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What Should We Do When The Government Makes And Industry Takes?

2015 November 8
by Greg Satell

Apple recently announced its 4th quarter earnings and they are breathtaking. The company, already by far the most valuable in the world, grew revenues 22% to $51 billion. Profits grew a whopping 30% to $11.1 billion. What’s more, even after massive stock buybacks, the firm still holds more than $200 billion in cash.

Yet as Rana Foroohar points out in her review of the new US edition of The Entrepreneurial State, economist Mariana Mazzucato argues that much of Apple’s technology was actually funded by taxpayers. So, Mazzucato argues, it is only sensible and right that some of the profits should be returned to the government.

It’s an interesting idea. She is certainly right that most of the innovative technology we enjoy today has its roots in the public sector. And clearly, those who call for government to “just get out of the way” are seriously confused about how the modern economy functions. Still, the idea that government is due some massive windfall gets the real story of innovation wrong.

Apple’s Debt To The US Government

To understand Mazzucato’s argument, let’s look at the iPhone, which according to the current financial report makes up 63% of Apple’s earnings. The iPhone is, without a doubt, an icon of innovation, fusing impressive technology with beautiful design and an intuitive interface.

Yet look a little deeper and it becomes clear that the technology that drives the iPhone was developed not by Apple, but through public sector investment. Certainly the Internet, the Web and GPS all came from government programs. So did the basic architecture of every computer.  Even Siri, Apple’s voice interface, was initially funded by the government.

So it’s easy to see Mazzucato’s point. If public funding contributed to Apple’s success, why should the company reap all the rewards?  Don’t we deserve something?  And why stop at Apple?  What about all the companies getting rich off of lithium-ion batteries, or blockbuster drugs or barcode scanners, all of which began with government funded research?

The problem with Mazzucato’s argument is that if it was valid we would expect to see a strong correlation between government funding and innovation across the world. That’s clearly not true. In fact, it’s not even close. The US dominates in just about every advanced industry you can think of. There’s something special about innovation in America and what she describes is not a bug, but a feature of the system.

A Feature, Not A Bug

To understand America’s current technological dominance, you have to go back to World War II.  In 1941, as tensions began mounting, Vannevar Bush persuaded President Roosevelt to set up the Office of Scientific Research and Development (OSRD) to focus the country’s scientific talent on the war effort.

The program, which led to the development of radar, atomic energy, battlefield medicine and countless other innovations, was an enormous success.  So much so that as the war was ending, Roosevelt asked Bush to make recommendations for how the United States could best build on its wartime scientific efforts during peacetime.

Bush’s report, titled Science, The Endless Frontier, was delivered to President Truman in 1945 and laid out the basic architecture of American scientific investment in the post-war world. Bush explained the reasoning behind government funding of basic research in very clear terms:

 

Basic research leads to new knowledge. It provides scientific capital. It creates the fund from which the practical applications of knowledge must be drawn. New products and new processes do not appear full-grown. They are founded on new principles and new conceptions, which in turn are painstakingly developed by research in the purest realms of science.

 

He also argued that “there must be a stream of new scientific knowledge to turn the wheels of private and public enterprise.” So he was very explicit that he expected private companies to benefit from government funded research and this aspect was much discussed in the congressional deliberations that followed Bush’s report.

Since Bush’s time, the government has added a number of programs that drive innovation and benefit private corporations which aren’t dedicated exclusively to basic research. DARPA, for example, invests in defense applications—like the Internet and GPS—that often have private benefits. SBIR and In-Q-Tel provide financing for young and innovative firms.

A Red Herring

We should not be at all surprised that companies like Apple benefit from government funding. That is a facet of their design. What’s truly surprising is how incredibly successful the architecture that Bush created has been. It is the envy of the world and we should understand why.

Mazzucato argues that a number of countries take equity stakes in innovative companies and points to Finland’s SITRA, which profited handsomely from its investment in Nokia. She says that allows it to put more money toward funding “other Nokias.” Fair enough. But where are the other Nokias? And why did a US company buy Nokia and not the other way around?

The truth is that the American system works because each program is designed for a specific purpose. Agencies like the NSF and NIH fund basic research that is published openly. Programs like SBIR fund small grants so that innovative new companies can attract larger investments from the private sector. They perform these functions extremely well.

Yet if every time someone read a research paper they would have to worry about a lawsuit somewhere down the line, then the purpose of the NSF and NIH would be undermined. In much the same way, if every SBIR company had to give the US government an equity stake, they would be less attractive for investors looking to take it beyond the seed stage.

But perhaps the most damning indictment of Mazzucato’s argument is that the US government does, in some cases, take equity stakes (e.g. In-Q-Tel) and often charges licensing fees through various technology transfer programs, but these have produced nothing like the windfall that she describes. That’s because government investment is most impactful in areas where there is not yet clear market potential.

Government Funded Science Is The Engine Of Innovation And Prosperity

I think it’s fair to say that Mazzucato’s proposal for transforming science programs into cash cows is a red herring.  Beyond the risk of corrupting the purpose of these programs, there are also practical problems, because the discoveries they produce are often in the realm of basic science with no clear application.

Still, that should not take away from her larger point.  It is the US government, not any private company, that is the true engine of innovation and prosperity.  Moreover, it has been our openness—to both new people and new ideas— that has made us the exceptional nation and it is something that we should be enormously proud of.

That’s why it is curious, to say the least, that many politicians seem hell bent on waging a war against science, questioning the validity of scientific discoveries, cutting funding for scientific programs and, in the case of the House science committee, engaging in McCarthyite tactics to intimidate scientists when their findings don’t sit well with political beliefs.

Public R&D programs are not especially costly. The President’s most recent proposal was just $134 billion—half of which was for Defense research—or less than 4% of the federal budget to fund virtually every technological wonder and miracle cure that we enjoy today.  So the real question isn’t whether companies like Apple should pay us a dividend, but why we aren’t investing more to create companies like Apple?

– Greg

12 Responses
  1. Carsten Rose permalink
    November 8, 2015

    To address this upshot:
    “So the real question isn’t whether companies like Apple should pay us a dividend, but why we aren’t investing more to create companies like Apple?”,
    I’d suggest the folowing shortcut:
    We just simply have to introduce and enforce proper taxation (and by the way treat tax avoidance as what it is – a crime) and we’ll be able to invest more in creating those companies.
    Just my two cents.

    Greg Reply:

    Thanks for sharing Carsten.

    Barry Rabkin Reply:

    Personally, I want every company to pay the taxes it owes but not one penny more. Governments establish a taxation set of rules; companies have to follow those taxation rules. If a company can find a way to follow the taxation rules in such a way that they pay less taxes, that is fine with me.

    Companies are not “communities” – they have no ethical or morale responsibility to pay one cent more than the rules state they should pay.

    Greg Reply:

    I would agree Barry. Also, as I pointed out in the article, Mazzucato’s proposal doesn’t make a whole lot of sense. Firstly, because applying them in the context she is suggesting would subvert and undermine some very successful programs and second, because the US government does have programs like the ones she describes and they don’t create anything like the windfall she expects.

    However, that shouldn’t take away from her larger point about the role the public sector plays in private innovation. When you see the amazing work that companies like Google and Tesla do, they are largely building off of work that is publicly funded. In effect, firms that invest in highly innovative products are taking a financial risk (i.e. they don’t know if it will be profitable, but not so much of a technological risk (i.e. they’re pretty sure it’ll work).

    That’s a real problem because in recent years funds for government research have been drastically cut and many politicians are calling for more. The Department of Energy—which runs some of the world’s most advanced labs—has been a prime target. This is most probably because many politicians, like Sarah Palin, think that it has something to do with oil leases (it does not, that’s the Bureau of Land Management, which is in the Department of the Interior).

    Ironically, this is, in fact, the complete opposite problem that many people have been complaining about, namely that the private sector is engaging in “quarterly capitalism” and isn’t investing for the long term. The reality is that business investment in both capital and innovation is at historically high levels. (Although, because much of the analysis focuses on “private investment” which includes residential investment, that isn’t always obvious). The truth is that it is public sector investment that is falling behind in both infrastructure and research.

    So while I agree with you that Mazzucato misses the mark, the issues she raises are more complex—and more important—than they would first seem.

    – Greg

    Barry Rabkin Reply:

    I agree with you that the situation is complex. However government – whether local or federal – provides the same “infrastructure” for everyone. It is, as one point you make, up to people to decide to take a risk to create new products and services. If the risk succeeds they, and their companies, become quite wealthy (which is more than fine with me). I don’t think they should be expected to pay any more in taxes (or fees) than required by the taxation rules because their risk turned into a commercial success.

    Greg Reply:

    I see your point, but that isn’t exactly true in this case. These programs aren’t like roads and bridges. In some cases, (like SBIR) funds go directly to private companies to develop technology. In other cases (like NIH and NSF) the funding goes to private institutions (usually universities) that perform research. The fruits of this research is often then licensed somewhere down the line. Eventually, somebody makes money off of it.

    Nevertheless, these programs are designed to benefit the private sector. So you’re right that we can’t say, “Hey, it worked. Now you owe us money!” At the same time, when the US government does take equity positions (e.g. In-Q-Tel) and licenses technology, it doesn’t generate near the kind of money that Mazzucato seems to think they will.

    The basic problem is something economists call “the appropriability principle.” The broader the research, the harder it is for someone to appropriate the benefits from it, which is why government is best positioned to invest in basic research. Investment in more narrow, applied areas is more likely to produce a return that can be appropriated, but the overall returns aren’t nearly as big.

    Another point to consider is that when private corporations invest in basic research (e.g. IBM and Microsoft), they, like the government, often publish openly and don’t expect a return. So the distinction between open inquiry and proprietary applied research does not only apply to the public sector.

    – Greg

  2. November 8, 2015

    Very interesting, informative and brief article.

    “Yet if every time someone read a research paper they would have to worry about a lawsuit somewhere down the line, then the purpose of the NSF and NIH would be undermined. ” I guess that says it all.

    It does seem insane that our politicians so openly demonize the genii of science. They would kill the Golden Goose given a chance.

    My primary thought on this though is WHY can’t Apple and the rest just pay their darn taxes!!! Taxes are the price of Civilization and in their case, it was taxes that paid for the development of the technology that made it possible for those companies to get rich on the product they sell.

    Greg Reply:

    Apple actually does pay its taxes. The one thing that it’s been chastised for is keeping foreign profits offshore. Seeing how the US is the only country that taxes worldwide income no matter where it is earned, that’s a pretty small infraction.

    The much bigger problem is what’s going on in congress to defund science, especially in the House science committee, which routinely subpoena’s scientists whose work ends up with results not to their liking.

    – Greg

  3. November 8, 2015

    Thanks for providing one of the most unpleasant ideas I’ve ever read. Obviously there are far too many people who continue to want to find ways to debilitate or otherwise seriously harm US innovation.

    Greg Reply:

    Your welcome (I think).

    – Greg

  4. Duane E Sharrock permalink
    November 9, 2015

    Excellent article. It could help fuel an interesting debate in high school classrooms across the country (USA). Students in US History courses as well as Civics or even government related courses might explore these ideas.

    Greg Reply:

    Thanks Duane. I appreciate the sentiment.

    – Greg

Comments are closed.