Wrong way to promote innovation

By , Merritt B. Fox, associate professor of law at Indiana University in Bloomington, is writing a book entitled ''Finance and Industrial Performance: Theory, Practice and Policy.''

The House last week joined the Senate in passing by a wide margin the Small Business Innovation Research Act. The act would require federal agencies with significant research and development budgets to set aside approximately 1 percent of their budgets for grants to small businesses to conduct R&D projects with potential commercial applications. If differences between the Senate and House versions are resolved, the President will be under strong pressure to sign the bill into law.

Universities and big business currently receive the lion's share of government R&D support and small business very little. Proponents of the act argue that this imbalance is a key reason why the United States is lagging behind its major trading partners in productivity growth and introduction of new products. Big business has the cash to fund development of new products and processes but its bureaucratic structure often makes it too conservative to undertake such projects. Small business can act boldly but lacks internal resources. Because outside money to finance such projects is difficult for small business to obtain, many promising projects never get off the ground. Grants under the act would provide vital seed money and a flood of new innovations would result.

Opposition to the act is primarily based on a fear, disputed by the act's proponents, that most of the nearly half billion dollars required annually by the mid-1980s to fund the grants would come at the expense of already dwindling support for basic research. But closer examination suggests that adoption of the act would be a mistake, whatever the source of funds. Choosing proposals for development of products and processes on the basis of their commercial promise is a new role for government and not one it is well suited to perform.

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Basic research expands our general fund of scientific knowledge. The relationship between the discoveries of basic research and products and processes of value is usually indirect. Without a substantial level of public funding, our economy would seriously underinvest in basic research. Since the eventual applications of basic research are impossible to ascertain, the government uses scientific merit as the criterion to decide which projects to fund.

Applied research takes a scientific idea and turns it into a useful product. The government funds a substantial amount of applied research, but only for products for which it is the primary customer, for example weapons.

Applied research to turn ideas into commercially marketable products or processes is different. One who expends money for a wisely chosen commercial applied research project can expect to capture as great a portion of the value of the resulting products and processes as one expending money on any other good investment. Engaging in the process of discovery gives the developer a substantial lead over competitors and often the results are patentable. Government aid is thus not necessary in order to assure that promising projects are funded. The profit incentive is enough.

Small business, the act's proponents argue, is a special case. It cannot act on its ideas because private capital markets, frightened by high risk, will not provide the money to conduct the necessary research. But the very fact that without a program of government grants so many small businesses have brought important innovations to market demonstrates that the riskiness of a project alone does not automatically bar such private support.

If we add a program of government grants as a second source of funding, most firms would see if they could obtain a cost-free grant before even trying to find private support. The government, unlike private sources, does not require repayment or sharing of profits. For that portion of the recipients that would have obtained private support had the program not been available, the grants are giveaways of taxpayer money. For the rest of the recipients, some of their projects will succeed, but most will not. The cost of searching out the winners is the funding of the losers.

A proposed project is not a worthwhile place to invest society's resources unless a well-informed observer assesses its probability of failure to be counterbalanced by a commensurately high rate of return in the event of success. Making these kinds of assessments is what suppliers of venture capital are in the business of doing.

Projects which would not have received private support are projects which would have been rejected by persons who are highly motivated to make their assessments of risk and return well. Each has a strike against it. It is unfair to expect that government officials, whose traditional expertise is choosing projects on the basis of scientific merit or potential to meet government needs, can select from such a group a set of grant recipients containing a high percentage of winners.

If the proponents are correct that small businesses in fact have had worthwhile innovative projects which have gone unfunded, the problem is that venture capital suppliers have not had as much money to dispense as they should have, not that they are afraid of risk. Then the question is what are the biases in the flow of funds within our financial system that work to shortchange suppliers of venture capital. Identification and correction of such biases, to the extent they exist, would do far more to enhance the capacity of our economy to innovate than could any program of government aid.

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