Commercialization and the Canadian Business Environment: A Systems Perspective

Transcription

1 Commercialization and the Canadian Business Environment: A Systems Perspective Comments on Public Policy Support for Innovation and Commercialization in Canada Roger L. Martin Dean, Joseph L. Rotman School of Management Chairman, Institute for Competitiveness & Prosperity James B. Milway Executive Director, Institute for Competitiveness & Prosperity July 4, 2005

2 Commercialization and the Canadian Business Environment: A Systems Perspective Executive Summary The federal government has set out innovation and commercialization as key areas of focus for public policy attention. It recognizes that innovation and commercialization are important elements of improving Canada s productivity and competitiveness performance. Industry Minister Emerson recently announced the creation of an Expert Panel on Commercialization to ensure more new technologies and products make their way to the marketplace to benefit all Canadians. This paper assesses the elements of Canada s innovation system and provides broad policy recommendations for consideration. We conclude that public policy on innovation and commercialization is problematically unbalanced. It has focused too much in areas that support the supply of innovation and its financing but has not adequately addressed areas that provide pressure for greater demand of innovation by business leaders in Canada. Canada needs to address some of the more fundamental challenges in our business environment and in our innovation financing system to strengthen our capacity for innovation and upgrading. The paper first sets out a framework for assessing an innovation system and then assesses each element of this framework to develop a diagnostic of the challenges facing the system. It concludes with broad policy recommendations for consideration. In summary these recommendations are in each area of the innovation system framework: In the supply of innovation, we recommend that public policy be informed by a broader view of innovation recognizing more fully the importance of breakthroughs in business and management processes. To improve financing for innovation, we encourage governments to shift their attention away from the increasing the quantity of venture capital towards improving its quality. Labour Sponsored Investment Funds and direct government funding of venture capital should be eliminated while initiatives to improve venture capital reporting information and to raise the overall quality of venture capital providers should be encouraged. Policies to strengthen the demand for innovation should include pursuing fundamental tax reform to lower the cost of business investment while scrapping targeted measures such as the R&D tax credit. Governments need to continue their efforts at raising educational attainment by managers and employees. They also need to identify opportunities for increasing beneficial competitive pressures in our economy. -2-

3 The Innovation System Public policy needs to be based on a systematic view of innovation, not a piecemeal view which is typically the case. The innovation system is based on the interaction of three elements the supply of innovation, the demand for innovation, and the link between them - financing for innovation (Exhibit 1). Three components of the Innovation System The supply of innovation includes the activities and resources dedicated to increasing the stock of innovation. It includes highly qualified personnel and their facilities and resources. They can be found in universities, research labs, and corporate R&D departments. Without these base activities and resources, scientific breakthroughs, and new ideas will not be available for commercialization. However, the fact that they are critical does not imply that this is the entire innovation system. The demand for innovation is the direct complement to supply. There are two important levels of demand. First is customer insistence for new products and process breakthroughs. Without customer demand for innovation, there will not be successful, sustained innovative activity. Second is the corporate demand by which the CEO decides to allocate corporate resources to innovative activities as opposed to either existing activities or current profit, thereby generating demand for innovation within the firm. As economists have observed, supply and demand interact to create markets or systems for specific goods and services. When supply increases on its own without an increase in demand prices fall; in this context the value of innovation drops. When demand increases on its own prices will rise; in this context the value of innovation rises. The innovation system includes financing of innovation. This is an important bridging device between demand and supply since, even if these two factors are in balance, significant funding is typically required to commercialize new ideas and scientific breakthroughs. In many cases an intermediary firm is required to translate the supply of innovation into products and services that are in demand. Risk capital of a truly speculative nature angel equity, venture capital, and other private equity - must often be raised de novo rather than out of retained earnings or as part of a corporate investment portfolio. Consequently in examining the innovation system we need to understand the dynamics of financing as well as the demand and supply. -3-

4 The importance of Pressure and Support in the Innovation System In a strong innovation system, we would expect to find supply of innovation and demand for innovation rising over time, spurred on by financing of innovation that expands to meet the challenge. How are signals sent between the elements of the innovation system so that supply is responsive to demand, demand takes advantage of what can be supplied, and financing is robust? In our view the drivers of continuous upgrading are in the form of pressure and support that act on each of the three elements of the innovation system (Exhibit 2). That is to say, each element needs to have support to make its task easier but also pressure to provide incentives to move ahead. All support and no pressure creates a cushy and lazy environment inimical to innovation and upgrading while all pressure and no support creates a harsh and barren environment, equally inimical to innovation and upgrading. Support and pressure can come from outside the innovation system (e.g., government) or from another of the three elements within the system (e.g., financing supporting supply). Support and Pressure for Supply of Innovation. Government funding of R&D is a major source of support for the supply of innovation. University education of Masters and PhD students also provides support for supply of innovation. Beneficial pressure for upgrading innovation supply is generated by the competition for peer-reviewed research funding and by pressure from sophisticated financiers of innovation. Support and Pressure for Demand for Innovation. Beneficial pressure derives from sophisticated customers who demand and reward successful innovations and by competitors who compete on the basis of innovation and upgrading. Support comes from capable managers who understand the importance of innovation activities and pursue strategies based on innovative products and processes. Support and Pressure for Financing of Innovation. Support comes from favourable tax treatment of risk capital and from skilled investors who understand financing necessary to support innovation. Pressure comes from providers of capital who insist on high returns from investing in innovation and from competition between providers of risk capital. It is this pressure and support in each element of the innovation system that link the three and ensure ongoing upgrading of capabilities. If one element lacks the necessary pressure or support, then the whole system will not perform to its potential. Having an imposing strength in one element will not make up for weakness in another. If Canada were to enjoy robust supply of innovation but weak demand, the supply of innovation will flow to the demanding US market. This is a system in which the chain is only as strong as the weakest link. Public policy in innovation needs to be built on an assessment of pressure and support in each of these areas and should seek to fill gaps where appropriate. -4-

5 In this paper we review each of the three elements of the innovation system through the lens of support and pressure. But first we review evidence that indicates we have an innovation challenge in Canada. Evidence of Canada s lagging innovation performance A significant challenge in assessing a nation s innovative capacity is in measurement. One key measure of innovative capacity and processes is patenting. While it is important to note that not all innovative activity is captured by patents (e.g., in management process improvements or in software), many academics who study innovation agree that patenting is a solid measure of a nation s or region s innovative output. 1 To measure Canada s innovative capacity the Institute for Competitiveness & Prosperity gathered information on patents by Canadians at the U S Patent and Trademark Office. US patent information is a good indicator for Canadians because patents are often sought first and foremost in the US where the standards for patentability are more stringent than in most European countries. 2 In addition, because of its size and economic strength, the US market represents a significant potential market for a typical patent. A patent grants exclusive commercial use of a newly invented device. According to Trajtenberg, For a patent to be granted, the innovation must be non-trivial, meaning that it would not appear obvious to a skilled practitioner of the relevant technology, and it must be useful, meaning that it has potential commercial value. 3 To measure patent output in Canada, the Institute compiled patent records where a Canadian inventor was named. 4 It sorted patents into year of issue, province, Census Metropolitan Area, and industry and classified each by traded/local/natural resource distinctions. Within the traded industries, it assigned patents to one of 41 traded clusters consistent with the methodology developed by Michael Porter s Institute for Strategy and Competitiveness. 5 In both Canada and the US patenting rates are strongest in traded industries, but Canada trails the US significantly (Exhibit 3). 1 See Michael Porter, The Economic Performance of Regions, Regional Studies, Vol. 37, 66 &7, p. 551 and note 9, p. 572 for a review of the academic work in using patents as a measure of innovative capacity. 2 Manuel Trajtenberg, Is Canada Missing the Technology Boat? Centre for the Study of Living Standards, 1999, p. 4 3 Ibid., p.5 4 US Patent and Trademark Office data compiled for the Institute by CHI Research 5 See Institute for Competitiveness & Prosperity(2004), Working Paper 5, Strengthening structures: Upgrading specialized support and competitive pressure, July 2004, p. 24 for a discussion of traded clusters; Visit for more information and US results -5-

6 As in the United States, Canada s traded industries are more innovative than local industries because they are more specialized and face greater competitive pressure from a wider set of competitors and customers. Canada has a good mix of traded clusters, but they are less effective in delivering innovative output. Our mix of clusters is such that, if they matched US patent results, Canada would be only 25 percent behind the peer states. Instead, we trail by 70 percent per employee. Over half of this disadvantage (45 of the 70 percentage points) is because of lower effectiveness (Exhibit 4). In all but three of 41 clusters of traded industries, Canada s patent output per employee is behind the US output. Patent performance while not a perfect measure is indicative of an innovation gap in Canada. We look first at the supply of innovation to understand why this gap exists. -6-

7 Supply of innovation government policy overly focused on support in the hard sciences Policy makers in Canada appear to focus mainly on one of the three elements of the innovation system supply and on one of the two levers support. Furthermore, policy narrowly focuses on supporting the supply of innovation in the area of technology and hard sciences. As we review government policies and programs, we conclude that the implicit model driving public policy toward innovation in Canada is an assumption that we do not have enough innovation because we have an inadequate supply of certain key factors that lead to innovation. More specifically, the model implicitly assumes that we lack innovation in Canada because we have an inadequate supply of scientists and engineers, we lack adequate risk investment funds, and our businesses need specific incentives to increase the amount of research and development they conduct. The logic behind the current model starts with the way innovation and commercialization are defined. Governments tend to focus on scientific or technical innovation versus business innovation. Thus, innovation is thought of as the result of scientific and technical R&D in Canadian universities, hospitals, and research centres. Notably, this R&D accounts for less than half of all R&D spending in the country. Although public innovation derives from a small percentage of the total R&D spending, it naturally receives a lot of attention because public officials control both the level and the allocation of that spending across regions and study areas. By contrast, more than of half of R&D spending that is performed by business is difficult to track and analyse, partly because the innovations are often incremental (adaptive rather than breakthrough), and partly because they are process innovations. For example, Masonite International, one of Canada s global leaders, developed its leading competitive position in the door products market by a manufacturing process breakthrough and by developing category management skills with home improvement centres that allowed it to serve retailers and customers better. Many of these innovations would not be found in R&D or patent data. Similarly, Cott Corporation increased its share of the carbonated beverage market by focusing its operations on the production of retailer brand, or private label, carbonated beverages, allowing retailers to better target beverages to the preferences of its customers. Again, this innovation would not appear in the public R&D or commercialization data. Even in mature industries where one firm achieves growth from innovation by gaining market share at the expense of competitors, the industry s productivity advances. Either the winning firm raises the industry productivity simply by accounting for more of the industry s volume or it spurs along innovation and productivity by other participants in response to the first mover s innovation. From focusing on the centrality of scientific and technical innovation, government policy attention turns to places where this occurs scientific and technical departments of universities and other laboratories and research centres. The logic is: If we had enough people doing innovation and enough money to fund them, we should have enough innovation. Since we do not have enough innovation, these factors must be missing or inadequate. Following this logic, governments in Canada have generally provided adequate infrastructure to give general support for innovation and upgrading as we shall see. In addition, they have invested primarily in two areas of specialized support: the supply of a scientific and technical labour force and the supply of funds for R&D (Exhibit 5). -7-

8 The federal government funds, administers and supports a host of foundations, organizations, partnerships and scholarships designed to fuel innovation and broaden Canada s R&D base. Much of the federal government s research support is organized across three funding agencies. The Natural Sciences and Engineering Research Council (NSERC) supports basic research and advanced training, with $850 million budgeted to support over 10,000 professors and 20,000 students in The Canadian Institutes of Health Research (CIHR) is a specialized program that funds over 8,500 researchers in 13 specialized life science institutes across Canada at a level of $662 million in The Social Sciences and Humanities Research Council (SSHRC) which supports research outside the technical and scientific fields is by far the smallest of the three, with a budget of $230 million. An important role of the three agencies is to allocate funds in the Canada Research Chairs (CRC) program. Ottawa has provided $900 million to establish 2,000 research professorships across the country in part to keep the most capable and qualified Canadian researchers teaching in Canada. As of June 2005, 1,509 chairs had been established. Fully 77 percent of these chairs are in natural sciences, engineering, and health research with the remainder in social sciences and humanities. The three councils are also involved in the direction of the National Research Council Canada s oldest federal research institution. With an annual budget of over $750 million, it supports 20 research institutes across three major disciplines, physical sciences and engineering, life sciences and information technology, and technology and industry support. Much of the funding is aimed at hard sciences and technology. The Canada Foundation for Innovation (CFI) was founded in 1997 with an endowment of $3.7 billion. It supports 40 percent of the infrastructure costs associated with a research project (with partners from outside government covering the remainder). CFI is focused on hard sciences; since 1998, only 10.3 percent of projects accounting for 5.4 percent of funding have been in the social sciences and humanities. 6 In summary, federal policies and programs are narrowly aimed at supporting supply of innovation, and within that support they have a narrow focus on the hard sciences, such as engineering and the natural sciences. There is pressure to ensure the academic soundness and rigour of this research based on a traditional peer review process in funding decisions. But as we shall see, this supply of innovation is lacking the pressure from business and from risk capital providers

9 Financing of innovation current policies focus on supporting the quantity of funds, not in creating pressure for greater quality Canadian public policy has recognized the importance of financing of innovation and has put in place several policies and programs in support of financing. However, there has not been adequate consideration of factors of pressure for high quality financing. Venture capital is an important component of the innovation environment, providing the resources needed to create successful, innovative firms. Federal policy appears to be built on the notion that we need more support for venture capital. There are four identifiable vehicles utilized by the federal government to generate funds to support innovation and commercialization: labour-sponsored investment funds (LSIFs), the Business Development Bank of Canada (BDC), Technology Partnerships Canada (TPC), and Networks of Centres of Excellence (NCE). Policies focus on supporting the quantity of funding for innovation Labour Sponsored Investment Funds (LSIFs) are a Canadian phenomenon offering generous tax credits of 15 percent at the federal level and 15 to 20 percent at the provincial level, as long as the investment is capped at $5,000. When combined with RRSP credits, LSIFs provide a total tax credit for an individual at the highest tax bracket which equates to a 10.8 percent annual return over eight years, the required lifetime of a fund. 7 Because individual investors receive a high return on their investment through the tax credits irrespective of fund performance, they are not overly concerned with the actual return of the fund. In addition, because most investors in LSIFs are individuals, they each have very limited exposure and are fragmented. Hence the funds do not benefit from the pressure exerted by sophisticated investors with a significant stake in success. Finally, LSIFs are restricted in the type and geography of their investments and are required to invest some funds in the year they are raised. It is no surprise, then, to see that their returns have been dreadfully low. Recent data show that the median five-year return on laboursponsored funds is minus 2.0 percent, while the median five-year return on Canadian small-cap equity funds is 10.8 percent. 8 The labour-sponsored program has raised large amounts of money from retail investors in Canada. In 2004, LSIFs alone contributed 63 percent of all venture capital raised in Canada. However, the program may be hurting the overall Canadian venture capital industry more than it helps by increasing the supply of venture capital funds and lowering the industry returns. Finally, the program also represents a significant burden on the provincial and federal treasuries, with an estimated total tax expenditure of $3.3 billion between 1992 and Finn Poschmann, Better Options for the Venture Capital Market. The Howe Report (private circulation.) July. 8 Ibid. 9 Douglas J. Cumming, Jeffrey G. Macintosh, Crowding out Private Equity: Canadian Evidence, University of Alberta Working Paper

10 Some have argued that LSIFs are necessary because of the limited participation of institutional investors in Canadian venture capital. They point to reports that Canadian pension funds and foundations invest a lower percentage of their overall assets to private equity in general and to venture capital in particular, than their US counterparts. But recent research suggests that their labour-sponsored venture capital corporations have so energetically crowded out other funds as to lead to an overall reduction in the pool of venture capital and that their existence has led to 400 fewer investments per year on a Canadawide basis, representing approximately $1 billion per year in value. 10 The Business Development Bank of Canada (BDC) offers a host of managerial and financial services to start-up companies. The BDC currently manages over $300 million in venture capital assets in the fields of life sciences, information and telecommunications and advanced technologies. In its 2003/04 fiscal year BDC accounted for 6 percent of total venture capital disbursements and 9 percent of transactions in Canada. In the 2004 federal budget, the BDC received an extra allocation of $250 million to support startup and early stage companies. There is no evidence that this federal support for the supply of innovation is effective. Over the past five years (ending March 2004), BDC s venture capital portfolio has earned a net income of $25 million in the last three it has lost $136 million. In the US, experience with direct government involvement in supporting the supply of financing for innovation has been unsuccessful. The Small Business Administration s Participating Securities Program accumulated losses of $2.7 billion in its ten-year life. Losses could be even higher as the program s total exposure is at $11.25 billion. 11 Technology Partnerships Canada (TPC) is a special Industry Canada agency with a mandate to fund strategic R&D. Since its inception in 1996, the program has funded 693 projects worth $2.8 billion. TPC s disciplines consist of environmental technologies, life sciences, information technologies, and advanced manufacturing. Canada s Networks of Centres of Excellence (NCEs) are partnerships among universities, governments, private sector firms and nonprofits. In ,with an annual budget of over $77 million, the NCE connected 882 companies, 243 federal and provincial departments and agencies, 49 hospitals, 184 universities and more than 326 other organizations from Canada and abroad. While the NCEs foster partnerships between suppliers and demanders of innovation, their orientation is to enhance the supply of innovation through mobiliz[ing] research talent across Canada and apply[ing] it to creating social and economic benefits for all Canadians. 12 Strengthening the quality of financing for innovation is Canada s real challenge Support to increase the quantity of venture capital is not the answer. In fact, evidence indicates that the availability of venture capital funds in Canada is in line with US experience, except for the huge run-up of US investment experienced during the dot.com bubble (Exhibit 6). 10 Ibid. 11 Wall Street Journal, Venture Capitol-ism, April 13,2005, page A

11 In fact, during the period, when federal and provincial governments were increasing the supply of venture capital, the cumulative amount of capital raised in Canada surpassed the amount invested by $1.7 billion. 13 So it is hard to argue that Canada is suffering from an inadequate quantity of venture capital funds. In addition, the low returns from venture capital in Canada relative to the United States indicate that the challenge we face in Canada is to strengthen the quality of our venture capital investments, not the quantity. Quality of support appears to be more of a problem. Evidence from successful firms indicates that venture capital firms are not playing as substantial a role as they might in helping innovative firms succeed. Successful venture capital firms not only provide financial resource, but also human resources and strategic support. They lend their expertise and skills to guide fledgling firms and help drive innovation and commercialization of new ideas. But the evidence indicates that innovative Canadian firms are not benefiting from this full range of support that is expected from venture capital firms. The Institute for Competitiveness & Prosperity engaged The Strategic Counsel, a Toronto-based market research firm to conduct a survey among venture-backed firms who have achieved sustainability through an initial public offering or have merged or been acquired. The pool of such firms in Canada is relatively small drawing on publicly available information Macdonald & Associates identified 60 such firms located in Ontario. The Strategic Counsel was able to conduct to 20-minute interviews with leaders of these firms with good perspective on their company s history. 14 In one question respondents were asked to identify from a list the types of support provided by their venture capital firms or angel investors. The results indicate that venture firms are not providing much support beyond helping with capital and some business strategy support. On several factors critical to the success of any start-up, more respondents indicated that their venture capital firm was not important to their success than those who thought they were important (Exhibit 7). 13 Institute for Competitiveness & Prosperity(2004), Working Paper 6 Reinventing innovation and commercialization policy in Ontario, Oct. 2004, pp Survey results are available on the Institute s Web site,

12 Net, we need better quality of support from venture capitalists, not greater quality. The more difficult challenge related to the supply of venture financing for Canada is in the area of pressure. As we have seen public policy in the area of financing for innovation has focused in the area of support narrowly defined as making more financing available. But is there adequate pressure being applied to enhance quality in the venture capital industry? Increasing the presence of pension funds in venture capital and private equity is one area that would enhance pressure for quality. As we have shown, measures to date have drawn in the small retail investor, perhaps at the expense of larger, more sophisticated investors. Measures announced in the recent federal budget to eliminate the 30 percent restriction for foreign holdings and alternate investments ought to increase pension funds investments in venture capital. Also required are steady improvements in the returns data so that pension funds managers have a clearer understanding of the risks and rewards from this asset class. Current efforts by the industry through the Canadian Venture Capital Association to enhance pension fund managers understanding of the benefits from investing in the sector as well as ongoing efforts to improve information on returns are in the right direction. The Canadian venture capital industry is still young compared to the US industry. Consequently it lacks a long track record of returns, consistently applied valuation standards, private equity products, and industry information. 15 In summary, in the area of financing for innovation public policy has been aimed at providing greater support and has focused on solutions that are more easily implemented providing funding and using tax credits to attract capital from individual investors; the real breakthrough will come form effecting more fundamental change by broadening and strengthening the quality of support provided by venture capitalists to innovative start-up firms and by creating the climate for pension funds to invest in this asset class and ratchet up the pressure to upgrade their quality. 15 McKinsey & Company, Private Equity Canada

13 Demand for innovation not being driven by appropriate support and adequate pressure Turning to the demand for innovation we once again use the lens of support and pressure. Public policy has aimed at strengthening support for the demand for innovation. A cornerstone of this support has been the R&D tax credit. But the evidence indicates that more fundamental reform in Canada s tax system is required to support the demand for innovation. Equally important is the enhanced support from sophisticated management. On the pressure side, we find that Canadian management is not being challenged enough by sophisticated customers and capable rivals to provide greater innovation. We discuss each of these factors in turn. Supportive tax policies appear ineffective Federal policy has recognized the importance of tax policy in stimulating the demand for innovation. Canada has one of the most generous tax incentive programs for R&D among OECD countries. But Canada also has extremely high effective tax rates on business capital investment. The net effect appears to be that tax policy is not helping to encourage firms to increase their investments in innovation. To stimulate R&D investments from Canadian companies, the Canadian federal government has created a generous plan of R&D tax credits. The Scientific Research and Experimental Development Program (SR&ED) gives corporations a 20 percent tax credit for relevant investments in research and development, and gives small private companies (CCPCs) a credit of up to 35 percent of R&D expenditure. 16 These tax incentives have been well used over the years, costing the government of Canada an estimated $1.8 billion annually. 17 Unfortunately, despite those incentives, Canada still fares poorly in R&D investments as a proportion of GDP, compared with other nations (Exhibit 8). This is especially true for Business Expenditures in Research and Development (BERD), the sector of R&D that influences GDP most strongly. Additionally, the BERD investments in Canada have been highly concentrated, with a single telecommunications firm, Nortel, accounting for around 40 percent of all business R&D in Smaller CCPCs refer to Canadian-controlled private corporations with prior-year taxable income under $400,000 and prior-year taxable capital employed in Canada under $15 million OECD, OECD Economic Surveys Canada, Volume 2003/14 September. -13-

14 One explanation is that the tax credits encourage firms that are already doing R&D to spend more, or simply gives them a tax break for doing the research they were planning to do anyway. In fact, evidence from international research questions whether tax incentives have a meaningful positive impact on R&D spending strategy. 19 This would support the hypothesis that these credits do little to stimulate firms that do not already do R&D to start the process. The other explanation for Canada s low investment in business R&D is Canada s overall corporate tax structure. Since R&D credits only play a small role in the overall tax profile of a corporation, they may not be the main driver of R&D activity. In fact, as our research into Ontario s marginal effective tax burdens 20 shows, our businesses face a significant disincentive to invest in capital and in R&D relative to businesses in peer US states. The high effective tax rate burdens on business investments have a negative impact on all corporations, reducing their incentive to invest in innovation. 21 As a result of lower corporate taxes, no sales taxes on capital goods, and lower taxation of investment in general, all developed countries but Germany have a lower marginal effective tax rate (METR) on investment than does Canada (Exhibit 9). With Germany s recent announced tax reduction measures, Canada soon may have the highest effective tax rates on business investment of any highly-developed country in the world. The METR is the amount of corporate income and other capital-related taxes as a percentage of pre-tax profits for marginal investments, 22 and includes tax reduction measures, such as depreciation allowances and tax credits. Canada, with our relatively high corporate tax rates, provincial sales taxes applying to capital goods, capital taxes, and a less favourable tax treatment of investment in 19 Ibid. 20 Task Force on Competitiveness, Productivity, and Economic Progress, First Annual Report, Closing the prosperity gap, November 2002, pp and Second Annual Report, Investing for prosperity, November 2003, pp Jack M. Mintz, Most Favored Nation: Building a Framework for Smart Economic Policy. CD Howe Institute. p.99. Richard Harris in Canada s R&D Deficit And How To Fix It, C.D. Howe Institute Commentary, May 2005 suggests consideration be given to direct R&D grants instead of tax credits. But, such grants would be better administered by provincial governments instead of the federal government. Instead, it might be better for the federal government to spend current tax dollars by lowering overall corporate tax rates or providing additional incentives for investment (p. 11). Harris also draws on the evidence linking R&D expenditure with business capital investment and Canada s high taxation of business investment concluding that lowering taxes on M&E investment to US levels would be a major positive step (p. 16). 22 Chen and Mintz (2005). -14-

15 general, has a METR that is 20 percentage points higher than Ireland and Sweden and 8 percentage points higher than the United States. As with the venture capital, the challenge for government policy is to address the needs for more fundamental change in the support and pressure for financing of innovation. We need smarter taxation that encourages business investment overall, which will increase the demand for innovation i.e. the incentive for corporate executives to allocate resources to innovative investment activities. Canada lacking the support of sophisticated management. Our managers have lower educational attainment overall and in business education specifically. CEOs of our largest corporations tend less to have formal business education at the graduate level. And a key challenge for growing innovative firms is having access to management talent. Canadian managers have lower educational attainment overall than their US counterparts; only 31 percent of our managers possess a university degree versus 50 percent of US managers (Exhibit 10). If the link between education and innovation can be drawn, it is quite apparent why we are less demanding of innovative in Canada. The more educated managers are, the more likely they are to think innovatively and strategically and to operate more effectively. Our lower education level of human capital resources means that we are less able to compete in a technology-based knowledge economy, as well as to serve sophisticated and demanding customers in the global marketplace. -15-

16 At the pinnacle of Canadian corporations we find a lower incidence of MBAs than in the US. We compared the educational attainment of the CEOs of the 100 largest US companies as defined by the Fortune 500 and the 100 largest Canadian companies as defined by the Financial Post 100. We found that 37 percent of the US sample was headed by an MBA versus 24 percent in the Canadian sample. It is commonly held that technology businesses are fundamentally different than most businesses and that they must be led by people with a solid academic background in technology disciplines. In the US, there are seven computer and telecommunications hardware and software firms that have reached the Fortune 100 in size. All are legendary globally-competitive firms IBM, HP, Dell, Microsoft, Intel, Motorola, and Cisco. However, rather than being highly technically trained, the CEOs of these hightechnology firms are business educated. Only two have any kind of scientific or technical degree; Edward Zander of Motorola and Kevin Rollins of Dell who hold undergraduate degrees in engineering but who later went on to earn MBAs. Five of the seven CEOs hold an MBA and a sixth has an undergraduate business education (Exhibit 11). Three of the firms Dell, Motorola, and Intel recently appointed CEOs with MBA degrees after having CEOs with scientific backgrounds. In addition, at Microsoft, Bill Gates, who is not a university graduate, was replaced as CEO by Steve Ballmer, an MBA. -16-

17 In the Institute for Competitiveness & Prosperity s research among successful innovative firms in Ontario which we discussed earlier, one of the most significant challenges they faced in their development was in gaining access to managerial talent to hire. Importantly this challenge area was perceived to be a significant disadvantage to their most important competitor who tended to be in the US (Exhibit 12). Survey results allow assessment of several resources on two dimensions the degree of access they have to these resources and whether the resources represent an advantage or disadvantage versus their competitors (who were mostly US-based). -17-

18 Survey respondents at these successful innovative firms indicated that: six of the 11 resources mentioned in the survey were relatively available in Ontario and did not represent a major disadvantage versus their competitor physical infrastructure, qualified scientific or technical talent, IPP laws, researchers and research labs, local technology suppliers, and suppliers of other expertise two of the 11 were seen to be of relatively low availability but did this did not represent a significant weakness versus competitors government financial support and government support other than finance three of the 11 were of relatively low availability and these represented major weaknesses versus competition. Two of these local customers to stimulate performance and managerial talent to hire have not been significant targets of public policy, while the third capital has been a major priority. These results from the Institute s survey indicate the lack of beneficial support from managerial talent is one of the three most important gaps for growing innovative firms in Canada. Pressure from local customers is the most important gap we discuss this below. To be sure, access to capital is also a significant disadvantage for Canadian innovative start-up firms but it is not the only challenge they face. A key factor in the shortage of managerial talent for leading innovation and commercialization in Canada s firms is the lack of investment in business education in Canada. Canada s universities produce only half as many business graduates per capita relative to the US. Within SSHRC, which is the smallest of the federal research granting agencies, only 8.3 percent of research funding was in the business discipline in , which represent only 1.1 percent of total research funding from the three federal granting agencies. Given the low rate of business research funding by SSHRC, only 17 of the 1,509 already-named Canada Research Chairs are in management studies 23 despite business degrees accounting for 11.5 percent of all degrees granted (in Ontario). Since 1998, the Canadian Foundation for Innovation as funded only 22 projects in the business discipline accounting for 0.19 percent of total funding. Clearly government policy assumes that business research and education is simply not relevant to innovation and commercialization. Increasing the pressure for management to demand innovation The larger challenge is to increase the pressure for Canadian CEOs and their management teams to demand innovation. A CEO has a fundamental budget decision with respect to innovation. How much should be spent on developing new products and processes versus running the current business? Innovation activity will be demanded by firms only to the extent that it serves their particular business strategy. If corporate boards and CEOs have not demanded business strategies that call for innovation, then innovation will not be sought, regardless of whether there is available if not abundant supply of innovation capacity and largely regardless of the price of innovation capacity. Hence innovation is a choice driven by the strategy of the firm. Shareholders can pressure management for strategies for which innovation is a critical component. Or alternatively, they can demand strategies for which innovation is unimportant or even completely inconsistent. Firms following strategies of 23 Canada Research Chairs Chairholder Profile (online) available at

19 innovation aim at creating and selling a unique product/service or creating a uniquely valuable process for delivering an existing product/service or both. Firms like RIM and Cognos would be in the former camp. Firms such as Masonite, Cott, and Four Seasons would be in the latter camp using unique and superior processes for creating products and services not technically dissimilar to those of competitors. Firms with strategies of innovation emphasize marketing and branding strategies over pure selling capabilities. They compete across the broad range of the value chain aiming for advantage in areas such as after-sales service or customer partnerships, not just being low cost or having broad distribution. They aim to secure competitive advantage based on innovation, not access to low cost inputs. They seek to dominate niches of global markets instead of being broadly successful in local markets. If CEOs across a given economy, in general, are pressured to choose strategies requiring innovation, they in turn will demand high volumes of innovation and the economy will be seen as highly innovative. If its supply of innovation is lower than the amount demanded, there will be market pressure for greater supply of innovative capacity. If instead, CEOs in a given economy are not pressured to choose strategies requiring innovation, they will demand modest volumes of innovation and the economy will be seen as not innovative. In such an environment there will not be meaningful private market pressure for greater supply of innovative capacity or for high quality financing support. And if there exists a high innovation capacity as a result of public sector spending on innovation, then much of that innovative capacity will be exported by way of scientific and technically-trained individuals leaving to find jobs outside the country and intellectual property (e.g. patents) being exploited outside rather than inside the country. Clearly there is interplay between the supply of innovation and the demand for innovation. If a jurisdiction is very weak in the supply of innovative capacity i.e. scientists and technically trained workers, research universities, research laboratories then when considering their strategies, CEOs may correctly and wisely conclude that a strategy not dependent on innovation is wisest and set their company actions accordingly. Evidence from the World Economic Forum s country competitiveness indices indicates that Canada s business strategies are not based on innovation and are in fact mediocre. The Business Competitiveness Index is a useful measure of the levels of pressure and support in Canada, the United States, and nearly 100 other countries. Much of the information contained in the index is from the Executive Opinion Survey, a mail survey administered in each country to executives in sectors in proportion to the sectors share of the overall economy. 24 The survey is made up primarily of a series of statements for which the respondents indicate how well they think their country s economy performs on various factors. The statements are aimed at eliciting views on the respondent s own country and do not ask for comparisons with other countries. The World Economic Forum results indicate that because Canadian businesses are not facing high levels of pressure from capable rivals and sophisticated customers and are not benefiting from local specialized support they are not being driven to strategies relying on innovation. Our firms strategies tend not to emphasize the full range of value chain activities; they do not focus on building innovative capacity nor do they depend on company research and development. 25 Canada also trails on the national innovative capacity index largely as a result of business strategies and operations. The World Economic Forum also draws on the Executive Survey and other data to 24 For a more detailed description of the Business Competitive Index and the Executive Opinion Survey see World Economic Forum, The Global Competitiveness Report, , pp Strengthening structures, pp

20 measure countries innovative capacities. Their research indicates that management strategies are the most significant challenge for Canada in building its innovative capacity. The national innovative capacity index (NICI) was developed by the World Economic Forum 26 as a broad indicator of a country s potential to create commercially relevant innovations. The index assesses various dimensions of the national capacity for innovation, weighted according to their observed statistical relationship with international patenting. The NICI, computed as the sum of the five sub-indices, is found to have a strong and positive relationship with GDP per capita, the measure of prosperity adopted by the Institute. It is also positively correlated with the Business Competitiveness Index. In 2003, Canada ranked 12 th among 78 countries on the NICI, a drop from 9 th in Among the 43 countries with half of Canada s population or more 27, Canada ranked 7 th in 2003 falling from 5 th in 2002 while the US has maintained its top position on the index. Among the larger countries, Canada in fact ranks second in GDP per capita. Our lower rank in NICI indicates our under-performance in innovation capacity given the underlying competitiveness of our economy. NICI s sub-indices are: the innovation policy index, the proportion of scientists and engineers index, the cluster innovation environment index, the innovation linkages index and the operations and strategy index. Canada ranks well behind the US on the overall NICI index fully 9.5 percent or more than two standard deviations behind US performance. This gap is driven largely by our poor performance on the company operations and strategy sub-index and, to a lesser extent, the innovations linkages sub-index. Canada trails the US less significantly on the other three sub-indices. Canada matches the US on the innovation policy sub-index, a measure of the effects of government policies, such as R&D incentives and intellectual property protection, on the innovation environment. Canada scores higher than the average of the top twenty countries in the innovation policy index, ranking 4 th among the larger countries. Of all the sub-indices, Canada ranks closest to the US on the innovation policy sub-index (Exhibit 13). This sub-index has the lowest variance among the top twenty countries of any of the sub-indices. This is likely a result of the limitations of public policy in producing innovation once a certain level has been reached. It may also reflect the tendency of countries with advanced economics to borrow successful policies from their peers. Canada trails on the proportion of scientists and engineers sub-index, the share of total employment made up by scientists and engineers - the one empirical measure used in the NICI. This index provides a measure of the availability and effect of the R&D labour force on innovation. Among larger countries, Canada ranks 5 th on this index and the US ranks 2nd after Japan. Canada s position is high on the cluster innovation environment sub-index, which measures the quality of a nation s economic clusters and its effect on innovative output. Canada scores above the average of the top twenty countries on this index. Among larger countries, Canada ranks 5 th trailing Japan (1 st ), the US, Germany, and Taiwan. Canada trails on the innovation linkages sub-index, a measure of the strength of the connections between a nation s innovation infrastructure (e.g., universities and private and public institutions) and its clusters. This includes the availability of research associations and venture capital for risky projects. 26 Michael Porter and Scott Stern, Ranking National Innovative Capacity: Findings from the National Innovative Capacity Index, WEF, The Global Competitiveness Report , 2004, p We compare Canada s performance against countries with half of Canada s population or more to focus on economies with similar breadth and complexity. -20-