DRAFT May 2011 National Innovation Strategy

Knowledge, Innovation and Long-Run Growth

Dr. Albert G. Zeufack, Lim King Yoong and Devendran Nadaraja. Khazanah Research and Investment Strategy Macro Modeling Project

1.
1.1

Introduction Background

In its sustained effort to achieve Vision 2020, Malaysia has embarked on a new economic model to transform Malaysia into a knowledge-based and innovation-rich nation1. This strategic direction is reflected in the New Economic Model (NEM) reports and the 10th five year Development Plan (RMK10, 20112015). The NEM highlights the need for growth to be Innovation Driven in its Strategic Reform Initiative 7 (SRI 7), while the 4th Big Idea of the 10th Plan points to increased innovation as a necessary condition to achieve Vision 2020. The focus on knowledge and innovation cannot be overemphasized. There is ample empirical evidence that innovation is positively associated with firm performance, as measured by revenue growth, irrespective of the industry in which the innovative firm operates. Also, firms knowledge assets are positively associated with firm-level innovation. Firms with higher levels of capabilities are more likely to introduce innovations (see Thornbill, 2006). Moving to High-Income status would therefore require growth in Malaysia to result increasingly from knowledge, innovation, combined with a deeper stock of physical and human capital. For this painful transformation to take place, a number of policies requiring significant effort and resources from the Government would need to be implemented. For example, a serious upgrading of skills across a broad spectrum and a sharp increase in the quality of education would have to happen. Also, the Government may need to launch a much more aggressive and effective promotion of research and development (R&D) activities in the private sector and support the emergence of a strong venture capital industry. However, in a post 2008 global recession environment where resources are scarce and sovereign defaults are spreading to an increasing number of countries, including advanced ones, the Malaysian Government may need to make some trade-offs. Making the right trade-offs in the allocation of public resources requires an understanding of the growth effects of these various policies.

1

PMs Interview to the Star, March 13th, 2010.

1.2

Can Innovation Extricate Malaysia from the Middle Income Trap (MIC)?

Knowledge and innovation are key to escaping the MIC Trap. Indeed, there is a natural limit to growth based on accumulation of capital stock. Increased competition from low cost producers in neighboring Asia and increased in Malaysian labor costs overtime inevitably lead to a decline in industrial competitiveness. Increasing productivity is therefore crucial. Yet productivity levels and growth both labor productivity and Total Factor Productivity (TFP) have been rather modest in Malaysia. TFP growth in Malaysia has been considerably lower than that in selected Asian countries in recent years. TFP target of 2.3% for 2011-15 is achievable only if full potential of innovation can be unleashed skills development and enhancing innovation capabilities are been given greater focus. A proper resources allocation mechanism able to redeploy resources away from inefficient uses and innovation and provides benchmarks for Malaysia. Figure 1: Malaysia caught in the middle income trap.

Source: World Development Indicators, Khazanah Research & Investment Strategy (KRIS)

Figure 2: Sources of growth in Malaysia

Source: 10th Malaysia Plan (EPU)

2.

Benchmarking Malaysias Innovation Capacity

An innovation is the implementation of a new or significantly improved product (good or service), or process, a new marketing method, or a new organizational method in business practices, workplace organization or external relations. There are many types of innovation such as product innovation, process innovation, marketing innovation and organizational innovation. The relationship between innovation and economic development is widely acknowledged. Hence, good measurement of innovation is essential for policymaking. Measuring innovation is complex. There are enormous numbers of macro-indicators to measure and benchmark innovation capacity such as innovation indicators in OECD statistical database. However due to inadequate and missing data for Malaysia, we only could look at limited number of indicators to benchmark Malaysias innovation capacity against other countries. Mentioned indicators are as follows:

Expenditure on R&D. Number of researchers in R&D. Number of patents. High technology exports. Global Innovation Index. ICT infrastructure indicators. ICT expenditure.

The worlds most innovative economies are also the worlds fastest growing economies such as Korea, India and China. Is Malaysia spending enough on research and development (R&D) and is this spending efficient? The level of spending on R&D seems to be determined by the volume of research. The limited supply of researchers may itself reflect weak demand for R&D spending. Indeed it is a two-way causation. R&D expenditure as a percentage of GDP in Malaysia is relatively low compared to Japan, South Korea, Singapore and Hong Kong. The trend shows R&D expenditure over the years in Malaysia did not increase much. (Refer Figure 3). Malaysias gross expenditure on R&D as a proportion of GDP in 2006 was 0.64 percent although it targeted to increase gross expenditure to 1.5 percent by 2010, according to the Malaysian Economic Planning Unit (EPU). Singapore, on the other hand, spent 2.31 percent of its GDP on R&D in 2006, and it targeted 3.0 percent of its GDP on R&D by 2010. The figures for Japan in 2006 were 3.32, South Korea (3.22), Taiwan (2.58) and China (1.42). Since the late 1990s, mainland China has boosted its R&D spending by 50 percent. Now, China wants to increase that spending to 2.5 percent of GDP annually. Finland, the Nokia country with only 5.2 million people, invested 3.4 percent of its GDP in R&D, one of the highest percentages in the world.

Figure 3: R&D expenditure as % of GDP.

Source: World Development Indicators, KRIS.

If we further breakdown the R&D expenditure in Malaysia, it is evident that the public sector appears to be driving the R&D activities after year 2006 (Refer Figure 4). Whereas, in South Korea the private sector contribution is more prevalent (Refer Figure 5). Malaysia should strive to boost more private sector involvement in the R&D activities to create a healthy competitive and innovative business environment. Figure 4: Malaysias expenditure in R&D by sector

Source: MASTICs National Survey of Research and Development 2008.

Figure 5: Koreas expenditure in R&D by sector

Source: OECD Reviews of Innovation Policy of Korea.

The same trend of R&D expenditure applies to the number of R&D researchers in Malaysia (Refer Figure 6). The ratio of researchers to the total population has increased rapidly in Singapore over the years. Increasing the number of R&D researchers is a big challenge and tougher than pumping more in R&D spending since developing research skills and capabilities takes much longer time. Increasing R&D expenditure with inadequate number of R&D researchers will lead to ineffective consumption of the spending and low value product development. Figure 6: Number of researchers in R&D.

Source: World Development Indicators, KRIS.

An economys capability to innovate is continuously translated into patenting activity. Developed nations have the most number of patents. Malaysian firms do very little patenting (Refer Table 1). More than 90% of patents granted and applied to the Malaysian Patent Office are to foreign residents (Refer Figure 7 and 8). Only a small number of patents are granted to local residents. Patenting activity in Malaysia is relatively low compared to Taiwan, South Korea, Hong Kong and Singapore. Patents granted by USPTO to Malaysian residents are mostly for semiconductor and electronics industries only. Table 1: Patents Granted by USPTO to foreign residents

Source: USPTO

Figure 7: Number of patents applied in Malaysia.

Source: MyIPo, KRIS.

Figure 8: Number of patents granted in Malaysia.

Source: MyIPo, KRIS.

Malaysia has high technology exports as % of manufactured products and the trend was increasing for some time (Refer Figure 9). However, its mainly contributed by electrical and electronics industry. In order to become an innovation led economy, Malaysia has to come out from its conventional semiconductor and electronics trap box. Malaysia needs to expand and diversify its patent activity to many other fields like engineering, biotechnology, automotive, agricultural technology and many more. Figure 9: High technology exports (as % of manufactured exports).

Source: World Development Indicators, KRIS.

The Global Innovation Index 2008-2009 is the most comprehensive report to assess innovation in 130 countries. Lower ranking denotes better innovation capability of a nation. When we analyze the sub components of global innovation index, we found that performance of Malaysia in general and ICT infrastructure seems not satisfactory relatively to Japan, South Korea and Singapore (Refer Figure 10). We collected the data that make up General and ICT Infrastructure and tabulated it. Malaysia has lower internet users and broadband subscribers than South Korea (Refer Figure 11 & Table 2). Figure 10: Global Innovation Index (GII) of Malaysia.

Source: Global Innovation Index, 2008-2009 Note: Ranking over 130 countries, lower ranking denotes better performance.

Figure 11: GII of Malaysia, Japan, South Korea, Singapore.

Source : Global Innovation Index, 2008-2009

Table 2: ICT infrastructure in Malaysia and Korea.

Source: World Development Indicators, ITU World Telecommunication Indicators

ICT expenditure as % of GDP in Malaysia is relatively low compared with Japan, Hong, Singapore and showing decreasing trend from year 2000 to 2006. However, ICT expenditure in South Korea is slightly lower than Malaysia (Refer Figure 12). Figure 12: ICT expenditure (as % of GDP)

Source: World Development Indicators, KRIS.

Malaysia has 5 broadband internet subscribers per 100 people whereas South Korea 32, Singapore 21 and Hong Kong 28. Malaysia was parallel with other East Asian economies in broadband penetration in 1996 when Multimedia Super Corridor (MSC) launched. But currently several years after that launch, we have not moved far forward either in terms of broadband penetration or

innovation. Number of broadband subscribers in Malaysia is significantly lower than South Korea, Japan, Singapore and Hong Kong. South Korea, Singapore, Hong Kong and Japan had a huge rise in number of broadband subscribers from year 1998 to 2005. We can see the dynamics of increase in broadband subscribers per 100 people for the mentioned countries in the scatter plot below (Refer Figure 13). Malaysia shows little movement. Korea has made good use of broadband penetration to promote multimedia-based activities and web services especially in Seoul. Figure 13: Broadband subscribers per 100 people.

Source: World Development Indicators, KRIS.

The IT infrastructure in particular is becoming a vital aspect influencing the efficiency of research efforts. Better IT infrastructure permits researchers to connect globally, to exchange ideas, to search for ideas, to access papers and so on. We expect broadband penetration rate in Malaysia will be higher in coming years, since Prime Minister launched the National Broadband Initiative (NIB) in March 2010. NIB is expected to provide next generation high-speed broadband (HSBB) access. Government has allocated RM1bil to provide schoolchildren from poor households with Internetenabled notebook computers, as part of the National Broadband Initiative. Another RM60mil would be invested to set up community broadband centres that would benefit 615,000 households in 246 locations in the country. Government will also set up 138 Internet centres at state information department offices that will benefit 400,000 people. The Government will also set up 1,105 e-kiosks at community centres nationwide, at the cost of RM40mil in total (Refer Figure 14).

Figure 14:

National Broadband Initiative (NIB).

Source: Malaysian Communications and Multimedia Commission, 2010

In spite of many policy initiatives and institutional support to move Malaysia towards an innovationled economy, comparative analyses showed that the incidence of innovation is low in Malaysia, compared to what it should be based on its level of development. While the knowledge content at the industry level showed improvements, knowledge constraints such as the lack of financial sources and soft skills remained a stumbling block for firms to move up the value added chain. Hence, there is a continued role for the government in subsidizing training and knowledge-based upgrading activities to propel industries and the economy at large to the desired goal of a truly knowledgebased economy.

3. 3.1

An Analytical framework: The Malaysia Vision 2020 Model (MV20 model) The MV20 Model: Innovation, Knowledge and Human Capital in one framework

The analytical framework adopted in this Chapter, the MV20 model, is an Overlapping Generations (OLG), endogenous growth model that studies the links between innovation and long-term growth of the country. Consistent with most endogenous growth literature2, it adopts a dynamic general equilibrium framework that captures interactions between individuals, firms, and the Government in determining long-term growth path of an economy. At the same time, it is also in coherent with the ideologies and strategies advanced by the World Bank and OECD in developing a knowledge economy3, by stressing on the importance of knowledge and human capital in driving innovation-led growth. More specifically, the framework emphasizes on the inter-linkages between human capital accumulation, knowledge creation and transmission, the talent pool distribution, the labour market allocation, and their resulting implications on growth.

The term OLG comes from the division of the population into three generations at any one time: children, working adults and senior citizens. Each generation has a duration of 25 years, which makes it appropriate in analysing long-term growth. Given that different generations are involved, decisions made at the household level would naturally have dynamic implication on the next generation, and therefore need to be taken into account in determining the outcomes of the next period. For example, the savings of working adults are calculated as consumption in old age, i.e. when they move into the senior citizens category. Similarly, the decision to acquire higher education before entering the workforce is a determinant of the level of wages earned as working adults.

In addition to household level decisions, the MV20 model is also complemented by four additional broadly defined sectors, which include the final production sector, intermediate goods sector, education sector, and innovation sector. All five sectors of the economy interact with each other in determining the long-run balanced growth equilibrium of the economy. Apart from the endogenous nature of the five sectors, the MV20 model also emphasizes and measures the impact of the public sector in spurring innovation, both through investments and public expenditure allocations, to create an enabling environment for innovation and growth.

Another distinctive, key feature of the MV20 model is that it also explicitly attempts to analyze the talent pool distribution of the economy, despite the practical difficulties involved due to lack of

2

For surveys of the technical literature on economic growth, see the Handbook of Economic Growth (edited by Aghion and Durlauf, 2005). 3 For details, see World Bank (2007) and OECD (2007, 2010b).

official statistical data and indicators of such nature. It introduces a generic measure of cognitive skills, which would play a very important role in analyzing labour market incentives, and the resulting distribution of workers across different sectors. Given that strategic human capital is fundamental to growth and innovation, this attribute of the model further outlines the importance in understanding and therefore creating a broad labour market environment that is conducive to innovation-led growth. The inter-linkages of the various sectors in the analytical framework are illustrated in Figure 15, as follows: Figure 15: A stylized depiction of the overall feature of the MV20 model framework

As a result of the uncertainty in human capital and cognitive skills distribution, an economys longrun growth may be characterized by two different labour market environments. In the first scenario,

there is a general misallocation of talents across the economy. A lot of talented graduates with high abilities, who could perform well in a specialist role, are not willing to work in the innovation sector due to unattractive relative wages differentials, when compared to remain in the final output sector as generalists. In the second environment, growth is constrained by a lack of labour quality across the broad human capital of the economy. Under such environment, despite the fact that higher education may have produced high number of graduates, the graduates in general lack the necessary cognitive skills required to work in the innovation sector. Since the impact of any policy action undertaken would naturally differ between the two different labour market environments, the need to understand the different labour market conditions of the economy is essential in determining the best policy prescription to be administered in fostering an innovation-led growth in the economy.

The analytical framework is calibrated based on most recent data for Malaysia. However, against the backdrop of a lack of broad innovation statistics and indicators, some parameter values for countries at similar stage of development are used. It provides a rich policy simulation tool to analyze and address long-run macro issues associated with innovation-led growth. Consistent with the initiative to drive Malaysias transition to a high-income economy, the model provides a macro-framework that not only outlines the broad economic environment in an innovation context, but also allows for the analysis of certain policy actions, their respective tradeoff and transmission mechanism in stimulating growth.

The basic features of the model are discussed below, with the various sectors being further structured into four thematic blocs to facilitate readability:

3.2

Production structure Final Output Production and Intermediate Goods sector

The key feature of the model is that growth is driven by horizontal innovations, that is, through the introduction of new varieties of intermediate goods. This implies that new varieties of intermediate goods are assumed to be of the same quality as previously invented goods. Firms in the final production sector, in addition to the standard inputs of capital and labour, use the intermediate goods produced in the intermediate goods (IG) sector to produce final output for the economy. Meanwhile, firms in the IG sector use the blueprints designed (or trademarks and patents) purchased from the innovation sector to produce the intermediate inputs that are made available to final output firms in each period.

While such simplified production approach is commonly found in most dynamic growth models, recognizing the shortfall that firm innovations extend beyond that of the introduction of new

products and technologies, the final production function also implicitly incorporates the element of process innovation and quality-improvements on a broad aggregate context. This is done through the introduction of two elasticity parameters with respect to intermediate goods shares of intermediate goods in final output production and elasticity of substitution between pairs of intermediate goods. The former is an elasticity parameter in the final production function while the latter affects the net price mark-up for IG producers.

In the context of the model, any growth that results from incremental innovation, such as improvement in production routine and organisational efficiency, would be reflected in a larger elasticity parameter with respect to the shares of intermediate goods in the final production function. On the other hand, a smaller elasticity of substitution between pairs of intermediate goods would naturally reflect the outcome of access to specialised technology and experts. When IG producers gain greater access to specialised technologies through value innovation over time, the elasticity of substitution parameter would be lowered, and therefore allows IG firms greater net price mark-ups over its marginal cost.

3.3

Education Sector, Human Capital, and Labour Allocation

For simplicity, the labour in the economy is broadly categorized into two different categories, qualified skilled workers and non-qualified low-skilled workers. The resulting classification is modelled as a direct result from households inter-temporal decisions with respect to pursuing advanced education. At early adulthood, individuals decide on whether to pursue advanced education, depending on wage incentives of the labour market. Obtaining advanced skills qualify individuals to potentially work in either the innovation or final goods sector. For individuals who choose to acquire advanced skills, human capital then depends on factors such as education in childhood, income shares and time allocated to education, public capital spent on education, as well as existing stock of ideas or knowledge (as a result of spillover effect of innovation on learning). On the other hand, the general human capital of individuals who choose not to acquire advanced education (and therefore restrict themselves to only able to work in the final production sector) would be modelled as function of childhood education, as well as positive externality benefited from working with the qualified skilled workers. This proximity effect fittingly captures the concept of workplace and organisational learning, where higher degree of spillovers and proximity through cooperation and collaboration would improve the broad human capital of the economy. The assumed flows of human capital accumulation modelled are illustrated in Figure 16, as follows:

Figure 16: Graphical depiction of the education and human capital sector of the MV20 model framework

While the analytical framework assume all individuals as receiving the same advanced education, graduates nonetheless, leave with different distribution of cognitive skills (or in short, abilities). The different cognitive skill levels, coupled with the relative wage differentials across sectors, would determine the allocation of graduates across sector. The aggregate uncertainty introduced in the distribution of abilities would therefore result in two distinct labour market environments. As explained earlier, there is a general misallocation of talents across the economy in the first case. There are adequate talented graduates with high cognitive skills that are capable to work in the innovation sector, but some of these talents opted not to do so due to the relative wages differential across the final output and innovation sector. Matching the model context to a real world perspective, this simply means that jobs in the innovation sector are simply not compensated enough, be it salaries, non-remuneration benefits, and other non-observable incentives. The presence of labour market distortions across both sectors could have contributed to this misallocation too, which are explicitly modelled in the framework.

On the other hand, in the second case, growth is constrained by a lack of labour quality across the working age population in the economy. Under such environment, despite the fact that higher education may have produced high number of graduates, the graduates in general lack the necessary abilities and cognitive skills required to work in the innovation sector. This results in an undesirable low quality talent pool, therefore making educational and curriculum reform a top priority in order to escape this growth trap. Hence, while the former calls for better labour mobility and allocation, the latter is clearly a quantity issue (better known as brain drain) where most policy tools would likely to be less effective, in the absence of a long-term reformation of the education system and learning culture. A diagrammatic interpretation of the two possible labour market environments is presented in Figure 17, as follows: Figure 17: The two possible labour market environments under MV20 model framework

As will be shown in the Strategy Simulation section later, the ability to diagnose the current state of the labour market environment is essential in order for any policy prescription to be effective. In reality, the true labour market conditions are likely to differ across industry, where in some cases, an industry suffers from both misallocation of talents and low labour quality traps. Furthermore, in practice, the true distribution of cognitive skills of the working age population is unobservable in the absence of official indicators on intellectual assessments. Perhaps, this shortfall highlights the dire needs of establishing a competencies assessment of international standards, such as that of the OECDs Programme for International Student Assessment (PISA).

3.4

Innovation Sector and Knowledge Capital

Within the framework of the model, innovation is conveniently measured through the intensity of research & development (R&D) activities, where firms generate blueprints and designs to be used in the production of intermediate inputs. In return, the successful researches are compensated with monopoly rents extracted from the patent price charged on IG sector. The production of the blueprints or designs is specified as a function of the existing stock of designs, effective high-skilled labour with the minimum cognitive skills required to work in the innovation sector, access to public capital, as well as shares of public expenditure on R&D support. Technical knowledge enters production in two distinct ways. First, new designs or blueprints enable the production of new intermediate inputs; second, the new designs contribute to the accumulation of total designs, thereby increasing the productivity and intensity of research and innovation in the future. In similar spirit to other production functions, various elasticity parameters are also introduced to better capture the non-linearity of these effects.

While the product of innovation is conveniently labeled as designs or blueprints on a nondifferentiated basis, one can easily interpret the innovation function in a more intuitive manner, i.e. production of knowledge. In such perspective, the innovation sector can then be viewed as a collection of various professionals, inclusive of firms in-house designers, research consortia, scientists, technopreneurs and those knowledge networks that are collectively known as knowledge brokers (OECD, 2010). Given that not all researches are entitled to be filed for patents and trademarks, the existence of knowledge brokers, such as international organizations, consultants, applied researchers, advisory firms, and science journalists, helps to package information and bridge the knowledge gaps between academicians and applied practitioners. Their roles in facilitating creation, transmission and accumulation of knowledge would help fostering greater innovation and by extension, growth.

Within the model context, their long term impacts to growth are implicitly captured by the innovation elasticity parameters, particularly the elasticity with respect to public-private capital and governments spending on innovations. While policy-targeting involving elasticity coefficients are hard due to the imprecise nature of parameters, the framework nonetheless introduces extra potential innovation strategies that could be applied, i.e. one that involves nurturing and cultivating the knowledge ecology of the economy. Hence, policies that stimulate collaboration and network initiatives, and facilitate greater rates of ideas sharing and communication would be viewed as favourable to growth within the framework of the innovation production function. The graphical interpretations of the knowledge generation process flows within the context of the innovation production function are illustrated in Figure 18, as follows:

Figure 18: Graphical depiction of the innovation sector of the MV20 model framework

3.5

Government as a facilitator in enabling innovation-led growth

The analytical framework assumes a simplified structure for the public sector, where the Government in the economy is assumed to maintain a balanced budget with no external borrowing, i.e. it finances its expenditure in any period using the taxes collected. Given the current federal budget deficit position, this feature assumed may be subjected to much debate. Nevertheless, this is highly consistent with the Strategic Reform Initiative 8 (SRI 8) outlined in the NEM, where the Government is to promote sustainability of growth through improved public financial management and fiscal discipline4. Given the long-term forward nature of the MV20 model, making an assumption of balanced budget in allocating future public expenditure will indeed be more appropriate compared to a budget deficit assumption.

See the New Economic Model for Malaysia, Part I, page 108.

The total government expenditure at any period is classified into four separate components, consisting of spending on public capital in infrastructure, education spending, spending to support innovation and R&D activities, as well as all other non-directly productive spending, such as subsidies and other wasteful public expenditure programmes. In line with other blocs of the economy explained earlier, efficiency parameters are attached to the three main components of public spending. While the expenditure shares are calibrated according to real fiscal data of Malaysia, the efficiency parameters assumed in benchmark calibration are consistent with other developing nations in similar stage of developments5. Serving as a facilitator in enabling innovation and sustainable growth in the economy, the Government can directly intervene in the economy through altering the composition of public expenditure permanently. More specifically, the Government may increase the shares of spending on infrastructure, education, or innovation activities, at the trade-off of other non-productive spending, to create an enabling environment for innovation and growth.

In addition to direct intervention through public expenditure programmes, the Government may also implement other indirect policy interventions to foster a conducive environment for innovation-led growth. For instance, improving the efficiency of infrastructure spending through fiscal reforms and more efficient procurement process would naturally be expected to have positive implication on long-term growth. Similarly, improving governance and measurement system, enhanced public sector research programme, as well as the adoption of international best practices are measures that would likely lead to a permanent increase in efficiency of public expenditure on education and innovation activities.

Other than capturing the aforementioned public policy interventions, the flexible analytical framework also allows for other possible policy tools, with selected innovation strategies examples explained in earlier sub-sections. Additionally, in order to create an enabling job market environment that would foster innovations, the Government is also afforded the luxury to directly intervene in the talent pool and broad labour market of the economy. More specifically, given the explicit modelling of the talent pool (by cognitive skills distribution) and labour market imperfection (by the relative cost mark-ups to labour market distortion across sectors), the Government may directly influence the labour market and demographic structure to create an enabling environment for innovation-led growth over time. The policy simulations of such interventions are explained further in the next Section.

See Agnor and Neanidis (2010)

4. 4.1

Strategy Simulations Background

This section demonstrates the effects of various policy options in stimulating innovation activities and by extension, sustainable long-run growth in Malaysia. More specifically, it explains the transmission channels involved and the resulting impacts to growth of selected policy options spanning over a period of 25 years, i.e. equivalent to five standard Malaysia Plan regimes. Given that any successful and sustainable innovation-led growth strategies would inevitably involve a certain degree of, or in some cases extensive, long-term structural transformation and addressing the bottlenecks of the economic system, the adoptions of such long-term timeframe in policy thinking and simulations are both necessary and well warranted. Again, the key word to be emphasized here is sustainable growth, consistent with the nations long-term goals outlined in the NEM.

It is of this rationale in the needs to address long-term macro issues that a dynamic OLG model is selected in anchoring the framework, where the model calibrated mirrors that of the current economic system of Malaysia. This is accomplished through the baseline calibration of the model, with relevant parameters selected based on official statistics of Malaysia. In the event where certain parameters are not available, they were selected based on countries in similar stages of development or empirical estimates from established literature. The benchmark calibration parameters and respective sources are presented in the Appendix.

To illustrate the effectiveness of various policy options, the two different states or environments of the Malaysian labour market, i.e. the low labour quality and talents misallocation environments, are accounted for in the simulation studies conducted. Despite the wide range of possible innovation strategies available within the model framework, this section nonetheless presents only those major policy simulations that would most prepare an enabling background and environment for innovation-led growth in Malaysia, and fittingly raise the curtain for specific micro-innovation strategies documented in subsequent Chapters.

4.2 4.2.1

Labour market and innovation Labour market reforms

Given the importance of the relative wages across sectors in serving as an incentive mechanism, as well as in determining the economy-wide labour supply allocations, the second broad policy simulation exercise involves that of broad labour market reforms. More specifically, it uses the MV20 model to simulate the impact of labour market reforms in terms of reducing labour market distortions in the innovation and final output production sector. The term labour market distortions may be broadly defined as including all forms of rigidity that impede the proper functioning of the market as an effective labour allocation mechanism, which encompasses that of rigid labour market regulations, hiring and firing costs, and non-wage related costs. However, within the analytical framework, these are collectively modelled as a proportional cost mark-ups with respect to labour market distortions imposed by both the final output and innovation sector producers. The overall cost distortion to the broad labour market is then measured as the relative cost mark-ups of the innovation sector over that of the final output producers, where the parameters are initially calibrated as 1.10 and 1.07 respectively, reflecting a relatively larger existing distortion to cost in the innovation sector.

From Figure 19, it is shown that the potential output growth effects are inversely related to changes in the cost of labour market distortions in the innovation sector. Simply put, wages in the innovation sector naturally increases with a reduction in the distortions of job market for the innovation and knowledge generating sector. This would then intuitively induce more qualified and skilled labour to work in the sector. However, such impact is only observed under the labour market environment of talents misallocation due to weak incentives in the innovation sector. Reallocation of skilled labour to engage in innovation activities is only possible under this labour market environment since the economy is inherently populated with capable talents for the innovation sector. Under the alternative labour market setting of low labour quality, this policy option is effectively useless since no amount of job market reforms will result in higher innovation and growth, given that there is innate low quality labour situation in the first place. Interested workers in other production sector who are willing to move to innovation sector will not be able to work and succeed in the innovation sector as they lack the necessary skills required.

Figure 19: Simulated growth impacts of a reduction in the cost of labour market distortions in the innovation sector

Baseline
financed by cut in other

The simulation results presented seem to suggest that the growth effects may depend on the relative wage distortions across sectors, instead of merely a function of the cost mark-ups in the innovation sector. Simulations are then conducted based on various combinations of labour market reform across both sectors first, a uniform reduction in the cost with respect to labour market distortions across sector; second, greater focus of labour market distortions in the innovation sector. The simulation results are presented in Figure 20 and 21. Figure 20: Uniform reduction in the cost of labour market distortions in both sectors

Figure 21: Reducing labour market distortions at higher rates in the innovation sector

From both sets of simulation results with respect to broad labour market reforms, it can be observed that a uniform reduction of labour market distortions proportionately in all sectors would have a slightly negative impact on growth. On the contrary, a greater focus in reducing labour market distortions at the innovation sector relative to the final output production sector would bring positive impact to growth over the long-run. These policy simulation results clearly outline the roadmaps for any potential economy-wide labour market reform and liberalization policies. In order to transform Malaysia into an innovation-led economy, the desirable labour market policies that would best foster knowledge and innovation activities would be policies that would shift the focus away from the traditional manufacturing sector towards the innovation and knowledge sector, particularly to those industries that suffered from serious distortion in wage incentives and in dire needs of reducing labour market distortions.

4.2.2

Achieving a critical mass by increasing the talent pool

Drawn to attention in the NEM and World Bank studies6, the traditional reliance of Malaysian firms on low skilled foreign labour and by extension, the lack of demand for highly skilled talents, have reduced the countrys ability in attracting talents required for the innovation and knowledge generating sector. This traditional business model has left the existing talent pool of skilled workers in Malaysia much to be desired. It is also reported that job vacancies arose because most workers did not have the required skills looked for by firms. These evidences highlighted the countrys growing concern of an increasingly depleted talent pool due to migration of skilled Malaysian Diaspora, as well as its inability to attract high skilled talents. In order to achieve the necessary critical mass from

6

See World Banks Doing Business Surveys.

a network of skilled researchers in preparing the country with the required capacity of a innovationled economic model, increasing the talent pool becomes an important policy agenda.

Besides, as observed from earlier policy simulations, a labour market characterized by insufficient labour quality is totally irresponsive to any form of reduction in labour market distortions, while showing lower positive growth effects towards any discretionary increase in public spending when compared to a labour market environment with talents misallocation. However, given some of the evidences cited earlier, there is a high possibility that some part of the countrys labour market, or job market in some industries, does experience issues with respect to low labour quality. In such instances, as Malaysia attempts to shift towards an innovation-led economic model, increasing the talent pool of the economy, in addition to educational reform, becomes the most effective policy tools in stimulating greater innovation and consequently, higher potential growth for the country.

The analytical framework attempts to explicitly model the talent pool distribution of the economy, despite the lack of measured statistics or official indicators. More precisely, to facilitate policy simulation experiments, the cognitive skills distribution of the graduates in the economy is modelled as a uniform distribution normalized to unity, and indexed within the range of zero to one. The minimum required cognitive skill level required for innovation workers is set arbitrarily at 0.6, therefore resulting in a baseline average cognitive skill level of 0.8 for the knowledge sectors labour pool.

Consider the policy simulation that capturing policies of a direct intervention into altering the distribution of the existing talent pool of the economy. In practical terms, such policy intervention may be broadly defined as policies that include importing highly technical-skilled foreign talents, attracting the Malaysian Diaspora in overseas, as well as reducing the reliance on low-skilled foreign labour. These are all measures that directly enlarge the distribution of the talent pool and therefore increase the average cognitive skills in the workforce, with the former two examples of raising the ceiling of the population cognitive skill distribution, while the latter being a classic example of addition by subtraction.

As expected, the simulation results show that there is a positive relationship between growth and the size of the Malaysias talent pool, assuming there are no corresponding changes in other policy variables. Consistent with other earlier simulation results, it is observed again that a labour market setting with talents misallocation will be more responsive, but only slightly, to such policy intervention when compared to one characterized by low labour quality. This is again due to the

additional labour reallocation effect of existing misallocated labour to the innovation sector, on top of the positive direct effect of a bigger talent pool available to the economy. Figure 22: Simulated growth impacts of a direct intervention in changing the talent pool
Baseline

From Figure 22, it is shown that increasing the current talent pool permanently by 10% for the next quarter of a century is expected to push the potential growth rates of the country up to 7.5% (in the case of talents misallocation) and 7.4% (in the case of low quality labour market) respectively, from the benchmark rate of 6.0%. In the same manner, for a bullish upside scenario, permanently increasing the current talent pool distribution by 30% would generate strong growth effects that may potentially deliver 10.2% and 10.0% respectively. Conversely, a continuously shrinking talent pool would naturally result in lower growth rates, especially so if the country had shifted to an innovation-led economic model.

Interestingly, besides its positive growth effects, policies to attract foreign talents and enlarge the existing talent pool also have positive consequences for the education and innovation-led sectors. Figure 23 shows that the completion rate for advanced education, in addition to the share of graduates in innovation sector, is expected to increase naturally as a result of a positive changes in the size of the talent pool, even in the absence of any extra educational policy intervention. Unlike in other policy simulations where such outcomes are observed only in the framework with labour market characterized by incentive-induced misallocation of talents, this actually true for both environments of the labour market. This observation, coupled with the non-significant difference of growth effects between both labour market settings, reaffirm the believes that directly altering the existing talent pool represents one of the most effective policy tools in tackling a low quality labour

market environment, in order to create the most enabling macro-environment for innovation-led growth. Figure 23: The completion rate of advanced education is endogenous to the overall talent pool
Baseline

4.3

Direct policy interventions through discretionary public expenditure programmes

The simulations on the growth effects of a potential change in the composition of discretionary government spending are also discussed. Discretionary public expenditure programmes, be it an increase in the share of expenditure on innovation supports, an increase in the share of education spending, or an increase in the share of core infrastructure spending, represent the most direct form of policy interventions in fostering innovation activities. Given the importance of all three forms of public expenditure programmes outlined, the policy simulations examined will involve budgetneutral reallocation of government expenditure, i.e. each simulated increase in the share of spending would be assumed to be financed by an equivalent-percentage cut in the other expenditure component of public spending.

4.3.1

Increased share of spending on innovation supports

The first policy simulations examined involves that of a budget-neutral increase in the share of government spending on innovation supports, i.e. the initial benchmark budget allocation of approximately 0.03 percentage points is revised upwards by 1% share to 0.04. Note that within the context of the model, this practically means the share of innovation spending is permanently increased for a sustainable period of 25 years, not merely a one-off revision in an annual budget. Consider first the environment where there is insufficient labour quality in the countrys labour

force, i.e. the economy is trapped with low labour quality and therefore inherently lack of resources in supporting innovation-led growth. In such instance, a permanent 1% share increase would lead to an increase of 0.4 percentage points compared to the current baseline potential growth rate of 6.0%. Thus, a direct increase in budget allocation of public expenditure to innovation supports while spending less on other non directly-growth promoting expenditure will pull the countrys potential growth rates up, despite an innate lack of labour quality. However, if the expenditure increase is financed by a cut in other productive components, such as public expenditure on core infrastructure and education, or at a trade-off of lowering the current efficiency level of innovation spending by 30% (from 0.60 to 0.42), the resulting long-term growth impacts will instead be negative, at lower potential growth rates of 5.6%, 4.7%, and 5.9% respectively. These simulation experiments highlight the importance of always maintaining, if not improving the efficiency and shares of spending on productive components, in the event discretionary reallocation of public expenditure programmes are undertaken.

Consider now the alternative scenario of the labour market environment, i.e. one that suffers from misallocation of talents and low incentives. In such instance, an equivalent one percentage point budget neutral increase in innovation spending would result in a larger increase of 0.9 percentage points in the countrys long-term potential growth rates, compared to the potential growth impact of 0.4 percentage point increase in growth rates under the earlier low labour quality labour market environment. Assuming all other policy variables remain constant, this larger growth outcome is well expected, given that the country is now stocked with talents with enough calibre to succeed in the innovation sector, only to be kept away due to low incentives. The simulated policy will now produce a labour reallocation effects and subsequently promotes greater human capital accumulation, in addition to the earlier direct growth channel identified, i.e. higher intensity in innovation activities. Given that higher spending on innovation sector will naturally lead to higher marginal products and greater job incentives (wages and non-wages) in the innovation sector, greater shares of the calibre talents will now opt to pursue an innovation career by engaging in research and development (R&D) and other knowledge generating activities. This then, indirectly, would also result in higher incentives for Malaysian to enroll for further advanced education, and by extent, eventually embark on a career in the innovation sector. These extra job incentives and labour reallocation effects therefore lead to relatively higher potential growth impacts.

Despite the higher potential upside to growth, one should nonetheless, exercise extra care in managing innovation-led growth policies under an environment of talents misallocation due to incentive issues. The situations are quite different when the expenditure increase is financed by a same percentage point cut in other productive components, such as public expenditure on core infrastructure and education, or at a trade-off of lowering the current efficiency level of innovation spending by half. This time, under the labour market environment with misallocated talents, the

impacts to growth are magnified too, but negatively. A spending increase in the share of innovation supports, at the trade-offs of the three simulated scenarios outlined above, would reduce the longterm potential growth rates of Malaysia dramatically to 5.1%, 2.3%, and 5.8% respectively. These reversed amplified effects are intuitively similar to the spending increase simulations, as higher calibre talents of the economy are now further driven away from the innovation sector, opting to stay on with the final by cut in productionut sector, which has relatively lower financed by cut in other value-adds and growth Baseline financed output financed by by ciut on financed c n i ther financed by cut in spending, but at cost of 30% inanced by cut in spending other other s that education spending impacts for a countrypendingstuck nanced by cut in other ininfrastructure income trap, such as in the case for Malaysia. of the middle reduction in efficiency
innovation spending anced by cut in other Baseline nced by cut in other spending, Figure 24: Simulated cgrowth impactsut ofother spending, financed by ut in spending by c in a one percentage point increase in share of government ced spending on innovationy supportsspending, ed b cut in other d by cut in other spending, by cut in other spending, but by cut in other spending, but y cut in other spending, but at cut in other spending, but at cut in other spending, but at ut in other spending, but at t in other spending, but at in other spending, but at cost in other spending, but at cost aseline n other spending, but at cost other spending, but at cost of seline other spending, but at cost of ther spending, but at cost of eline her spending, but at cost of er spending, but at cost of line r spending, but at cost of 30% spending, but at cost of 30% ine spending, but at cost of 30% pending, but at cost of 30% ne ending, but at cost of 30% nding, but at cost of 30% e ding, but at c education 4.3.2 Increased share of spending on advancedost of 30% ing, but at cost of 30% ng, but at cost of 30% Consider now a one percentagebut at cost of 30% point permanent increase in the share of advanced education g, spending (from the baseline value aofost of 30% reduction financed by a cut in the share of other non, but t c 0.05 to 0.06), b productive government spendingut at cost of 30% reduction next quarter of a century. Under both labour consistently for the but at cost of 30% reduction market environments, the generalat cost of 30% reduction in effects are quite powerful. In the innate low ut equilibrium growth t at c the potential growth rate of final output increases from 6.0% to labour quality market environment,ost of 30% reduction in at cost of 30% reduction in 7.7%, whereas potential growthat cost ois30% reduction in jump to 10.1% under the talents misallocation rate f expected to t ost o of the innovation environment. As people are at the cheartf 30% reduction in process7, spending more on advanced education cost of 30% reduction in promotes growth directly throughof greater advancement of average human capital of the labour cost 30% reduction in ost higher intensity force, as well as indirectly throughof 30% reduction in of innovation activities. Under the misallocation st of 30% reduction in of talents environment, the long-term growth impact is naturally stronger, given the positive t of 30% reduction in snowballing incentive and reallocation effects documented earlier, which result in greater stock of of 30% reduction in efficiency of 30% reduction in efficiency f 30% reduction in efficiency 7 See OECD (2010b), Chapter 3, page30% reduction in efficiency of 55. 30% reduction in efficiency of 0% reduction in efficiency of % reduction in efficiency of reduction in efficiency of reduction in efficiency of eduction in efficiency of duction in efficiency of

knowledge accumulated, larger population share with advanced education, and larger share of skilled labours participation in the innovation sector. Hence, to create, apply, and unleash knowledge and innovation, a sustained efficient public spending on core human capital advancement, assuming unchanged demographic factors, becomes a necessary policy tools in long-term innovation policies.

To examine the tradeoff of various policies, the same policy option of a one percentage share increase in advanced education spending is repeatedly simulated, this time at the cost of an equivalent percentage cut in the share of core infrastructure spending, share of spending on innovation supports, and a 30% drop-off in efficiency of advanced education spending (from 0.60 to 0.42). For the tradeoffs involving other components of productive spending, the growth impacts remain positive under both labour market environments, though at lower rates compared to the one financed by a cut in other non-productive components of government spending. For the policy tradeoff involving a reduction in spending efficiency, arbitrarily set at 30% reduction, the growth impacts actually become negative under both labour market settings. In this case, the simulated outcomes for long-term potential output growth are merely 4.7% and 2.4% for the low labour quality and misallocation of talents environment respectively. These simulation results deliver significant policy implications on the uses of direct discretionary public spending as policy tools, particularly with respect to public expenditure on advanced education. Simply pouring extra money into advanced education sector, without thorough planning and cost-benefit assessments that would other financed by cut in spending financed bby cut n y cut i financed by cut in financed by cut in spending ensure at least the same spendingfinanced y cut isn in efficiency, could potentially result in adverse growth effects.30% n spending, but a n spending inanced by cut it cost of o inanced b other spending infrastructure pending on innovation supports Figure 25:
nanced by cut in anced by cut in Baseline nced by cut in education Simulated growth impactsut in ea one percentage ced by c of ducation ed education spending on advanced by cut in education d by cut in education by cut in education by cut in education y cut in education cut in education cut in education ut in education t in education spending in education spending in education spending n education spending education spending education spending ducation spending ucation spending cation spending ation spending tion spending ion spending

point increase

reduction n e in spending nanced by icut fficiency of on education spending anced by cut in spending on nced by cut in spending on in sharein of government ced by cut spending on ed by cut in spending on d by cut in spending on by cut in spending on by cut in spending on y cut in spending on cut in spending on innovation cut in spending on innovation ut in spending on innovation t in spending on innovation in spending on innovation in spending on innovation n spending on innovation spending on innovation spending on innovation pending on innovation ending on innovation nding on innovation supports ding on innovation supports ing on innovation supports ng on innovation supports g on innovation supports on innovation supports on innovation supports

4.3.3

Increased share of spending on core infrastructure

For completion, consider now a one percentage point increase in the share of public spending on core infrastructure, from an initial value of 0.08 to 0.09. Public infrastructure, particularly modern telecommunication facilities and ICT infrastructure, influences the growth dynamics through a number of channels. First, it directly increases the public-private capital ratio, which in turns promotes final output, intermediate goods, human capital and innovation activities production. Second, the increase in the production of human capital indirectly helps to promote innovationrelated activities, while the creation and accumulation of knowledge exerts positive externality in the production of human capital. These effects operate under both labour market settings, hence directly contributing to a 0.7 percentage point increase in potential output growth for the economy with inherently low labour quality.

In addition, under the labour market setting with talents misallocation, the increase in access to infrastructure tends to also increase directly the productivity of labour, and therefore wages in both sector. However, the additional effect on wages in the innovation sector turns out to be larger, as the general expansion of the economy tends to increase also the demand and therefore profits of the intermediate goods sector, resulting in higher patent prices, and consequently further raise wages in the innovation sector. These leads to a net labour reallocation effect, where more skilled graduates will now seek employment in the innovation and knowledge generating sector. These then induced greater accumulation of both stocks of human capital and knowledge, and consequently higher intensity in the knowledge sector, and by extension, growth. Under this labour market setting, the simulation of a permanent 1% increase in the share of spending on public infrastructure over the next 25 years, ceteris paribus, would be expected to result in a higher potential growth rate of 7.6%.

The same policy tradeoffs examined earlier are also assessed in this simulation scenario, i.e. a one percentage share increase in public spending on infrastructure, financed by either an equivalent percentage cut in the share of advanced education spending, innovation-related spending, and at an opportunity cost of 30% drop-off in efficiency of public infrastructure expenditure, from initial value of 0.650 to 0.455). In these instances, the net effects of policy shift are mixed under both labour market settings. For the increased infrastructure spending financed by a cut in innovationrelated expenditure, the growth effects remain positive under both labour market settings, i.e. a 0.2% (low labour quality) and a 0.4% (misallocation of talents) increase in potential growth rates, compared to the baseline 6.0%. However, if the increase in infrastructure spending were to be financed by a cut in advanced education spending, or came with the opportunity cost of 30% reduction in efficiency, then adverse growth effects would be observed instead, under both labour market environments.

Figure 26: Simulated y cgrowth Baseline ofcut in one percentageut point change in by cut in other public impacts by a financed by c in spending financed share of financed b ut in financed spending, but at cost of 30% infrastructure spendingeducation spending on innovation supports other spending
Baseline
financed by cut in reduction in efficiency of infrastructure spending

aseline seline eline line

Overall, to create an enabling environment for sustainable innovation-led growth through a balanced ine budget increase in government expenditure, the non-productive operating expenditure components ne of the budget would need to be reallocated to either of the productive spending components of e advanced education, public infrastructure, and innovation supports. As illustrated in the simulation results above, these three public expenditure components are ranked exactly in the same order, in terms of their effectiveness in stimulating growth. The magnitudes and growth effects observed are stronger, in both positive and negative directions, under the labour market environment with weak innovation incentives compared to a labour market with low labour quality. From the perspectives of policy tradeoffs, cares must be exercised when any discretionary increase in public expenditure is implemented, in order to ensure that the sudden increase in discretionary spending is not met with the opportunity costs of severe reduction in spending efficiency. Perhaps, this concern highlights the needs for continuous public sector reform and services enhancement in order to improve and ensure the efficiency of any public expenditure allocation.

4.4

Advanced education policies

In addition to a direct increase in discretionary public spending on advanced education, education polices-related simulations within the context of the model include campaigns and scheme-driven changes in households budget allocation to advanced education, as well as tertiary educational curriculum reform-induced changes in time allocated for higher education.

4.4.1

Increased households budget allocation to pursue advanced education

An increase in household spending on higher education may be interpreted in two ways. First, it may be considered as a pure households decision. An increase in household spending on higher education means increased allocation in the cost incurred in acquiring the advanced degree such as tuition fees, academic books, etc. Second, it may be interpreted as special government programmes, such as mandatory EPF deduction or special incentive schemes for households to spend more on pursuing higher education. While the former is intuitive given that voluntary pursue of higher education by citizens would naturally lead to higher rates of human capital accumulation, it is nonetheless an outcome of households choice that bears little policy implication, compared to the latter.

For policy simulations, the proportion of household spending on higher education is assumed to be permanently revised upwards from the baseline 10% to 20% of total expenditure. Notes that any simulated shock introduced in the analytical framework represents that of a permanent shock for 25 years, this basically represents a cultural change in the Malaysian society to one that is more receptive towards pursue of advanced education. When the labour market setting is one of low labour quality, the potential growth rate of final output is expected to increase from 6.0% to 6.6%. On the other hand, if the labour market environment is one of incentive-induced misallocation of talents, the growth effects will be larger due to the extra reallocation effects, raising potential growth rates to 7.5%. Figure 27: Simulated growth impacts of changes in household spending share on higher education

Baseline Baseline

4.4.2

Curriculum reform-induced increase in time allocated for higher education

Next, the growth effects of a curriculum reform-induced increase in time allocated for changes in time allocated for advanced education are examined. Increasing the time allocated for higher education may be perceived as a consequence of efforts to strengthen the curriculum of higher learning institution. In a sense, graduates must now spend more time (either in advanced coursework or laboratory research) to acquire an advanced degree. For this particular simulation, given the complexity involved in simulating shock of time allocation in an overlapping generation context, the original direct linearity effect of time allocated for advanced education in the production of human capital is scaled down to the power of 0.2, in order not to overestimate the growth effects of a change in time allocated to studying.

More specifically, the particular simulation result examined involved increasing the time allocated to advanced education from the baseline 18% to 26%. Given the definition of time in the MV20 model, this is equivalent to 24 months of extra postgraduate coursework or research in the highest level. In the low labour quality labour market setting, the potential output is expected to increase from the current 6.0% to 6.7%. In contrast, in an environment where incentives to engage in knowledge and innovation are weak, the potential output growth rate is expected to jump from 6.0% to 7.6%. In this instance, the extra labour reallocation effect is expected to result in a natural increase in advanced educations completion rate. The reason why the growth effects of this policy simulation experiment can only be considered as moderate is that, when people spend more time to pursue advanced education, they necessarily spend less time in market work, hence constraining the equilibrium growth effects. Figure 28: Simulated growth impacts of changes in time allocated to pursue higher education
Baseline

References Agnor, Pierre-Richard, Fiscal Policy and Endogenous Growth with Public Infrastructure, Oxford Economic Papers, 60 (January 2008a), 57-88. , A Theory of Infrastructure-led Development, Journal of Economic Dynamics and Control, 34 (May 2010a), 932-50. , Schooling and Public Capital in a Model of Endogenous Growth. Forthcoming, Economica (September 2010b). Agnor, Pierre-Richard, and Kyriakos Neanidis, Innovation, Public Capital, and Growth, Working Paper No. 135, Centre for Growth and Business Cycle Research, University of Manchester (February 2010). Aghion, Philippe, and Peter Howitt, A Model of Growth through Creative Destruction, Econometrica, 60 (March 1992), 323-51. , The Economics of Growth, MIT Press (Cambridge, Mass.: 2009). Bassanini Andrea, Stefano Scarpetta, and Ignazio Visco, Knowledge, Technology and Economic Growth: Recent Evidence from OECD Countries, Working Paper No. 259, OECD Economics Department (October 2000). Blackburn, Keith, Victor T. Hung, and Alberto F. Pozzolo, Research, Development and Human Capital Accumulation, Journal of Macroeconomics, 22 (March 2000), 189-206. Choong, Christopher, Z. Mahyuddin, D. Ridzwan, Erhanfadli M.A., Labour Market and Innovation in Malaysia, KRIS Views, Khazanah Nasional Berhad (July 2010) Economic Planning Unit (EPU), Malaysia Plans, various years, at http://www.epu.gov.my EPU, Knowledge Content in Key Economic Sectors in Malaysia Phase, (August 2009). Grossmann, Volker, How to Promote R&D-based Growth? Public Education Expenditure on Scientists and Engineers versus R&D Subsidies, Journal of Macroeconomics, 29 (December 2007), 891-911. INSEAD, Global Innovation Index 2008-2009, (2009) Jones, Charles I., Growth and Ideas, in Handbook of Economic Growth, ed. by Philippe Aghion and Stephen N. Durlauf, Vol. 1B, Elsevier (Amsterdam: 2005). Khazanah Nasional Berhad, MV20 Model Technical Report, unpublished (June 2010). Lucas, Robert E.B., The Malaysian Diaspora, Boston University, (January 2008). Malaysia Communications and Multimedia Commission (MCMC), http://www.skmm.gov.my Ministry of Science, Technology http://www.mosti.gov.my and Innovation (MOSTI), 2007, Innovation Model,

Malaysia Science and Technology Information Centre (MASTIC), Ministry of Science, Technology and Innovation. Malaysian Science and Technology Indicators: 2004 Report (Malaysia: 2004). MOSTI, National Survey of Innovation, various years. MOSTI, National Survey of R&D, various years. MOSTI, Malaysian Science and Technology Indicators Report, various years. Nadaraja, Devendran, H. Tuah, and Z. Jaafar, Benchmarking Malaysias Innovation Capacity, unpublished paper presented at the 8th Globelics International Conference, Khazanah Nasional Berhad (August 2010). National Economic Action Council (NEAC), Impact of foreign workers on the Malaysian economy, NEAC (Malaysia: 2004) ,, The New Economic Model for Malaysia (NEM), NEAC (Malaysia: 2004) OECD, Innovation and Growth: Rationale for an Innovation Strategy, OECD (Paris: 2007). OECD, Measuring Innovation: A New Perspective, OECD (Paris: 2010a) OECD, The OECD Innovation Strategy: Getting a Head Start on Tomorrow, OECD (Paris: 2010b). OECD/IDRC, Innovation and the Development Agenda, ed. by Erika Kraemer-Mbula and Watu Wamae, OECD (Paris: 2010) Romer, Paul M., Endogenous Technological Change, Journal of Political Economy, 98 (October 1990), s71-s102. Shapira P., J. Youtie, K. Yogeesvaran, Z. Jaafar (2006), Knowledge Economy Measurement: Methods, Results and Insights from the Malaysian Knowledge Content Study, Research Policy. Tuah, Hamri, Devendran Nadaraja, and Maryam H.H. Wong, Tertiary Education and Innovation: An OLG Model Analysis for Malaysia, unpublished paper presented at the 8th Globelics International Conference, Khazanah Nasional Berhad (August 2010). United Nations, Malaysia: Public Administration Country Profile [Online], (2005) Available: http://unpan1.un.org/intradoc/groups/public/documents/UN/UNPAN023317.pdf [Accessed on June 2010]. United States Patent and Trademark Office (USPTO), http://www.uspto.gov World Bank, Doing Business Surveys (2008, 2009 & 2010) World Bank, World Development Indicators (2008)

National Innovation Strategy Chapter 1: Knowledge, Innovation and Growth

Dr. Albert G. Zeufack, Lim King Yoong and Devendran Nadaraja Khazanah Research and Investment Strategy Macro Modeling Project

Appendix 1

Executive Summary

In its sustained effort to achieve Vision 2020, Malaysia has embarked on a new economic model to transform Malaysia into a knowledge-based and innovation-rich nation8. While the definition of innovation varies from the implementation of new and significantly improved product and practices, to the incremental improvements of processes in terms of value creation, the key success factor of an enabling environment for innovation-driven growth ultimately lies in the accumulation and efficient allocation of both human and knowledge capital. Getting the broad macroeconomic settings right is therefore essential. This chapter conducted comprehensive analysis on Malaysias innovation landscape, by first reviewing and benchmarking the innovation capacity of the nation, and subsequently followed by robust macro-analysis and policy simulation on the nations long-term growth implications using an analytical framework conveniently named as the Malaysian Vision 2020 model (MV20 model). The MV20 model examines the key inter-linkages between human capital accumulation, knowledge creation and transmission, talent pool distribution, labour market allocation, and their resulting implications on the nations potential growth capacity. More importantly, it allows for the identification of key structural challenges to be faced and overcome by Malaysia in order to create a fostering environment for innovation-led growth over the next decade. From the studies, six (6) key messages and policy recommendations, broadly categorized into data analysis-relevant and policy-relevant recommendations, are identified and put forward. The former includes building and promoting new measurement agenda for innovation that is in line with international best practice, while the latter involves capacity-building policies that will create the best macroeconomic environment for innovation-led growth. First, the benchmarking exercises conducted highlighted the needs for Malaysia to invest in a high quality and comprehensive integrated innovation database. While it is acknowledged that there is existing data infrastructure on science and technology (S&T) maintained by the Malaysia Science and Technology Information Centre9 (MASTIC), this recommendation focuses on the adoption of a new measurement agenda for innovation, in line with those documented in the OECD Innovation Strategy10. This calls for the promotion of new statistical methods, the adoption of a wider and

PMs Interview to the Star, March 13th, 2010. For further references, please refer MASTIC official website, at www.mastic.gov.my 10 OECD (2010), Measuring Innovation: A New Perspective, OECD, Paris.
8 9

interdisciplinary approach in data collection, as well as the establishment and maintenance of a new integrated innovation database that is both timely and publicly available. As the success of any national policy and plan, inclusive of the NIP, needs to be measurable against well-designed Key Performance Indicators (KPIs), the adoption of international best practice in tracking and monitoring the nations performance in innovation-related indicators is therefore indispensible. Second, in terms of data analysis-relevant recommendation, it is also proposed that independent research institution, with possible tie-ups to domestic institutes of higher learning, be established to facilitate improved empirical studies and econometric analysis in broad areas that are highly relevant to the national innovation agenda. As evidenced in the development of the MV20 model framework, well-established innovation policy research literature is in severe lacking which forbids any serious analysis to be carried out to identify more prcised innovation drivers for Malaysia. Both policy recommendations outlined above share the same concern in terms of capacity inadequacies, and therefore lead to similar institutional implications. These will likely involve the establishment of a special unit within the Special Innovation Unit (UNIK) that will serve as the custodian and one-stop centre for innovation policy-relevant data analysis and research. It is envisioned that the unit would co-operate closely with various agencies, such as MASTIC, Department of Statistics (DOS), Ministry of Higher Education (MOHE), Ministry of Finance (MOF) and relevant agencies in the construction of the integrated innovation database, as well as leading policy research initiatives in innovation issues, form S&T, education, human capital, bibliometrics, firms-level innovation, to green technology. The other four recommendations would focus on intervention in key policy areas. For instance, the key findings in this chapter highlighted the need to recognise the different characteristics across various job markets in Malaysia. To promote greater incentives for both firms and employees to invest and engage in research and development (R&D) activities, it is necessary to recommend for a broad reduction in labour market rigidities with a greater emphasis on R&D and knowledgeintensive sector. More specifically, this will involve tackling existing labour market distortions in terms of firing cost. Empirical literature shows that Malaysia has a high level of firing regulation rigidities and redundancy cost, on average, above that of its peer economies in the East Asia Pacific and OECD region11. Given the higher labour cost confronted by firms, these are likely to create a detrimental impact on wages offered and therefore reduce the incentive in hiring highly-salaried knowledge and R&D workers. In such instance, a reduction in redundancy cost, particularly with greater emphasis on the R&D sector, will likely improve the wage incentive for knowledge workers. From this recommendation, it is also worth noting that a policy of minimum wages will not be helpful in this implication, since such policy will further equalize the wage differentials between high-skilled and low-skilled workers, leading to lower incentive to participate in R&D activities. In

11

World Banks Doing Business Survey, reviewed in Choong et all (July 2010).

terms of institutional implications, it is therefore proposed for UNIK to engage with Ministry of Human Resources in conducting comprehensive industry reviews on existing labour market regulations, as well as conducting comprehensive job market studies in terms of firing and hiring practices. The fourth recommendation focuses on tackling another main job market issues highlighted in this Chapter, i.e. industries that faced a severe skill shortage and depleting labour quality. The recommendation therefore focuses on targeting a broad enlargement in the talent pool of Malaysia. More specifically, on the demand side, it is proposed for UNIK to co-operate and work closer with the Talent Corporation in identifying, targeting and attracting specific overseas talents and diaspora needed for innovation and R&D activities. From the angle of the supply side, improvement in the talent pool over the long-term will necessary require UNIK to engage and work with the Ministry of Education, in terms of advising the adoption of best international practices in Science and Technology syllabus, as well as promoting curriculum reform that is more tailored for innovation. The fifth recommendation calls for the streamlining and sharpening of fiscal incentives in general for innovation and R&D activities. The analysis conducted in this chapter highlighted the importance of creating a flexible environment that provides the strongest incentive for fostering innovation, in order to position Malaysia in successfully transforming to an innovation-led economy. Given that the contribution of R&D workers are generally not-as-easily identifiable and measurable compared to direct revenue-generating workers in the absence of a perfect intellectual property and patent regime, this will require direct intervention in altering the overall incentive structure of the economy, in promoting greater appreciation for innovation. Broadly, this involves incentivising the knowledge and R&D workers through a series of tax savings incentives, both directly to the R&D workers, as well as to firms. In terms of institutional implications, this will require greater cooperations between UNIK and relevant agencies, such as Malaysia Investment and Development Authority (MIDA), MOF and the various agencies under its umbrella, to formulate specific tax incentives that are pro-R&D and S&T activities. One specific example may be to provide tax waiver and exemptions to reward firms that increase the hiring of research workers, which will significantly alter the current Malaysian business culture and landscape in terms of promoting the roles of research and innovation. Lastly, the final and sixth key messages will emphasize on the importance on promoting overall infrastructure and capacity for innovation, in addition to standard direct R&D supports in the form of research grants. As shown in the chapters simulation exercises, direct government expenditure to R&D supports is not as powerful as when comparing to spending the equal amount of money in building pro-R&D and S&T infrastructure. Hence, this final recommendation will focus on getting the big idea right, i.e. setting the environment right for innovation. These, broadly, will include promoting the continued emphasis on investment in soft infrastructure, such as state-of-art modern infrastructure in the form of telecommunication services and ICT equipments, which are

essential in fostering greater level of human capital and knowledge accumulation, as well as promoting greater research practices across firms and institutions, such as simulating crossinstitutional project collaboration, practice of information sharing and resource mobilisation, efficient knowledge management, and cross-research citations and alliances. In short, the six recommendations proposed emphasize on the needs to intervene in terms of improving resources allocation and fixing the misaligned incentives in innovation activities at the macro level. This involves long-term commitment in attempting to create and cultivate an eventually better national landscape and culture for research and innovation.

Matrix of Strategy Recommendations

Recommendations Rationale Institutional Implications Timeline

Data analysis-relevant 1 Invest in a high quality and

comprehensive integrated innovation database

The need to adopt a multidisciplinaryEstablishment of a special

approach in measuring innovation, in lineunit within UNIK to cooperate with MASTIC, with international best practice; Timely and transparent monitoring andDOSM, MOHE, MOF, etc. to serve as one-stop tracking mechanism for the NIP. centre for innovation database.

2 Establishment of
independent research institution specifically for innovation agenda

To facilitate improved empirical studies andEstablishment of a special

analysis in broad areas that are highlyunit within UNIK with tierelevant to the national innovation agenda; ups with local institute of To serve as leading example in facilitatinghigher learning. greater knowledge and research ecology for innovation.

Key policy intervention-relevant 3 Reduces existing labour Malaysia has a high level of firing regulationUNIK to engage with

market distortions, in terms rigidities and redundancy cost whenMinistry of Human of firing cost, with emphasis Resources in conducting compared to its regional peers; on R&D and knowledge This indirectly increases labour cost forcomprehensive industry intensive sector. reviews on existing labour firms, and therefore oppressing talent market regulations. mobility and wages in the R&D sector.

4 Broaden the talent pool

To tackle the severe skill shortages andUNIK to collaborate with through both the demand depleting labour quality problems faced byTalent Corporation in (attracting overseas talents) demand strategies; while many industries in Malaysia; and supply (S&T curriculum To create a domestic talent base that is well-assisting MOE in adopting reform) channels. equipped for S&T and R&T developmentsinternational best standards of S&T into in Malaysia. curriculum.
incentives for innovation and R&D activities the economy, and in promoting greaterprovide advisory studies to appreciation for research and innovation; MIDA and MOF with To incentive knowledge and R&D workers,respect to fiscal incentives for R&D and S&T as well as firms in conducting more R&D, through a series of tax savings incentives. workers.

5 Streamline and sharpen fiscal To improve overall incentive structure ofUNIK to co-operate and

6 To sustain commitment and To

to promote set the right environment forUNIK investments in improving the sustained high level of innovation; overall modern infrastructure To promote greater collaboration, researchinvestments of ICT and human capacity for green ideas, and information sharing practicesinfrastructure, innovation, in addition to technology, as well as between organisations standard direct R&D education & trainings, to supports in the form of both public and private research grants. investment institutions.