by Mitt Romney
We are used to thinking of research and development (R&D) as one activity. In fact, it refers to two categories of activity. Research seeks new understanding and ideas. Development takes these ideas and transforms them into products or services that can be sold in the marketplace. Research itself covers a broad range of activities. At one end of the spectrum is basic research or science. This is work that is devoted to fundamental learning about science that may or may not be pursued with any commercial application in mind. Examples are the space program’s Hubble telescope or missions to Mars. Some research, on the other hand, is highly focused on potential commercial application, as with that carried out by pharmaceutical companies. During the period of my career in business, I have seen a reduction by many enterprises in the amount of resources they devote to research of either type. I’m convinced that the short-term personal financial incentives of executives are a fundamental part of the problem. Because research takes years to pay out, managers are often inclined to trade their company’s future prospects in exchange for near-term but shortsighted profits.
When management and owner incentives are aligned with the long-term value of a business, R&D becomes a much higher priority. Back when I worked as a private equity investor, my partners and I acquired a very unprofitable business from a publicly traded company—it had lost over 70 million during the prior year, and its public parent had slashed costs across the board to reduce the losses. The company, which made equipment for oil production, was losing market share at an alarming rate to a competitor that produced superior products. Because we had taken the company private, we didn’t have to worry about short-term stock price. We hired a new CEO who, like us, would primarily be compensated based upon the long-term value of the business, not its short-term annual earnings. He opted to invest heavily in R&D, which predictably depressed short-term earnings, but he was banking on the opportunity to leapfrog our competitor with better-quality products. His plan worked—the company began to regain market share, stopped shrinking, and became a thriving and profitable business once more.
As with government funding, if corporate funding of research does not accelerate, we will lose a good portion of our lead in technology and innovation. For us to see rising private investment in research, shareholders and boards need to reorient executive compensation toward the long-term value of the enterprise. It’s in their interest, and it’s in the nation’s interest.
Government’s Impact on the CapitalThat Fuels Productivity
Fortunately for all of us, innovation and entrepreneurism are deeply embedded in the American DNA. But more often than not, it also takes capital for an idea to be implemented. Where capital is scarce, hard to find, or not available to entrepreneurs and innovators, good ideas simply die in the mind.
Having grown up in Detroit, I tend to think in automotive terms. If we imagine that the economy is an engine, then capital is its fuel. If the fuel is too expensive, if shortages occur because it is being diverted to less-productive purposes, or if it’s simply being drained away and wasted, the engine may be unable to get enough fuel to operate. In that case, it will sputter and stall, with no capital, no fuel to grow productivity. Productivity, in fact, is a measurement not only of the performance of the workforce, but of capital as well. And government plays an awfully big role when it comes to the availability of capital.
Most fundamental, government manages the currency and the financial system. If people don’t have confidence in the future value of the currency, they may not be inclined to invest because they can’t be sure what value their money will have when they get it back—their return from their investment. No one would deposit money in a bank if the only guarantee it made was that you’d get back 90 percent of what you deposited. But that’s the effect of inflation. That’s why the Federal Reserve must be committed to a monetary policy that promotes stability and seeks to prevent inflation from rising above approximately 2 percent. When inflation is high and volatile, people worry about making investments that take time to mature and to return their capital. Given this worry, they may ask for a return on their capital that is very high—so high that the entrepreneur or business can’t afford it. When this happens, capital isn’t available to start new businesses or to expand and innovate in existing ones; productivity and the economy grind to a halt.
The same unfortunate outcomes occur if the financial system through which capital flows is lethargic, unreliable, or unpredictable. One of the reasons why America has so many entrepreneurs, start-ups, and small businesses is because we enjoy by far the largest and most responsive venture-funding market in the world. Our largest corporations also have an investment advantage relative to those in many other countries thanks to our substantial equity markets, commercial paper market, and the extensive number of commercial lending institutions.
Clearly, if the financial system were to shut down entirely, the free market couldn’t operate, and the entire economy would collapse. This is what we were facing at the end of former president George W. Bush’s term in late 2008. When Lehman Brothers went bankrupt, it was not only shareholders, debt-holders, and employees who lost out. Billions of dollars in commercial paper lost its value. Unlike equity and long-term debt, commercial paper—unsecured bank promissory notes—from an institution like Lehman Brothers was considered to be virtually risk free, as safe as cash. When that long-standing assumption turned out to be false, the entire commercial-paper market dried up, making it extremely difficult for some companies to pay their employees or to secure vital financing. It also precipitated a run on other financial institutions. Commercial paper is one of the instruments in which many money market funds had invested. The millions of Americans who owned money market funds had every confidence that their money was entirely safe. When the Lehman bankruptcy put that into question, people and businesses began pulling their money out of money market funds—and banks. The shock of the collapse had ricocheted around the nation and the globe. Wachovia and other banks began to fail. Former treasury secretary Henry Paulson was getting phone calls from banks all over the country warning of imminent peril. A cascade of bank collapses was on its way. That’s why President Bush and Secretary Paulson rushed to Congress just before they left office to ask for billions of dollars. It wasn’t to bail out Wall Street, but rather to attempt to keep the entire financial system from failing.
I understand why so many people were and remain outraged at the emergency measures. They are offended by the idea of a bailout, and they don’t much like Wall Street, either. The suspicion of bailouts is entirely sound. It doesn’t make sense to bail out individual companies or banks or financial institutions that get in trouble. As we’ve seen, creative destruction is part of a growing, productive economy. Bailing out sick enterprises is a lot like what Great Britain did in the first few decades after the war—by using precious resources to prop up unproductive businesses, it was unable to invest sufficiently in emerging ones and therefore failed to keep up in the global marketplace. Subsidizing failure doesn’t stop the failure—it merely prolongs the final act.
But Secretary Paulson’s proposal was not aimed at saving sick Wall Street banks or even at preserving jobs on Wall Street. It was intended to prevent a run on virtually every bank and financial institution in the country. It did in fact keep our economy from total meltdown.
A majority of senators and congressmen understood the gravity of the situation, and the reality that what was at stake ultimately was every home, every dollar of savings and every job in America. It was in the middle of John McCain’s campaign for president. He knew that the measure was not good politics. He voted yes because it was right for the country.
But TARP as administered by Secretary Timothy Geitner was as poorly explained, poorly understood, poorly structured, and poorly implemented as any legislation in recent memory. Even to this day, the American people have not been given a clear explanation of how the funds were used. It was originally sold as a program to acquire financial institu
tion assets that were temporarily depressed in value—assets that could later be sold, potentially at higher values. But now we are given to understand that direct balance sheet investments were made, sometimes in equity. Institutions were informed after the fact that TARP funds brought government big brother into management decisions, even when banks hadn’t requested TARP funds in the first place.
Secretary Paulson’s TARP prevented a systemic collapse of the national financial system; Secretary Geitner’s TARP became an opaque, heavy-handed, expensive slush fund. It should be shut down.
In addition to government’s role in managing the currency and keeping the financial system intact, its policy directly influences our four major sources of capital: individual savings, corporate savings, savings from abroad, and government surpluses
The government affects how much money we save, and savings are a key source of capital for loans and equity investments. By definition, when you tax something, you get less of it—tax savings and people will save less. In the United States, we tax savings and investment twice. Imagine that your uncle starts a software company with an investment of 1 million he raises from family, friends, and an angel investor. Let’s say that each year, the business earns 100,000. Combined, the federal and state governments charge the company an income tax of about 40 percent, leaving the investors with an annual dividend of 60,000 to take home. But then, each investor is also taxed personally as well—say, another 40 percent, leaving them with just 36,000 in net earnings. Considering the total of both taxes, your uncle and his investors have paid nearly two-thirds of what was earned from their software investment to the government. If they had opted to forgo their dividend and reinvest it in the company, they could have eventually taken their profit as a capital gain, taxed at 20 percent, and in that case the government share would only have been about half. Either way, your uncle and his investors would likely find themselves thinking long and hard about their decision to invest in a new business to begin with: the government would get half to two-thirds of the profit even if the business was good enough to be successful in the first place. When government heavily taxes investment, innovation, and entrepreneurship, we get less of those things—and fewer new high-paying jobs.
If we want to make more capital available for investment, we will have to lower taxes on saving and investing, either at the corporate or the individual level, or preferably both. Our current corporate tax rate is tied with Japan’s as the highest in the developed world, but lobbyists and a willing Congress have seen to it that myriad tax breaks are available, which can lower the rates some companies pay. They hire teams of lawyers and accountants to take advantage of every legal means to lower their tax bill. This is rational behavior, but the process is an enormous waste of time and money—a lower rate would accomplish all that the special breaks do, and improve the incentives for investment and entrepreneurship as well, creating growth and jobs.
As noted, the obvious solution is to simplify the code and reduce the rate across the board. Personal taxes on dividends, interest, and capital gains for all middle-income families should be completely eliminated—something that wouldn’t cost the government a great deal because most of this tax today is paid by high-income individuals. What this change would do is increase the size of our national capital pool and foster a mutuality of interests between our employers and our citizens.
Some people advocate the fair tax as a means of boosting savings, a system that would entirely replace federal and state income and payroll taxes with a consumption tax—a kind of sales tax. If we funded the government with the fair tax, your uncle and his investors in the software company wouldn’t pay any tax on its 100,000 in earnings—until they spent some of it. That’s a big incentive to save. They would instead be taxed on all their purchases of goods and services, such as food, cars, housing, movies, landscaping, and haircuts—everything.
Fair tax proponents estimate that a tax rate of 23 percent would be sufficient, but detractors claim that it would be closer to 40 percent. With the federal government consuming 22 percent of the GDP and with exemptions for lower levels of income, it’s logical that the rate would be between 25 and 30 percent. If a consumption tax were to replace taxation at the federal, state, and local levels of government, the rate would probably be near 35 percent.
Under the fair tax, the Internal Revenue Service would be eliminated—to the objection of very few people, of course—but a government agency of some kind would have to ensure that people weren’t bartering or finding other means to avoid paying such a substantial tax on the goods and services they purchased. And just as happens with our current system, tax cheaters would suffer rather severe penalties. One challenge with the fair tax is that the very rich would see their taxes go down—a lot. If Bill Gates makes about a billion dollars a year on his investments, for example, his current taxes would be at least 200 million. Let’s say he spends 50 million on himself and his family every year—which is a huge sum and I doubt he spends that much, but let’s use it for illustration: Under the fair tax, Bill Gates would pay only about 17 million in taxes—his tax bill would thus drop from 200 million to 17 million. The Wall Street Journal found that the enormous amount saved by the wealthiest under the fair tax would be made up by a higher tax burden on the middle class. This is not an outcome that will or should gain traction with the American public.
The fair tax would boost savings. The effect on consumption is less certain. Some people would work hard not to buy anything because products would look much more expensive with the tax added to them. They’d be cutting hair at home, eating at home, painting their own houses, and passing things along to family members rather than buying new. That doesn’t sound so bad—in the abstract. But the effect on the economy and jobs of such a dramatic change in consumption patterns is hard to predict. What if the new system didn’t work as well as promised? What if it produced massive cheating and the sales tax rates had to jump, spurring even more cheating? And if national consumption dropped precipitously, we could be thrown into a recession deeper than the one we’ve recently experienced.
It would be instructive if we could give the fair tax a fair test, but that would be difficult. In concept, the idea of a consumption tax is very appealing because of its potential to propel economic growth, but there are a number of potential drawbacks that will have to be worked out. At a minimum, the fair tax would have to be structured to avoid a windfall for the very rich and the extra burden which would fall on the middle class.
A Value Added Tax (VAT) is a flat tax on consumption, like the Fair Tax, but it can be implemented in a way to reduce the compliance problems. Because it is collected in stages along the production process, tax evasion is much more difficult. And because it would not entirely replace the current tax system, it would not mean a windfall for the wealthy. As attractive economically as is the VAT, its drawback is that big government spenders could simply add it to the current tax burden. That is why we should not open the VAT door.
The best course in the near term is to overhaul and to dramatically simplify the current tax code, eliminate taxes on savings for the middle class, and recognize that because we tax investment at both the corporate and individual level, we should align our combined rates with those of competing nations. Lower taxes and a simpler tax code will help families and create jobs.
Government policies also directly affect our second major source of capital—corporate profits reinvested by the business that earns them. Technically, these are personal savings—shareholders could theoretically demand that a company they collectively own pay them all its earnings as dividends. But practically, if a company has good investment opportunities and the management is persuasive, it will invest its profits back into the company. Corporate profits—retained earnings—are a source of our national savings.
If you’re a Republican running for office—and particularly if you’ve made a living in the private sector—one of the lines your opponent is certain to throw at you
is that you put profits ahead of people. But I think recent economic events have led voters to understand a more fundamental truth. They’ve seen all too clearly what happens when our nation’s employers don’t make profits—they lay off people, shrink, fail, and go out of business. Even though this hard truth is much more widely appreciated in 2010 than it was in 2008, many people still don’t know where a company’s profits actually go. In the first six months of 2009, for example, Comcast reported a profit of 1.7 billion. How much of that goes to pay bonuses for the company’s executives? None. Profit is what’s left after compensation of every kind has been paid to management and employees. How much did stockholders receive? About 22 percent was returned to them as dividends. The remaining 78 percent of Comcast’s profit was reinvested in the business, financing the accounts of new customers, expanding the network and equipment, purchasing capital products from others—in other words, doing things that mean more jobs for people. Profits ahead of people? No, profits for people.
High corporate tax rates reduce the amount of a company’s profit that can be devoted to new investments, new hiring, and greater productivity. And high corporate taxes also encourage companies to move elsewhere. There’s a misconception both in Washington and around the country that if business taxes are raised, companies will simply knuckle under and pay. That may have been true at a time when businesses required large physical assets—blast furnaces, machining equipment, transfer lines, and the like. But manufacturing makes up only 11 percent of our employment today, and much of that 11 percent is light manufacturing and assembly that is not very difficult to move. Businesses today look carefully at comparable tax rates when they decide where to locate new plants or facilities. Daniel Vasella, CEO of Novartis, the multibillion-dollar pharmaceutical company, has explained that his company doesn’t have a headquarters. Instead, Novartis’s upper-level executives work from offices all over the world. Increasingly, companies choose where to incorporate—and where to pay their taxes—based on state and national tax rates.