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To Combat “Growth Deficit,” Invest in R&D While Cutting Elsewhere

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This was a post on the Doing What Works project’s competitiveness blog.

Discussions of U.S. economic policy in recent weeks have focused on the need for more fiscal and monetary stimulus to boost the pace of recovery, and on the need for a credible multiyear plan to reduce the federal government deficit. Both the so-called QE2 “quantitative easing” policy of the Federal Reserve and the tentative agreement on taxes between the Congress and the Obama administration are designed to strengthen aggregate demand and to ease the current “jobs deficit.” Together these policies will have a significant beneficial effect on growth and job creation in 2011.

The budget plans proposed by the president’s National Commission on Fiscal Responsibility and Reform and by the Bipartisan Policy Council provide blueprints for addressing the nation’s second deficit—its long-term fiscal deficit. There are many important differences between these plans but they both recognize that the nation is on an unsustainable fiscal path, with the growth of the federal government’s debt outstripping the growth of gross domestic product. Both plans also acknowledge that cuts in spending, reductions in tax expenditures, and increases in revenues will all be necessary to meet the deficit challenge once the unemployment rate has fallen to more normal levels and the economy is operating closer to its capacity.

The country also faces a third deficit that threatens future prosperity and that is often overlooked in current policy discussions: a growth deficit. Growth has slowed sharply as a result of the recession and there are several reasons to be worried that the economy’s long-run or “secular” growth rate will be lower even after the economy has fully recovered. As a result of the recession, workers have lost skills and experience and the labor force participation rate has declined. Investments in research and development and physical capital that would have been made under buoyant market conditions have been foregone. Strong recoveries in the rest of the world have also encouraged many U.S. companies to increase their investments abroad relative to their investments at home. As a result of these trends, the growth in human capital, physical capital, and knowledge capital is likely to be slower for several years—and that means slower overall growth in the future.

Higher long-term interest rates in the absence of a credible plan to address the fiscal challenge will also constrain future investment and growth. Rates have already shot up as global investors worry about the long-run budget implications of the proposed tax agreement that is likely to add nearly $1 trillion to the government’s debt over the next two years. Higher interest rates will both offset some of the agreement’s stimulus effects on reducing the jobs deficit and will worsen the growth deficit. That’s why prompt passage of a long-term deficit reduction package must be a priority—not as an end in itself but as a means to a faster recovery over the next few years and to a higher growth rate in the future.

But deficit reduction must not come at the expense of federal government support for innovation. Well more than half of U.S. economic growth depends on productivity growth, and the major driver of productivity growth is innovation. Innovation depends on our ability to create and acquire knowledge, to apply that knowledge to new goods and services, and to introduce these goods and services into the marketplace. Good government policies can help to:

  • Fund research and development
  • Train scientists, engineers, and workers with the technical skills necessary for today’s technologies
  • Attract global talent through balanced immigration policies
  • Enhance intellectual property protection and foster competition
  • Ensure a modern infrastructure, including affordable broadband access
  • Create tax incentives for private-sector research and innovation

R&D spending was about 2.7 percent of GDP in the United States in 2007, and it has been relatively stable over the last 10 years. But the ratio in many other countries has been increasing, with significant gains in Japan, China, and South Korea, and by 2007, the United States ranked eighth on this indicator. Even more worrisome is the fact that federal funding for R&D as a fraction of GDP has declined by 60 percent during the last 40 years, and today it accounts for only about one-third of all R&D spending with industry accounting for most of the rest. Federal funding remains the primary source of support for basic research on fundamental scientific questions. And it has been critical to the development of many commercially successful technologies including new drugs, fiber optics, magnetic resonance imaging, computer-aided design and manufacturing technologies, data compression, and the Internet.

Forty years ago, the federal government was the major source of all funds for R&D but the federal share fell below the business share in the late 1970s, and industry’s share has been rising since that time. As a result, U.S. leadership in science and technology industries is now highly dependent on R&D investments by the private sector. Business R&D spending was about 1.96 percent of GDP in 2007, and it has been relatively stable over the last decade. But the ratio has been rising rapidly in many other countries, with the most dramatic gains in China, and by 2007 the United States ranked sixth on this indicator.

Federal support for R&D investment is a key driver of new knowledge creation and innovation, and such support should be increased even as many other areas of discretionary government spending are cut. The social returns from investments in both basic and applied research are large, usually considerably larger than the private returns earned by individual researchers or companies doing the research.

The existence of substantial social returns provides a powerful economic justification for generous government support of R&D both through direct funding, such as grants for basic research by universities, and through tax incentives for applied research by industry. In the absence of such support, private decision-makers will base their R&D investment on private returns, will overlook the potential social returns from such investment, and will therefore underinvest in R&D relative to the level that would be beneficial for society.

The United States was the first country in the world to introduce a tax credit to support industry R&D. Numerous studies have confirmed that the credit has been effective in the sense that each dollar of foregone tax revenue has caused industry to invest more than an additional dollar in R&D. And the credit would have been even more effective had it been a permanent provision of the corporate tax code rather than a temporary measure necessitating annual extensions. In recent years, as more countries have recognized the importance of R&D investment for innovation and growth, they have introduced their own more generous tax incentives. According to a recent study, the United States ranks 16th among OECD countries in terms of the size of its tax subsidy for industry R&D.

Five years ago in its influential “Gathering Storm” report, the National Academies warned that the U.S. competitive position in innovation was eroding and called for significant increases in government investments in research and development, education, and infrastructure to reverse this trend. In a sobering new report, the National Academies conclude that during the last five years most of its recommendations have not been fully implemented and the U.S. competitive position has continued to decline while many other nations have shown dramatic progress. The challenge is daunting and inescapable: A plan to reduce the long-run deficit must be crafted to address the growth deficit and to reverse the nation’s competitive decline at the same time. We must invest more on the foundations of innovation even as we spend less on most other government programs.

Laura D. Tyson is the SK and Angela Chan Professor of Global Management at the Haas School of Business, University of California, Berkeley, and former chairman of the Council of Economic Advisers and National Economic Council.

This was a post on the Doing What Works project’s competitiveness blog.

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