Innovation is key: Why does India's private sector not spend more on R&D?

The one most important reason on why firms may or may not undertake R&D is not government incentives but the absence of competitive forces

There is a general agreement in India, almost a consensus, that the country needs to undertake greater research & development (R&D) to progress faster and more effectively. While this is the objective, most also agree that India’s expenditure on R&D is quite low. The oft-repeated statistic (sourced from the World Bank, which aggregates national data) shows that compared to countries such as Taiwan (3.6 per cent), South Korea (4.8 per cent), China (2.4 per cent), and even Brazil (1.2 per cent), India’s spend on R&D as a share of gross domestic product (GDP) is barely 0.65 per cent.

Of course, it is true that countries with higher per capita incomes do tend to spend more on R&D. India has a lower per capita income than all of these countries, so if we judge India’s R&D performance by its income class, it may not fare that badly. Given its low income level, therefore, a case can be made that India’s current spending on R&D is somewhere in the vicinity of the global average for its income level and size.

But that is obviously not good enough. The effort India needs to put into R&D needs to be gauged not from where it is, but where it aspires to be. If incomes need to quadruple over the next two-three decades while simultaneously addressing the inclusion and sustainability challenges, innovation will clearly need to play a key role.

With that in mind, the government has been attempting to increase expenditures on R&D, and its share of total R&D spending in India has consistently risen since the early 2010s. Currently, it accounts for over 60 per cent of the total R&D expenditure in India.  But government agencies that account for the bulk of R&D in India are primarily focused on defence, space, agriculture and nuclear research, with a significant portion of funding directed to academic institutions, according to government R&D statistics. In other words, security and related areas (including food security) account for a large share of the government’s R&D. While that by itself cannot be faulted, in an economy dominated by the private sector, the innovation and development component of R&D arguably needs to be driven more by the private sector.

The business sector’s share in the total R&D in India has fallen from about 45 per cent in 2012-13 to 40 per cent in 2020-21 (more recent data is not yet available). So why do businesses in India not spend more?  Much has been written about this and arguments include a lack of appropriate incentives, difficulties in accessing government benefits, and an underdeveloped R&D culture in the country.

Arguments can no doubt be made about the lack of incentives. Few micro, small and medium enterprises (MSMEs), for instance, have the wherewithal to protect their intellectual property rights, especially given India’s well-known court delays, and the current R&D tax deduction of 100 per cent doesn’t yield significant benefits. Then, there are difficulties in accessing those incentives given the transaction costs involved in paperwork and certifications, among other things. But these issues are relatively minor. The one most important reason why firms may or may not undertake R&D is not government incentives but the presence or absence of competitive forces.

One clue emanates from global data. Proponents of greater R&D expenditure typically compare India with developed countries, or those that have performed well in global competitiveness, such as South Korea, Taiwan, China. But other countries such as Indonesia (0.28 per cent), Mexico (0.3 per cent), South Africa (0.6 per cent) spend a lower share of GDP on R&D, even Malaysia’s at 0.95 per cent is not that much higher. These are all resource-rich countries, therefore, indicating that it is not merely per capita incomes but a combination of the underlying economic structure and exposure to competition that influences R&D spending.

The exposure to competition is best possible when domestic markets are open to global firms. Protective actions such as high tariffs and non-tariff barriers, therefore, do not only lead to higher prices domestically, and reduce competitive forces therein, but they also reduce the R&D orientation of domestic firms. If these same domestic firms were, however, competing in global markets, they would have no option but to undertake greater R&D either to develop globally oriented products, reduce costs, or to enhance quality. But larger Indian firms, especially in manufacturing, are typically small players in global products markets. Even in the IT sector, where Indian firms have a large global footprint, the largest companies operate primarily in the business services segment, where the benefits of in-house R&D are relatively limited.

This leads to the next question: Can firms not use greater R&D and resultant innovation to enter new markets?  The Japanese success with small cars in the 1970s and 1980s is an example of how domestic innovation was leveraged to enter new markets.  But later evidence from other countries, such as South Korea, shows that innovation in the product space yields returns only if firms have a pre-existing presence globally.

But, if there are many firms in most industry segments in India, why doesn’t domestic competition lead to greater R&D? There are two arguments that could conceivably answer the question. The first is that domestic competition is actually not that high, and oligopolies have implicitly marked out their spaces.  The second is that there is a cultural problem, in that Indian entrepreneurs are short-sighted and prefer to access currently visible markets rather than put their money on unpredictable results from R&D.

Both arguments have merit and deeper analysis is required to disentangle them. The profitability of large firms has been stable or growing for a long time, and the future profitability expectations also look bright, as evidenced by the high price-to-earnings ratios prevalent in India. Arguably, therefore, there is little incentive for firms to invest more in R&D, as higher earnings are anticipated due to high growth in a protected domestic market. As an aside, this could also explain why profitable and cash-rich Indian firms rarely invest in other countries, since profitability and growth are higher in India.

And, therefore, the so-called cultural argument is an economic argument. There is little incentive for large Indian businesses to invest in R&D, since growth expectations and protected markets create conditions where it does not make sense for rational players to put money on uncertain R&D investments. 

In other words, it is not only R&D incentives that will give rise to greater innovation and productivity, but also the presence of greater competitive forces and consequent need for innovation that will yield greater R&D.

The writer is president of the Centre for Social and Economic Progress (CSEP). These views are personal