How Might Changes in Federal Policies Boost Innovation and Productivity?

Posted by
Nathan Musick
March 2, 2017

At the beginning of February, while testifying to the House Budget Committee about the outlook for the federal budget and the economy, CBO’s Director was asked how federal policy might affect economic productivity. Because answers during Congressional hearings must be brief, this blog post provides some additional information on the subject. The post also complements yesterday’s discussion of infrastructure spending, which mentioned the effects of that spending on productivity.

Workers become more productive when they can make use of improved equipment and processes. In turn, consumers benefit when new goods and services become available or when existing ones become better or cheaper. However, the transition can be disruptive to established firms and workers as new products and processes supersede old ones. Such 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 and productivity through two broad channels: spending and tax policies, and the legal and regulatory systems. In a 2014 report, CBO examined 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 Boost Productivity?

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

  • Increasing funding for federal programs that support research and development (R&D);
  • Increasing 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);
  • Implementing tax policies that provide more incentives for private spending for R&D or other sources of innovation; and
  • Increasing 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.

Research and Development. Economic studies have shown that federal support for R&D—particularly early-stage research—has for many years been very important in promoting innovation. Total federal spending for R&D was $132 billion in 2015, more than double its 1962 value after being adjusted for inflation. Of that amount, $71 billion went to defense-related R&D (for example, to develop weapon systems) and $61 billion to nondefense R&D (about half of which was for health and medical research).

As a share of gross domestic product, federal spending for R&D has declined by roughly half since 1962 (although spending for early-stage research has increased slightly). The decline in the federal share of total spending for R&D 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 2015, postsecondary institutions received about $103 billion in revenues from the federal government (including federal contracts and grants but not tuition financed with federal student loans), amounting to about 17 percent of the total revenues that those institutions received.

The effect on innovation of increased federal spending for education generally is uncertain. Additional spending for STEM education might contribute to innovation. 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.D.s working in the laboratories of established scientists.

Tax Policy. The tax code provides financial incentives to individuals and businesses to pursue innovation through the R&D tax credit and other tax preferences. Largely because it accounts for an outsize share of the nation’s private-sector R&D spending, the manufacturing sector is often viewed as an important source of innovation. However, a large share of manufacturing is not very R&D-intensive, so increasing federal support for manufacturing generally—say, through larger tax deductions for investment in plant and equipment—would not be a well-focused way to boost innovation.

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 already obtain private funding or funding projects whose social costs outweigh their benefits.

How Might Changes in the Federal Legal and Regulatory Environment Boost Productivity?

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 implementing policies that increase federal spending or tax expenditures would.

Immigration Policy. Foreign-born workers—and particularly highly skilled workers—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. Many highly skilled workers are admitted to the United States temporarily—with H-1B visas, for example. However, only about 5 percent of the people who become permanent residents of the United States were granted authorization because they were classified as highly skilled workers.

Policymakers could modify immigration law to increase the number of highly skilled noncitizens who 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, but generally the effects are believed to be small.

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. Second, 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.

Nathan Musick is an analyst in CBO’s Microeconomic Studies Division.