INNOVATION AND SMEs

Convened by Terry Cutler and Mark Dodgson

Brisbane, September 2007

In the past twenty-five years the UK has experimented with a wide range of policies to promote small and medium size businesses (SMEs). Recently there has been a major overhaul of SME support policies in general and of science and innovation support in particular. So it is a convenient time to reflect on the emerging lessons from this experience.

My talk draws on a long-term programme of SME and policy evaluation research carried out at the Centre for Business Research (1). This has included a regular biennial survey of over 2000 SMEs carried out since 1991 as well as several innovation policy evaluations and a unique innovation survey benchmarking the UK and the USA. My point of departure today however is what is widely regarded as a nonsense poem.

It is The Hunting of the Snark: An Agony in Eight Fits by Lewis Carroll (see Figure 1). I think it should be required reading for all people who want to develop small business policy. It involves the multi-pronged pursuit of a mythical animal (the snark) which gives the promise of all sorts of benefits if it can be ensnared. The snark, however, is elusive to capture and when it finally appears within grasp changes into something else (a boojum) and vanishes, taking its captor with it. I think this is a useful analogy for SME support policy and that the poem and its subtitle is a suitably cautionary tale for the SME policy developer.

In the poem a very large number of people pursue the Snark, and you can recognise many of the parties that are involved in SME policy today. There are lawyers who say an awful lot and then fall asleep in pursuit of the Snark. There are bankers who tear their hair out in frustration. And there is a wise old uncle who gives some advice, who you might think of as an academic at a Business School: 'beware of the day if your Snark be a Boojum! For then you will softly and suddenly vanish away, and never be met with again!'

My main message today will be that small business policy has been hunting snarks (in the sense of supporting individual small firms) which when taken as a whole are claimed to offer all sorts of valuable contributions to the economy. The nearer we get to an evidence-based capture of this snark, however, the more it seems that the appropriate target is a Boojum, a systems-based policy where we do not think of small firms on their own as the focus of attention. Instead, we should treat small firms as part of an integrated system, often interacting with large firms. This leads to policy built around systemic failures, rather than market failures, affecting individual small firms and preventing them from fulfilling their potential.

In what follows I will usually define SMEs as those businesses in the UK employing less than 500 people and occasionally, for data availability reasons, as those employing less than 250 people. These are conventionally used cut off points. I will discuss policy in headline terms in order to convey the wide range of policies and the overall amount of resource committed to them in the UK. I will also look in depth at one particular innovation support programme--the Small Firms Merit Award for Research and Technology (SMART)--to illustrate the difficulties in figuring out whether a policy is working or not. Finally I will use some of the long run survey data from the Centre for Business Research and UK official statistics to see if we can identify any broad changes which we may associate with the programme of SME support policy as a whole. I will then try and draw some policy implications.

According to recent official statistics the UK has 4.3 million enterprises of all sizes. However over three million of them have no employees. There are another million firms that employ less than ten people. Only 200,000 firms employ between 10 and 249 people, and there are only around 8,000 firms that employ over 250 people. This highly skewed size distribution is a familiar picture for advanced economies. In the UK this results in 1.2 million SMEs (i.e. those with less than 250 employees) accounting for 40% of employment whilst those enterprises employing over 250, roughly numbering only 8,000, nonetheless account for 60% of employment, and 62% of turnover. From a policy point of view this means we have a target policy group of over a million heterogenous small businesses.

It is also useful to try and capture the significance of small firms in terms of innovation-related activity. Official UK statistics suggest that only around 448 million [pounds sterling] out of a total of 30 billion [pounds sterling] expenditure on R&D is accounted for by independent firms with less than 250 employees, which is 3.3% of total business expenditure on R&D (BERD). This seems likely to be an underestimate, but even if were wrong by 100% it remains small. In terms of product innovation we have economy-wide data for firms employing between 10 and 250 employees. There are 50,000 of these who report product innovative activity and they account for about 6% of employment. Firms with more than 250 employees are more likely to be product innovative and, those which do, account for a much higher share of employment than small firms. If we turn from product to process innovation the story is similar. Arguments for support of the SME sector on the grounds of the scale of innovative activity per se are not strong. However it can be argued that innovative activity could be higher if SMEs did not face constraints which may weaken their performance compared to larger firms.

There are several familiar arguments put for believing that the share of activity and innovative performance of small firms may be constrained and which, therefore, justify policy intervention. These arguments are so familiar I will set them out only very briefly.

First, it is widely argued there are major skill problems in small firms but that they under-invest in training and have difficulty in accessing training provision. Under-investment is likely to occur, it is argued, because employers cannot capture all the value of the training they provide and may lose workers to poachers who do not train. Hence intervention is necessary to meet these market failures.

Second, it is argued that small firms face unduly high tax burdens in complying with VAT tax regulation. It has also been argued that, given the degree of risk they face, a lack of incentive to business creation may arise if a wedge develops between personal tax rates and those facing the self-employed or small business owner. As a result a lot of effort in the UK over the past twenty years has been spent on reducing the VAT compliance burden and the actual tax rates on small businesses. Thus, for example, whilst corporation tax rate for large firms is 40% over the past twenty years it has been reduced for small firms from 40% to 20%, even though it bounced back a bit in the last Budget to 22%.

Finally, capital market failures may arise in principle from indivisibilities in the costs of providing finance for small businesses, from asymmetric information and the moral hazards facing banks which lead to credit rationing for small firms, and from excess risk aversion by venture equity providers in supporting innovation. Such arguments have led to major policy interventions with a particular recent emphasis on support for risky innovation-related investment by offering tax breaks for investors to complement grant-based schemes to support SME innovation.

The outcome in terms of support policy has been a plethora of schemes, a selection of which is set out in Figures 2 and 3. The first 'financial' figure includes loan guarantee schemes, venture capital support schemes, community enterprise and ethnic support schemes, and several other attempts to influence capital market behaviour.

Figure 3 summarises key innovation-related programmes.

It is important to note that, increasingly, these programmes are moving away from a concentration on grants for individual firms towards interventions that are targeted at system-wide relationships or contract support for firms through public procurement. An important recent policy innovation has been the establishment of a Technology Strategy Board charged with responsibility for delivering key innovation support policies. This agency will operate at arms length from the UK government. It will have responsibility for the collaborative R&D scheme, for knowledge transfer networks that are sector-wide relationships across defined sectors and, in particular, they are developing the notion of innovation platforms. Thus in addition to thinking about sectors like food processing, it will be possible to think about the range of technologies that may be necessary to address a given area like, for example, security systems or intelligent transport. The knowledge transfer partnerships target collaborative arrangements between higher education institutions and individual firms and typically involve the transfer of a PhD student to work in a firm on a particular project.

The development of support policy on such a wide canvas has absorbed increasing resources. The most recent estimates are shown in Figure 4 which shows that 3.6 billion [pounds sterling] per year has been given in tax breaks to support the sector and, in addition, there has been direct government expenditure of over 4 billion [pounds sterling]. Skills and training related spend has dominated. Relatively small amounts (through the Department of Trade and Industry and the Office of Science and Technology) are provided for innovation related programmes. Regional development agency programmes and EU linked programs make up the balance. Total support is nearly 8 billion [pounds sterling] p.a. This means that over 200 [pounds sterling] pounds for every person of working age in the UK is going to support this sector. Within the broad headings shown in the box there are a massive number of programmes: over 260 central government programmes, over 50 focusing on innovation support, and over 3,000 national, regional and local support delivery programmes. This is a complex structure of industry support, and highly expensive. It is under review with the objective of streamlining and reducing the plethora of schemes within a new departmental structure.

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