High-Tech Freeze-Out
An R&D specialist tells how government policies make life tough for the independent innovator
"The inventor" is firmly entrenched in American folklore. From Eli Whitney to Thomas Edison to Bill Lear, the history of technology is peppered with colorful cases of individuals who tinkered and toiled to bring to fruition their ideas for new or better products and ways of doing things.
Yet many Americans remain unaware of just how important such inventive entrepreneurs are in our high-technology era. Yesterday we had Alexander Graham Bell and today we have Bell Labs; with increasing technological complexity, it is perhaps natural to conclude that the corporate giants, with funds and personnel at their disposal, must be responsible for major innovations. The fact is, though, that small businesses can claim a disproportionate share of technological breakthroughs. Unfortunately, it is also a fact that, in spite of much ado about regaining America's competitive edge in the world of high technology, federal policies serve to discourage rather than encourage inventor-entrepreneurs' striking out on their own.
The Reagan administration has effected a host of measures aimed at stimulating business investment and revitalizing the economy. It has reduced the tax rate on interest and investment income, from 70 to 50 percent over a three-year period, to make private capital increasingly available for productivity improvements and for developing new products. It has pushed for a more predictable money supply to encourage long-range capital investments. It has moved toward an economy uncluttered by nonproductive, senseless regulations. But are these reforms enough to revitalize the nation's economy?
Conspicuously missing from this grand strategy is any attention to America's inventive entrepreneurs. Such entrepreneurs do not work to develop innovations favored by some corporate or government committee. Nor do they seek to duplicate the successes of long-forgotten entrepreneurs by setting up new businesses in now-familiar areas, such as new cleaning and auto-service establishments. Instead, what these special entrepreneurs do is pursue their own ideas, setting up shop, when they can, to develop and bring to market new products and processes. And in spite of all of the Reagan administration's tax, fiscal, and monetary reforms, these special entrepreneurs who hope to advance their economic positions by venturing their own ideas are still left "slowly twisting in the wind" by an almost invisible combination of federal tax, research and development, and procurement policies.
ESTABLISHMENTARIANISM Take the tax code, for instance. Before making out their checks to the IRS, established firms can write off new-business costs. From revenues gained from their existing products and services, these firms can deduct costs for research, development, and marketing of new ventures. Our special entrepreneurs cannot. Not yet in business, and thus without sales income, they have no choice but to draw from their personal after-tax equity to advance their ideas far enough to attract outside investment.
In fact, one Reagan administration tax reform starkly reinforces the tax code's basic inequality between those already in business who hope to profitably expand their businesses and others who hope to profitably go into business and pursue their own innovative ideas. This is the newly legislated R&D tax credit. It makes more generous the tax deduction for new-product costs—a boon for ongoing businesses, but a meaningless tax credit for entrepreneurs not yet in business.
By favoring business expansions over the start of new enterprises, the tax system promotes venture inequality before the law. Large, often-stagnated firms are thus shielded from entrepreneurial challenges, which can hardly be helping the economy or the US world trade position.
In spite of the venture inequality ingrained in the tax code, "small-time" innovators have, historically, been very important in the nation's economic success. In recent decades, however, the tax favoritism has been exacerbated by two administrative policies that lay hidden in bureaucratic complexity. Combined with the tax code, they virtually put America's innovator-entrepreneurs out of the business of going into business.
During fiscal 1981, federal R&D policy governed $35 billion and procurement policy $110 billion of our tax money. (This doesn't even count $30 billion spent on procurement under assistance programs.) These two nonlegislated policies support a vast array of innovations aimed at public and private markets.
Precisely which innovative ideas should be selected and followed up, and how far into innovation should each be carried by government spending our tax money? To an exploratory, prototype, or production position? These critical decisions face the government once it begins dispensing R&D monies. The answers lock in the characteristics and prices of future goods and services. The decisions are not made by independent, competitive investors who stand to lose or gain a great deal by putting up venture capital; they are made by monopolistic agency committees.
Fiscal 1981's $35-billion federal R&D budget put directly under government control as much research and development money as was independently spent by all US companies to competitively develop their own ideas for new goods and services. Nearly $15 billion of this amount flowed back to industrial firms governed by federal procurement policy. But this policy places more value on proposals offered by established firms—especially government contractors—than on proposals offered by entrepreneurs who are not yet government contractors but who hope to be, based on the attractiveness of their ideas.
Evidence of past innovative successes, ownership of R&D and production plants and equipment, and access to credit are all valued more highly than are ideas during risk-averting agency committee selections for R&D contract awards. Entrepreneurs don't yet have evidence of any of these, and few can afford to propose ideas to federal agencies regardless of special "small"-business favoritisms found in government's statutory codes and administrative procedures. These favoritisms may boost the fortunes of existing firms with 500 or fewer employees, but they do nothing for inventor- entrepreneurs who are not yet in business.
What it comes to is that the federal procurement system, including its small-business rules, faithfully captures the business-expansion favoritism promoted by the tax code and reinforces the risk-averting tendencies of bureaucracy. This is no mere speculation: over 95 percent of 1981 R&D funds distributed under federal procurement policy went to long-established firms. It is not necessarily that they propose better ideas; they are simply better risks.
INNOVATIVE CHOICES What is the object of all the R&D support from government? A major share of the $35 billion nationalized, new-product "seed" capital—about $21 billion—was spent by federal agencies to select and bring to production ideas that were aimed solely at their own agency markets. There is literally no other domestic buyer for the products of their R&D expenditures.
New weapon and space systems are the most obvious examples. They are purchased domestically only by NASA and the Defense Department. In this "single buyer" situation, government taxes all income earners for the experimental money, explores alternatives ideas, and finally purchases and operates a preferred choice, such as the nationalized space shuttle and MX missile. A much smaller amount of taxpayer-financed R&D is similarly spent to select and explore innovations for the nationalized air traffic control and Coast Guard systems.
The remaining $14 billion of fiscal 1981 government R&D funds was spent on scientific research, purchasing R&D plants and equipments, and selecting and partially innovating an array of ideas that were not aimed solely at agency markets. They were aimed instead at widely diverse, private, commercial and industrial markets—at private energy markets, transportation markets, housing markets, and antipollution markets, among many others. Later, our vaunted "capitalist enterprise" system will fully develop and produce whatever it was that government had earlier decided was "best" for all the rest, with profit gained at little risk to the companies' shareholders, with venture cash-flow provided by taxpayers, and with no ownership dilution demanded in return for taxpayer risk-taking.
Government's risk instruments—R&D contracts, grants, and a new gimmick called a "cooperative agreement"—cannot be matched by Wall Street's bonds, commercial loans, and equity stocks. Unlike government's risk instruments, Wall Street's are offered to the innovator only in exchange for taking on debt, diluting ownership, or mortgaging assets.
When government intervenes in the economy with its unmatchable risk instruments, entrepreneurs, firms of all sizes, and universities and other nonprofit institutions will swarm to Washington like bees to honey. By drawing researchers and inventors to the US Treasury this sweet flower of taxpayers' money centralizes science, technology, and venture decisionmaking within the benign and noncompetitive environment of bureaucracy, politicizing decisions critical to our economic future.
HIDDEN MONOPOLIZATION A look at two government reports—one from the National Science Foundation,"Federal Funds for R&D" (1981), the other from Congress, "Investigative Report on Utilization of Federal Laboratories" (1978)—shows how the centralization of science and technology results from its R&D funding decisions. Putting together the data from these two reports, one finds an otherwise hidden "university-agency complex" that monopolizes the seed capital needed by innovative entrepreneurs to start new firms. The university-agency complex consists of universities, federal agency laboratories, nationalized laboratories, and technical elements of state and local governments; plus universities, other nonprofits, and industrial firms that administer and operate government-owned R&D facilities, such as the Sandia Nuclear Laboratory operated by Western Electric and the Livermore Nuclear Laboratory operated by the University of California.
Established industrial firms benefit handsomely from this arrangement because they gain basic and applied scientific knowledge useful in their commercial ventures, without risking shareholders' profits or capitalizing the needed R&D plants and equipment. The NSF report shows that 10 major companies benefit in this fashion, as do 20 major universities.
The university-agency complex has a centroid of nearly 800 nonprofit laboratories that employ over 100,000 scientists and engineers. When we add technicians, other supporting personnel, and administrators, nearly a quarter-million people are funded by taxpayers to homogenize the nation's science and to start new ventures that they are not accountable to finish.
Every year their sponsoring federal agencies award to private members of the complex noncompetitive R&D contracts or grants to finance their operations. The agencies also purchase expensive R&D plants and equipment for their "free" use. In addition, the US Treasury directly covers the operating costs of nationalized and agency laboratories.
Here is how government's $35-billion R&D expenditure was distributed in fiscal 1981. Federal agencies spent $2 billion to purchase R&D plants and equipment for their own and nationalized laboratories and to purchase government-owned R&D plants and equipment for "free" use by universities, other nonprofits, and industrial firms. The remaining $33 billion was spent on research and development activities, with 54 percent ($17.8 billion) going to the university-agency complex and the remaining 46 percent ($15.2 billion) to profit-incentive firms.
This may seem like a fair enough split of taxpayers' money between profit and nonprofit organizations—unless we go a bit further and ask just what "kind" of R&D was distributed to each. The National Science Foundation report addresses this. The university-agency complex received about $10 billion in research funding, both basic and applied; industry, about $2 billion. Industry, however, received about $13 billion in development funding. Yet the university- agency complex garnered $8 billion in development funding, which means that it is very much in the business of bringing its own favored ideas all the way to production positions.
THE BIG GET BIGGER The distribution of the federal R&D budget leads to an inescapable conclusion. The university-agency complex, by its dominance in taxpayer-supplied research funding, goes a long way, if not toward nationalizing, at least toward homogenizing, the nation's science and technology. This complex is in the business, not only of deciding what scientific research is pursued, but of starting new ventures it deems best for all the rest. By means of the federal procurement system, the complex will later transfer these partially completed ventures to profit-making firms for prototyping and final development. And the bigger the firm, the smaller the risk for agency decisionmakers and hence the more likely to be selected for development.
These data have ominous implications for inventors not yet in business for themselves but hopeful of going into business to advance their own economic positions—our entrepreneurial community. If, for example, you have come up with an idea that you believe is responsive to a national need, such as energy independence, and you hope to benefit by profitably introducing it into commercial or industrial markets, you would be at a severe competitive disadvantage compared to those who are in a position to tap the US Treasury for the needed seed capital.
This distorted situation extends even into Uncle Sam's own markets for weapon and space developments. Established weapon and space system contractors, regardless of size, are indirectly paid their costs for independent research and development, as well as for preparing and marketing new weapon and space system proposals. These new-business-getting costs appear as price mark-ups on their current weapon and space system contracts. These costs are also tax-deductible.
For example, during 1979 the Defense Department's 93 largest contractors out of a total 24,000 separate suppliers were aggregately paid over $1 billion to perform research and development and to prepare and market new weapons proposals. These costs were recovered as price mark-ups on $33 billion weapons contracts awarded to the 93 contractors during 1979. And because these costs are tax-deductible under the tax code, these firms saved nearly an additional $500 million. In brief, these 93 weapons contractors aggregately enjoyed a $500-million tax advantage over their nonestablished, entrepreneurial counterparts. Entrepreneurs who are not yet federal contractors but hope to be are behind the eight ball right from the beginning. They have no choice but to draw from their family after-tax resources to first prove what they propose to prove. It's a classic Catch-22. Most entrepreneurs go broke if they are foolish enough to try. Those who do try often later find that their ideas have been absorbed into the university-agency complex or incorporated into procurements that only large, capitalized contractors are qualified to bid on, simply because they already own the "machinery" needed to innovate them.
We see in this the intimate ties between nonprofit, taxpayer-supported scientific and technical organizations that start new ventures and the R&D and production plants and equipment owned by established firms that are needed to finish them. America's inventive entrepreneurs stand on the outside looking in as this connection does its work—which doesn't always work.
For example, after partially innovating a standard city bus, the Department of Transportation found that no foreign or domestic bus manufacturer was interested in finishing it. We, as taxpayers, dropped over $50 million on this aborted venture, financing the university-agency complex while it struggled with the mysteries of economic bus design. And most are familiar with America's supersonic transport fiasco. Taxpayers sank nearly $1 billion into that one—but no company went out of business because of it, nor did the sponsoring Federal Aviation Administration.
Many other examples can be found of ventures started by the university- agency complex but never finished; yet its operations continue to expand, and its employees' salaries and benefits continue to increase. This is because the complex is immunized from the competitive challenge of new ideas and innovations; there are no marketplace checks-and-balances on its growth and extent of operations.
Regardless of the Reagan administration's economic reforms, the powerful combination of the tax code and federal procurement and R&D policies makes "Yankee ingenuity" and "America the land of opportunity" the stuff only of nostalgia. They are not today's realities. People can no longer put much store by venturing their own ideas in order to advance their own economic positions. Government has blunted such hope and ambition. Inventors are thus steered toward employment by existing firms or by the university-agency complex as their best opportunity for advancing their own ideas beyond personally affordable positions. Hence, big firms get bigger, economic concentration grows, diversity of consumer choice narrows, economic freedom diminishes, competition wanes, America's world trade position worsens, and the nation's economy deteriorates.
R&D INNOVATIONS The Reagan administration could turn this situation on its ear—and further its budget-cutting goals—by redirecting the $14 billion in civilian R&D funds that lies buried in the R&D accounts of 37 nonspace, nondefense federal agencies. Returning a major portion of this vast amount of new-enterprise seed capital to private capital markets whence it came would substantially improve entrepreneurs' chances for finding individual investors and advancing their ideas beyond personally affordable positions. If federal agencies are to help rather than hinder an economic recovery, they must look to incentives that motivate private inventors, investors, innovators, and consumers to achieve that goal. To nationalize the means to such an end by centralizing R&D can only lead to a cloned society where goods and services, and their prices, are the same for everyone, dictated by bureaucracy.
Then there is the military-industrial complex, labeled as such by President Eisenhower more than 20 years ago. Policies governing the $21-billion R&D for new weapons and space systems ought to be radically reformed. Today, taxpayers are forced by such policies to protect the market positions already held by established weapon and space system suppliers. Existing R&D and procurement policies further entrench the economic concentration of the aerospace industry evident since World War II, when winning the war at any cost was all that mattered.
Nonetheless, while these moves are necessary, they are not sufficient to revitalize the nation's economy. That requires venture equality before the law. Federal tax, procurement, and R&D policies must be massively overhauled such that all, ongoing businesses and individuals alike, stand equally before federal laws and administrative policies when hoping to advance their economic positions by venturing their own ideas—whether these ventures are aimed at profitably expanding an ongoing business or at establishing a new, profitable enterprise; whether they are initially geared to private or to public consumer markets.
The key to achieving venture equality before the law for everyone is for Congress to understand fully that the cost of "getting" future business is a cost both for ongoing businesses that hope to expand and for entrepreneurs who hope to advance their ideas far enough to attract outside investment. Whether an ongoing business or an entrepreneur, the aim is to "get" future business by innovating their own ideas. Both ought to be treated equally before the law.
Ideas are created by people, not by organizations, a fact unfortunately not recognized in public policy. Organizations, however, are required to advance ideas to market; and America needs more new, innovative organizations. The American people have never been short on ideas.
Basic public policy changes in the present, cozy R&D arrangement will surely be resisted by the university-agency complex and by corporate business associations. But we ought to start before it's too late, before individual economic freedom and liberty also become the stuff of nostalgia.
David G. Soergel is president of DGS Associates of Potomac, Maryland.