Debunking the Myth That Federal R&D Investment “Crowds Out” Private R&D

Robert D. Atkinson August 25, 2020
August 25, 2020

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Research and development spurs productivity growth, regardless of whether it is conducted by the private sector or the public sector. Yet some free-market advocates argue against increasing federal investments in R&D on the grounds that it simply substitutes for, or “crowds out” private R&D. If this were true, then it would be a powerful argument for government not to increase R&D, because it would be using scarce public resources to do something the private sector would otherwise handle satisfactorily on its own.

But it’s not true. In fact, the scholarly evidence finds that public R&D “crowds in” private R&D—with increases in public R&D on average leading to greater, not less, business R&D. In other words, the more the government invests in R&D, the more businesses invest in R&D (all other factors being constant). As an OECD study found, “Direct government funding of R&D performed by firms (either grants or procurement) has a positive effect on business financed R&D (one dollar given to firms results in 1.70 dollars of research on average).” And an additional $1 of public contract research added to the stock of government R&D has the effect of inducing an additional $0.27 of private R&D investment.

Most other studies of the issue have found similar results, with the effect differing from around $0.10 to $0.30 of additional R&D for every $1 of government funding for university or government laboratory research. What’s more, research has shown there is a strong positive correlation between private R&D investment in a year, and public R&D spending in the year prior to that. For the life-sciences industry, $1 of National Institutes of Health (NIH) support for research leads to an increase in private medical research of $0.32. One survey of over 60 academic articles on whether public sector R&D crowds out private sector investments concluded, “There are a number of econometric studies that, while imperfect and undoubtedly subject to improvement and revision, between them make a quite convincing case for a high rate of return to public science in this [life science] industry. It is worth noting that there are, so far as we are aware, no systematic quantitative studies that have found a negative impact of public science.”

The reasoning behind the complementarity between private and public R&D is two-fold. First, public R&D investment corrects the market failure of private markets underinvesting in R&D (because businesses cannot capture the social benefits of R&D). Public R&D dollars expand the knowledge base, which businesses then invest further R&D into in order to turn research into innovative commercial products. Public support for a promising line of research helps convince firms to boost their own efforts in these areas. Advances in science and engineering make private development efforts more productive.

Second, businesses that receive federal R&D funding are able to attract and expand private R&D investments. One reason is that federal R&D grants have strict evaluation processes, which serves as good indicators of companies’ potential to private investors. For example, economist Sabrina Howell found that companies that receive Small Business Innovation Research awards doubled their chances of later receiving venture capital.

In short, it’s time to retire this urban myth that government R&D competes with private. And given the fact that federal government invests less in R&D as a share of the economy than before Sputnik, there is a strong case to me made for boosting federal investment, not scrimping on it.