THE COMPETITIVENESS EQUATION— THE INNOVATION ECOSYSTEM

In our hypothetical board room, with the need to decide where to locate a new facility, the focus thus far has been on labor costs, the availability and quality of human capital, and the creation of knowledge. But other ingredients will affect where new plants, offices, and laboratories—and the jobs they provide—are to be. This so-called innovation ecosystem, a combination of factors defining the “innovation-friendliness” of a country, plays a large role as managers and boards decide where to locate new facilities.

One such factor—arguably of declining importance—is the proximity of potential customers. Between 2012 and 2020, China will pass the United States to become the largest consumer market in the world. By 2030 China alone is expected to have more middle-income consumers than the entire population of the United States at that time. India’s middle class is projected to grow from today’s 50 million citizens to just under 600 million by 2025.

Another factor affecting the selection of a location for a new business venture has traditionally been the availability of investment capital. America has long enjoyed an immense advantage. California alone has far more venture capital than any nation on earth (other than the United States). This is rapidly being neutralized because financial capital now crosses porous geopolitical borders literally at the speed of light as it chases opportunity. In 2005, for the first time in 20 years, US investors put more new money into international stock funds than into US stock funds and did so by a substantial margin. As



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Is America Falling Off the Flat Earth? THE COMPETITIVENESS EQUATION— THE INNOVATION ECOSYSTEM In our hypothetical board room, with the need to decide where to locate a new facility, the focus thus far has been on labor costs, the availability and quality of human capital, and the creation of knowledge. But other ingredients will affect where new plants, offices, and laboratories—and the jobs they provide—are to be. This so-called innovation ecosystem, a combination of factors defining the “innovation-friendliness” of a country, plays a large role as managers and boards decide where to locate new facilities. One such factor—arguably of declining importance—is the proximity of potential customers. Between 2012 and 2020, China will pass the United States to become the largest consumer market in the world. By 2030 China alone is expected to have more middle-income consumers than the entire population of the United States at that time. India’s middle class is projected to grow from today’s 50 million citizens to just under 600 million by 2025. Another factor affecting the selection of a location for a new business venture has traditionally been the availability of investment capital. America has long enjoyed an immense advantage. California alone has far more venture capital than any nation on earth (other than the United States). This is rapidly being neutralized because financial capital now crosses porous geopolitical borders literally at the speed of light as it chases opportunity. In 2005, for the first time in 20 years, US investors put more new money into international stock funds than into US stock funds and did so by a substantial margin. As

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Is America Falling Off the Flat Earth? recently as 6 years ago, only 8% of the money newly invested in US stock funds went overseas; now the fraction has reached 77%. There remain a number of other factors in the US innovation ecosystem that might lead firms to locate new facilities elsewhere. For example, The US effective corporate tax rate of about 40%, including state taxes, is, according to the Tax Foundation, higher than that of all but one other developed nation. Exacerbating the problem, most US corporate taxes, unlike those of many other nations, apply to global earnings. For example, a US firm competing in Ireland has imposed on it a 35% net US federal tax rate, whereas an Irish firm pays 12.5%—which was reduced from 50% as Ireland successfully girded itself for the global economic race. Many nations offer “tax holidays” for a specified period when new entities establish themselves within the nations’ borders. In the early 1990s, the United States ranked first among OECD nations in offering tax incentives for R&D; but by 2004, it had fallen to 17th place. Perhaps the most significant factor in this regard is the federal R&D tax credit that requires renewal by Congress and the president each year and is therefore unreliable and diminished in value to companies addressing the long-term decisions implicit in the conduct of R&D. The US patent system is in many respects antiquated. In the words of Michael Splinter, CEO of Applied Materials, Inc., “Those of us who are patenting inventions are becoming hostages to those who are inventing patents. The current system is an invitation to litigation.” It seems that the jobs that our patent system is creating are largely for lawyers, not scientists, engineers, and entrepreneurs and those they serve. US firms are among the few that directly bear the responsibility for funding major portions of the health care received by their employees, their employees’ families, and their retirees and their families. That is an admirable social practice, but the cost of providing such benefits must be recovered in the prices that the firms charge for their products or services. It is not an immaterial cost: General Motors now spends more on health care than on steel; Starbucks spends more on health care than on coffee. Many executives responding to a recent PriceWaterhouseCoopers survey indicated that health-care costs, now 16% of the entire GDP, have had a “major impact” on the competitiveness of their businesses. The secretary of health

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Is America Falling Off the Flat Earth? and human services, Mike Leavitt, observes that “there is simply no place on the economic leader-board for a nation that spends a fifth of its domestic product on health care.” Similar considerations are related to employer-provided pensions. Bethlehem Steel in 2001 celebrated its impending 100th birthday by declaring bankruptcy. The number of workers that the firm employed during World War II had dropped by a factor of 27 by the time the company was liquidated in 2004, down to 11,000. But, the company had over 5 times that many pensioners on the roles still drawing benefits from the firm. Similarly, General Motors supports three pensioners for every worker now on the payroll. Time magazine offers the following summary: “Dig through the financial statements of the Detroit Three … and you can easily conclude that they are money-losing retirement and healthcare organizations just masquerading as money-losing carmakers.” But perhaps most troubling of all, the lack of portability of most pensions will make them almost irrelevant to the needs of the average worker in an increasingly turbulent job market. Finally, as previously noted, and perhaps most astounding of all, US industry consistently spends three times more on litigation than on research. This is in part attributable to the malfeasance of some business leaders who abuse their fiduciary responsibilities and in part to the actions of some members of the legal profession who exploit the vagaries of the judicial system for their personal gain. Whatever the cause, the result is clear, and it is not a formula for survival in the emerging, intensely competitive world. It is presumably because of such considerations that only 41% of the global corporations responding to a recent survey ranked the United States as an “attractive” location for new R&D facilities, compared with 62% for China. This, of course, represents a remarkable shift. Perhaps the most incisive summary to be found, as far as the nation’s competitiveness ecosystem is concerned, comes from the 2,500-year-old writings of Aeschylus:

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Is America Falling Off the Flat Earth? So in the Libyan fable it is told That once an eagle, stricken with a dart, Said, when he saw the fashion of the shaft, “With our own feathers, not by others’ hands, Are we now smitten.”