I think we can agree that innovation is critical to an improving standard of living. Then the questions become what creates a culture of innovation, how does our economy measure against those markers, and how can we improve performance. The keys to innovation, I believe, are: creative insights, motivation, access to skilled labor, and access to capital.

Where do ideas and concepts for innovation come from? I believe they come from perceiving a need or a problem, and marrying that with a knowledge of how to fulfill or solve it. Clearly education, especially of creative thinking rather than rote memorization, will help with the latter. The perception of need or problem is aided by good communications and widespread dissemination of ideas, events, and issues. Creativity is also fostered by living in a culture which accepts change, and empowers individuals to believe they can create change.

Motivation is also key. For someone to devote the enormous amount of energy and perseverance, to take the risks involved, and to turn down other easier life options, there has to be a significant reward that goes to the successful. Not everyone is motivated by money. Some would create just for the sheer joy of creation, some for the advancement of scientific knowledge, but for most people the prospect of significant personal economic gain is extremely important. It is not an accident that the societies that have produced the most innovation are not communist or socialist economies.

Skilled labor is developed by a widespread and good education system, and not just for college graduates. Mechanical, electrical, metallurgical, and programming skills are all valuable. Labor mobility is also key, because startup companies have to be able to attract talent from more mature and stable ones. Labor mobility is partly cultural, partly motivated by rewards for the risk, but also is aided by an education that enables understanding of new visions.

Finally, availability of capital is critical, to fund startups, to compete against established giants. Investors who take the enormous risk of funding startups have to have a route to eventual liquidity and the possibility of significant rewards. An economic system that permits those rewards and established liquid markets for securities are essential, as is a taxation regime that does not confiscate too much of the gain.

What nations show the greatest innovation? I believe that the 18th and 19th century U.K., Germany prior to World War II, and today, the U.S. and Israel would head the list. The U.K. began the Industrial Revolution, Germany pioneered modern chemistry, engineering, and automobiles, and today the U.S. and Israel have the most patents per capita year in and year out. What do these nations have in common? A sound education system (compared to other nations at their time period), a free, capitalistic economy, and an emphasis on things scientific are characteristics in common.

How does the U.S. stack up, and where can we improve? First, on the motivation and risk/reward for entrepreneurs, we do pretty well. Our culture does respect and sometimes glorify them, and we are forgiving of failures. In this we are unlike several European nations where an entrepreneur who failed is branded by that for the rest of his life. Through the availability of pools of risk capital, we create the opportunity of creating something big, not just a shoestring, or small business. And with a reduced income tax on capital gains, we allow the entrepreneur to keep a large portion of potential gains.

For the generation of ideas and concepts, we provide excellent communications, between the wide variety and availability of Internet, television, and print media. On creative thinking abilities, I am not so sure. We seem to be falling behind other nations in rank on K-12 education, but our university system is the envy of the world. In part, universities make up for it, but only for those who attend universities. And our STEM Universities are excellent– schools like MIT, Stanford, Cal Tech, etc. are tops. On the other hand we are educating more young people in Gender Studies or Sociology than we are in Physics, or in welding, for that matter, and that is not a good sign for the future. Neither High School nor College has to be vocational training (though we could do more in this arena), but the education should prepare students to have the basic skills the job market desires.

Access to skilled labor is affected by some of the educational issues discussed above. We have a favorable culture toward labor mobility, as there is no shame attached to leaving one employer for an opportunity to advance one’s career, even job-hopping is acceptable for a while, and career changes are not infrequent. We could aid this further, by limiting non-compete agreements (as California has done), by passing laws to make health insurance fully portable, and making retirement plans vested on day one and fully portable.

We do quite well with access to capital, but again, we could do even better. Laws and regulations matter. In the late 1970’s, President Jimmy Carter tried to raise the tax rate on capital gains. Congress rebelled, and passed the Steiger amendment, drastically lowering that rate. Almost immediately thereafter, investable funds started to flow into the hands of Venture Capital firms, and from them to startups and young companies, unleashing a tide of entrepreneurs and innovation. We could consider a capital gains tax rate that encouraged patient investment by starting at 50% for investments held less than a year, and going down by 5% per year held, until a 10 year investment had its gains untaxed–or some variation thereof. Alternatively we could have a taxation scheme that favored direct investment into companies (including IPOs) as opposed to purchase in the secondary markets. We could give even more regulatory relief of Sarbanes-Oxley costly reporting requirements for small and newly public companies.

Another area we could do better in is fostering more scientific and engineering research. Our companies are pretty good at development of product, but much of it is enabled by prior pure research. Many of our innovations from the 1960’s through today were based on research in defense (DOD), space (NASA), or health (NIH) done through research universities and private laboratories. This is pure research high risk investing, not generally attractive to companies or venture capitalists. I’m in favor of reducing government spending, but not in this area.

A thought I have had over the years is to make a change in accounting rules to encourage companies to invest more in basic research in fields related to their endeavors. We could allow business to capitalize funded research (either done inside or contracted to a research university or laboratory) as an intangible asset while deducting the expenditure for tax purposes, as opposed to immediately expensing the sums on their income statement. They would only write off the asset against earnings if the project was abandoned as valueless; this might make basic research more attractive.

The most important two things we can do, however, are to improve K-12 education, especially in STEM subjects, and to make sure every law and every regulation is questioned as to whether it will help, hurt or be neutral to innovation.

5 thoughts on “Economics–Innovation, part 2

  1. A great post as always. I think there are a couple other key factors that contribute to our success as a nation in innovation that you may want to include in your thinking. One of them is our bankruptcy laws – it’s not just that entrepreneurship and failure are ok…it’s that they don’t spell permanent financial ruin for individuals. Another is intellectual property protection. While I can list out a bunch of areas where I think patent reform is critical around new technologies, the fact is that patents and trademarks in the US are an important underpinning of entrepreneurial success and risk taking.

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    1. Thanks for the comment. You raise a couple of good and relevant points. I’m not familiar enough with other countries’ bankruptcy or patent law to contrast them with our own. My impression is that patent law is fairly favorable in most Western nations, but certainly not relevant in China today.

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  2. While it’s certainly true that, for a long time, patents in the USA were “an important underpinning of entrepreneurial success and risk taking,” in recent years, changes to the patent system under the banner of “patent reform,” as well as a number of adverse patent-related decisions coming out of the Supreme Court of the United States, have clearly weakened the amount and degree of patent protection that inventors and innovators had come to expect in our country. So, things change and, believe it or not, recently, an increasing number of North American intellectual property firms and patent owners have actually started to look to Europe and, of all places, The People’s Republic of China, to enforce their patent rights.

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    1. Thanks for the comment, Paul. I was unaware of these trends, and think it distinctly unhelpful. There might not be much we can do about court decisions, but our Congress could certainly amend the patent law. Is there a movement to do that? Who is in opposition?

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