Industrial policy: A double-edged sword for Australian innovation?

Industrial policy offers potential for innovation but carries risks, and effective design is crucial to avoid distorting market dynamics

The resurgence of industrial policy on the global stage may reflect a growing recognition of its potential to drive innovation and economic growth, aside from opportunistic political considerations. However, the renewed focus also raises significant concerns about the design and implementation of these policies. The primary challenge lies in crafting policies that stimulate innovation without distorting market dynamics or entrenching inefficiencies. As Australia's economy navigates this evolving landscape, the implications of these policies on innovation, financing, and the broader economic environment are critical considerations.

While representing an opportunity to foster innovation, these policies can be costly if poorly designed, making a clear strategy essential. That involves avoiding policies that act as a form of trade protection and distort the allocation of scarce resources away from activities in which Australia has a comparative advantage. As such, “there are dangers in this new burst of industrial policy, even though it seems to be well received by many industries,” according to Professor Kevin Fox in the School of Economics at UNSW Business School.

At the recent AIEA-NBER Annual Conference on Innovation and Entrepreneurship organised by UNSW Business School's Associate Professor Elvira Sojli and Wing Wah Tham and the Centre for Applied Economic Research, Prof. Fox led a forum featuring six key figures to discuss the impact of industrial policy. Panellists included:

•  Josh Lerner, Jacob H. Schiff Professor of Investment Banking at Harvard Business School and NBER Fellow;
•  Scott Stern, David Sarnoff Professor of Management of Technology at MIT and NBER Fellow;
•  Catherine de Fontenay, Productivity Commissioner;
•  John Simon, former Head of Economic Research at the Reserve Bank of Australia (RBA);
•  Michael Falk, Chief Economist at IP Australia;
•  Michael Brennan, E61 CEO and former head of the Productivity Commission;
•  David Masters, Head of Global Public Policy at Atlassian; and
•  Stephen Rodda, Professor and Pro Vice-Chancellor Industry and Innovation at UNSW Sydney.

The AIEA-NBER Annual Conference on Innovation and Entrepreneurship roundtable forum

According to Prof. Fox, recently enacted US policies, particularly the CHIPS and Science Act and the Inflation Reduction Act, have prompted other countries to focus on their industry policies. “Other countries are thinking, ‘Well, we’d better get on this as well; otherwise, all our innovations and talent are going to be sucked into the US,” he said.

However, as Commissioner de Fontenay stressed, the prime concern should remain to develop a strategy for policies that do more good than harm. “We have a whole literature in economics on endogenous protection that says that once you create subsidies or tariffs for a new industry, and that industry grows up, you’ve created a whole bunch of firms that have a very strong vested interest in keeping those subsidies/tariffs,” she said. “First, we just need to pause and recognise the scale of the problem.”

An evolving definition

Industrial policy has historically been about fostering the building blocks of innovation, such as the research and development (R&D) tax credit and export market development grants. But that’s been shifting recently, Commissioner de Fontenay explained.

“What has changed is that we now have industrial policy that is pursuing a broader set of goals,” she continued. “We want to facilitate the net-zero transition; we want to ensure national security in certain dimensions; we want to help workers transition from fossil fuel industries. But you have to make very sure that the policies you’re putting in are not going to deter innovation and are going to encourage as much innovation as possible in the way you structure them.”

Read more: How to innovate responsibly in an era of AI democratisation

The ideal outcome is a policy that is “technology-agnostic”, she said. “It’s challenging once we start talking about supporting specific industries because the more you get down to the level of a specific industry, the more you’ve implicitly made some technological choices.”

Much of industrial policy is rooted in microeconomics, focusing on the bottom line of productivity, Mr Simon explained, adding that his view is that industrial policy “all too often takes as the starting premise the way things are and then says, we should do something to help this particular industry.”

“It’s basically a two-wrongs-make-a-right approach because what you’re saying is, we’ve got this pre-existing set of regulations and incentives in the economy, and we’re going to pick one and provide incentives to offset it. My macroeconomic perspective is, isn’t most of industrial policy just good policy? And why on Earth should we be limiting it to particular industries?

“We want to encourage,” Mr Simon added. “Industrial policy might be carbon taxes, but that’s just a very general proposition that we should tax externalities, and you can apply that much more broadly. My approach, taking the macroeconomic lens, is thinking about, what are the economic institutions that create an environment of innovation generally and that will get you 80% of the way down the road?”

Scaling challenges, policy solutions

Industrial policy affects the way companies structure their operations from a skilling perspective, Mr Masters explained, pointing to the importance of the R&D tax incentive and the export market development grant. “If you talk to any scaling Australian startup, they talk about how important that is in helping them grow export-focused markets,” he said.

As a software-focused business, Atlassian operates in a global market for talent, where scaling is less about capital investment and more about operating investment and investment in skills, Mr Masters explained. Scaling workforce has been a challenge for Australian tech companies, which are competing against markets like the US and India that have many times more software engineers, for example. But this is where good policy can come into play.

“As a global company, we will invest in talent in a number of markets, but as a consequence of the energy tax incentive and a few other things, we retain a lot of our intellectual property here in Australia,” Mr Masters said. “Some decisions that were taken 20 years ago and refined seven or eight years ago have solved some of the capital challenges that particularly software industries have had in Australia.”

These policies have also helped foster a venture capital (VC) industry in Australia, another key support for innovation. “We’re seeing the superannuation industry and the rest of the financial sector starting to treat VC as an asset class they’re prepared to invest in,” Mr Masters said.

Read more: Sustaining Australia’s economic success: A roadmap for the future

Pulling the right levers

Another essential step in designing an effective industrial policy is understanding what makes Australia’s economy unique, Mr Brennan said. “Australia is overwhelmingly a resource exporter and a service economy,” he said. “We’re very innovative on the resource side, but, overwhelmingly, the big issue with innovation for Australia is, how do you pull off service innovation?”

Importantly, considering Australia’s strength means that key objectives do not necessarily require fighting to be at the frontier of breakthroughs. “But they do involve us having sufficient entrepreneurial wherewithal to identify business models that can leverage these technologies,” Mr Brennan said. “I think, for Australia, that’s it; that’s the main game for us. If we should worry about anything, it’s not whether we’re at or near the frontier in terms of the discovery process, but whether we’re entrepreneurial enough about the application.”

As Prof. Rodda pointed out, there are many levers that can and must be pulled for an industry policy to work, including investment from VC and superannuation. “It’s great to get companies launched and out there, but if they’re going to die because there’s no access to capital, no access to workforce, then no one’s going to win on that front,” he said. “I think that’s both the opportunity and the challenge for where things can be shaped from an administrative policy perspective.”

Comparative advantage and innovation

According to Prof. Stern, these issues come down to harnessing comparative advantage and orchestrating its evolution, particularly in regional contexts. And there is a “very high payoff to encouraging innovation,” he said. For example, in the US, each dollar spent on R&D is worth $4 in GDP; in Australia, each dollar of R&D adds $3.50 in GDP.

“There’s almost nothing else in the economy, except maybe primary education, that pays off like that,” Prof. Stern said. “I think there’s a strong argument for moving towards that knowledge-based, even service-based, innovation economy grounded in comparative advantage.”

And while innovation policy is challenging for small nations, policymakers can benefit by thinking about what makes appropriate industrial policy for their economies – “setting the table in terms of thinking carefully about the preconditions that make for good environments for innovation and entrepreneurship,” Prof. Lerner said.

“A lot of it is in the spirit of not coming in with preconceptions,” he continued. “Rather than saying, ‘Whatever the flavour of the moment is globally, we want it here,’ it’s more informed by a notion of, ‘Let’s create an overall environment that works, but let’s also hear about what’s working elsewhere, who can raise some money or generate some interest, and try to support them, rather than trying to come down with the tablets (solutions) and hand them out.”

Read more: Unveiling the secrets: what VCs look for in early-stage startups

Clusters and ecosystem-building

The panellists also debated the virtues of clusters in helping to incorporate startups, university research and risk capital in a local industry space – “all of that pushing in with fit-for-purpose interventions that get through the latency,” according to Prof. Stern. “Clusters and comparative advantage are just the latent strengths of the region and building institutions that respond to them. And human beings are not terrible at building those.”

These endeavours can help promote the “stickiness” of an ecosystem, Prof. Fox said. “You see whether people mature and graduate from that with some level of connectedness back to it, that sense of wanting to give back,” he said. “But it’s also that element of, how do we get all boats rising with the tide in that environment?

“That’s maybe where government policy can come in, because you can start to affect those things on an almost competitively neutral plane as it relates to that cluster or that ecosystem, without it being a disadvantage or advantage to someone else,” he added. “Instead, it’s playing to the comparative advantage of the system or region.”

Industrial policy might, therefore, hinge on the government “getting out of the way”, according to Mr Simon. “It’s setting the table, perhaps, but it’s completely technology-neutral, and it’s allowing those agglomerations to happen.”

Or, as Prof. Fox elaborated: “Sometimes, governments need to know when not to turn up to the dinner party as well, and when not to intervene. If something is working, let’s just let it run and even help to clear the path.”

Building talent at home

One area in which Australia can improve, with significant implications, is capturing innovations that occur in one part of the economy and deploying them effectively in other parts, Mr Masters said. “We tend to see that expertise leave our shores because there’s no ability to scale it here,” he said. “I don’t know the answer to solving that problem, but I think the easier we can make it for people to take that expertise and use it in Australia, the better.”

This need for orchestration helps justify the role of industry policy, Prof. Stern said. “If you opened up the lever on immigration, then you would get complementary things,” he noted. “As you start to invest in particular areas and give people internships in industry that give them approaches to problem-solving, it all runs.”

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Prof. Lerner said he likes the idea of “trying to lure people with honey” to build up the ability to deploy local money, which remains a critical need. “The problem with international money is that it tends to be the first to leave when things turn south,” he noted. “So, we should be trying to build up a local pool, but less through stick and more through carrot.”

Better activation of local capital is also crucial to building an ecosystem of innovation. “Entrepreneurs tend to continue to be entrepreneurs their whole life, and they continue to invest in that risk-based capital,” Mr Masters said, adding that Australia is “terrible at incentivising that.”

“The good thing here is that we have Canva, so there’s a whole bunch of money that’s come through the local venture capital system that’s about to come back into that system, which is about to prove that you can make returns in that asset class,” he said.

“This is the great thing about venture capital: one bet out of 100 pays off, but then you’re okay, and that one bet pays off really, really well. Then, it kind of subsidises the whole system and creates more of an ecosystem. And those people who’ve developed that expertise and generated that capital inside care – but they will take that elsewhere,” Mr Masters added. “We should be stimulating more local capital in Australia.”