To Understand Chinese Innovation Success, Look No Further Than Government R&D Subsidies

October 23, 2019

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Data from the Organization for Economic Cooperation and Development (OECD), which is derived from official government figures, shows that the Chinese government subsidized 3.7 percent of Chinese business research and development (R&D) expenditures in 2016. This percentage is remarkably low. Consider that U.S. federal and state governments that year provided $23.9 billion in funding for business R&D, or 6.4 percent of the $374.7 billion that businesses in the United States invested.

In light of the massive investments China makes through projects like Made in China 2025, it is difficult to believe that the United States subsidizes nearly twice the percentage of business R&D that China does. So: are Made in China and other programs “smoke and mirrors,” or are official Chinese statistics inaccurate?

It looks like the latter is true—the Chinese government appears to underreport R&D subsidies, likely to hide the true extent of its involvement in the Chinese innovation economy. A more accurate calculation comes from a Harvard Business School study. Examining the effects that Chinese anticorruption campaigns had on government R&D subsidies, the study estimated that the Chinese governments (national, provincial, and local) paid for a whopping 22.2 percent of business R&D in 2015, with 95 percent of Chinese firms in 6 industries receiving government cash—petrochemicals, electronics, metals and materials, machinery and equipment, pharmaceuticals and biotechnology, and information technology.

In fact, nearly 25 percent of all R&D expenditures in China come in the form of government subsidies to firms. As the study notes, “The labyrinth of technology bureaus offers a wide variety of subsidies, including direct monetary subsidies for the development and testing of new products, for major R&D projects, for the commercialization of new technologies, for small and medium-sized technology enterprises, and for patent application fees and associated costs.” In other words, Chinese firms in technology industries are competing with a strong wind at their back: yuan from the Chinese government.

But even these figures understate the disadvantage most innovative businesses in the United States face due to Chinese R&D, because U.S. government R&D subsidies are largely confined to a modest number of firms producing weapons systems for the government. In fact, 97 percent of federal government funding went to just three sectors: transportation equipment, which includes such as fighter jets, missiles, and the like ($14 billion); professional, scientific, and technical services ($5 billion); and computer and electronic products ($4 billion). 

To match China’s R&D funding ratio, Congress thus would have to appropriate $86 billion more per year in direct funding to support industry R&D. Imagine how much more competitive U.S. firms would be if they could expand their annual R&D expenditures by around 20 percent due to federal support.

But direct grants are only a part of the package. The Chinese R&D tax credit is between 3 and 4.6 times more generous than the U.S. credit. To match China’s R&D tax credit generosity, the U.S. rate for the Alternative Simplified Credit would have to be increased from 14 percent to between 35 and 40 percent. In addition, Chinese “government guidance funds” controlled $585 billion at the end of 2018, while government support helped Chinese firms secure $31 billion in venture capital funding in 2018—nearly $4 billion more than firms in the United States received that year. And this does not include the array of other subsidies Chinese firms receive in the form of free land, discounted electricity, and low- or zero-interest loans from government banks, as well as the extremely low profit rates that state-owned enterprises are allowed to earn year after year.

Some conservatives will say that any increase in government support for business R&D is wasteful industrial policy. But surely free-market advocates would also agree that, when two firms are competing in the marketplace, all else equal, the one that has a lower tax rate or increased government subsidies will likely take market share from the other. At the same time, some liberals will say that any government support of business R&D only helps wealthy corporations at the expense of the middle class. But the United States needs jobs to employ middle-class workers, and the continued loss of U.S. competitive advantage in R&D-based industries will make job creation more difficult.

To be sure, it would be ideal if the Chinese government dramatically reduced its innovation subsidies so American workers in innovation industries would face a level playing field, but the chances of that happening are slim to none. Absent that, it is time for the federal government to step up its game and provide significantly more support for industrial R&D.