, doctoral and post-doctoral research undertaken within New Zealand businesses. The level of uptake of these programmes did not greatly increase in the two following years (T. Hadfield, FRST, pers. comm.).

MoRST's policy at this stage, was to encourage co-operative or complementary investments through the public good science funding mechanism. In the past, the Manufacturers Federation had expressed negative views on private sector use of the PGSF system. A survey of manufacturers in 1995 revealed that 34 per cent thought current PGSF projects were totally irrelevant and only 6 per cent thought they were highly relevant; the relevance of the programmes as a whole was considered very low, and the relevance of intra-sector programmes (in relation to the respondents own sector) was extremely low (NBR, March 21, 1997). The Federation was in favour of an investigation of small company behaviour; how can the uptake of technology be improved, what infrastructure is required, and what skills are required? (9)

Government responses

In August 1999, the National Government announced its Bright Future: 5 Steps Ahead plan. This involved funds for 1500 enterprise scholarships and post-doctoral fellowships, a taskforce to look at tertiary education, a transfer of money from the PGSF to a New Economy Research Fund aimed at funding research in new areas, funds for teacher fellowships, a proposal for a small business stock exchange, and funds for an ideas incubator. These proposals focused on facilitating Research and Development rather direct interventions such as a tax concession on Research and Development expenditure. Ministers did not rule out tax concessions at some later date. The policy was clearly based on a new appreciation of a knowledge-based global economic environment. The proposals aimed to expand the nation's intellectual and knowledge base to encourage an innovatory approach to Research and Development, and sought to encourage industry to undertake a more strategic role in knowledge development . Out of this, a greater commitment from the business world to Research and Development might emerge (NBR August 20 1999).

The 2000 Budget appears at first sight (as this paper went to press) to build on this approach. Total public investment in research, science and technology is $473.9m, a rise of 10 per cent on the previous year. New funding of $30m is to be allocated to private sector research encouragement, the New Economy Research Fund, and the Marsden Fund. The private sector component consists of a $9m increase in funding for Technology New Zealand and a new $12m grants programme (details not provided). The question of tax concessions has again been set aside though Ministers left the door open to further negotiations. The Minister of Finance told Parliament after the Budget presentation that it had been estimated that revenue of $100m -$120m would be lost through businesses using such a scheme for tax avoidance (Evening Post 21 June).

These policy announcements represent an incremental change to existing policies for private sector co-operation and support in Research and Development. Their effects on business behaviour will have to be assessed further down the track. What remains to be done is to examine actual research fund allocations since the reforms commenced.

6. Evidence for increased participation of private entities in Research and Development

Positive changes in the physical quantum of private investment in research (funding) is one measure of greater participation by the private sector. The second measure is the quantum of research conducted by private sector interests - approximately measured by the expenditure incurred by private research providers.(10) Measuring the effects of complementary spending by the PGSF is difficult (apart from case studies), but could possibly yield to some form of covariance analysis if data were available. The overall rate of up-take of public research goods by the private sector can be measured by an aggregate econometric analysis of sector performance(11) The following analysis is based on the actual trends measured in the MoRST surveys.

Funding: has government's share of research spending diminished?

The trend in research funding by institutional category since 1990-91 is shown in Table 2. The government contribution to departments, universities, CRIs and the private sector has grown from $437m to $579m in money terms or 32 per cent up to 1997-98. The business contribution to departments, universities, CRIs and the private sector has grown from $213m to $338m, or 58 per cent over 7 years, while the universities/other have expanded their funding by 153 per cent. The latter includes own funds (fees and earnings) for the universities, private non-profit funds and all other funds. Thus private funding of own research and research in other entities has expanded markedly and well above the government's contribution as the policy decisions dictated.

Funding: where is private funding being allocated?

Further detail of private funding of research is shown in Table 3. There has been a rapid expansion of private funds going into both government and university research providing institutions. Overall funding by the private sector in New Zealand increased by 58 per cent, but business own research funded only increased by 36 per cent. Private sector funds allocated to government increased by 203 per cent, and funds allocated to universities increased by 224 per cent. The use of these funds (particularly by the CRIs) is discussed further below. Total funds provided by the private sector have increased by 6.9 per cent per year while private spending on research within house has only increased by 4.4 per cent per year.

Funding: where are the universities getting their funding?

The involvement of the private sector in university funding is shown in Table 4. This shows the source of funds for all university research undertaken. While the main source is Vote Education, this has declined and then built up over the years shown. The next most important sources are `own funds' and the rest of government (FRST). Starting from a low base, private sector funding increased up to 1996 and then declined. The shifts in funding in university research have been quite considerable in recent years and reflect changes in the internal organisation of all university funding. Evidently, an earlier trend to finance university research by the private sector has not continued.

Providers: who provides the research facilities and carries out the research?

Trends in expenditure in the different institutional providers is shown in Table 5. The university data is only fully reliable from 1992-93; but the surveys of the business and government sectors have been consistent through the whole period shown. Business providers have expanded expenditure in money terms at 6.3 per cent per year since 1990-91, government providers by 3 per cent, and the universities by 13.5 per cent per year. Over the same period, the GDP deflator increased by 23 per cent or 3 per cent per year; hence the private sector (firms and industry associations) and the universities have been able to actually spend more real resources in the years since the reforms began. The Budget constraints on the government sector are confirmed.

Providers: how does the private sector fund its operational research?

Table 6 shows the sources of funds for all business enterprise Research and Development provision. Own funding rose up to 1993-94, declined in 1995-96, but increased again up to 1997-98. Government funding (mainly FRST) has increased steadily. It is not clear where the Technology New Zealand programmes are recorded. Overall there has been a small movement away from self-provision of Research and Development.

Providers: have the CRIs established themselves in the private sector?

Table 7 shows trends in private earnings among the different CRIs [who are classified by MoRST as government] and their dependence on public funds. AgResearch, NIWA, Landcare, and HortResearch have expanded into the private sector the most. The gross total of private funding of CRIs has risen from $115.7m in 1993 to $173.3m in 1999 (+50 per cent). Most CRIs get about two thirds of their funding from the Crown; only ESR is an exception. Some of this difference is explained by the way ESR's funders are classified by the Auditor-General as non-crown.(12)

This shift in the funding of Research and Development is the most transparent feature of the science reforms. The bidding process for FRST funds and its consequent transaction costs have rationed public sector funds to the CRIs as was probably intended by the science reformers like Treasury. Perusal of the Annual Reports of the CRIs indicates a high level of search activity for new funding.

In summary, this section shows that private enterprises (which include the research associations) are investing proportionately less in their own Research and Development, and slowly increasing funds to other research providers. They are drawing more funds from FRST and overseas sources. They are providing more funds to the CRIs and the universities. In turn, some CRIs are expanding their private funding sources more rapidly than others. The amount invested in university research by private enterprise is small and has not increased in recent years.

Concluding observations

The data for justifying government intervention in the New Zealand Research and Development market has not been generated until recently. High public investments in the past were explained by paternalistic policies which assumed that producers were not able to organise nor fund their own Research and Development. Industry involvement started with the government sponsorship of industry research associations on a partial funding basis which later grew to fully self-sufficient institutes. Conduct of government research was partially privatised when the Crown Research Institutes were established in 1991.

In terms of crowding out, the verdict is not proven. (13) In a historic sense, Government was dominant in spending and setting the priorities. To this extent, an alternative system did not develop. However, this review suggests that in the past the spending and the priorities established were not the right ones for the business sector (in the main). Since government was not doing the research that suited business it can hardly be said that private research was crowded out. The review shows that New Zealand firms were too small (on average), too dispersed by region and type of output, and unwilling to invest in the necessary skills and planning. Benefits were too slow in coming in the face of high discount rates for the private sector, and communication of known research results was deficient.

The reasons for the small size of the private research market remain:

1. the historic dominance of government conducted research;
2. the small size of private companies, on average;
3. the historic dominance of research into primary production;
4. the removal of government funding from research associations;
5. the shift in emphasis in information and communications away from the private sector;
6. a gap between what the government system provided and the private sector's capacity to utilise the results;
7. the really big achievements of the past (plant breeding, animal breeding, aerial topdressing) only benefited primary production and not the firms servicing the farm sector and elsewhere; and
8. a history of protectionism in New Zealand manufacturing.(14)

The expansion of private funding into the CRIs and to a lesser extent the universities indicates a willingness to sponsor more research if not to conduct more. More information is needed to discover any special characteristics of this process though it clearly conforms with MoRST objectives. To obtain the benefits of such sponsorship, the private sector needs to be closely associated with the research programmes and its objectives including its transfer potential to the real situation. The association with the universities also provides a challenge to see that the results are applicable in practice and some positive national benefit emerges from the investment.

References

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Endnotes