Global Investment Games
With election season upon us, politicians on both sides of the aisle are especially motivated to avoid the distraction of yet another budget debacle. Thus, in August 2019 a two-year budget deal was agreed to and signed. To ensure its passage, both political parties blatantly surrendered to any and all spending requests made on either side of the aisle in a spectacular abdication of fiscal responsibility. Unsurprisingly, the bill is illustrative of many themes discussed on this website. It raises concerns related to the long term viability of our budget deficits. It illustrates shortcomings in today’s taxation system. And it continues a pattern of reactive rather than proactive spending in areas such as healthcare and defense.
While the composition of the bill is in no doubt concerning, it is, at its core, emblematic of a far more fundamental and systemic issue. The act is a biproduct of a governing body that has increasingly failed to establish a long-term strategic vision for the future of American competitiveness.
While China invests in ports and trade routes through its brick road initiative, the United States funds border walls further aggravating its relationship with its closest trading partners. While Saudi Arabia continues to grow its renewable energy wealth fund — partially funded by the sale of a portion of the state’s oil assets — the United States slashes budgets related to green energy innovation and infrastructure. While India’s government invests in the e-hospitals of the future under its Digital India initiative, the United States continues to earn its title as the country with the most expensive and least productive healthcare spending in the world.
The bill is illustrative of the government’s denunciation of its role as a major force for innovation. Despite suspending the debt ceiling and authorizing spending that will increase the deficit by more than $320 billion, the bill slashed spending on research and development across nearly every major agency.
This is occurring in an environment where private sector investment and R&D spending are down while businesses continue to play to short term incentives.
To explore the consequences of recent budgetary decisions, what follows is a 3-part series evaluating the ramifications of the failure to both envision and invest in a coherent strategy for the future of US competitiveness. Over the course of this series, five topics will be discussed as followed:
- Research and Innovation
- Sustainable Infrastructure Investment
- Human Capital Development
- Debt Implications Across Different Forms of Spending
- Non-Discretionary Funding Innovation
The first article in this series will focus on the foundation for, and implications of, US investment in research and innovation.
RESEARCH AND INNOVATION
Innovation is a fundamental keystone of increased economic productivity, rising standard of living, national security, and global competitiveness.
During budget-related senate hearings deficit hawks frequently identify areas of comically wasteful spending. A favorite, often quoted, example includes the National Science Foundation’s $1.5 million dollar investment to improve the taste of tomatoes. While with all things, I am sure there is additional context to the efforts cited, it goes without saying that federal investment dollars are at times mismanaged. Inappropriately allocated federal funds are, at best, disbursed without much strategic vision and fail to return economic benefit. At worst, such funds are disbursed or withheld as the result of special interest lobbying efforts that do not have the greater good of the American economy in mind.
Where the comedy of delicious tomatoes ends, is when it leads voters to believe that the solution to budget neutrality is to slash government investment and R&D spending. To draw this conclusion is to forget three very important purposes of the federal government.
DEFINING A VISION — Government leaders throughout history have helped define strategic national imperatives. Their support emanates not only through federal investment dollars, but also through the communication of a vision for the future of national competitiveness. Demonstrating leadership, these individuals garner support across party lines, engage the private sector, and involve their constituents in the efforts required to realize a strategic vision.
In their article, Concrete Economics: The Hamilton Approach to Economic Growth and Policy, Hamilton project authors summed this concept up succinctly:
“In successful economies, economic policy has been pragmatic, not ideological. And so it has been in the United States. From its very beginning, the United States again and again enacted policies to shift its economy onto a new growth direction. … These redirections have been big. And they have been collective choices. … Government signaled the direction, cleared the way, set up the path, and, where needed, provided the means. And then the entrepreneurs rushed in, innovated, took risks, profited, and expanded that new direction in ways that had not and could not have been foreseen.”
MANAGING RISK AVERSION — In the United States, David and Goliath stories of entrepreneurship and radical innovation evoke a sense of national pride. Business schools and Hollywood alike, herald stories of startups founded in suburban basements that go on to disrupt industries and build empires. Innovation and entrepreneurship are bedrock components of the American dream. Heroes such as Thomas Edison, Ray Croc, Steve Jobs, and Elon Musk are looked up to for their willingness to take risks, their ability to persevere in the face of failure, and their capacity to envision something the rest of the world couldn’t see.
What is too frequently pushed aside are the public agencies and programs that fostered these innovators in their early years. For many entrepreneurs, federal support was critical to jump starting the revolutionary innovations they pioneered. Government funded research served as the origins for the internet, GPS, vaccinations, shale gas extraction, LED lighting, and much more. Beyond benefitting from publicly funded innovations, many truly revolutionary thinkers benefitted from public loan guarantees as they pursued breakthrough technologies.
CREATING AN ENVIRONMENT OF INNOVATION — In the story of American entrepreneurship, a second widely overlooked component of private sector success is the role of regulators and policy makers. These bodies play a fundamental role in shaping an environment where businesses are enabled to thrive.
The policies governments enact have a significant impact on the private sector’s incentive and ability to innovate. Policy makers and regulators have the ability to enact trade policies, define tax law, set business reporting requirements, and institute regulations that promote competition and protect private citizens.
Trade Policies — When enacting trade policy, politicians are often split between the imperative to promote their own country’s competitive advantage and the responsibility to protect constituents against the sometimes unfair trade policies enacted by foreign governments. These two objectives must be simultaneously balanced as they advocate for the efficiencies and standard of living improvements promised by global free trade. The ever more salient reality of trade policy is that these three objectives are often incongruitous. Furthermore, the increasingly interconnected nature of the global economy creates high levels of uncertainty for even the most well intended trade policy decisions.
Dani Rodrik categorizes trade policies into two categories: “beggar thyself” and “beggar thy neighbor.” In short, the economic costs of trade policies and related regulations are born first either at home or abroad. The line between these two categories is often unclear and may evolve under rapidly changing circumstances.
While beggar thyself policies may not make sense in the abstract, they are far more prolific than one might think. US corn subsidies are a perfect example of a beggar thyself policy. Every year billions of tax dollars are poured into corn production. The subsidies began in 1978 as the government’s attempt to support what it then thought to be the energy of the future and the answer to the 1970’s oil crisis.
To support the increased production, policy makers put in place laws requiring the biofuel be mixed into traditional fuel supplies. Even now, well after we have established that ethanol is not the future of energy, the subsidies and related regulations remain in place. In theory this subsidy was a way to promote American energy independence; in practice is raised taxes and lead to an excess of corn production that is still in effect today.
On the other side of the coin, beggar thy neighbor policies have recently been put in the limelight as the current administration has sought to punish external actors for, what it considers, unfair trade practices. The economic inefficiencies of beggar thy neighbor policies may in many cases be justifiable for economic or political reasons. Nevertheless, these types of actions run a high risk of becoming beggar thyself policies. Recent tariffs in the ongoing Chinese-American trade war are a prime example of this risk.
One of the major factors driving whether the consequences of trade policy are felt at home or abroad, has to do with the concept of elasticity. Elasticity as shown below is a function of whether market players have alternative buyers, suppliers, or substitutes. Elasticity is also a function of the price at which a consumer will find value in a given good or service. These variables can be very difficult to predict, and they are always subject to change.
This is still a relatively simplistic understanding of what drives price elasticity and the burden of tariffs. There are many additional factors at play such as currency valuation and supply chain mobility. Supply chains can also be configured in a number of different ways with different seller and consumer relationships. These nuances are discussed in much greater detail in an earlier three part series on trade here, here, and here.
Even strategies that begin as beggar thy neighbor policies have the potential to have incidental and long term consequences that are ultimately born at home. For example, the money businesses have spent moving supply chains to non-tariff countries takes away from capital and labor that could be better directed towards long term investments with future returns. It also puts smaller companies who lack the capital or market power to alter their supply chains at a disadvantage compared to their larger peers. In the long run this hurts competition and disincentivizes entrepreneurship. Inappropriately designed tariffs are also a form of regressive taxation that can further contribute to income inequality over the long term.
Beggar thy neighbor policies certainly have a place in trade policy, especially as they address unfair trade practices, protect intellectual property, and ensure national security. Anti-dumping measures enacted in response to the Japanese government’s efforts to sell steel below cost to capture market share is a perfect example where the US government needed to intervene. Trade restrictions have also played an important role in in protecting national security. While not a long term solution to addressing the corrupt practices of foreign governments, they can be impactful in the short run.
Tax Law — The tax code has long been an instrument to support innovation and small business growth. Incentives within the tax code aim to foster small and emerging businesses, increase investment in research and development, and encourage the adoption of new and emerging technologies.
Reflective of the American entrepreneurial spirit, small and emerging businesses receive a great deal of support from the US tax code. These entities benefit from lower effective tax rates, additional deductions, expedited write offs of specific expenditures, and fewer tax penalties for regulatory non-compliance.
Tax law also serves to incentive available capital on the securities and exchange market. Initial public offerings and stock issuances are critical sources of capital for businesses looking to expand their operations. Preferential tax treatment is given to financial gains precipitating through the purchase and sale of stock. Beyond encouraging initial investment, the tax code attempts to encourage the stability of such funds by promoting some degree of long-termism. Profits made on securities are only subject to lower tax rates if the purchaser maintained ownership of the investment for a full year before sale.
Historically, the tax code also served to incentivize private sector R&D spending through a provision granting companies the ability to write off R&D related expenditures in the year incurred. This particular provision, however, is one that captured headlines after the enactment of the Tax Cut and Jobs Act. The act rolled back provisions allowing companies to deduct R&D expenses in the year incurred, and instead instituted a 5-year amortization window over which companies would divide the expense. Understanding the time value of money, the requirement effectively, “…raises the cost of investment, discourages R&D, and reduces the level of economic output.”[i]
Reporting Requirements — Other governing bodies also play a major role in supporting businesses and encouraging long term-ism. The Securities and Exchange Commission (SEC) is a regulating body given the responsibility of acting as the watchdog for companies who may be “cheating” to gain competitive advantage.
One SEC regulation that has been highly contested in recent years is that of required quarterly earnings reports. Companies interested in playing to the long term have petitioned to reduce the number of times a year a company is expected to report its financials. Stock prices are highly reactive to earnings reports and companies are often motivated to ensure that financial targets are met prior to each filing date. This has frequently come at the sacrifice of long term strategic planning. By lengthening the reporting cycle businesses would have more time to pursue long term investment strategies that promise future returns.
Regulations — Policy makers have many tools in their arsenal to correct market failures while fostering competition and innovation. Standards around labor rights, emissions, and product safety protect consumers and help mitigate negative externalities that are not naturally corrected under a free market system. Policy dictating the information companies must disclose to buyers, helps address information asymmetry that might cause market distortions. The legal protection of intellectual property rights ensures that companies are able to benefit from innovations and are buffered from unfair business practices.
Just as regulations can serve to promote innovation and support entrepreneurship, poorly designed and lobbied for regulation can erect barriers to competition, discourage new market entrants, and disincentive long term thinking. Improperly designed policies can result from a lack of expertise, lobbyist influence, or an incentive structure in the political system that motivates politicians to play to election cycles rather than the long term.
Policies that impact corporate players or special interest groups inevitably attract fleets of lobbyists with strong opinions on what should be done. Lobbying organizations compete to be first to the negotiating table in order to help craft policy that works to their benefit. Those willing to be first at the table have historically benefitted in a number of important ways. As an example, the pharmaceutical industry has benefitted immensely from anti-competitive regulations including laws prohibiting the importation of prescription drugs from other countries. Regulators further shield free market participants from competitive forces as they fail to break up monopolies or regulate the anti-competitive actions of large corporations.
Even when properly designed policies are crafted and brought to the floor, the politics of policy making often serve as road blocks to enactment. Politicians are often handicapped by election cycles and the rigidity of the political process.
Few (sustainable) policies related to economic development elicit the desired behaviors and economic outcomes in the very short term. Change is uncomfortable, and change with highly uncertain outcomes is frightening. For most voters who are unable to keep abreast of the economic arguments made in favor of a policy, this fear can quickly derail support. It also leaves considerable room for lobbyist funded marketing campaigns to form opinion. For politicians seeking re-election, experimental and uncertain policy can be a difficult platform to run on. In this way, short term election anxieties and threats levied by lobbyist groups can stall good policy from ever being enacted.
Uncertain outcomes pose another significant hurdle for effective economic development policy. Given the ever more complex and global nature of the economic system, policy in some cases needs to be experimental. Unfortunately, once enacted, policies are generally extremely difficult to repeal. A quick look over the tax code will offer proof of this reality.
The stickiness of policy is largely political in nature. First, politicians are not overly keen on admitting failure. Second, they often fear being labeled as a “flip-flopper” when they reverse an opinion on a policy that did not produce the intended outcomes.
The stickiness of policy is especially difficult for bills enacting sweeping legislation. Trying to overhaul a major area of public policy with a host of reform measures can make it extremely difficult to identify what worked and what didn’t. Further, if only specific measures within a bill fail to attain their desired outcomes, it can be extremely difficult to repeal these measures without taking down the entire reform.
This was first article in a three part series that attempted to address the three primary responsibilities of government in spurring innovation and global competitiveness. The proceeding two articles will begin to dive deeper into the sources of innovation and growth spending that is critical to maintaining the United States’ competitive position in the global economy.
[i] https://taxfoundation.org/research-development-expensing-tcja/
