Cato Online Forum

Unleashing Innovation

By Derek Khanna
November 2014

Creative destruction is the process that drives innovation. When competitive intensity is high, old firms that refuse to innovate cease to exist. When competitive intensity is low, old firms that refuse to innovate stagnate and get even bigger. Start-ups are the disruptors that can force competition and introduce new products and market models. But in many sectors the barriers to entry, created or reinforced by government actions, are prohibitively high to all but the most well financed start-ups. We are seeing that large sectors of the economy are effectively not open for competition. And consequently, entrepreneurship has reached abysmally low levels.

GDP growth of 2 percent a year should not be our new normal. It’s only the new normal if we allow incumbent businesses to corrupt the creative destruction process for their particular industries. But so far that is precisely what is happening. As a result, the engine of our economy - the formation of new companies - is no longer functioning properly.

The good news is that innovation still happens in the United States. We have some of the most creative people in the world. Our human capital, financial resources, and scalability make the United States the perfect place for most founders to start their company. But human capital is now global, venture capital is exploding around the world, and the internet scales any company’s potential users from 1 to 3 billion with the click of a button. It’s critical that we get America back on track before the next Facebook or Google is launched in India or China.

Policymakers are currently disengaged, allowing problems to get even worse. The question for policymakers is: why is the tech sector growing at around 8 percent a year when the overall economy is growing so much more slowly? In fact, the success of the tech sector may be even starker than those figures indicate, because many of the benefits coming out of the tech sector don’t actually contribute, and may even subtract, from GDP - think of free searching on the World Wide Web, cheaper taxis with Uber X, free phone calls with Skype, free social networking with Facebook and Twitter, etc.

One of the primary ways that the federal government regulates the private sector is through its provisions of patents and copyrights. Patents and copyrights are government-granted protection to incentivize creation and risk-taking, but they are also a form of market limitation - a limitation on our individual liberty. Those limitations, particularly in the cases of patents, need to be justified, because otherwise the government is limiting particular markets to only one participant, or a few participants, thereby creating government-implemented monopolies or oligopolies. Such restrictions drive up prices, remove competitive intensity, and can reduce or even eliminate innovation. In the case of true inventions, the Founders believed that this patent exclusivity is justified (otherwise we wouldn’t have those incredible technologies that may cost billions to develop, such as a new drug). But in other cases where they are not warranted, patents can perversely discourage innovation: big firms have filed patents on non-inventions to ensure high barriers to entry. Often patents have become a moat to protect incumbent firms, a moat created and enforced by the government to stop competition from raiding the castle through competition.

Patents must be reserved only for true inventions, as every time patents are granted for something that is not truly novel, the government is intervening in the market by pulling the emergency brake on innovation and growth and giving a bounty to one producer. Copyright policy is just as problematic, as modern copyright policies are unclear and, from an originalist perspective, unconstitutional. Websites that feature copyrighted content are increasingly finding themselves liable for millions or billions of dollars of liability-this discourages legitimate innovation. This is why some venture funds, such as Y Combinator, warn entrepreneurs that they will not invest in any start-up that touches content/copyright because the legal landscape is so fraught with uncertain liability.

Our tax code is another area of government policy that has been corrupted to benefit incumbent industry rather than create a level playing field. One could imagine a benefit to having emerging companies pay less in taxes to help foster creative destruction; instead, U.S. policy is the opposite. Big companies have enough loopholes and lobbyists to ensure that they rarely pay the actual corporate income tax rate. The only companies that pay our full corporate income tax rate, the highest corporate tax rate in the entire world, are new companies.

Thus we have a system where new companies, those that drive economic growth and innovation, pay many times more in taxation than what established firms pay; therefore, essentially, the government is subsidizing the market models of old. It’s almost as if policymakers read Schumpeter’s theory of creative destruction and sought to foster the opposite. The solution is a complete rethinking of the U.S. tax code, systematically eliminating the opportunities for loopholes and deductions written by lobbyists effectively creating two tax codes. Low taxes are important, but stable tax policy that provides an even playing field is much more critical for innovation and growth. Both political parties have been complicit in creating tax uncertainty and tax handouts.

The government has a critical role in funding basic research. Patents are one method for society to effectively subsidize research, but patents are often insufficient to incentivize basic research (they only last 20 years). Basic research pushes the economy forward into new frontiers:it seems like every major advance in science brings with it new questions to answer, and new scientific frontiers to explore. As the scientific landscape has become more varied, basic science research has not kept up. In fact it has slowed down. Investing in basic science is the best investment society can make for its future economic growth. Basic science is a classic example of market failure where the government needs to play an active role. American laboratories and universities are the best in the world, but hey need funding to keep up with their ambition. The multiplier effect from this spending is significant for the broader economy.

If we want to grow our economy, then we need to push our economy to new frontiers and systematically identify areas of basic research that are being underfunded by the private sector. For example, longevity research, understanding the basic science of why humans age and how to address the root causes of aging and its impact on the body, could hold incredible implications for extending human lifespan. But the field has received minimal private research dollars in comparison to its potential impact because of difficulty monetizing breakthroughs.

We need to push space frontiers: in the 1960’s President Kennedy called for us to go to the moon, “not because it’s easy, but because it is hard.” We must have a similar focus today, pushing the bounds of the possible. Economists have said that the impact of developing a space elevator, a device to connect earth and space, would be profound upon the U.S. economy, and despite its roots in science fiction literature (like most of our space program), many scientists, including a NASA study, believe that building such a device is possible but difficult (as was going to the Moon in the 1960’s). The government should leverage X-Prizes to reward the private sector for developing the particular technologies that will be needed to develop a space elevator by 2025/2030, which would open space for tourism, enterprise, and exploration. Building the space elevator would push the bounds of material science with widespread spillover benefits.

New technologies will push our society forward, but only if we let them. Upcoming innovations not only push the bounds of the possible, but also push the bounds of the legal. For several important new innovations, the limiting factor on advancement and adoption is the government. The home genetic testing industry was shocked when 23andMe was banned from providing DNA test analysis to consumers by the FDA - thereby not only inhibiting 23andMe, but also stifling the home diagnostic market just as the cost of a DNA test, for active proteins, fell below the $1,000 mark. FDA policy needs to be revised to let innovative companies compete in home diagnostics and to bring down the costs of drug approval.

Robotic and autonomous cars may have an impact upon society and our economy larger than anything since the World Wide Web, but autonomous cars will present novel policy questions that haven’t been addressed and will slow development and adoption. But autonomous cars will eventually replace car ownership for many Americans, save thousands of lives, and alter how society arranges itself, making it viable to live further away from work.

3D printing will revolutionize many industries, but consumer use of 3D printing may be clouded in copyright concerns. The Internet of things is upon us, with sensors and chips in all our home devices, but unless the Digital Millennium Copyright Act is updated, tinkering with our own devices to make them interoperable may be illegal.

Drones can change delivery structures for businesses and create entirely new industries, but business use of drones is currently banned by the FAA.

These technologies will likely spawn new technologies that we can barely comprehend: for example, drones, material sciences, robotics, and 3D printing-related technologies may fuse together to revolutionize the construction industry. Imagine houses, office buildings, or highways entirely constructed by robots, constructed with new methods and new materials that provide better insulation and quality than what can be physically assembled by humans, with embedded sensors to warn of problems well before they manifest themselves, perfected through repetition and learning from every previous robotic construction mistake, built in just a fraction of the time of current construction and for a fraction of the cost. Such changes are not just possible, they are likely, and they will transform our buildings and infrastructure.

The United States ought to be the leader on these emerging fields. Peter Thiel’s new book Zero to One argues that the question we need to ask is how do we develop the developed world? His answer is technology. It’s up to policymakers of both parties to get the clue.

If policymakers want a better country, and care about economic growth, employment and raising the earnings and living standards of average Americans, then they should be holding regular hearings with the pioneers of innovation to ask them, “What is working and what is failing in the U.S. economy? How can policymakers make the U.S. safe for innovation? What sectors do you not invest in because the regulatory climate is too uncertain or onerous? How can Washington help you grow?” The answers may surprise you-many of their problems can actually be fixed.

The opinions expressed here are solely those of the author and do not necessarily reflect the views of the Cato Institute. This essay was prepared as part of a special Cato online forum on reviving economic growth.

Derek Khanna is a fellow with New America’s X-Lab.