The Entrepreneurial State - towards an investment and innovation-led recovery in Europe

Tuesday, 15 November, 2016

by Mariana Mazzucato

What makes the iPhone so smart? Was it only the individual genius of Steve Jobs and his team, and the visionary finance supplied from risk-loving venture capitalists? No. In my book, The Entrepreneurial State: debunking public vs. private sector myths,[1] I tell the missing part of that story through an analysis of the public funds, that allow the smart phone to do what it does so well with the Internet, touchscreen display, GPS, and the SIRI voice control—all funded by the tax payer!

The point is not to belittle the work of Jobs and his team, which was both essential and transformational. But to render more balanced the historiography of Apple and its founders, where not a word is mentioned of the collective effort behind Silicon Valley. The question is: who benefits from such a narrow description of the wealth creation process in the high tech sector today?

This year has seen inequality rise up the political agenda—with the OECD documenting just this month how bad inequality is for growth. But the current debate is often focused only on redistribution. If policy-makers want to get serious about tackling inequality they need to radically rethink—not only areas like the wealth tax that Piketty is calling for—but even the received wisdom on how to generate value and wealth creation in the first place. When we have a narrow theory of who creates value and wealth, we allow a greater share of that value to be captured by a small group of actors who call themselves wealth creators.

This is our current predicament, and the reason why progressive parties on both sides of the Atlantic are struggling to provide a clear story of what has gone wrong in recent decades, and what to do about it.  Let’s start with some definitions: the market.

The path-breaking work of historian Karl Polanyi teaches us that talk of “state intervention” in “free markets” is a historical fallacy. In his epic 1944 book, The Great Transformation, Polanyi argued: “The road to free markets was opened and kept open by an enormous increase in continuous, centrally organised and controlled interventionism . . . Administrators had to be constantly on the watch to ensure the free working of the system.” 

The public sector’s active role in shaping and creating markets is even more relevant in today’s “knowledge economy”. Traditional economic theory, which guides policy-making worldwide, justifies state intervention only to solve market failures. But what the state has done in the few countries which have succeeded in producing innovation-led growth has been to create new markets. Sectors such as the Internet, biotechnology, nanotechnology and the emerging green economy have depended on direct ‘mission oriented’ public investments, creating a new technological landscape—not only facilitating existing ones—with business following only after returns were clear in sight.

So why have we accepted such a biased story of the state’s role, when as the story of Apple shows, it has done so much more than just “fix” market failures? What is the relationship between this false narrative of who the real risk-takers are and increasing inequality? Here are three areas we need to look at:

Socialising risks and rewards

The pretence that government only spends, regulates, administers and, at best “de-risks”, or “fixes” market failures prevents us from seeing that it has been a lead risk taker and investor. As a result, government has socialised the risks but not the rewards. Some economists argue that the reward for the state comes through taxation. Indeed, this is – in theory – right. Innovation-led growth should lead to an increase in tax revenue. But not if the companies that benefit the most from innovations don’t pay much tax compared to the income they generate—not only due to the infamous loopholes but also due to their continual lobbying for tax incentives and tax cuts—all in the name of innovation. Indeed, it is not a coincidence that it was the National Venture Capital Association which convinced the US government to reduce capital gains tax by 50 per cent in only five years in the late 1970s – an “innovation policy” later copied by Tony Blair’s government. A policy that Warren Buffett himself has infamously admitted has had no effect on investment, but lots on inequality.

Similarly, in the name of promoting innovation, different types of tax “incentives” are constantly introduced – such as the “patent box” system, which allows companies to pay virtually no tax on profits generated from patented goods and services. By targeting the income generated from patents (state granted monopolies for 20 years), rather than the research that leads to them, such measures have little to no effect on innovation.  

Building more symbiotic innovation ecosystems

Sharing risks and rewards also requires making sure that private sector commitment on innovation increases. Of course business invests in R&D, but the emphasis is increasingly on the D, building on earlier public sector investment in R, as well as a reliance on small firms doing niche research, which is then reduced when they are acquired by larger firms.

Furthermore, as Bill Lazonick and I have argued in our recent work,[2] in areas as different as pharma, IT and energy, large companies are spending an increasing proportion of profits on share buybacks, to boost stock options, and executive pay. Indeed, Fortune 500 companies have spent a record $3 trillion dollars in the last decade on share-buybacks—greatly outpacing R&D. Thus, a serious ‘life-sciences’ strategy should not only be about Government increasing its financing of pharma’s knowledge base, but also be confident enough to ask big pharma to become less ‘financialized’ and invest more of its own profits in research and human resources to address skills shortages. And when countries ask Google, Apple and Amazon to pay more tax, this should not only be because they use public roads and infrastructure, but also because the very technologies that drive their record level profits, were tax payer funded.

We hear a lot about how new technology hurts those without the skills required by the modern economy, and that this is the key link between innovation and inequality. But where do skills come from? They are the result of investment. And today we have a massive crisis of investment. The skills problem is not unrelated to the corporate governance, and short-termism, problem.

A New Deal . . . and a more serious deal!

What we need to kick start investment is not only a new Keynesian deal, investing in areas like infrastructure, but also more serious “deals” between business and government that benefit both sides.

For example, how could the patent system better reflect the collective public-private contribution to innovations? In the US in 1980, the Bayh-Dole Act aimed to increase the commercialisation of science by allowing publicly-funded research to be patented. Lawmakers were rightly wary that this could lead to taxpayers stumping up twice: first for the research (the US National Institutes of Health spends $32bn a year), and then for high prices of drugs. So they suggested that government put a cap on the prices of drugs that were publicly funded. Yet the US government has never exercised this right. 

We should also reform the tax system, to reward long run value creation, over value extraction, opening up the debate about risks and rewards: are there other tools that might offer a better deal for taxpayer-funded investments and innovations? This might come in the form of regaining a “golden share” of the patents; or retaining some equity in companies that receive early-stage financing from government; or giving businesses loans whose repayments are income-contingent, just as we do to students. 

My point is not to argue for or against any one of these mechanisms, but to start a broader discussion which begins with the view of the state as market maker not only fixer. And a recognition of the massive risks that this involves: for every successful government investment in areas like the Internet there are failures, in areas like the Concorde. For every successful guaranteed loan to a company like Tesla there are many unsuccessful ones to companies like Solyndra—both having benefitted from half a billion dollars’ worth of guaranteed loans from Obama. Some have argued that any direct non-tax based mechanisms for the state to reap back rewards for its risk taking are “problematic” and suggest that corporate taxes are sufficient. This defence of the status quo, particularly in these times of austerity, seems unsustainable when what is at stake is the ability of business to capture a disproportionate share of value that was created collectively. Indeed, precisely in a world of big data—so celebrated by the innovation enthusiasts—we can surely create better ‘contracts’ and deals between the public and private sectors, even if this means putting a dent in the profit-wage ratio that is rising at record levels (and no, profits are not related to managerial performance).

So how can we change the narrative of the left from one of ‘redistribution’ to one that champions value creation in which both risks and rewards are shared more equally? Let’s first agree that the market is not a bogeyman forcing short-termism, but a result of interactions and choices made by different types of public and private actors. We need to stop talking about the public sector ‘de-risking’ and facilitating ‘partnerships’ and more about the kind of public risk-taking that led to all the general purpose technologies and great transformations of the past. A change of language from general ‘partnerships’ to more detailed commitment about the kind of partnerships that will lead to greater, not lower, private investment in long run areas such as R&D, and human capital formation.

Changing our understanding of how wealth is created, not only distributed, is the first step in refueling the government coffers which have not only funded innovation but also the public institutions in health, education and welfare that make this the kind of society I, for one, want to live in.