Misappropriation of Subsidies Massively Weakens the Effectiveness of Chinese Innovation Policy

With the 14th Five-Year Plan, the Chinese government has set itself the ambitious goal of creating a more innovation-based economy and becoming the world’s leading nation in science and technology by 2050. To this end, gross expenditures on research and development (R&D) are targeted to grow by at least seven per cent annually between 2021 and 2025. There are plans to stimulate more R&D in companies through extensive subsidies and other policy incentives. However, this is not the end of the story. As a recent study by ZEW Mannheim shows, misappropriation of subsidies has been widespread in China in the past and has long stood in the way of efficient use of state funding. Therefore, as early as 2006, a seminal change in China’s innovation and industrial policy took place and numerous measures were introduced to improve funding instruments and curb their misuse. “Should such measures become even more effective in the future, China will turn into an increasingly innovative competitor on the world market and at the same time become more attractive as an R&D location for foreign companies,” says Dr. Philipp Boeing, China expert at ZEW, commenting on the results of the study.

In China, the share of firms receiving any kind of subsidy among listed companies increased massively after the turn of the millennium: from 31.7 per cent in 2001 to 90.0 per cent in 2011. On average, about 10 per cent of total government subsidies to enterprises were specifically earmarked for R&D activities. However, the current ZEW study shows that 42 per cent of recipients of R&D subsidies in the period 2001 to 2011 misappropriated the funds in whole or in part by using them for non-research purposes. At the company level, misappropriation was measured by comparing the actual R&D expenditure published in the annual report with the R&D subsidies received. Overall,  53 per cent of total R&D subsidy payments were ultimately not used for research purposes. Often, subsidies are misused to cross-subsidise non-R&D related investment, e.g. to reduce production costs, which may distort competition in international markets. However, compliance with the funding guidelines should also be in the interest of the Chinese government. “The increase in R&D spending by subsidised companies could have been twice as high as it actually was. However, this would require an end to subsidy misuse,” Boeing confirms. Compliance with the funding guidelines would also have led to a further increase in the companies’ investment in physical capital, employment and sales. By contrast, R&D policy has no impact on grantees’ productivity, IT high-tech orientation of patenting, university-industry collaborations, or employment of foreign inventors.

The ZEW study further reveals potential for optimisation in the selection of companies receiving support. “In the case of state-owned enterprises, R&D subsidies have so far had no effect at all,” comments co-author Professor Bettina Peters, “and subsidies in the high-tech sector should also be granted in a more differentiated way in the future.” Overall, a funding policy in which subsidies are paid out less frequently or in smaller amounts has produced better results. “With the Mid- to Long-Term Plan for Science and Technology Development, expiring in 2020, China has already been able to address some structural problems in its innovation system, and initiate necessary improvements,” says Peters. In addition, the administration of subsidy programmes has been reorganised so that companies can now be selected more precisely and the use of subsidies can be better monitored. These reforms had a clear impact, as the ZEW study confirms. If the 14th Five-Year Plan succeeds in further improving the design and implementation of China’s innovation policy, business productivity is likely to increase in the future and lead to economic growth driven by ‘Innovation Made in China’. Policymakers and businesses in Europe would be well-advised to already prepare for more intense competition in high-tech sectors, the authors say.