Submission tot he Ralph Inquiry into Business Taxation

January 1999

The City of Melbourne believes that local, regional and national prosperity in a world of disappearing trade barriers will be determined by the capacity for technological and commercial innovation.

Such innovation includes product differentiation, both through the introduction of entirely new goods and services and the innovative packaging and design of existing offerings. It also means finding ways of delivering the same or superior quality outcome for customers at lesser cost. In other words, competitiveness demands continuous investment in the ‘knowledge intensity’ of goods and services.

For small, trade exposed economies, growth is increasingly dependent on the capacity to tap ‘brainpower’ and is less able to be underwritten by natural resource endowment. Guided by these principles, the City is preparing local economic development strategies aimed at making Melbourne a centre for knowledge based industries (see below).

The nexus between innovation and growth is demonstrated by the superior performance of new ventures versus established enterprises. White (1998) quotes a survey of comparative performance of 400 mainly US companies over 33 years (1962 – 95). This showed that new entrants during this period achieved, on average, a 20% return for shareholders, compared to 13% for the whole sample. The largest 50 firms managed an average return of only 10%.

Murray (1997) shows that during the first half of the 90’s, venture backed new technology based firms (NTBF) outperformed large, well established companies in employment and sales growth in both the US and Europe. NTBF’s were also strongly global in orientation, displaying strong growth in export sales (see Table 1).

The City of Melbourne has recognised that Greater Melbourne and Victoria generally have great potential to develop innovative, ‘knowledge based’ economies.

Victoria continues to lead the nation in the dedication of resources to R&D. Research spending accounts for about 1.9% of Victoria’s Gross State Product (GSP), compared to 1.6% for Australia as a whole and 1.5% for NSW. To some extent, this leadership is due to the historically strong representation of Commonwealth funded and non profit R&D institutes in Melbourne (e.g. the CSIRO and various medical and health research institutes clustered in the Parkville area). But the main driver of Victoria’s R&D effort over the past decade has been business spending.

Business expenditure on R&D represented some 1.1% of Victoria’s GSP in 1996/97 (the equivalent ratio for NSW was 0.8%). Victoria now ranks in the same territory as countries like Canada and the UK, which reported business R&D spending of 1.03% and 1.3% of GDP respectively for the same period. Moreover, Victoria has one of the world’s fastest growing business funded R&D sectors.

The State’s economy is now sharply differentiated from the commodity based orientation of much of the Australian economy. Overseas exports of Elaborately Transformed Manufactures (ETMs) from Victoria are 1.4 times greater than those from NSW, and more than twice the level shown by the rest of the country when counted on a per capita basis.

The changing direction of the Melbourne and Victorian economies towards dependence on high value added and high knowledge content products appears to be flowing through to the educational and career choices of young people. Victoria’s enrolments in university science and engineering courses are significantly higher than those in NSW, both in proportional and absolute terms. Victoria overtook NSW in this area in 1993 and the trend has intensified ever since.

Analysis of the changing composition of jobs in Melbourne and Sydney between 1986 and 1996 highlights this shift in the structure of the Victorian economy (Jureidini and Healy, 1998). It also signals the continuing potential for a new partnership between these cities. Globalisation has seen a deepening of Sydney’s specialisation in finance and business services, while Melbourne has developed as the nation’s principal centre for advanced manufacturing, communications, research, transportation and several parts of the arts and culture industries.

Amongst the initiatives undertaken by Council to promote and develop the City as a centre for knowledge intensive industry has been joint leadership (with the Committee for Melbourne) of the Thinking Melbourne Program.

The objectives of the Program are to:

• significantly increase the spin off of new enterprises from Melbourne’s institutional research base and support the growth and further development of these businesses; and
• accelerate the take up of new technology in Melbourne’s traditional industries.

Until recently, the program’s main focus has been a general marketing campaign to raise awareness of Melbourne’s R&D, design and advanced manufacturing capabilities. Addressing specific opportunities for, and barriers to, investment in targetted industries is the priority in the current phase of the program. To this end, the City and the Committee for Melbourne has prepared a Strategic Business Plan for the Program, to guide activities over the next 3 years.

Preparation of the business plan for Thinking Melbourne included consultations with business, research institutions, technology commercialisation specialists and other stakeholders.

The impact of Australian tax laws on access to venture capital loomed large in these discussions.

Many participants indicated that the problem facing small and medium sized enterprises (SMEs) in financing high technology initiatives was not a lack of venture capital funds per se. This is corroborated by the 1998 AVCAL survey which reported that respondent venture capital firms had access to almost $800 million in uncommitted funds.

Not all of these funds would be immediately available as there is usually an extended draw down period (often 3 years) on capital raisings. Also, fund managers require a degree of liquidity for new investments and follow on investments. Nevertheless, the extent of uncommitted funds is suggestive of a relatively risk averse nature in the Australian venture capital industry.

Other AVCAL figures support this hypothesis. Only 5% of funds raised by venture capital firms are invested as seed capital in start up enterprises. In recent years, the industry has been directing most financing support to existing, well established companies which are seeking to expand. As AVCAL puts it, "this supports the perception that the industry in Australia has attempted to lower the risk profile by investing in companies with a longer track record". It is also telling that the majority of venture capital funds (60%) are being directed into general industrial and service enterprises rather than hi-tech businesses.

There is, therefore, a general perception that venture capital is difficult to source in Australia. Of the 46 countries covered by the World Competitiveness Yearbook, 1996, Australia ranked only 20^th in terms of whether ‘venture capital is readily available for business development’ (Lawn, 1997).

These access difficulties, together with the competitive disadvantage of a small domestic market, have been authoritatively quoted as stifling the growth of Australian NTBF’s. For example, in their review of Australia’s information industries, Charles, Allan and Buckeridge (1997) concluded that….

A distinguishing feature of the Australian venture capital industry is its non - globalised nature. For example, whereas the UK venture capital industry sources more than a third of its funds in the USA and a further 20% from continental Europe and other non UK countries, Australia has failed to attract significant investment interest from off-shore.

Aside from the large pool of uncommitted venture capital funds in Australia, industry participants in the Thinking Melbourne consultations put the lack of foreign involvement in the domestic venture capital market down to Australia's tax laws. In particular, they referred to;

Charles et al (1997) encountered very similar views in their consultation program.

• When some of them have assessed Australia and Australian venture capital management capabilities, the application of the Australian capital gains and withholding tax regime has been a show-stopper." P 81

Arguably, the main damage done by tax laws to Melbourne’s aspirations as a centre for high technology investment is not the reduced stock of venture capital as such. Rather it is the reduced exposure of the domestic venture capital industry to the methods and strategies of aggressive operators from the US and elsewhere.

The effective ‘protection’ of Australia’s venture capital industry fuels the tendency towards risk aversion. It dampens the competitive imperative to fully investigate new start up and early stage investment opportunities. The fact that Australian venture capital fund managers have achieved only modest returns on their investments by comparison with best practice overseas (the median Internal Rate of Return on realised investments reported by respondents to the 1998 AVCAL survey was only 21%) may be symptomatic of dulled competitive pressure.

In turn, the modest performance of Australian venture capital funds has slowed the growth of this sector. Over the past 35 years, the US venture pool dedicated to private equity investment has grown to US$43.5 billion. In contrast, the Australian venture and mezzanine finance pool reached $A1 billion for the first time at the end of 1996. Demonstrated strong returns have led to US institutions allocating some 3% to 4% of their funds to venture capital (Charles et al, 1997). In Australia, major institutions have been sluggish in dedicating any of their funds to private equity investments as a distinct asset class.

American experts have also commented on the conservative nature of the Australian venture capital industry and the impact this has on growth of this sector and NTBF’s. In an article published in PC Week in December 1996, Bruce Frederickson, president of US based Channel Tactics, was quoted as saying that venture capital was a major obstacle to industry development in Australia and implied that the finance sector needed to lift and diversify its risk assessment skills. "Unlike the US, potential funders in Australia are very risk-averse, even though when it comes to a gold mine they are not risk-averse. Funders need to take the view that not every company will succeed, but the few that do will be very successful".

Similarly, Charles et al (1997) argue that opening up the Australian venture capital market to foreign involvement by (amongst other things) addressing capital gains and other tax issues, would speed up the development of local risk assessment skills.