Here's One Tax Break All Americans Can Support

By Enrico Moretti

The future of the American worker depends on research and innovation.

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Reuters

Innovation is the engine that sustains the American economy and its workforce. Over the past three decades, traditional manufacturing employment has collapsed, while employment in innovative industries has skyrocketed. But the United States is not investing enough in research and innovation. As a consequence, our salaries and our jobs are not growing at the rate they should.

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At the heart of the problem, there is a serious failure in the market for knowledge. It stems from the fact that the creators of new ideas are not always fully compensated for their efforts, as some of the benefit of their research inevitably accrues to others in the same industry.

Consider, for example, the introduction of the iPad. Because the product was completely new, nobody really knew its market potential. Apple carried substantial risks, because it had invested significant resources in the iPad's development. Indeed, when Steve Jobs unveiled the device in front of a select group of journalists and opinion leaders in San Francisco in 2010, many industry analysts were skeptical, arguing that the iPad was just an expensive gadget and therefore destined to remain a niche product. Some ridiculed it as an out-sized iPhone without the phone, and predicted that it would generate little interest. After the launch, however, it became clear that the iPad was going to be an international sensation, and many competitors -- including Samsung -- immediately started developing their own versions. Essentially, those competitors benefited from the information generated by Apple's risk-taking.

This matters not just for Apple's profits, but for the future of the American economy. Although patents in theory protect intellectual property, in practice, innovative companies that invest in research appropriate just some of the benefits of their efforts. This is an unavoidable feature of the way innovation is created today and the speed at which new ideas and new knowledge spread in the tech industry.

The magnitude of these knowledge spillovers is substantial. In two of the most rigorous studies to date, economists Nick Bloom of Stanford and John Van Reenen of the London School of Economics followed thousands of firms and found that the spillovers were so large that R&D investments of one firm raised not only the stock price of that firm but also the stock price of other firms in the same industry.

Part of the spillover is global in scope. For example, an increase in R&D investment by U.S. firms in the 1990s translated into significant productivity increases for U.K. firms in similar industries, with the majority of the spillover accruing to firms with an American presence. But a significant part of the spillover is local, because it occurs between firms that are geographically close. So new knowledge generated by American companies benefits other American companies.

In essence, private investment in innovation has a private return for the firm that makes that investment, but it also supplies a social return that benefits other firms. This means that the market provides less investment in innovation than is socially desirable, because the return on such investments cannot be fully captured by those who pay for it. To correct for this market failure, and compensate those who invest in R&D for the external benefits that they generate, the United States government subsidizes R&D through tax breaks.

The problem is that the difference between private and social return on innovation is much larger than the current subsidies. Bloom and Van Reenen estimate that the social rate of return on R&D is about 38 percent, almost twice as large as the private return. The implication is jarring. The United States is not just underinvesting in R&D; our current level of R&D investment is barely a fraction of the socially optimal level. This is not just an American problem, but it is more salient for the United States than for other countries because of the role that innovation will play in our future growth.

Knowledge spillovers are even more pervasive in basic research. Academia has traditionally provided the basic science upon which the private sector builds new commercial applications. This is a big reason that the federal government subsidizes academic research through institutions like the National Science Foundation and the National Institutes of Health. The problem is that this funding has not kept up with the increased value of knowledge. Globalization and technological change have resulted in increased returns on the economic value of new discoveries in basic science. If the return on an investment increases, the rational reaction is to invest more. And yet the resources that the federal government devotes to supporting basic research have actually declined.

The lessons for Washington are clear: The tax credit for corporate spending on R&D should be increased as should federal support for academic research in science and engineering. We also need to make the R&D tax credit permanent, to give innovators more certainty about the future. These are solid investments that will ultimately pay for themselves.

It is important to realize that this is not about fairness -- it is purely about economic efficiency. The government should not subsidize innovators because it has a moral obligation to do so. It should subsidize innovators because it is in the interest of American workers to do so. It will create well-paying jobs in the short run, and even more in the long run. Irrespective of our political inclinations, this is a tax break we can all support.


This essay was adapted from The New Geography of Jobs (Houghton Mifflin Harcourt, 2012).

This article available online at:

http://www.theatlantic.com/business/archive/2012/09/heres-one-tax-break-all-americans-can-support/262943/