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Abu Dhabi, UAEThursday 15 November 2018

Economics 101: How VAT can help Gulf countries increase good R&D

Research is good but not all research is economically useful

Tourists in the UAE will be able to claim the five per cent VAT they have paid back when they leave the country. Getty
Tourists in the UAE will be able to claim the five per cent VAT they have paid back when they leave the country. Getty

Technological progress is the primary reason many of us enjoy the comforts of modern life, as opposed to the squalor of the pre-industrial age.

Moreover, rather than being a random phenomenon, it is the result of purposeful effort, most typically in the form or research and development (R&D).

The Arabian Gulf countries have always had low levels of R&D compared with most other countries, relying instead on technology imports, but this has undermined their capacity to develop their own cutting-edge technologies. Their economic visions have correctly surmised that the transition to a sustainable, prosperous knowledge economy requires a persistent increase in the level of R&D spending. Ironically, the introduction of taxes such as value added tax (VAT) may hold the key to doing it.

To see how, the first point that needs to be established is that, in general, economically valuable technological progress requires research, but that not all research yields economically valuable technological progress. Your local university illustrates this dichotomy starkly. In the English literature department, you will find scholars employed full time whose job it is to analyse the meaning of Shakespearean texts. This is research, but its economic value is virtually nil; without the government funding such research, private donors would fund close to zero. In contrast, in the medicine department, you will find scholars employed full time whose job it is to develop new treatments. This is research, and it is has significant economic value, as indicated by the fact that biomedical and pharmaceutical companies spend billions of dollars on such research annually.

Understanding this distinction is important because it means that policymakers must be careful to devise interventions that lead to improved technological progress, and not just improved research, as the latter may simply imply intellectually interesting but commercially frivolous activities. Note that this is not a domain-specific issue - there is plenty of economically useless research conducted in the hard sciences and mathematics; while humanities researchers occasionally make a commercially valuable contribution.

The default policy for improving technological progress across the entire world, including the Gulf, is for the government to fund research directly, such as by the creation of funds to which researchers can apply for financing, or via paying the salaries of university academics. The main problem with this approach is that while it surely leads to an increase in research, it invariably leads to a lot of commercially useless research, meaning a failure to realise the original goal, which is technological progress that benefits the economy.

This is because it is virtually impossible for a government to distinguish, at the funding stage, between economically useful and useless research. How are civil servants supposed to know the difference? They could hire expert scientists, but even they don’t really know what will end up being useful versus what will not. When Newton developed calculus in the 17th century, he had no idea what the applications would be.

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Moreover, if a company has a good idea for cutting-edge research, it will not want to share that idea with a funding committee whose job it is to evaluate it, since a central part of the value of the research to the company comes from its secrecy and first-mover advantage. The company will rightly fear that if its proposal is rejected, competitors may gain access to the proposal, and the idea may be stolen.

The only way to force people to have a more discerning eye, or to avoid the risk of ideas being stolen, is to make the researchers themselves have skin in the game, by either paying for the research, reaping the benefits, or both, preferably. That is why pharmaceuticals such as Glaxo SmithKline have research output comparable to a medium-sized university, although with a much higher economic return than research conducted in universities.

And this is where taxation - ironically - can play a critical role. Since direct government funding undermines the incentive to conduct economically useful research, the alternative - deployed in many advanced economies - is to provide companies that conduct research with tax credit. This keeps them highly motivated to be judicious in the choice of research, as compared to the more flippant attitude that direct government funding brings about

In the context of the Gulf countries, traditionally, taxation is virtually absent, meaning that this policy option is not available, forcing them to use the government funding route. The result has been a struggle to produce economically impactful research, despite the presence of world-class resources. In contrast, top companies such as Saudi Arabia's Aramco and Sabic do produce excellent, commercially valuable research, primarily because they fund it themselves, conduct it secretly, and harvest the returns exclusively.

The introduction of VAT opens a new possibility. Now, if a government wishes to encourage economically useful R&D, it can offer companies that conduct it credit on their VAT. There exist other fees that governments might consider granting R&D exemptions for, such as foreign worker fees and commercial registration fees. The key is for governments to repeatedly affirm the maxim: valuable technology requires research, but not all research yields valuable technology.

Omar Al-Ubaydli (@omareconomics) is a researcher at Derasat, Bahrain.