Innovation-oriented Industrial Policies Needed

With the emergence of a knowledge society, innovation has come to play an increasingly important role in improving corporate competitiveness and national economic growth. Whilst competitive advantage can be come from size, or posession of assets, etc. the pattern is increasingly coming to favour those organizations which can mobilize knowledge and technological skills and experience to create new products, prcesseses, and services (Managing Innovation: Integrating Technological, Market and Organizational Change, John Wiley & Sons, 2nd ed., 2001).

Companies competing globally are urging their governments to implement pro-innovation policies, and governments are trying to respond to this need. As such, industry and industrial policy are evolving in tandem around the world.

At the same time, national innovation policies in different countries seem to be converging. If the government of one country implements an effective pro-innovation policy, companies in other countries are at a disadvantage in global competition. To prevent this, these companies urge their own governments to implement similar policies. Countries thus try to emulate each other's "best practices." In this column, I would like to introduce the main points of the Council on Competitiveness report and examine various issues it raises (i.e., co-evolution of companies and institutions including government policies, as well as convergence among national policies).

The "Innovate America" report was released December 15, 2004 by the Council on Competitiveness, a non-profit, private-sector organization that has significant influence over U.S. trade and industrial policies. The report, compiled by the council's National Innovation Initiative (NII) working group, is also known as the "Palmisano Report," after Samuel J. Palmisano, chairman and CEO of IBM Corp. and co-chairman of the NII working group. The NII report begins by declaring, "Innovation will be the single most important factor in determining America's success through the 21st century," and goes on to say America's task over the next quarter century is to "optimize our entire society for innovation." The NII recommendations are presented in the three broad categories of talent, investment and infrastructure.

[Talent]

In this human dimension of innovation, the report, first of all, calls for developing a national strategy for innovation education, thereby securing a creative and technology-capable workforce. To achieve this end, it recommends the following steps:

• Establish tax-deductible private-sector "Invest in the Future" scholarships for American S&E (science and engineering) undergraduates;
• Empower young American innovators by creating 5,000 new portable graduate fellowships funded by federal R&D agencies;
• Expand university-based Professional Science Masters and traineeships to all state university systems;
• Reform immigration to attract the best and brightest S&E students from around the world and provide work permits to foreign S&E graduates of US institutions.

Second, to spur the next-generation of American innovators, the report recommends the following:

• Stimulate creative thinking and innovation skills through problem-based learning in K-12 (kindergarten to 12th grade), community colleges and universities;
• Create innovation learning opportunities for students to bridge the gap between research and application;
• Establish innovation curricula for entrepreneurs and small business managers.

Third, to empower workers to succeed in the global economy, the report recommends the following:

• Stimulate workforce flexibility and skills through lifelong learning opportunities;
• Accelerate portability of healthcare and pension benefits;
• Align federal and state skill needs more tightly to training resources;
• Expand assistance to those dislocated by technology and trade.

The very fact that the "talent" issue is presented as the first priority of the National Innovation Agenda probably reflects the reality that United States, just like Japan, has a serious shortage of next-generation human resources (particularly in the field of science and engineering) who will take a leading role in developing science and technology in the future, as well as the growing concern within the U.S. industry over this situation. It is a well-known fact that U.S. success in science and technology owes much to talent imported not only from Europe but also from developing countries in Asia and other regions. From this point of view, the call for immigration reform may be interpreted as a warning against the widespread prejudice against Muslims in particular and foreigners in general that has escalated since the September 11, 2001 terrorist attack.

[Investment]

In the area of investment, the NII report sets out three goals and proposes a set of measures for each. First, to revitalize cutting-edge and multidisciplinary research, it calls for the following measures:

• Stimulate high-risk research through "Innovation Acceleration" grants that reallocate 3 percent of agency R&D budgets;
• Restore the DoD's (the Department of Defense's) historic commitment to basic research by directing 20 percent of the S&T (science and technology) budget to long-term research;
• Intensify support for physical sciences and engineering to achieve a robust national R&D portfolio;
• Enact a permanent restructured R&E (research and experimentation) tax credit and extend the credit to research conducted in university-industry consortia.

These recommendations are the flip side of ongoing flows of government research funds (i.e., areas that have hitherto received little federal funding). Public funding for research up to now has concentrated on projects that are more closely tied to application and more likely to bring short-term gains, with excessive emphasis given to life science projects. The NII report seems to be sounding the alarm about this trend and calling for a more multidisciplinary approach.

Of the above recommendations, the fourth one concerning the R&E tax credit is modeled on a similar R&D tax credit system in Japan. This is evidence of the innovative and pioneering approach of the Japanese system, which is based on policy proposals by RIETI, and has been realized by the concerted efforts of the Ministry of Economy, Trade and Industry, the Ministry of Finance, the Japan Business Federation (Nippon Keidanren), and other concerned parties.

The second goal of the investment agenda is to stimulate an entrepreneurial economy. To achieve this end, the following measures are recommended:

• Build 10 Innovation Hot Spots over the next five years to capitalize on regional assets and leverage public-private investments;
• Designate a lead agency and an inter-agency council to coordinate federal economic development policies and programs to accelerate innovation-based growth;
• Increase the availability of early-stage risk capital with tax incentives, expanded angel networks, and state and private seed capital funds.

The second proposal concerning policy coordination may be an example of international policy convergence, stemming from the work of the Council for Science and Technology Policy (and its predecessor) of Japan and the White House's Office of Science and Technology Policy. Meanwhile, the third proposal indicates that even the U.S. has a shortage of early-stage capital funds. This brings up the inevitable question: Do we have sufficient innovation support measures in place in Japan?

The third goal in the investment agenda is to reinforce risk-taking and long-term investment. To achieve this, the NII report proposes the following:

• Align private-sector incentives and compensation structures to reward long-term value creation;
• Create safe-harbor provisions to promote voluntary disclosure of intangible assets;
• Reduce the cost of tort litigation from 2 percent to 1 percent of GDP;
• Convene a Financial Markets Intermediary Committee to evaluate the impact of new regulations on risk-taking.

The costs associated with tort litigation in the U.S. are equal to a 5% tax on wages, amounting to $233 billion, or $800 per person per annum. However, the report also points out that the actual impact, including additional costs that cannot be can be captured in numbers, can be far more pervasive and detrimental to innovation. Out of fear of litigation, according to the report, physicians, for example, become cautious in providing medical treatment, teaching and developing products. Doctors often order more testing than medically necessary while companies, particularly in the pharmaceutical and aviation industries, are discouraged from developing new products or withdraw from promising product lines in the face of excessive safety regulations.

The Enron scandal and the stock option problem were likely to have prompted the recommendation about "private-sector incentives and compensation structures." Indirectly, however, the recommendation may point to the strengths of Japanese-style, long-term employment and internal promotion systems. (Co-chairman Palmisano is the CEO an American company that has adopted such a Japanese-style management approach.)

[Infrastructure]

The first goal of the infrastructure agenda, according to the NII report, is to create a national consensus for innovation growth strategies. To achieve this, it recommends the following:

• Enact a federal innovation strategy through the Executive Office of the President;
• Catalyze national and regional alliances to implement innovation policies and innovation-led growth;
• Develop new metrics to understand and manage innovation more effectively;
• Establish National Innovation prizes to recognize excellence in innovation performance.

In short, the report calls for shifting from a pro-patent policy to a pro-innovation policy.

Meanwhile, in order to create a 21st century intellectual property regime, which is presented as the second goal in the infrastructure agenda, the report calls for the following measures:

• Build quality in all phases of the patent process;
• Leverage patent databases into innovation tools;
• Create best practices for collaborative standards setting.

The rapid growth in the number of patent applications, the extensive use of the equivalence doctrine in judging the scope of patent protection, and the gaps in the ability of individual patent examiners have raised questions about the quality of American patents; some even call the current situation critical. Japan should take this as a lesson and improve its own patent regime.

Third, to strengthen America's manufacturing capacity, the report proposes the following:

• Create centers for production excellence including shared facilities and consortia;
• Foster development of industry-led standards for interoperable manufacturing and logistics;
• Create Innovation Extension Centers to enable SMEs (small and medium enterprises) to become first-tier manufacturing partners;
• Expand industry-led roadmaps for R&D priorities.

To achieve the fourth goal of building 21st century innovation infrastructures - the health care test bed - the report recommends:

• Expand electronic health reporting;
• Establish and promote standards for an integrated health data system;
• Establish pilot programs for international electronic exchanges on healthcare research and delivery;
• Expand use of performance-based purchasing agreements.

The fact that the health care sector has been chosen as a test bed is indicative of both the strengths and peculiarities of the U.S.

In France, too, the aforementioned report submitted to President Chirac urges government-supported innovation programs to create the Airbus or Ariane of tomorrow by investing in "national champions" or promising high-growth companies. The report, submitted by the chairman of Saint-Gobain, a multinational conglomerate, recommends that "industrial support be focused on strengthening strong corporations instead of, as in the EUREKA program of the European Union, scattering assistance too widely among start-up companies," according to media reports. Toward that end, the French government plans to create an "agency for industrial innovation," thereby channeling funds into "national champions" in innovative areas such as information technology, nanotechnology, biotechnology and renewable energies. The government intends to use some of the estimated 1 billion euro in proceeds from its forthcoming privatization program to create the agency, which will invest in large-scale R&D projects by major French and EU companies.

This is a call for industry promotion policies, including implementation of large-scale projects, which are identical to those pursued by the Japanese government as a means to foster key industries. Civil aircraft manufactured by Airbus S.A.S., as well as the development and launching of Ariane rockets, show Europe's technology competence; whereas the U.S. demonstrates strengths in the information technology (IT), biotechnology and aerospace industries, where massive amounts of federal R&D funding, including military funding, have been invested.

Although some people speak as if the Japanese automobile industry developed without any support from the government, extremely finely-tuned industrial policies implemented by the government, along with the involvement of highly-capable technocrats, played a significant role in nurturing the industry. For instance, in negotiating conditions for importing foreign technologies, the government raised the issue of the foreign currency allocation system as a means to restrict automobile imports to help create conditions favorable for nurturing the domestic automobile industry. The government also implemented foreign ownership restrictions to keep the foreign capital ratio of automobile companies below 50% and set industry-wide standards for auto parts (from a lecture by Shogo Sakakura, president of the Japanese Standardization Association).

Although some people seem to believe industrial promotion policy is a thing of the past, I believe this perception is wrong. Industry and government are not conflicting entities. It is not enough for government to be a mere guardian of the market. A government of the 21st century should seek to become an active promoter of innovation, catching signals from the industry and co-evolving with the industry.

A Japanese government panel, the Fundamental Issue Subcommittee, operating under the Industrial Structure Council's Industrial Science Technology Policy Committee, put forward a draft report on January 11 provisionally entitled "Science Technology Policies Toward Technological Innovation." The report calls for shifting the emphasis of science technology policy toward the promotion of innovation in order to ensure sustainable growth of the Japanese economy and society, as well as to contribute to the sustainable development of society. Proposals included in the report seem both to compete and to resonate with moves in the U.S. and France. In the 21st century, companies are exposed to ever-intensifying global competition in innovation. Likewise, countries are now being tested as to how quickly they can formulate and implement superior innovation-oriented policies. On February 14, RIETI will hold a Policy Symposium entitled "Japan's Innovation System: Its Strengths and Weaknesses." I hope the symposium will help Japan survive the era of "mega-competition" in developing innovation-oriented policies.