Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / How Government Grants Create Zombie Businesses
Transcript
- Lucas: So there's this paper from a couple of economists at the University of Toronto — they looked at a Canadian government grant program called IRAP, the Industrial Research Assistance Program. It's been running since the 1940s, hands out about 300 million Canadian dollars a year to small and medium tech firms. Luna: That's a classic 'help small innovators' program. Sounds good on paper. Lucas: Right. But here's what they found: about 40 percent of the firms that received IRAP grants would have gone out of business without them. And these aren't promising startups that just needed a bridge — these are firms that had been struggling for years, with declining revenues and no path to profitability. Luna: So the grant is keeping them alive, but not helping them grow. Lucas: Exactly. They become what economists call 'zombie firms' — businesses that survive solely because of government support, but that are actually less productive than their competitors. They drag down industry-wide productivity because they tie up capital and talent that could be used more efficiently elsewhere. Luna: And I imagine the grant program doesn't check for that. It's just 'here's money for R&D'. Lucas: That's part of the problem. IRAP grants are non-dilutive — the government doesn't take equity, doesn't ask for repayment. So the firm gets cash, but there's no accountability for outcomes. The researchers found that grant-receiving firms had no higher patenting rates, no higher sales growth, and no higher employment growth compared to similar firms that didn't get grants. The only difference was survival. Luna: So the program is essentially a life-support system for businesses that shouldn't exist. Lucas: That's the uncomfortable conclusion. And it's not just Canada. The European Union has poured hundreds of billions into structural funds and innovation grants. A 2023 study from the European Central Bank found that regions receiving the most EU grants actually had higher shares of zombie firms — firms that are over ten years old with low productivity and high debt. Luna: So the grants might be making the problem worse, not better. Lucas: Seems that way. The mechanism is pretty clear: when you give money to firms that can't compete on their own, you delay the natural process of creative destruction. The weak firms hang around, and that depresses prices and wages for everyone, making it harder for genuinely innovative firms to thrive. Luna: But surely some grants work. Isn't the US Small Business Innovation Research program considered a success? Lucas: SBIR is often held up as the gold standard. And it does have better outcomes — partly because it's more competitive and more focused on specific technology milestones. But even there, the evidence is mixed. A big study from the National Bureau of Economic Research found that SBIR grants increased employment and sales only for firms in the top quarter of the applicant pool. For everyone else, no effect. Luna: So the best firms would have succeeded anyway, and the others just get a lifeline. Lucas: Right. It's a selection problem. The grants are supposed to pick winners, but in practice they often just pick survivors. And once a firm gets a grant, there's a strong incentive for politicians and program administrators to keep the money flowing — cutting off a grant means admitting the firm is a failure, which is politically awkward. Luna: So you get a self-perpetuating cycle. Lucas: Exactly. The OECD has been warning about this for years. In a 2022 report, they noted that zombie firms now account for about 14 percent of all firms in advanced economies, up from 8 percent in the early 2000s. And they argue that government subsidies are a major contributor — along with low interest rates, which is a whole other conversation. Luna: But if you're a policymaker, what do you do? You can't just stop helping small businesses. There's a political cost. Lucas: There are better designs. One idea is to make grants time-limited — say, two years, with a clear exit clause. If the firm isn't profitable or doesn't meet milestones by then, no more money. Another is to shift from grants to equity — so the government shares in the upside if the firm succeeds, and has a stronger incentive to monitor performance. Luna: That's how venture capital works. It's aligned with outcomes. Lucas: Exactly. Some countries are experimenting with this. Finland's VTT, a technical research center, takes equity stakes in spin-off companies. And the UK's Innovate UK has moved toward a mix of grants and convertible loans. The early data suggests better survival and growth rates. Luna: But that requires a different skill set in government — people who can evaluate business models, not just approve applications. Lucas: That's the real bottleneck. Most grant programs are run by career civil servants who are good at following rules but not necessarily at assessing commercial viability. You'd need to bring in people with private-sector experience, and that's hard when government salaries are capped much lower than market rates. Luna: So the problem isn't just the grants — it's the institutional capacity to manage them well. Lucas: Right. And that's a much harder problem to fix. But there's a simpler first step: transparency. Most grant programs don't track long-term outcomes. They report how much money they gave out, not what happened to the firms. If you started publishing five-year survival rates, revenue growth, and patent counts for every grantee, you'd create accountability. Luna: And you'd probably find a lot more zombies. Lucas: Which is why it's not done. But if we're serious about getting value from taxpayer money, we need to confront the possibility that many programs are doing more harm than good. The goal of industrial policy should be to create a dynamic, innovative economy — not to keep every business alive forever. Luna: Speaking of keeping things alive... we should mention how this show stays alive. Lucas: Yeah, that's fair. We do this without ads — no sponsors, no corporate backing. It's just listener supported. A small group of people chip in monthly at buy me a coffee dot com slash fexingo, and that's enough to keep us going. Luna: And it means we don't have to pull punches on topics like this. If we were funded by a grant-making agency, you can bet we'd be more careful about criticizing grant programs. Lucas: So if you get value from these deep dives, consider joining that group. No pressure — just know that it's what makes this possible. Now, back to the zombies: there's one more piece I want to bring in. Luna: Go ahead. Lucas: There's a study from the Bank for International Settlements that looked at zombie firms across 14 advanced economies. They found that industries with more zombie firms had lower investment, lower productivity growth, and higher markups — because the zombies can't compete effectively but they also don't exit. Luna: So they create a kind of dead zone in the market. Lucas: Exactly. And the study estimated that if you could reduce the share of zombie firms by just 2 percentage points, you'd see a 0.5 percent increase in aggregate productivity growth per year. That's not trivial. Luna: So fixing grant programs isn't just about saving money — it's about unlocking growth. Lucas: Exactly. And to be clear, I'm not saying all grants are bad. The issue is that we've built a system that's very good at handing out money and very bad at evaluating whether it works. If we can fix that, we might actually get the innovation we're paying for. Luna: That's a high bar. But worth aiming for. Lucas: Absolutely. And it starts with being honest about the zombies in the room.