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While small and medium companies, public research institutions and universities assume the risks of innovation, large corporations capture the profits that flow from it. hyoin min/Flickr, CC BY-NC-ND

Profiting from the innovation of others? Why governments must manage the spoils of new ideas

The Turnbull government’s imminent innovation statement should acknowledge an element often missing in discussion of innovation policy – the role of government in balancing who pays for and who profits from innovation.

Some large multinational firms have been very successful in positioning themselves at strategic points in global markets that enable them to capture the profits from the innovation of others. If governments, small technology and engineering-intensive firms and the broader workforce are unable to capture a greater share of the profits from innovating, it’ll become increasingly difficult to fund innovation.

Towards risk-free

Large publicly listed firms are investing less in innovation as a proportion of their revenues than they did 30 or 40 years ago. They’re too busy competing with each other to attract major investors and professional fund managers to sustain share value.

Unfortunately, investors favour short-term returns. They are very suspicious of high-risk research and technology development, which offers only the possibility of returns – and only in the long term.

Consider, for instance, a recent statement by BHP chief executive Andrew Mackenzie that protecting BHP’s dividend was “almost my most important job”. This is bad news for the engineering and technology firms hoping that one of Australia’s largest companies might support the development of the nation’s technology and engineering capabilities.

The commitment from BHP, like other large companies, to return value to stockholders has meant such companies have less revenue to invest in their workforces and in developing new technologies and engineering capabilities. These investments are all essential for innovation.

Indeed, the focus of the world’s largest and most profitable firms on distributing profits to shareholders has meant citizens and small technology-intensive firms have to bear an increasing share of the cost of innovation.

Outsourcing risk

For decades, shareholders have strongly discouraged potentially high-growth yielding investments in risky innovation in favour of divestitures and share buy-backs. That means profits are being used to increase the wealth and income of shareholders and chief executive officers rather than invest in skills and technology that support growth.

Large publicly listed firms are now less significant contributors to innovation than the large multinational firms of several decades ago. And much high-growth innovation originates in publicly funded research institutes and high-growth small- and medium-sized firms supplying to large firms.

We see a good example of this in Australia. The publicly funded research institutions and the engineering and technology firms that supply major miners have generated a significant share of patents in the mining sector.

Indeed, many large firms now outsource high-risk innovation to public institutions and small and medium (SME) players in global value chains. These SMEs – and government research institutions and universities – assume the risk of technology development. But what is their share of the rewards?

By positioning themselves at strategic points in global markets, large multinational firms can capture profits from the innovation of others. John Watson/Flickr, CC BY-NC

Here’s an example: around 1,000 games are uploaded to the Apple site daily, where over a million titles are available. Many games development firms receive little revenue from their investment and are struggling to survive. Apple assumes none of the cost of high-risk development, but is guaranteed 30% return on every sale.

Greedy behemoths

Unfortunately, the global economy is characterised by more and more of these “bottlenecks” whereby lead firms capture much of the rewards from innovation because of their incredibly strong bargaining power or strategic position in global markets.

The other way large firms capture the benefits generated by technology-based small firms – and public research institutes that often generate the fundamental knowledge sitting behind inventions – is by buying them out. They do so once the research institutions and smaller firms have taken on the risk and demonstrated market viability for their product or service and their success has become fairly certain.

This occurs when large multinationals buy out our successful engineering and technology firms. And it ensures capture a high share of the profits from innovation without assuming the risk, because they don’t have to pay for unsuccessful research and innovation.

And this has led to a small number of firms capturing a substantial share of the gains from innovation and growth. The top 200 US firms doubled their share of total business profits between 1950 and 2000.

Any solutions?

What, then, can governments do to manage who pays for and who profits from innovation? First, they need to support the scale-up of Australian firms that commercialise the technology and engineering capabilities funded and developed by Australian citizens.

The government needs to support these firms to diversify across industry sectors and to participate in international markets so they grow big enough to have sufficient bargaining power in these markets to capture returns on Australia-funded innovation.

This will help ensure such scaled-up firms’ share of profits from innovation better reflects the extent of their high-risk contribution. And this will mean more of the gains from innovation are captured by Australian citizens who bear a substantial share of the risks and costs of innovation.

Second, governments need to ensure global multinationals that capture profits from innovation also contribute to the costs of innovation, including unsuccessful innovation. Given the general reluctance of these corporations to invest in high-risk technology development, the most effective mechanism to secure their contribution to the cost of innovation is taxation.

Much attention has been given recently to the taxation of multinationals. Yet rarely has it been framed in terms of the need for these companies to “pay back” some of the profits they’ve generated from the high risks being undertaken by small engineer and technology firms, research institutes and the broader workforce.

The role of government is not just to fund innovation, it is also to ensure that the economic actors who profit from innovation – large multinational firms, their shareholders and chief executive officers – pay for innovation. How else will we fund future innovations?

This article is part of our series Why innovation matters. Look out for more articles on the topic in the coming days.

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