Influencing Innovation: Government’s Role in Subsidizing R&D

Firms often underinvest in research and development (R&D) when there is no government intervention. There are many uncertainties and risks that discourage firms from investing in R&D, which slows the pace of innovation. To address this problem, governments can provide firms with subsidies to incentivize new product creation or improve existing products. In a recent paper, Raffaello Bronzini and Paolo Piselli examine the effect of an R&D subsidy program in northern Italy. They find that subsidies have a positive effect on innovation, as indicated by an increase in the number of patent applications and the likelihood of application submissions.

R&D projects can be risky because the project may be more expensive or take more time than anticipated. Due to the high risks associated with an R&D project, a firm may not want to invest in developing new products and services because of fear of financial losses from a failed project. The uncertain nature of R&D projects also dissuades banks from giving loans to firms, especially smaller ones. Subsidies from government can reduce firms’ fear of financial losses by reducing the costs associated with research, thereby increasing firms’ willingness to undertake new R&D projects.

In the study, firms had to score at least 75 out of 100 on an assessment of their project proposal by a committee of experts to receive the subsidy. The assessment evaluates a proposal in four areas: technological feasibility, financial feasibility, managerial competence, and regional impact. The authors focus on firms that have scores close to the 75 point threshold to ensure that the firms studied have similar characteristics. The only difference between these firms is whether they receive subsidies or not, which allows the authors to isolate the effect of the subsidy.

Bronzini et al. use patents as a proxy for innovation. The authors admit that patents may not be a perfect measure for innovation because some firms may choose to protect their innovation by keeping it secret. However, it is an objective and reliable metric for innovation compared to other types of proxies that require surveys, which can be biased by personal opinion.

The authors find that the average number of patent applications submitted by subsidized firms is 1.4 times the average of the unsubsidized firms. If the government in northern Italy wants to induce a firm to apply for one additional patent, it has to provide a subsidy of approximately €206,000 to €310,000 ($220,000 to $340,000). The probability that a firm will apply for a patent also increases by 12 percentage points when a firm receives a subsidy.

The effect of subsidies on innovation also depends on the size of the firm: The authors find that R&D subsidies lead to a larger increase in the number of patent applications for small firms. Among small firms, the number of patent applications from subsidized small firms is twice the number of applications from unsubsidized smaller firms. On the other hand, the number of patent applications from subsidized large firms is 1.2 times that of large unsubsidized firms. Subsides increase the likelihood that a small firm will apply for a patent, but not large firms. One possible explanation for this observation is that without subsidies, smaller firms will not be able to sustain the large financial loss if an R&D project fails.

Subsidies are one promising mechanism for increasing innovation in northern Italy as seen by the increase in the number of patent applications. It is possible for other regions to create a subsidy program similar to the one in northern Italy to induce firms to innovate more. However, not all subsidy programs will be effective in stimulating investment everywhere, as there may be other region-specific factors that influence R&D investments. Therefore, other governments should evaluate the impact of subsidy programs over a period of time in their regions or countries to determine whether R&D subsidy programs could be effective.

Article source: Bronzini, Raffaello and Paolo Piselli. “The impact of R&D subsidies on firm innovation.” Research Policy, 2016.

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