Supplementary memorandum submitted by
Rolls-Royce plc
REGIONAL PRODUCTIVITY—UK
COMPETITIVENESS
We very much appreciated the opportunity to
give evidence to your inquiry into regional productivity last
month. From my perspective, the session offered direct insights
into the key aspects currently influencing business investment
decisions and the competitiveness of manufacturing industry in
the UK. We hope that the Committee found the session useful.
We undertook to provide the enclosed paper summarising
work that Rolls-Royce has recently sponsored and assisted to evaluate
the wider economic benefits which flow within the economy as a
result of R&D conducted in sectors such as aerospace. This
work has been undertaken by Oxford Economic Forecasting, working
with independent oversight by Dr Bill Robinson of PwC. We decided
to undertake this work because we believed that the moderate and
falling level of R&D in the UK was a likely factor in the
UK's productivity gap and because of the potential importance
of an up to date assessment of the social returns to R&D for
policy making.
In summary, the analysis concludes that large
economic spill-over benefits arise beyond the company conducting
the R&D and improve the productivity of the economy overall
beyond what would be expected given the level of capital and labour
invested. This general conclusion is consistent with pre-existing
literature but, as the attached paper explains, has been confirmed
by means of an innovative analysis of cross country data within
the G7. Even for the UK economy on average, the social return
to R&D is around 70% real of which the private return to the
original investor is only around 15% in value-added terms. This
is compatible with the market failure that long been understood
to exist in connection with
R&D. Industrial sectors vary widely and
for example civil aerospace R&D seems to offer social returns
of around 100%
We believe these benefits occur in large measure
through supply chains with suppliers applying the technologies
and business processes required and provided by their major customers
across other activities. In this way better technologies and processes
diffuse across the economy between industrial sectors involvement
of trained people is also a factor.
As implied above, these large social returns
are not accessible to the original investor and therefore cannot
influence private investment decisions. As a result the level
of R&D is below the social optimum and can only be leveraged
by Government intervention, we see this intervention in most countries
where we have a presence - most notably the U.S.A., Canada, Germany
and Spain. This implicit market failure and the scale of social
versus private returns to R&D should be important considerations
in the development of Government policy—for example in considering
the adequacy of the R&D Tax Credit and other measures in context
of the UK goal to raise R&D as a percentage of GDP over the
next 10 years.
If there are any aspects of the paper which
you or the Committee members would like to pursue please do not
hesitate to contact me.
16 December 2004
THE WIDER ECONOMIC BENEFITS OF R&D—A
RESEARCH PAPER ON SPILLOVERS
INTRODUCTION
— It has long been recognised that
R&D and R&D-intensive industries can produce wider economic
benefits but the scale of these beneficial externalities and the
practical mechanisms through which they are created have not been
well understood.
— In parallel with the recent Aerospace
IGT activity with DTI, Rolls-Royce has sponsored an economic study
to examine evidence on the scale of these wider economic effects
at a macroeconomic level. This macroeconomic analysis has been
conducted by Erik Britton and Adrian Cooper of Oxford Economic
Forecasting (OEF) with independent oversight by Dr Bill Robinson
of PricewaterhouseCoopers (PwC).
— Separately, Rolls-Royce and OEF (without
PwC) have started to examine how the economic spill-overs from
R&D area realised in the aerospace sector.
— This paper provides a brief outline
of the emerging conclusions and invites further discussion on
what is clearly an important area for Government and industry
policy.
Macroeconomic analysis
— The economic benefits resulting from
R&D do not accrue solely—and perhaps not even mainly—to
the firm that undertakes that R&D.
— The substantial academic literature
(Table 1), suggests that the overall economic benefits resulting
from research and development (R&D) spending are large and
positive. Bernstein and Nadiri (1991) put the social rate of return
to R&D in the range 20%-110%. Nadiri (1993) gives a point
estimate of 50%.
Table 1: private and social rates of return
to R&D
|
| Author (year) | Estimated private rate of return (%)
| Estimated social rate of return (%)
|
|
| Nadiri (1993) | 20-30 | 50
|
| Mansfield (1977) | 25 | 56
|
| Terleckyj (1974) | 29 | 48-78
|
| Sveikauskas | 10-25 | 50
|
| Goto-Suzuki (1989) | 26 |
80 |
| Bernstein & Nadiri (1988) | 9-27
| 10-160 |
| Scherer (1984) | 29-43 |
64-147 |
| Bernstein & Nadiri (1991) | 14-28
| 20-110 |
|
| | |
— Our own research at OEF is consistent with the
range of estimates in the literature—suggesting that the
social rate of return to R&D is around 70%, with wide margins
of uncertainty in either direction. Our lower bound estimate is
around 20%, while our upper bound estimate is around 100%.
— That implies that spending 1% of GDP on R&D
this year will tend to increase GDP by between 0.2% and 1% in
future years. If this higher level of R&D where held in place,
it would lead to substantial cumulative effects over the long
term.
— These returns are likely to diminish ultimately
as the level of R&D spending increases.
— If the returns to R&D do lie in this range,
then low R&D in the UK compared to other developed economies
could be one factor explaining the "productivity gap"—the
low level of productivity in the UK relative to its peers. Chart
1 below shows how total factor productivity (TFP) varies across
countries over time.
— Total factor productivity is a measure of the
efficiency with which labour and capital are employed to produce
output. Theoretically it is a more interesting measure of economic
performance than labour productivity, since it controls for the
impact on output of the stock of fixed capital. But it is also
a less reliable measure, because accounting depreciation rules
are an imperfect measure of true economic depreciation.
— The difficulties are highlighted in Chart 1 by
the fact that Italy apparently enjoyed in 1980 a level of TFP
that the UK only attained in 2002.
Moreover, there is a particular difficulty with cross country
comparisons: we cannot be sure that these rules are applied consistently
across countries, and we have to translate our results into a
common currency using purchasing power parity exchange rates.
Chart 2 below shows how sensitive our results are to the estimates
of the PPP exchange rate.
— Notwithstanding these difficulties, some support
for the hypothesis that the UK's poor productivity performance
is linked to R&D is provided by Chart 3 above, which shows
most other countries increasing their R&D spend relative to
GDP, while the UK has reduced its R&D spend (the steep, but
temporary, reduction in German R&D spend is explained by unification).
— The controversy about the levels of TFP
across countries encourages many researchers to explore instead
the impact of R&D on growth rates of TFP—where
assumptions about the PPP exchange rates do not matter. Chart
4 below plots the growth rates of TFP in the G7 economies against
the level of R&D spending in each of those economies. There
is evidence of a positive relationship between the two, though
clearly a lot of the information on the different levels of TFP
has been discarded in this presentation.
Chart 4 Chart
5
— Chart 1 contains information (possibly misleading)
about cross-country differences in levels of TFP, which is discarded
in Chart 4. Chart 5 makes use of the information about the starting
level of TFP, which is likely to be one factor determining the
future growth rates of TFP. In this light of this, we could tentatively
group the seven countries into three categories: those with a
high starting level of TFP (whose future growth rates are lower);
those with a low starting level of TFP (whose future growth rates
are higher); and Italy (which frequently defies explanation).
This suggests that the relationship between R&D and TFP growth
might be stronger, once we have controlled for the starting level
of TFP.
— Obviously, R&D is unlikely to be the only
factor behind the UK's weak TFP performance. After accounting
for fixed capital investment, others include:
— Educational standards—our research finds an
important role for educational inputs in explaining TFP;
— Management techniques—research by McKinsey and
Co suggests that the UK lags other countries in its take up of
best-practice management.
— There is a host of other drivers of TFP explored
in the literature, but none presents a particularly appealing
explanation of the low level of TFP in the UK.
Sectoral analysis
OEF and Rolls-Royce have started to extend the above analysis
to look at the evidence of positive economic externalities to
R&D within the UK aerospace sector and to consider the likely
mechanisms:
— R&D supports TFP via a number of channels:
— Boosting productivity in the firm undertaking the
R&D;
— Boosting productivity down the supply chain to the
firm;
— Transfer of technologies, processes and "know-how"
from one industry to another or from one firm to another within
the same industry.
The first two channels above are the most important. For
a total social return of 70% the internal return to R&D is
estimated to be only around 15%. The external return is the remaining
55%, a large proportion of which is likely to accrue to firms
in the supply chain to the original source of the R&D. As
discussed below, there is no evidence of this being the case in
the aerospace sector.
Our research suggests that the social return on a unit of
aerospace R&D, in general, mirrors the whole economy average,
while civil aerospace R&D appears to be even more beneficial.
— Firms in the aerospace sector source most of their
inputs from four sectors: aerospace; precision equipment; computers;
and metals and metal products. In the UK there are two main sources
of R&D spend in the aerospace sector: Rolls Royce and BAE
Systems, jointly accounting for at least 90% of aerospace R&D
activity.
— The sectors supplying Rolls Royce and BAE Systems
enjoy an observable productivity premium—a margin of productivity
per employee above what might be expected given the level of fixed
capital expenditure per employee.
— Chart 7 shows that the productivity premium (in
terms of extra value added) enjoyed by these aerospace supply
sectors is of a similar order of magnitude to the estimated total
cumulated external return to UK aerospace R&D. Whilst this
does not prove a casual relationship, it is very strongly suggestive
of a casual link.
— Of course, UK aerospace supply chain companies
do not only supply the UK primes. Similarly, UK primes do not
procure exclusively in the UK. So whilst R&D spill-overs inevitably
arise between countries, this does not invalidate the broad observation.
— That a large proportion of the external return
to aerospace R&D might be realised down the supply chain to
the aerospace sector seems intuitively correct. Supply chains
participate in the development of products and in the processes
of manufacturing and bringing them to market. This further suggests
that the economic benefits from R&D are to a large extent
realised in the "D" part of R&D—in the development
and product realisation phase where networks of primes and suppliers
seek to create new production output at scale—rather than
in the pure research. It is much harder to see how the supply
chain would stand to improve its productivity as a result of pure
research undertaken elsewhere—especially where supply chain
R&D levels in general are significantly lower than for the
primes.
Returning to the UK economy as a whole:
— If the social returns to R&D are so high,
whey are we not doing more? If a large proportion of the total
return to R&D is captured by firms in the supply chain, why
do the primes not appropriate more of it themselves through contractual
arrangements with their suppliers? What should be done to bring
the level of R&D spending up closer to the socially optimal
level?
— The questions are many and in some cases obvious.
All that can be done here is to offer some pointers as basis for
further work and discussion:
— The return to R&D that matters for macroeconomics
is that measured in terms of the extra value added that it creates.
We have shown that on this basis, the external return to R&D
is much greater than the internal return: ie there are large,
positive externalities to R&D—and a large proportion
of these externalities may be realised down the supply chain.
— But the return that matters to companies is measured
in terms of profits—one component of value added—the
other being labour cost of employee compensation.
— If the internal value added return to R&D
is around 15%, then the return to companies in terms of profits
is more likely to be much smaller, perhaps less than 5% for the
UK economy on average. This may be low in relation to the cost
of capital to companies. Further, with social returns being dominated
by labour costs rather than profits it becomes clearer why the
wider economic benefits of R&D are not more readily appropriated
by the primes. On this basis, it is easy to see why the market,
left to its own devices, is unlikely to deliver anything like
the socially "optimal" level of R&D.
— The implications for Government policy are several.
With markets inevitably underinvesting in R&D relative to
the social optimum, there is a need to consider Government intervention—even
before accounting for the effects of foreign government supports.
Secondly, given the low overall private return to R&D across
the economy, it seems possible that Government incentives may
need to be substantial if company R&D investment decisions
are to be influenced in sufficient number to materially change
the overall level of R&D conducted within the UK.
CONCLUSIONS
— There is good evidence from the literature that
the wider economic impact of R&D is large and positive and
that social returns can overwhelm private returns to R&D.
This has been confirmed and reinforced by new work based on consideration
of cross country differences in TFP and R&D and suggests that
the low relative level of UK R&D expenditure may be a significant
factor in the UK productivity gap with international competitors.
— It should be acknowledged, however, that the date
used in estimating the effect of R&D are rather poor—with
inconsistencies across countries, and real controversies about
how they should be treated. Moreover, it is intuitively likely
(though difficult to prove) that R&D spillovers—such
as exist—are not confined to the country that undertakes
the R&D. For these reasons, it is appropriate to guard against
misplaced precision in our estimates of the impact of R&D—our
view is that the effects are large and positive, but there is
a wide margin of uncertainty around exactly how large.
— We are a long way from a full understanding of
the mechanisms through which the economic spill-overs from R&D
occur. However, there are clear indications that supply chain
relationships in the development and manufacture of new products
may be a key channel through which these large economic benefits
are realised. This further suggests that the "D" in
R&D is especially relevant to the realisation of large-scale
spill-over benefits. In contrast, Government policy has tended
to focus on distant-from-market research.
— With evidence that UK R&D expenditure in relation
to GDP is too low, there is a need both to determine what the
right level of R&D should be and to consider how—and
when—this might be delivered through a combination of public
and private sector inputs.
The role of Government procurement, the issue of defence
industrial policy, and the question of incentives for private
R&D are all natural elements of the debate.
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