The Social Return of Research

The first problem with the American economy is that public and private investments in research are insufficient. This is not to say that American universities and companies invest too little relative to other countries (although this is sometimes true) but rather that they invest too little compared to what would be socially optimal. This is caused by a serious failure in the market for knowledge. As we saw in Chapter 4, the existence of significant knowledge spillovers means 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. 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.

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 creation of new commercial knowledge, as we have seen. This means that the potential economic value of new discoveries in basic science has also increased. 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. As we saw in the case of solar energy, federal and state governments generously support factories and production facilities with dubious potential but devote far fewer resources to foundational science.

 Knowledge spillovers do not flow only from academia to private companies. The most important kind flows between private companies. Innovative companies that invest in research appropriate just some of the benefits of their efforts. Take a firm that develops a new energy-efficient battery for electric cars. A patent will give this firm a claim to the profits from its new technology. But when the patent is filed, all other firms in the industry can see the breakthrough that led to this innovation, and this knowledge is likely to inspire new ideas for related technologies or products.

The development of any new product generates similar spillovers. 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, including Al Gore, at an invitation-only event in San Francisco in January 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 outsized 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 immediately started developing their own versions. Essentially, those competitors benefited from the information generated by Apple’s risk-taking.

 In practice, the magnitude of these sorts of knowledge spillovers is substantial. In one of the most rigorous studies to date, two economists—Nick Bloom of Stanford and John Van Reenen of the London School of Economics—followed thousands of firms between 1981 and 2001 and found that the spillovers were so large that R&D investment 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 UK 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. The problem is 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. The only way to correct for this market failure is for the government to step in and compensate those who invest in R&D for the external benefits that they generate. This is the main reason that the United States government, as well as governments in most industrialized countries, subsidize R&D through tax breaks. It is important to realize that this is not about fairness—it is purely about economic efficiency. The government does not subsidize innovators because it has a moral obligation to do so. It subsidizes innovators because it is in the interest of the American economy to do so.

 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 half of the socially optimal level. The lessons for economic policy are clear: the current U.S. tax credit for corporate spending on R&D is far smaller than it should be. We need to increase federal support for academic research in science and engineering and especially for private R&D. This is a solid investment that will ultimately pay for itself. Other levels of government should do their part too. Because the benefit of spillovers is in part local—helping some communities but not others—the efficient distribution of cost is one in which state and local governments also contribute to the subsidy.

Interestingly, not all innovators deserve the same level of subsidization. When Bloom and Van Reenen zoomed in on specific companies, they found that some generate more social returns than others. Computers and telecommunications companies generate larger social returns than the social returns for pharmaceutical companies. R&D in the pharmaceutical sector often replicates what other firms are already doing, and it is not uncommon for several companies to be racing to patent a drug to treat the same condition. In this competition, the winner reaps the benefits and all the others end up having wasted precious resources. This business-stealing effect tends to reduce the social value of pharmaceutical R&D and suggests that R&D tax credits should be smaller in this industry.

The second fundamental problem with the American economy is significantly more difficult to address. America does not create enough human capital. Over the past thirty years the United States has failed to raise its percentage of college-educated young adults substantially. Companies—especially those in innovative industries—are finding it increasingly hard to hire employees with the right skills. And workers are experiencing a steep increase in income inequality. Both problems reflect a serious imbalance in America between the demand for human capital and its supply.

We have heard a lot of talk recently about America’s education crisis. But the argument I am making here is not only a moral one, although I do believe that we should seek to give all our children access to a first-rate education. It’s a pragmatic one. It’s about whether we want the third America—the America of hollowed-out urban cores, high crime, low wages, and short life spans—to be the only America.