Investments in R&D and innovations have been fundamental to long-termeconomic growth across countries. The worldwide experience shows that innovations are usually underinvested by private sectors, due to spillover effects, high level of risks associated with them and other market failures. The study explores some theoretical underpinnings of the innovation investment decision, existing problems in financing of innovations as well as the main financial instruments and public policy options in this sphere. 

Keywords: Investment, Innovation, Spillover effect, Innovation financing instruments 

The worldwide experience suggests that innovation is a key factor of economic development. Enabling “creative destruction” process, innovation ensures structural transformation of economies, enhances competitiveness of individual businesses, and promotes economic growth. Thus, in many developed as well as in catching-up countries promoting innovation and technological change is among the major priorities of economic policy (Gogokhia and Berulava, 2020; Berulava and Gogokhia, 2016). The success in fostering innovation and technological change, in turn, heavily depends on the availability of finances and relevant investments (Pérez, 2002). In countries with underdeveloped financial and capital markets, the lack of finance usually represents the major obstacle for businesses to undertake innovation and technological change (UNCTAD, 2011). This problem is further aggravated by market failures and spillover effects common for innovations, which causes underinvestment in inventions and technological change under ‘laissez-faire’ market conditions (Arrow, 1962). In this study, we explore the theoretical underpinnings of the innovation investment decision, existing problems in financing of innovations as well as the main financial instruments and public policy options in this sphere.

It is widely recognized that R&D and innovation activities require significant capital investments. Thus, the crucial prerequisite of technological change and innovation, is the availability of financial capital, which in turn depends on the organization and efficiency of financial and capital markets (Pérez, 2002). Generally, the following sources for private financing innovation can be distinguished (UNCTAD, 2013): Personal funds; Retained earnings; Business angel financing; Venture capital; Commercial bank loans; Stock exchanges; Bonds; Value chain financing; Microcredit; Crowdfunding.

Since the seminal work of Schumpeter (1942) it is commonly acknowledged in the economic literature that there are substantial issues in private financing of R&D and innovations under perfect market competition conditions (Nelson, 1959; Arrow, 1962). The main reason of these issues is that the output of investments in R&D and innovations is the knowledge, which is nonrival. To say distinctly, the use of new knowledge by the inventor does not exclude the possibility of its usage by other firms, and thus the inventor cannot appropriate solely the returns on the investments in the new knowledge. Thus, firms will have less stimulus to invest in R&D and innovation, causing undersupply of relevant investments. For instance, Arrow (1962, p. 619) expects that “…a free enterprise economy to underinvest in invention and research (as compared with an ideal) because it is risky, because the product can be appropriated only to a limited extent, and because of increasing returns in use….To the extent that a firm succeeds in engrossing the economic value of its inventive activity, there will be an underutilization of that information as compared with an ideal allocation.” Klette et al. (2000), based on the review of a number of micro-econometric studies, reveal that social rate of return for public investments in R&D is higher than private benefits of inventors, and that generally, public investments in R&D can mitigate these market imperfections.

Another problem with financing of innovations occurs when inventor and finance provider are different economic agents (Arrow, 1962). In this case the gap between the private rate of return and the cost of capital can cause the underinvestment in R&D and innovations. Hall and Learner (2010) explore the “funding gap“ for investment innovation with the focus on financial market reasons for underinvestment that occur even under the absence of externality-induced underinvestment. The authors find that small and new innovative firms face high costs of capital and that venture capital can only partly mitigate these costs. The same time the study reports mixed evidence for high costs of R&D capital for large firms, which prefer internal funds for financing R&D investments. The authors suggest that venture capital has only limited ability to solve the funding gap problem, and that this problem is especially acute in countries with underdeveloped public equity markets for venture capital.

According to above arguments, two major impeding factors that create obstacles for the financing of R&D and innovations can be summarized as follows:

• The first obstacle is caused by market imperfection or positive spillover effect of innovation, which limits appropriability of the new knowledge by entrepreneurs and makes their private profits lower than the social returns from innovation. This factor leads to underinvestment in R&D just due to distorted incentive structure and does not depend on the access to finance and development of capital markets.
• On the contrary, the second impeding factor is related to the accessibility of finance and development of capital markets which reflects the availability of financial resources needed for R&D investments and has no relation to positive externality of innovation. According to Peneder (2008), the ‘financing gap’ can be caused by capital market imperfections resulting from two factors. The first one is the adverse selection or asymmetry of information between entrepreneur and investor. While the second one is moral hazard issue, which represents an incentive problem, when entrepreneur has stimulus to take advantage at the cost of investor.

Each of innovation investment impending factors requires different type of public policy intervention. Peneder (2008) elaborates a policy mind map for financing of innovations. This map links the problem of private underinvestment in R&D and innovation with its causes and rationales, aims and targets, critical constraints, and the main finance-related instruments of innovation policy. Such a policy mind map clearly defines public policy priorities and enhances coordination and effectiveness of policy-making efforts for promoting investments in innovation. According to the policy mind map, the main objective of the public policy is to remove these obstacles through ensuring incentives for innovation investments and providing necessary financial resources (Peneder, 2008). These objectives can be attained by employment of both direct and indirect instruments of public policy.

The direct funding as an instrument of public policy provides more flexibility for government in ensuring targeted stimulus for entrepreneurs to invest in innovation. Especially, such remedies can be applied for supporting projects with high spillovers, or stimulating SME and start-ups (Peneder, 2008). Generally, policy-making and academic literature acknowledges the following types of the public direct financing instruments (UNCTAD, 2013): 

• Seed financing – used at the initial phases of R&D and innovation process,  and focused on the identifying the commercial feasibility (both technical and marketing) of new project or idea.
• Co-investment funds – is an instrument at a disposal of government that provides co-financing for private seed capital and venture capital financing.
• Innovation or technology funds – provide direct financing (through grants both on competitive and noncompetitive basis) for enterprise R&D and innovative activities, often at the early stages. These funds are usually established by government but can be co-financed by international organizations and private sector. Government can use these funds as an instrument for promoting technology development and innovation in selected industries according to national industrial policy priorities.
• Development banks - are usually established with the aim of providing finances and subsidies for industries and activities having highest priority for the country’s economic development.
• Innovation prizes – takes form of a cash reward for a person or firm for the most useful innovation in a certain field or for solving a specific technical challenge.
• International development assistance can supplement public direct financing of innovative activities through providing funds for the development of technologies and innovations in catching-up economies. A good example of international donor that supports innovation and technology development worldwide is the World Bank Group’s International Finance Corporation.

The indirect instruments of public policy usually employ fiscal incentives for R&D and innovation investments that can take the following forms (Klette et al., 2000; Peneder, 2008; UNCTAD, 2013):

• Tax incentives - provide stimulus for technology development and innovation, with the aim to encourage R&D by allowing R&D spending to be deducted from tax liabilities, usually up to some maximum percentage of total tax liabilities. Besides tax deductions, fiscal incentives may assume tax allowances – which offer firms the opportunity to deduct an additional percentage of expenditures on innovation from their tax base; tax credits – which allow firms to deduct a certain percentage of the targeted expenditures directly from their tax liabilities; the innovationpremium, paid to companies which have not earned a positive taxable income;  alternative tax base - where an R&D rebate can be deducted from the employer’s part of the wage tax and social security contribution of R&D-related personnel.
• Public loan guarantees -  this is a loan guarantee scheme provided by government with the aim to offset the risk aversion of banks in relation to SME loans. They achieve this by guaranteeing loans for selected SMEs seen as having good potential or those operating in specific industries or activities considered  strategically important for development in the country.
• The stimulation/simulation of capital markets through regulatoryreforms and equity programmes- which implies stimulation risk capital markets through regulatory reforms, for instance, by revising restrictions on institutional investors (such as pension funds, etc.); or simulation of the capital market by substituting private investors with public newly launched equity programmes.

In addition to direct and indirect public policy instruments, government may undertake publicly funded R&D at public research institutes and universities or provide other non-financial support measures (e.g. provision of necessary infrastructure, transfer of knowledge; guaranteed markets for the innovative products). 

References

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10. UNCTAD (2011). Science, Technology and Innovation Policy Review of Peru. United Nations. New York and Geneva.
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