Policy Settings for Innovation and the Digital Economy
5 August 2015
I am very pleased to speak to the Trans Tasman Business Circle – a particularly good forum in which to speak about policy settings to stimulate innovation and the digital economy.
New Zealand is run by a very competent centre right government – and its leading figures including John Key, Bill English and Stephen Joyce have built up an impressive track record of effective and cost effective policy in this area.
Earlier this year I attended the Australia New Zealand Leadership Forum in Auckland and I was pleased to join a panel discussing innovation policy, along with Stephen Joyce.
Let me highlight some of the impressive work he has done. As Minister for Communications he drove the fibre rollout in New Zealand. For 1.5 billion NZ dollars a fibre to the premises network will serve 75 per cent of all homes in the nation with an extension to 80 per cent, for a relatively modest capital commitment, recently announced, which looks like amazingly good value compared to the chaotic NBN mess we inherited from Labor in Australia.
More recently as Minister for Science and Innovation Stephen Joyce has driven a regeneration of innovation policy in New Zealand, including the establishment of Callaghan Innovation, a network of eight government supported incubators around the country to stimulate start up tech sector businesses.
Both sets of policy measures respond to an economic reality which is true for Australia, true for New Zealand and true for every advanced economy: we are undergoing a transformation which is every bit as profound as the industrial revolution, as the rate of technological change accelerates and networked computing power disrupts every industry.
In my remarks today I want to touch firstly on the nature of this transformation, and why it must engage the attention of policymakers.
Next I want to argue that there is a tempting – but wrong – policy response, which is to throw billions of dollars of public money at heavily or completely subsidised national champion companies. This is the approach favoured by the Labor Party and they are serial offenders.
Finally I will make the case that the real policy challenge is to create the right incentives and supports for a vigorous innovation response from private sector businesses.
There are important roles for government and for non-private sector players – but wise policy in this area respects the dividing line between private and public sector. As I will argue, this principle has been a touchstone for policy in New Zealand, and is also central to the Abbott Government's approach in Australia.
A Profound Economic Transformation
So let me come first to the point that we are seeing a profound economic transformation.
This is not a controversial proposition, but everybody has their own take on it.
Last year Scott Farquhar, co-CEO of Australian software company Atlassian, at my request gave the 2014 JJC Bradfield Lecture on the topic, "Capitalising on the Software Revolution in Australia." Scott compared the impact of software on our economy today with the impact of electricity 150 years ago – which, he pointed out, was the necessary condition for the modern assembly line and in turn a huge leap in productivity.
Scott went on to say this:
Like electricity, software provides an order of magnitude more productivity, paving the way for cost reductions and new products, and transforming how we work as a result. Standing at the start of the 20th century it would have been impossible to overstate the impact electricity would have on our lives. Similarly, as we stand here at the start of the 21st, it is impossible to overstate the impact software will have. 
As software transforms the economy, the disruption of existing businesses by a better, internet based offering is one of the great constants of modern economics.
Ask Kodak about digital photography; Fairfax about Seek.com.au; the free to air TV networks about Apple TV or YouTube; Angus & Robertson about Amazon; Blockbuster about Netflix; or Taxis Combined about Uber.
How extensive is the digital transformation of our economy?
A recent report from Deloitte estimates that the digital economy is already a large economic segment in Australia, contributing $79 billion or 5.1% to GDP in 2013-14. If it were treated as a single industry this would rank it as larger than agriculture, transport or retail. It is growing considerably faster than the overall economy, having increased in size by 50 per cent since 2011. 
This builds on earlier work from the same firm which found that almost one-third of the Australian economy faces imminent and major disruption due to the transformative power of the digital economy. 
Around the world every nation is facing this transformation – and the leaders of many nations speak of this issue regularly. Here is what Britain's Prime Minister Cameron said a couple of years ago:
…one of the most promising opportunities for new jobs and growth lies in a new wave of high growth, highly innovative digital businesses. We are competing in a global race and I am absolutely determined to make Britain the best place in the world in which to start and grow a business. 
According to a recent report by Chile's National Council on Innovation for Competitiveness, the Council was set up because of:
… a growing conviction that something different must be done to change the country's productive orientations, and innovation emerged as a promise for greater competitiveness, growth and quality of life for Chileans. 
And here is what New Zealand's Prime Minister Key said in a speech earlier this year:
Smart, innovative exporters are the key to a prosperous future for New Zealand. That's why we've made innovation one of the six focus areas in our Business Growth Agenda and we're backing that with significant extra government investment. 
Policies to stimulate innovation make sense for a number of reasons. First, if we want to enjoy continued economic growth, then a focus on the digital economy is obvious because it is growing much faster than the overall economy, as the Deloitte figures I cited earlier show. Across the developed markets of the G20, the internet economy was recently forecast to grow at 8 per cent a year over the next five years, much faster than traditional economic sectors. 
Second, the digital economy is key to the future of jobs. Old economy jobs are at risk: an influential recent study predicts 47% of US jobs are exposed to being replaced by technology in the next 20 years.  A recent report from CEDA argues that 40 per cent of Australia's workforce, more than five million people, could be replaced by automation within the next 10 to 20 years. 
Conversely, the technology sector creates new businesses, and new jobs, at a higher rate than the economy wide average. One US study found new business formation was 23 per cent more likely in the high-tech sector than in the private sector as a whole; in information and communications technology (a sub-set of the broader high-tech sector) it was 48 per cent more likely. The study also found that new and young firms in the high-tech sector are more robust job-creators than such firms in the broader economy. 
According to the OECD, one third of job creation in the business sector comes from young firms with fewer than 50 employees – even though these make up only 11 per cent of total employment. 
Thirdly, innovation and technological progress is key to driving productivity growth – something widely recognised as a key objective for the Australian economy.
Chris Roberts, then CEO of leading Australian knowledge economy business Cochlear, delivered a lecture on innovation in Australian business at my request in 2012. He said "…it has been helpful at Cochlear to think of innovation and productivity being twinned. They are inextricably linked."
Chris highlighted research showing that long term productivity growth depends heavily on technological change and innovation. 
In a similar vein, RBA Deputy Governor Philip Lowe in a recent speech highlighted the importance of innovation policy. He raised five areas: how we finance innovation including start ups; incentives for innovation in the tax system; how we support human capital accumulation; promoting entrepreneurship; and promoting competition which is so often the driver of innovation. 
The Wrong Policy Response
We can all agree, then, that there is a fundamental transformation occurring.
Does it follow, therefore, that the right policy response is to throw billions of dollars of public money at heavily or completely subsidised national champion companies?
That was certainly the view of the Rudd-Gillard-Rudd Government. Here is what then Prime Minister Rudd said in his April 2009 press release announcing Labor's decision to build the National Broadband Network:
It will help drive Australia's productivity, improve education and health service delivery and connect our big cities and regional centres… The Government will invest in this major nation-building infrastructure to stimulate jobs in the short-term and pay a dividend to the Australian people through enhanced productivity and innovation in the long-term. 
In other words, investing in the NBN was an absolute good and the case for investing billions of dollars of taxpayers' money was made out without further analysis being required – including, notoriously, without a cost-benefit analysis.
Labor's default approach was that if a sector was vital to the economy, then we needed to pump billions of taxpayers'dollars into establishing a state owned enterprise to dominate the sector. This was its justification for the establishment of the $43 billion NBN and similarly the $10 billion Clean Energy Finance Corporation.
I spoke earlier of the remarkable broadband outcome secured in New Zealand – and the very good value the Kiwi taxpayer is getting. The New Zealand approach of providing a targeted amount of public funding, and allocating it to existing telecommunications businesses through a competitive selection process, stands in stark contrast to the inept mess we inherited from Labor in Australia.
Steadily we are turning it around – when we came to government only 236,000 premises were ready for service on the terrestrial NBN network; today there are 1.13 million premises which are serviceable within standard lead times.
Unfortunately in recent months we have seen that Labor still thinks the right approach to innovation and new technology is to set a bold and large number, without any serious analysis, and then either allocate public money or impose a regulatory mandate.
In his budget reply speech Bill Shorten announced his plan for a $500 million Smart Investment Fund.
There was not much detail about how the fund will work, apart from Shorten saying that it would "partner with venture capitalists and fund managers to invest in early stage and high potential companies."
This sounds much like the Innovation Investment Fund, which ran from 1997 until 2014. But Shorten did not tell us how he would overcome the difficulties the IIF experienced in its later years, when it struggled to attract matching funding from private sector investors.
In 2013 the Labor Government announced $100 million under the IIF across three private sector managers. But two of the three failed to raise the required amount of private funding – and hence their funds did not go ahead.
This reflected the reality that venture capital as an investment class in Australia has generated poor returns over the last decade or so, making many investors reluctant to put money in.
It may be possible to learn from experience and design a government funding scheme which catalyses a thriving private market in venture capital. This after all has been part of the Israeli government's strategy over many years – with such success that a recent book about the technology sector in Israel is entitled "Start Up Nation."
But it is hard to believe a Shorten Labor Government would do a good job of this – particularly when you look at its approach with the NBN and the CEFC.
Most recently we have seen Labor's hastily conceived proposal for a 50 per cent renewable energy target. It seems no financial modelling was done before this idea was adopted. Credible economic consultants such as Frontier Economics and ACIL Allen estimate it will require capital expenditure of between $60 billion and $100 billion.
Whether it is information technology, biotech, clean tech or green tech, the approach of sweeping targets and massive government investment is always tempting to policymakers – and history shows that it is generally a serious mistake.
The Right Policy Response
What then is the right approach? How can we make sure that the economies of small, export-oriented nations like Australia and New Zealand capture the benefits of innovation and technological progress?
I want to highlight several important policy principles. In different ways, on both sides of the Tasman, these principles are underpinning the agenda of the Abbott and Key Governments to stimulate innovation.
The first principle is to back the private sector.
Wealth and prosperity is generated by the private sector – so it is very important to back the private sector, in innovation and the digital economy as much as other sectors.
Of course there is much the private sector has already achieved, if we look at the growth of the digital economy. A recent report by advocacy group StartupAus, Crossroads 2015 cites an impressive list of companies which have started up and grown to an impressive size, including such companies as Wotif, Seek, and Atlassian. 
But there is much more that we can do – and let me cite the world leader in research and development spending as the exemplar. In Australia, research and development expenditure as a share of GDP is 2.13%  , in New Zealand it is 1.27%  ; in Israel it is 5%, the highest in the OECD – and only one eighth of this comes from government.
Successful technology businesses spend heavily on R&D. Cochlear, for example, the Australian hearing implant company which has successfully commercialised research done at Melbourne University, is a market leader in its segment globally and generates revenues of around $900 million a year. It spends over $120 million a year on R&D. 
Companies which do this are in a virtuous cycle – they have market dominance which means they are profitable; in turn they can invest large amounts in R&D to maintain their market position.
But in Australia and New Zealand too few businesses are in this position. So the real policy challenge is stimulating private sector investment in R&D – something Israel has done with great success, including of course through tapping foreign investment into its tech sector.
In New Zealand, a key policy measure to stimulate the private sector in the high-tech economy has been the establishment of Callaghan Innovation, a specialist agency delivering funding and support into the sector. Here is what Prime Minister Key said recently:
…the really important challenge we have is to increase private sector investment in research and development, where New Zealand continues to lag behind some of the world's leading economies. The Government's main tool for lifting business research and development investment is Callaghan Innovation, and in particular its R&D grants. 
Similarly, in Australia the government released its Innovation and Competitiveness package last year. The Agenda set out six key initiatives: reforms to encourage employee share ownership; reforming the vocational education and training sector; promoting STEM subjects in schools; streamlining standards processes for certain product approvals; enhancing the 457 and investor visa programmes, and establishing Industry Growth Centres in sectors of national importance. 
Employee share schemes were a focus because they are vital for start up businesses. The previous Labor government was hostile to employee share schemes; its tax settings made such schemes unattractive to offer or participate in.
We have changed the law with effect from 1 July, and there are now expanded tax concessions for employee share schemes to make it easier for small start-up companies to attract and retain the talent they need to grow.
A range of other measures in the budget will also help to boost start ups. We will allow start-up companies to immediately deduct professional expenses incurred when they begin a business, and start up companies in the early stages of growth will face a lighter tax burden: for companies with an annual turnover of less than $2 million, the company tax rate will be cut by 1.5 percentage points to 28.5 per cent.
We have also made important changes to the Significant Investor Visa which are expected to stimulate new funding for start-up companies. SIV applicants are required to invest at least $5 million in complying investments – and from 1 July this year this must include at least $500,000 in eligible Australian venture capital or private equity funds investing in start-up and small private companies.
Just yesterday Small Business Minister Bruce Billson released a consultation paper on the regulatory framework for crowd sourced equity funding, ahead of our announced plans to introduce legislation in the Spring sittings.
The second principle is to promote competitiveness –and play to our strengths. Given the profound disruption occurring across the global economy, we need to have a clear idea of where our companies can be competitive. Where do we have strengths and how can we play to those strengths?
Australia certainly has the capacity to be world competitive in developing and exporting software –and unlike many other products, because it is weightless and incurs no transport costs, we do not face a cost disadvantage from being a long way from major markets.
But on the minus side, businesses located in lots of other countries can also be world competitive. So it becomes even more important to work out what your strengths are –and where you are going to be good enough to build not just a strong market share in Australia but a strong market share globally.
One implication of that principle, I believe, is that if Australia has a world class, large scale resources industry, or agriculture industry, then the development of IT applications and services to make that industry more productive and efficient might be a niche where Australian companies have an advantage.
Last year I had the chance to visit the extremely impressive Rio Tinto Control Centre in Perth. Some 300 people work in this centre, and it looks rather like a foreign exchange dealing room in a bank, enhanced with the largest and highest-resolution wall-size video screen I have seen since visiting the Foxtel network control room in Macquarie Park.
This centre controls 14 mines, multiple railway lines, and several ports –1500 km away in the Pilbara. It is a powerful demonstration that modern mining is extremely capital intensive, highly technologically sophisticated –and just as susceptible to productivity improvement through digital technology as is banking, travel, entertainment, or any other industry.
There are similar opportunities to develop world-leading technology to support the Australian agricultural sector – both in production and in exporting its products to the world.
Applying digital technologies, such as low-cost sensors, can assist farmers in monitoring irrigation, soil moisture, vegetation, livestock, and farm equipment.
I recently saw an innovative product designed to assist Australian exporters, when I met Perth-based business Gworld at Mobile World Congress, a big trade fair in Shanghai. Their software works to authenticate products in the 'internet of things' world.
When a consumer buys a wine bottle from a winery using their system (which includes special packaging for the bottle incorporating a near field communications chip) the product can be authenticated when the bottle is opened by waving it in front of a suitable smart phone.
With counterfeit products a big problem in the Chinese market, this gives consumers reassurance that the product is genuine – and communicates valuable information back to the winery about when and where its products are opened.
Another start up business I recently met, which exemplifies the principle of playing to our strengths, is Sydney based Disrupt Surfing – an online retailer which allows customers to order surfboards with customised designs.
The third principle is to get the enablers right. While ultimately it is the private sector which must build businesses and create jobs in the high-tech economy, there are key enablers which are delivered by government. That means an obvious focus for government is to get those enablers right.
On both sides of the Tasman that means building out a high quality digital infrastructure.
In New Zealand, the ultrafast broadband rollout recently hit the half-way point, with over 618,000 premises able to connect to the network. In June, the network connected its 100,000th user, and around one-in-seven customers in coverage areas have now connected to the network.
The rollout is now complete in 11 towns and cities, while more than 2,200 schools have fibre installed and ready for service. The rollout is on-track to being deployed to the 33 largest towns and cities in New Zealand by the end of the decade.
In Australia as I have mentioned we are working hard to deliver the NBN, turning around the mess we inherited from Labor and getting the rollout happening more quickly.
Another enabler is using digital technology to deliver government services much more efficiently. In New Zealand, the government has launched the 'RealMe' online identity verification service which allows users to access a range of government and private sector services online with appropriate security and privacy safeguards.
In Australia, our policy is that every government service with more than 50,000 transactions with citizens a year should be digitally accessible by 2017. Malcolm Turnbull is leading this work across government, and the recently established Digital Transformation Office in his portfolio is already building momentum, particularly as new CEO Paul Shetler has arrived from the UK and commenced work.
Early priorities for the DTO will include the creation of a Trusted Digital Identity Framework that will enable the use of a single 'digital identity' which citizens can use to log in to each of their government services – removing the need to complete separate log on processes for each government service.
A third enabler, of course, is our education system. It is vitally important that our universities are as strong as they can be, and that we boost the number of students taking STEM –science, technology, engineering and maths –subjects.
In last year's Innovation and Competitiveness Statement we announced $12 million for STEM education, including funding for the development of new online resources to support the maths curriculum; work to promote computer programming skills in schools; and seed funding to pilot an innovation-focused initiative styled on the U.S. 'P-TECH' (Pathways in Technology Early College High School) model.
Let me conclude, then, with the observation that economies around the world are transforming – and hence governments have a strong focus on policies to support and encourage innovation and the growth of technology based businesses.
But a key principle must be to back the private sector – because this is where the successful commercialisation outcomes will be secured. It is tempting, but a mistake, to simply pump government money into creating new companies or funds.
The governments of both Australia and New Zealand are working hard on policy measures to increase the role of innovative, technology-based businesses. There is a lot to do – but there is no doubt there are big opportunities to capture as our economies transform.
 S Farquhar, 2014 JJC Bradfield Lecture, "A Start-Up Nation: Capitalising on the Software Revolution in Australia", www.paulfletcher.com.au, downloaded 2/8/15
 David Cameron Speech at the launch of EE 4G Network, 6/12/13, as reported in Computer Weekly
 Tech Starts: High-Technology Business Formation and Job Creation in the United States, Kauffman Foundation, August 2013, http://www.kauffman.org/what-we-do/research/firm-formation-and-growth-series/tech-starts-hightechnology-business-formation-and-job-creation-in-the-united-states
 OECD Science, Technology and Industry Scoreboard 2013: Innovation for Growth. Executive Summary, p 13. http://dx.doi.org/10.1787/sti_scoreboard-2013-en, downloaded 20/7/14.
 Cochlear 2014 Annual Report p26
 John Key, 14 April 2015, Pre-Budget speech to Business New Zealand function, http://johnkey.co.nz/archives/1950-Pre-Budget-speech-to-Business-New-Zealand-function.html