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How to Encourage Manufacturing Innovation
Howard Richman, 6/28/2011

On December 5, 1791, President Washington’s Treasury Secretary Alexander Hamilton presented a Report on Manufactures to Congress which established America's tariff-based industrial policy for the next 150 years. He began by noting the general recognition of the importance of manufacturing to an economy:

The expediency of encouraging manufacturing in the United States, which was not long since deemed very questionable, appears at this time to be pretty generally admitted. 

And later in the report he noted the general recognition that the American people have a special aptitude for innovation:

If there is any thing in a remark often to be met with, namely: that there is a genius of the people of this country, a peculiar aptitude for mechanic improvements, it would operate as a forcible reason for giving opportunities to the exercise of that species of talent, by the propagation of manufactures.

In June 2011, President Obama’s President’s Council of Advisors on Science and Technology (PCAST) put together a Report to the President on Ensuring American Leadership in Advanced Manufacturing with a similar emphasis upon the importance of manufacturing and manufacturing innovation.

PCAST is a prestigious group including top academic and business leaders, including Craig Mundie, Chief Research and Strategy Officer of Microsoft, and Eric Schmidt, Executive Chairman of Google. Their report was based upon a workshop in which they heard testimony from leading manufacturers and innovation experts. The resulting report shows some good understanding of the problems of the U.S. manufacturing sector. It shows some good understanding of what has worked to encourage innovation in the past. But when it comes to economics, its recommendations are inadequate.

The report points out that after manufacturing moves abroad, research and development follow, and soon, Americans have little chance to be innovative. It recommends that $500 million be spent to encourage innovation, modeled upon the SEMATECH consortium which saved the American integrated circuit industry. Here is a description from the report of what happened:

The Federal government has also used public-private partnerships as a vehicle to advance key tech­nologies. The SEMATECH consortium of the late 1980s and early 1990s, for example, was a partnership between DARPA [Defense Advanced Research Projects Agency] and 14 U.S.-based semiconductor manufacturers, in response to the fact that Japan had captured a large portion of the integrated circuit memory chip market, and was poised to capture the majority of that market. This was viewed as a risk to national competitiveness and national security. SEMATECH, which matched $500 million in Federal government spending with equivalent industry spending over 5 years, advanced precompetitive research on the technology needed for next-generation chips. It also funded a test integration facility for tool and equipment suppliers in the semiconductor industry, allowing for prototyping of innovations in chip technology through direct contact between suppliers and the major companies in the consortium.

In his June 25 radio and Internet address, President Obama ran with this idea. He recommended that money be spent to create infrastructure that would promote innovation in advanced manufacturing. He said:

(T)his week, we launched what we’re calling an Advanced Manufacturing Partnership. It’s a partnership that brings our federal government together with some of America’s most brilliant minds and some of America’s most innovative companies and manufacturers.

Their mission is to come up with a way to get ideas from the drawing board to the manufacturing floor to the marketplace as swiftly as possible, which will help create quality jobs, and make our businesses more competitive. But they also have a broader mission. It’s to renew the promise of American manufacturing. To help make sure America remains in this century what we were in the last – a country that makes things. A country that out-builds and out-innovates the rest of the world.

Obama was trying to strengthen his argument, in his negotiations with Congressional Republicans over the debt, that federal government spending should be maintained or even enhanced in order to achieve prosperity. Specifically, he argued:

(W)e can’t simply cut our way to prosperity. We need to do what’s necessary to grow our economy; create good, middle-class jobs; and make it possible for all Americans to pursue their dreams.

But the report didn’t recommend an increase in federal spending in order to fund the public-private partnerships. It recommends that the funding be found by cutting elsewhere. I recommend that we take the funding from the excessive $2.5 billion spent by the federal government in 2011 to sponsor research on climate change. Not only does climate change funding show little economic benefit, but it may even be corrupting the scientific community, forcing scientists to give lip service to the outmoded man-made climate change models in order to maintain their funding.

But the report didn't just deal with the scientific problem of how to encourage innovation, it also deals with the economic problem of how to insure that American manufacturing innovations would be produced in the United States and benefit the American economy. This is indeed a huge problem. In fact, the report notes that many of the innovations developed in the U.S. in the past are currently being produced abroad. This statement appears in Box 1 of the report:

Research and innovation are essential, but alone they do not ensure a successful manufacturing sector. This is a sample of technologies and products with both commercial and defense applications invented in the United States and now produced primarily abroad:

• Laptop computers,
• Solar cells
• Semiconductor memory devices
• Semiconductor production equipment such as steppers
• Flat panel displays
• Robotics
• Interactive electronic games
• Lithium-ion batteries.

The report notes that comparative advantages in manufacturing are obtained through learning by doing:

(T)he United States no longer has the knowledge, skilled people, and supplier infrastructure required to produce light-emitting diodes for energy-efficient illumination, components for consumer electronic products like the Kindle e-reader, or advanced displays for TVs, computers, and handheld devices such as mobile phones. (See Box 1.) With respect to batteries, the United States had also lost its lead in manufacturing. (The recent Recovery Act provided $2.4 billion for advanced battery and electric drive component manufacturing, demonstrations, and infrastructure development, which should allow advanced batteries and components for plug-in and hybrid vehicles to be manufactured in the U.S. rather than be imported). Companies in Asia now design nearly every U.S. brand of cell phone and laptop computer, except for Apple. This transfer of knowledge and manufacturing capacity may have national security implications as well, increasing the risk of counterfeit or malicious components in critical security systems. New U.S. companies continue to emerge in new technology sectors, but many keep costs down, access emerging markets and high-skilled workers, and satisfy their investors by locating their facilities abroad, usually in Asia—instead of creating jobs at home.

The report notes that the problem is compounded when R&D follows the factories abroad:

The Nation’s loss of manufacturing leadership is not limited to factory jobs; there are also concerns that we are losing leadership in R&D employment and investment related to manufacturing. R&D activity linked to manufacturing is moving offshore to access emerging global markets, and to respond to global competition for talent and the growing supply of scientists and engineers abroad. This is occurring as other countries are increasing their R&D intensities. Over the past several years, spending by U.S. firms on R&D outside the United States has grown at three times the rate of their domestic spending. In the most recent employment statistics from the National Science Foundation’s Division of Science Resources Statistics, three industries—all of them in the manufacturing sector—reported U.S. domestic R&D employment as a percentage of worldwide R&D employment as below 70%: communications equipment, semiconductor and other electronic components, and motor vehicles, trailers, and parts. In the last of these industries, domestic R&D employment was only 55% of the global total in 2008. At the same time, many of the nation’s approximately 280,000 small and mid-size firms do not have the option to offshore R&D, and struggle to compete with foreign firms.

In order to keep these innovations in the United States, the report recommends that the marginal rate of the U.S. corporate income tax be reduced and that an already-existing R&D tax credit be reworded so that it specifically applies to manufacturing R&D:

RECOMMENDATION 2: IMPROVE TAX POLICY

The Federal Government should:

• Reform corporate income taxes, to bring the marginal tax rate in line with other OECD countries, as advocated by President Obama in his 2011 State of the Union address. This will create stronger incentives to locate manufacturing plants in the U.S. and help eliminate the disincentive to repatriate profits, and instead, draw companies to use them to employ U.S. workers.
• Extend the R&D tax credit permanently and increase the rate to 17%, as advocated in the Presidents’ Strategy for American Innovation and FY2012 budget request. Knowing that the credit will persist will encourage firms to lengthen their time horizon for R&D investments. The rules governing the tax credit should also be examined to make clear that R&D on manufacturing processes qualifies for the credit.

The R&D tax credit sounds like a good idea. But why should the federal tax code be full of incentive-distorting tax credits? Lowering the income tax rate would create improved incentives without distortions. The American corporate income tax rate is much higher than the rate of just about every other country. When American businesses make investment decisions, they must subtract the future income tax payment from any calculation of the potential return of the investment. The higher the corporate income tax rate, the more it discourages investment.

Furthermore, American corporations can avoid paying the American corporate income tax by locating their factories abroad without bringing their profits back to the United States. Every two years, when they are running for reelection, Democrats propose taxing American corporations on profits earned abroad. If they ever carried out that foolish recommendation, corporations would move their headquarters abroad to avoid the American corporate income tax altogether. We would not only lose factories, but corporate headquarters as well.

The obvious solution is to lower the corporate income tax rate. The PCAST report recommends lowering it from the current 35% to about 25%, the level of most European countries and of Rep. Paul Ryan's House Budget Plan. But many countries have corporate income tax rates below that. For example, Ireland’s corporate income tax rate is just 12.5%. Former Minnesota Governor Tim Pawlenty has recommended that the U.S. Corporate Income Tax rate be reduced to 15%. He thinks that lowering the corporate income tax that far would jumpstart American economic growth.

During the 2008 presidential elections, former Arkansas Governor Mike Huckabee went even further. He recommended reducing the corporate income tax to zero by substituting the FairTax (a sales tax) for the payroll taxes as well as both the personal and corporate income taxes. The FairTax is border adjustable, which means that it is paid on imports but excluded from exports, so it doesn't prevent domestic investment decisions.

Another possibility would be to replace the corporate income tax with a value-added tax on goods (since goods are involved in international trade). Almost all of America’s trading partners already have a value-added tax of at least 15%. Like the FairTax, the value-added tax is border adjustable which means that it is paid on imports but excluded from exports and so doesn't prevent domestic investment.

But even these reductions in the corporate income tax rate to zero would be inadequate because they would not stop our trading partners from practicing mercantilism in order to steal our industries. The more that we would innovate, the more they would steal.

Currently, we practice free trade, while our trading partners practice mercantilism. Take Mexico for example. Despite NAFTA, Mexico, copying China, manipulates the dollar-peso exchange rate so that it runs trade surpluses with the United States, and we don’t object. Mexico even is using tariffs on American products to gain access to America’s internal trucking industry, and President Obama is capitulating to their demand.

Or take South Korea. South Korea uses non-tariff barriers to keep out American products. It is no accident that we import about 700,000 cars each year from South Korea, while they only import about 6,000 from us. We are in the midst of ratifying a so-called “free trade” agreement with them which lets them continue to manipulate non-tariff barriers and the dollar-won exchange rate in order to continue running trade surpluses with us. As a result, this "free trade" agreement will likely cost us jobs.

The worst case of all is China. UC-Irvine economist Peter Navarro, author of the new book Death by China, writes:

The most potent of China's "weapons of job destruction" are an elaborate web of export subsidies; the blatant piracy of America's technologies and trade secrets; the counterfeiting of valuable brand names like Nike and Chevy; a cleverly manipulated and grossly undervalued currency; and the forced transfer of the technology of any American company wishing to operate on Chinese soil or sell into the Chinese market.

Until the U.S. requires that trade be balanced, any innovations produced in the United States will soon be manufactured abroad. Then R&D will follow the factories abroad. As a result, PCAST's encouragement of innovation would only provide the United States with temporary benefits.

PCAST should hold a second workshop, this time with our country’s top trade economists. The report acknowledges that PCAST was in contact with Ralph Gomory, a top former-industrialist and innovator with IBM who is simultanously a top trade economist. But the report certainly did not include Gormory's recommedations on how to balance trade. The next workshop should also include top trade economists Peter Morici and Peter Navarro.

If we were invited, we would explain our WTO-legal scaled tariff whose duty rate would be regularly adjusted with each individual country so as to take in half of the U.S. trade deficit with that country, forcing our trading partners to take down their barriers to American products. And the scaled tariff would not be a budget buster, quite the contrary. It would generate about $250 billion as federal government revenue in the first year. The public-private partnerships proposed by PCAST could be funded and still leave 499/500th of the new revenue generated to help balance the federal budget.

For the 200 years after 1791, when Hamilton submitted his Report on Manufactures to Congress, America’s growing manufacturing base produced growing prosperity. Our manufacturing, even more than our armed forces, won both World War II and the Cold War.

PCAST has done our country a service by bringing attention to our declining manufacturing sector which is resulting in our declining capacity for innovation. Unfortunately, their solution for jump-starting innovation wouldn't help much unless the United States simultaneously required balanced trade.

Comment by vhhjbk jkih, 6/30/2011:

Free Trade is great for China!

Democracy is only Dellusion 

US is for the Rich and by the Rich

Response to this comment by Howard Richman, 6/30/2011:
Fortunately, the American people may be given a choice in the coming election. Potential candidate Governor Sarah Palin is calling for balanced trade.

Comment by Bruce Bishop, 6/30/2011:

There is a fly in the ointment:  Liberal/Progressives (socialists) hate manufacturing because it results in unequal distribution of wealth.  Liberal elites in the media and in academia are particularly galled because they see people who are less educated than themselves, earning millions, while they struggle to get by on salaries in the low six figures. 

Also, it was the growth of U.S. manufacturing and the middle-class that thwarted the leftist dreams of a socialist utopia with the liberal elites in charge.

Obama has no intention of reviving manufacturing, although he must pretend to be doing something about it.  He has a history of appointing advisory commissions and then ignoring their recommendations.  Should PCAST come up with anything promising, Obama will drag his feet and the mainstream media will cover his tracks until the folks forget about it.

I was delighted to learn of your recommendations for "balanced trade," and agree that your proposal (or Mr. Buffett's) is reasonable and doable.  Unfortunately, the Republicans in Congress are too weak to take up such a measure, and the liberal/progressive Democrats would never let it fly.

Also, as important as saving manufacturing is, the bigger issue is getting federal spending under control.  If we are to bring back manufacturing, we must first have a sound fiscal platform.  Whether we will accomplish that in time to save the country is unknown.

The primary goal of the Tea Party movement is to see to it that Republican candidates in 2012 are, as far as possible, fiscal conservatives.  As I see it, our only hope for survival as a great nation is to elect a majority of fiscal conservatives to Congress.  If we can accomplish that, then all things -- including the resurgence of manufacturing -- are possible.  If we fail to accomplish that, then we are headed into the abyss.

Response to this comment by Howard Richman, 6/30/2011:
Bruce, thank you for your thoughtful comments. I agree. But keep in mind that balanced trade and balanced budgets are best done simultaneously: (1) trade balancing scaled tariffs provide revenue that would help balance the budget, (2) balancing trade stimulates the economy while balancing budgets withdraws stimulation, and (3) balancing budgets lowers interest rates while balancing trade raises them. In combination, the two strategies restore both long-term and short-term economic growth.