CBO Provides Options for Spurring More Innovation through Spending, Taxing, and the Regulatory System

from the Congressional Budget Office

Innovation is a central driver of economic growth in the United States. Workers become more productive when they can make use of improved equipment and processes, and consumers benefit when new goods and services become available or when existing ones become better or cheaper—although the transition can be disruptive to established firms and workers as new products and processes supersede old ones. Looking ahead, innovation will continue to be important for economic growth, in part because the supply of workers to the economy is expected to increase at a much slower rate in the future.

Innovation produces some benefits for society from which individual innovators are not able to profit, and, as a result, those innovators tend to underinvest in such activity. Policymakers endeavor to promote innovation to compensate for that underinvestment. The federal government influences innovation through two broad channels: spending and tax policies, and the legal and regulatory systems. In this report, the Congressional Budget Office (CBO) examines the effects on innovation of existing policies and systems and the possible effects of a variety of proposals for changing those policies and systems.

How Might Changes in Federal Spending and Tax Policies Promote Innovation?

Policymakers have a number of options for expanding the federal government’s contribution to innovation. CBO examined several:

• Increase funding for federal programs that support research and development (R&D);
• Increase federal spending on education (both efforts to raise the general educational level of the workforce and efforts to support education that focuses on science, technology, engineering, and mathematics, or “STEM” fields);
• Implement tax policies that provide more incentives for private spending for R&D or other sources of innovation; and
• Increase loans or loan guarantees for firms that bring innovative technologies to market.

Using more federal resources to spur innovation, however, would entail redirecting money from other federal programs, raising taxes, increasing budget deficits, or some combination thereof. Furthermore, the federal government is not the central actor in many areas crucial to innovation. Private firms and state and local governments spend significantly more than the federal government does for many areas of R&D and for education, respectively (see table below).

Research and Development

Economic studies have shown that federal support for R&D—particularly early-stage research—has long been very important in promoting innovation. Federal spending for R&D reached $132 billion in 2013, more than doubling its 1962 value after adjusting for inflation. As a share of gross domestic product, federal spending for R&D declined by roughly half over that period (although spending for early-stage research increased slightly). The decline in the federal share of total spending for R&D during that period is largely attributable to the expansion of private R&D and to the contraction of federal R&D associated with the end of the Cold War and the space race. Increases in federal R&D spending would be expected to boost innovation by increasing total spending for R&D, although the prospects for federal support for new products that are closer to commercialization are at best mixed. Devoting additional resources to efforts to transfer government technology to the private sector would help private innovators better utilize the specialized equipment and expertise available at federal laboratories.

Education

A more educated workforce could spur innovation in the economy in two ways: by developing more innovative ideas and by implementing those ideas more readily. In 2013, federal spending for education, not counting student loans, totaled $126 billion, amounting to roughly 15 percent of total spending on education nationally. The effect on innovation of increased federal spending for education generally is uncertain. Over the past 40 years, per-student spending (from all sources) at the elementary and secondary levels has more than doubled in real -(inflation-adjusted) terms, but student achievement has remained flat. Additional spending for STEM education might contribute to innovation. However, federal spending on STEM education programs, totaling roughly $3 billion, currently constitutes a small fraction of federal spending for education overall and is spread across many agencies and grade levels. The most significant federal contribution to the education of new scientists comes from the federal spending for university R&D, which often pays for the training of graduate students and newly minted Ph.Ds working in the laboratories of established scientists.

Tax Policy

The tax code can provide financial incentives to individuals and businesses to pursue innovation through the R&D tax credit and other tax preferences. In 2012, the R&D tax credit resulted in tax expenditures totaling $6 billion. However, the R&D credit expired in December 2013, raising the question of its extension or modification. Some analysts argue that the R&D credit stimulates some additional private R&D, whereas others contend that much, if not most, of the forgone revenues go to firms for performing R&D that they intended to perform anyway, regardless of the credit. Increasing federal support for manufacturing through increased tax deductions for investment in plant and equipment would be a very indirect way to increase innovation because only a modest share of such investment is made by manufacturing firms and a large share of manufacturing is not very R&D-intensive.

Loan and Loan Guarantee Programs

The federal government can also attempt to promote innovation by providing more loans or loan guarantees to private firms that commercialize new technologies with social benefits that are not fully reflected in the market, such as some sorts of renewable energy. Because private investors already devote substantial resources to commercializing innovative products and services, increasing financial support for such federal credit programs may be difficult without funding projects that could obtain private funding anyway or funding projects whose social costs outweigh their benefits.

How Might Changes in the Federal Legal and Regulatory Environment Promote Innovation?

To further encourage innovative activity, policymakers could also make changes to immigration policies, the patent system, and the regulatory regime. Modifying laws and regulatory policies would involve less of a commitment of federal resources than increasing federal spending (see table below).

Immigration Policy

Foreign-born workers—and particularly highly skilled immigrants—contribute significantly to innovation in the United States, partially because many are highly educated and disproportionately employed at high-tech firms, universities, and other institutions that foster innovation. However, U.S. immigration policy is more oriented toward family reunification than admitting workers who would be likely to contribute to innovation. Policymakers could modify immigration law to increase the number of highly skilled noncitizens that are allowed to enter and work in the United States and so promote innovation. Analysts disagree about whether increasing the immigration of such highly skilled workers would negatively affect the employment and wages of highly skilled native-born workers.

The Patent System

The patent system promotes innovation by helping inventors recoup the costs of their efforts in exchange for making their inventions public. The Congress is currently faced with calls to address a number of perceived shortcomings of the patent system, including the recent proliferation of supposedly low-quality patents, pronounced delays in processing patent applications, and the cost of infringement litigation (in particular, the frequency of “nuisance” lawsuits). Because modifications to the patent system could have both positive and negative effects on the incentives to innovate, and because research on important issues of concern today remains limited, estimating the net impact of specific proposals for patent reform is generally difficult.

Regulatory Policies and Tools

Policymakers could alter how federal regulations affect the pace of innovation in several ways. First, they could change the emphasis on innovation when there are trade-offs between innovation and other federal goals, such as public safety. Separately, policymakers could rely more on regulatory tools that draw on prices and market forces to reduce some of the costs resulting from regulation. Finally, federal policymakers could address the ways in which liability laws and other regulations promulgated by state and local governments affect the balance of innovation and other policy goals.

[read the entire study]