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Primer: Innovation Policy in the United States

April 28, 2017
The advent of the Internet has led to the proliferation of technology startups in the United States, be it Uber, AirBnb or Snap. With buzzwords like “block chain”, “sharing economy”, “3D-printing”, “artificial intelligence”, “gene therapy” and more, it appears we live in an age of perpetual innovation and entrepreneurship. However, the pace of innovation in the United States, by some metrics, has stagnated over the last decade.

For example, startups as a share of all firms decreased from 11 percent in 2006 to only 8 percent in 2014, while the share of employment in firms younger than age 16 years in operation has declined from 31 percent in 2006 to 26 percent in 2014 [1]. This is particularly problematic given older firms are traditionally more risk-averse and less responsive to technological changes. Indeed, productivity and income growth have remained lackluster in the United States. Labor productivity averaged a mere 0.4 percent between 2011 and 2015 [2], total factor productivity growth has halved from 1.8 percent during 1996 to 2004 to about 0.9 percent during 2004 to 2015 [3], and real median household income remained stagnant at about $56,500 between 2006 and 2014 [4]. With fewer startups, older firms, slowing productivity growth, and stagnating incomes, some contend that the United States is facing a period of technological stagnation and that government intervention ought to play a more active role in reviving its engine of innovation and growth.

 Image: Share of Employment in Startups in the United States Source: United States Census Bureau, ...

Image: Share of Employment in Startups in the United States

Source: United States Census Bureau, Business Dynamics Statistics


Image: Share of Employment in Startups in the United States Source: United States Census Bureau, ...

Image: Share of Employment in Startups in the United States

Source: United States Census Bureau, Business Dynamics Statistics


Historically, market interventions to stimulate innovation have often been criticized for “picking winners” or “saving losers”, in that bureaucrats should not interfere with the invisible hand of the economy.  More recently, critics point to the loan guarantees offered to 33 clean-energy projects by the Department of Energy during the American Recovery and Reinvestment Act of 2009. They highlight case studies like Solyndra, a Fremont solar manufacturer that filed for bankruptcy in 2011 after receiving $535 million in taxpayer-funded loans [5], and Tesla, an electric car manufacturer in California that used its $465 million government loans to research and develop luxury cars [6], to highlight the risk of government failure and regulatory capture inherent in attempting to artificially stimulate innovation in the economy. While these are legitimate concerns, it is similarly important to appreciate the limitations of markets and the consequences of non-intervention.

Indeed, it is certainly too naïve to simply assume that all forms of government intervention to stimulate innovation are unwarranted. The neoliberal economics view that the “invisible hand” results in a perfect and stable equilibrium quantity of innovation in the economy is simply not borne out by the available evidence. Crucially, there are important externalities and inefficiencies in the market that policymakers are singly equipped to address in order to craft a more coherent innovation strategy for the American economy.

First, there are significant spillover benefits to the entire economy generated by research and development conducted by private firms. Patents only protect certain types of inventions; a vast majority of innovations, such as new business models, product research and development, and technology adoption, are left relatively unprotected and can contribute to industry wide or even economy wide benefits. Indeed, Nordhaus concluded that inventors do not fully appropriate the benefit generated from their ideas. In fact, they gain on average a mere 4 percent of the total social value produced by their invention, with the rest of the economic gain spilling over to other firms and society [7]. Consequently, the level of innovation produced by private firms is nowhere close to what is socially optimal and requires additional government support and help.

Second, short-termism in the financial system has led numerous firms to under-invest in long-term research and development. For example, the ratio of dividends to investments in capital equipment increased from 45 percent in the 1990s to more than 60 percent in the 2000s [8]. This coincided with significant reductions in taxes on corporate dividends by Congress in 2003 as well as the rise of the so-called “shareholder value movement”. In fact, one does not have to look further than the global financial crisis for examples of market exuberance and short-term pressures to generate profits, as seen in the irrational growth of collateralized debt obligations. The “efficient market hypothesis” is not supported by empirical evidence and as such, government intervention in financing research and development projects may be required in appropriate instances.

Third, there are countless of coordination challenges present in the innovation process which contribute to significant market failures. A perfectly competitive market assumes perfect information, which is scarcely present in the real world. The interaction among private firms, government research institutions, financial banks, customers, suppliers, venture capitalists, and academic universities is highly complex, with each stakeholder possessing only a small portion of the knowledge and influence required for innovation to occur. One example of coordination failures relates to clustering and economies of agglomeration. Whether it is information technology in Silicon Valley, car manufacturing in Detroit, entertainment in Los Angeles or boat building in Maine, clustering helps to nurture the growth of secondary industries, incentivizes public investments in industry-specific infrastructure, promotes joint partnerships between firms, and more. Apart from agglomeration effects, some industries also face a “chicken and egg” problem, in which no individual industry player can absorb the risk inherent in investing in an innovation without a prerequisite market development. These examples include investments in developing a mobile payments infrastructure, centralized healthcare database, and near field communications-enabled network. Therefore, there is significant scope for public policy to strategically direct resources in a way that minimizes these coordination failures and maximizes the positive externalities for society.

Finally, there are numerous industries with principal-agent problems and market fragmentation that are especially slow to adopt proven technologies. For instance, in industries like accounting, healthcare, and education, the principals of the business are also the agents, in that the workers are also managers of the firm. Thus, there is a strong incentive for these firms to resist the adoption of any technology that potentially threatens their jobs. Furthermore, in sectors like construction and legal services, the relatively high degree of customer turnover results in a lack of sophisticated buyers in the industry. As a result, there are poor price and quality signals in the market, allowing inefficient and unproductive firms to remain. In these instances, the government can play an important role in creating incentives for firms to utilize better technology.   

In response to these multiple sources of market failures, policymakers should adopt a more proactive approach to accelerating innovation in the economy. This is achieved through the use of innovation policy, which refers to “a coherent approach that seeks to coordinate disparate policies toward scientific research, technology commercialization, information technology investments, education and skills development, tax, trade, intellectual property, government procurement, and regulatory policies in an integrated fashion that drives economic growth by fostering innovation” [8]. To be clear, these policies are distinct from sectoral and industrial policies, in that they are neutral with regard to industry, unless there are clear positive externalities generated in that industry that warrant additional government investment. Existing policy tools include industry clustering, national research roadmaps, research and development tax credits, lower corporate income taxes, patent boxes, investments in public research, preferential government procurement towards innovative solutions, national coordination of industry standards, and much more. Innovation policy, therefore, includes the aforementioned loan guarantees offered by the Department of Energy. In fact, these loans are an exemplary example of innovation policy in that it not only serves to accelerate the technological advancement in clean energy sector, generating jobs and higher incomes in the process, but also simultaneously stimulating the economy during the recession, promoting America’s energy independence and security, and reducing carbon emissions and pollution. Balanced against the risks of regulatory capture and government failure, it is more likely than not that the benefits far outweigh the costs in this instance.

While the United States has implemented a slew of innovation policies, they remain vastly insufficient. For example, America ranks 32th out of 35 countries in implied tax subsidy rate on research and development expenditures in 2016, behind nations like China and Brazil [9]. Moreover, countless of nations are racing ahead in their embrace of innovation policies. Countries like Switzerland, Netherlands, and France have introduced “patent boxes”, implementing a reduced tax rate for corporate income from the sale of patented products. Other nations like the United Kingdom and Finland have adopted strategic public procurement policies that stimulate “intelligent demand”, in which innovation is included as a criterion for government procurement decisions. In both instances, the United States has fallen behind. Most importantly, unlike Denmark’s Danish Agency for Science, Technology, and Innovation, Japan’s New Energy and Industrial Technology Development Organization, or India’s National Innovation Foundation, the United States lacks a national innovation agency capable of coordinating innovation strategies in a whole-of-government approach. Consequently, unlike its counterparts, the United States does not intelligently channel resources to strategic industries, such as autonomous transportation (which simultaneously tackles congestion, vehicle deaths, and commuting times), synthetic foods (which also enhances food security, climate change, and nutrition), and online education (which reduces the cost of education and promotes life-long jobs training). Not only does this represent a wasted opportunity to foster innovation and productivity growth, it also fails to achieve other important public goals like food security and education in a more fundamental manner. Clearly, more can and should be done.

While ruggedly individualistic entrepreneurship is a hallmark of American culture, it is no longer sufficient to depend on the individual successes of industrial pioneers to retain US competitiveness; a comprehensive and coherent innovation strategy by the federal government is sorely needed if the United States seeks to remain at the forefront of technological progress and invention.


  [1] http://www.kauffman.org/~/media/kauffman_org/resources/2014/entrepreneurshippolicy digest/september2014/entrepreneurship_policy_digest_september2014.pdf

  [2] https://fred.stlouisfed.org/series/MPU4900062

  [3] https://fred.stlouisfed.org/series/RTFPNAUSA632NRUG

  [4] https://fred.stlouisfed.org/series/MEHOINUSA672N

  [5] http://www.nytimes.com/2011/09/01/business/energy-environment/solyndra-solar-firm-aided-by-federal-loans-shuts-doors.html

  [6] http://www.nytimes.com/2012/09/30/automobiles/autoreviews/one-big-step-for-tesla-one-giant-leap-for-e

  [7] http://economics.yale.edu/sites/default/files/files/Working-Papers/wp000/ddp0006.pdf

  [8] https://books.google.com/books?id=zw0U8sTuUgoC&source=gbs_navlinks_s

  [9] http://www.oecd.org/sti/rd-tax-incentive-indicators.htm

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