Technology policy for the knowledge economy: Public support to young ICT service firms

Abstract

Public intervention in high-tech sectors is often advocated to resolve market imperfections that may possibly limit the viability of young high-tech enterprises. Although some European countries have adopted national government support policies that explicitly target this type of firm, in Italy and in other EU countries, there are no national support measures specifically designed for them. The paper focuses on the information and communication technologies (ICT) services sector in Italy. It aims to investigate whether both horizontal general-purpose direct support mechanisms at the national level and financial support measures provided by local administrative entities (which rarely have been specific to the ICT sector) permit an efficient allocation of public funds.

Introduction

The development of information and communication technologies (ICTs) plays a key role in contributing to improved productivity of labor and capital and in fostering economic growth, especially in advanced economies (OECD (2002), OECD (2004); Schreyer, 2000). High-tech startups in ICT-related activities have represented the fundamental engine of this process (Acs, 2004), and many young US firms (e.g., Microsoft, Cisco, Yahoo!, Google, Amazon) have attained worldwide leadership in the ICT sector, in both the manufacturing and service sectors, in a short period of time. Even if ICTs are defined as general-purpose technologies, there is growing evidence that the emergence and consolidation of a strong national ICT sector are a fundamental prerequisite for rapid “digitalization” of a country (Guillen & Suarez, 2001) and have a positive impact on the performance of the whole national economy (Daveri & Silva, 2004; Gordon, 2000). Europe has traditionally lagged behind the United States both in the creation of ICT startups and in the number and size of young high-growth firms in this sector (the so-called “gazelles”).¹ The favorable ecosystem in terms of innovation, entrepreneurial culture, functioning of capital and labor markets, and level of human capital in which new US high-tech ventures grow to maturity certainly contributes to explaining this difference in performance. As a result, public intervention to favor high-tech entrepreneurship is often advocated in Europe to overcome possible market imperfections and to sustain the creation and development of new ICT ventures that can compete in the global arena.

Basically, economic analysis has developed two main rationales for public sector support to new technology-based firms. First, the socially optimal level of R&D expenditures may be higher than the optimal level for private individuals because of the presence of R&D spillovers. Young, small firms may invest less than the social optimum because they are unable to defend innovation and extract most of the rents in the product market (Griliches, 1992; Jaffe, 1996; Teece, 1986). Secondly, a large body of empirical literature on entrepreneurship has pointed to the presence of financial constraints on new firms (Black, de Meza, & Jeffreys, 1996; Blanchflower & Oswald, 1998; Evans & Jovanovic, 1989; Evans & Leighton, 1989; Holtz-Eakin, Joulfaian, & Rosen (1994a), Holtz-Eakin, Joulfaian, & Rosen (1994b); Meyer, 1990). Access to the credit market is considered to be problematic, especially for high-tech ventures (Carpenter & Petersen, 2002; Storey & Tether, 1998; Westhead & Storey, 1997; see also Colombo & Grilli, 2007 and Grilli, 2005 for the Italian context). Many obstacles to external financing for this type of enterprise stem from the inability of banks and other financial institutions to distinguish good projects from “lemons” in sectors usually characterized by highly skewed returns, asymmetric information, both ex-ante and ex-post (e.g., hidden information and hidden actions), and a lack of inside collateral to secure debt (Carpenter & Petersen, 2002). On the other hand, even though for high-tech startups private equity financing has advantages over debt (Carpenter & Petersen, 2002), this mode of financing may still present problems related to ex-ante asymmetric information (Myers & Majluf, 1984) and high transaction costs (Asquith & Mullins, 1986; Lee, Lochhead, Ritter, & Zhao, 1996) that inhibit access to seed and startup equity capital for most new high-tech ventures.

Both arguments lead to the same conclusion: valuable innovative projects may be disregarded and remain unrealized because of spillover problems or lack of sufficient funds. Naturally, from a social point of view, these are missed opportunities calling for public intervention. But which form of public intervention is most suitable for sustaining young ICT service firms while avoiding distortions,² reducing the risk of wasting public resources, and consequently maximizing social well-being?

Policymakers have a wide spectrum of measures at their disposal. First, it is important to understand whether young ICT service firms need specific, customized programs (i.e., a vertical technology policy) or whether they may be effectively supported through horizontal programs with more general objectives (e.g., a program targeting support to innovation or entrepreneurship). Secondly, the question also arises whether national centralized governmental bodies or local ones are best suited to provide public support to this type of firm. Thirdly, it is also important to understand whether direct assistance programs or indirect ones (i.e., support to institutions that provide financing and other services to new high-tech ventures) are more efficient.

As was recently suggested by Siegel, Wessner, Binks, and Lockett (2003), assessment of the efficiency of public policy measures designed to promote innovation in high-tech firms and to resolve market inefficiencies has become a key policy issue. If evaluation methodologies present many issues and are a challenging field of research (see European Commission Joint Research Centre, 2002 for a comprehensive treatment of the issue, and also Lerner, 1999, 2001), there is less disagreement on the characteristics which a program should possess to be truly efficient. First, the program should avoid generating substitution effects in the target sector (Santarelli & Vivarelli, 2002). These occur when inefficient subsidized firms, because of the public aid they receive, have an artificial advantage over potentially more efficient but nonsubsidized ones. Under these circumstances, public intervention may end up distorting market process dynamics, hindering selection, and even promoting artificial incumbency of inefficient firms to the detriment of potentially more efficient competitors and new entrants. Secondly, the program should limit the risk of directing subsidies to beneficiaries that do not need public aid to realize their potential. If this does occur, then the policy measure does not produce any positive additional results with respect to the prior situation and in fact generates only deadweight effects (Santarelli & Vivarelli, 2002).

According to this view, policymakers should preferentially channel public subsidies to firms that: (i) exhibit genetic characteristics that distinguish high-growth-prospect firms from low performers, and (ii) are financially constrained and because of capital market imperfections cannot obtain the financing they need to realize their growth potential.³ Clearly both conditions are necessary for a policy measure to be efficient, and if one of these two prerequisites is absent, this should lead to a reconsideration of the public policy intervention as implemented.

Although most existing research studies evaluate the effectiveness of programs mainly by comparing the performance of subsidized and nonsubsidized firms (see Lerner (1999), Lerner (2002); Lerner & Kegler, 2001 for contributions that refer to new programs targeted at high-tech ventures), in the authors’ view, it is necessary to take a step back and examine which characteristics enable firms to obtain access to direct public financial subsidies. More specifically, the aim of this paper is to focus on condition (i) and analyze empirically whether direct general-purpose support mechanisms at the national level and financial support measures provided by local administrations (which have been predominantly horizontal in nature) are compatible with a scenario where public funds are optimally allocated to young ICT service firms. In fact, if condition (i) is not met, this is a sufficient condition for a policy measure to be inefficient.

In this context, the Italian experience is very interesting. In fact, Italy, like many other EU countries, has never had a national financial support program exclusively targeted to young high-tech firms in the ICT or any other sector (Storey & Tether, 1998), but these firms have benefited extensively from public assistance through measures that were also available to broader groups of firms. Furthermore, there has been no systematic indirect support to young ICT service ventures. In consequence, it is legitimate to question whether direct general-purpose policy measures have been efficient in supporting young ICT service firms. If it were determined that they are not efficient, this would call for a new technology policy approach towards this kind of firm and likely would require the implementation of more specific and customized measures (i.e., a vertical approach) rather than the current programs.

The paper takes advantage of a new data set based on a sample of 351 young Italian firms operating in the ICT service industry. Condition (i) can be tested by analyzing whether the genetic characteristics that are typical of young, high-growth prospect ICT service firms can explain the access of these firms to public subsidies at both the national and local levels. Data were provided by the Research on Entrepreneurship in Advanced Technologies (RITA) database developed at Politecnico di Milano. The firms in the sample were established in 1980 or later, were independent at the time they were founded and were still independent on 1 January 2004 (i.e., they were not controlled by another business organization, even though other organizations may hold minority shares). Highly detailed corporate-level data are available on each firm's activities, structure, and performance, on the characteristics of the founding team such as education level and prior working experience, and on access by each firm to national and local public direct support measures. Clearly the sample is very heterogeneous with respect to the variables of interest and in actual firm growth performance.

The paper proceeds as follows. Section 2 reviews the extant empirical literature on the determinants of high-growth performance in high-tech sectors to identify the genetic characteristics that are usually associated with best performers in these markets. Section 3 presents the data set, Section 4 provides some descriptive statistics which depict the ability of firms to access public direct support measures (both at the national and local levels) and highlights possible basic inefficiencies in the allocation of funds. Section 5 is devoted to an econometric exercise that tests whether public funds have been directed preferentially to those young ICT service firms whose genetic characteristics are typical of “gazelles” in high-tech sectors. The test will enable an evaluation of whether or not existing direct public subsidies for young ICT service firms are likely to have generated important substitution effects in the sector. A final section with a discussion of the main findings and some policy implications concludes the paper.