How Superstar Companies Like Apple Are Killing America’s High-Tech Future

Few would argue that America’s fortunes rise and fall on its ability to generate technological innovations — to put bold ideas to work and then bring them to market.

William Lazonick, professor of economics at the University of Massachusetts Lowell, and Matt Hopkins, research associate at the Academic-Industry Research Network, have investigated how the technology knowledge base gets created, what has gone wrong in America’s approach to innovation, and why the truth about who invests in the process is poorly understood. In the interview that follows, Lazonick shares findings from two recent papers that are part of the Institute’s project on the “Political Economy of Distribution.” He explains why successful companies like Apple need to make fundamental changes to the way they allocate resources and stop throwing away America’s most valuable asset for future innovation — you.

Lynn Parramore: Let’s talk about where high-quality, low-cost technology products actually come from. Who pays for the research that goes into creating a product like the iPhone?

William Lazonick: The iPhone didn’t just magically appear out of the Apple Campus in Cupertino. Whenever a company produces a technology product, it benefits from an accumulation of knowledge created by huge numbers of people outside the company, many of whom have worked in government-funded projects over the previous decades. Öner Tulum, a researcher at The Academic-Industry Research Network (theAIRnet), has shown how all of the technologies in the iPhone ­– things like touch-screen technology, GPS, and so on — originated with government spending, funded by taxpayer money.

That’s why a company like Apple should be using a substantial portion of its super-profits to support government investment in the next generation of innovation. Instead, the company runs an entire division devoted to finding ways to avoid taxation.

LP: Your work shows how the process of developing high-tech products has changed in recent decades and how the fruits of success are distributed. Who is reaping the rewards of high-tech innovation in today’s economy?

WL: If you were an employee in the “Old Economy” business model that was dominant in high-tech companies coming into the 1980s, you got to share in the success of innovation through a stable job, salary increases, and retirement security. Under a “retain-and-reinvest” allocation regime, a company reinvested profits in your capabilities and worked to keep your valuable human assets. You, then, would contribute to innovation by engaging in collective and cumulative learning about the company’s proprietary technologies, many of which had been developed in its corporate research labs. The pay of top executives was largely tied to the gains shared with the mass of salaried employees. IBM in the mainframe era is a prime example; through the 1980s the company had an explicit policy of “lifelong employment,” bragging that it had never laid off an employee involuntarily since 1921.

When “open systems” in information-and-communication technologies (ICT) came along in the 1980s, exemplified by IBM’s PC with its Microsoft operating system and Intel microprocessor, things changed. Older employees who were skilled and versed in a company’s proprietary technologies got pushed aside in favor of younger workers with the latest open-systems skills. Old Economy companies now had to compete for talent with “New Economy” startups that used stock options to convince high-tech workers to give up secure employment with the established companies. Top executives began to embrace a new and strange ideology: a company should be run not for its products and employees, but for its shareholders, even though these shareholders merely bought and sold the company’s stock and contributed nothing to the success of the company. In the name of shareholder value, these executives could avoid the uncertain process of investing in people, the source of all innovation.

In this new regime, executive pay became increasingly stock-based, rewarding top executives for the company’s stock-price performance, no matter how it was achieved. Executives got quick boosts to company profits by laying off experienced, and more expensive, employees, especially when the shift to open systems made their existing skills apparently obsolete. And a prime way of jacking up earnings per share was to do massive stock buybacks, a practice that was sanctioned by the Securities and Exchange Commission in 1982.

In the early 1990s, the Old-Economy icon IBM led the way in transforming from “retain-and-reinvest” to “downsize-and-distribute.” Sadly, over the past two decades, this has become the dominant resource-allocation regime among U.S. companies, high-tech and otherwise. My detailed research at the industry and company levels shows that this financialized mode of corporate resource-allocation has helped to concentrate income among the top 0.1 percent, and it has led to the ongoing erosion of middle-class employment opportunities in the U.S.

LP: You’ve noted a growing consensus that America’s is falling behind other countries when it comes to innovation and technology. How did this happen, and how do your findings tell a different story from what is commonly believed?

WL: A growing number of academic studies by experts on industry research are concluding that there is an “innovation crisis” in the U.S. In the Old Economy, decades of research collaboration between government agencies and business enterprises put in place the ICT infrastructure and knowledge base that has permitted companies like Netflix, Facebook, Uber, and Airbnb to emerge as dominant in a number of niches. But other nations are starting to catch up and even take the lead in developing the most advanced technologies. In 2007, researchers in France and Germany shared the Nobel Prize in Physics for the scientific discoveries that made possible the iPod and countless other digital devices.

So what is the U.S. doing wrong? A lot of observers of investment in science and technology point to a decline in government R&D spending as a consequence of the end of the Cold War. Others view the problem as a lack of business spending on R&D because of a financial-market environment that results in “short-term” thinking on the part of corporate executives. But research on investment in the high-tech knowledge base that I have done for Institute’s Political Economy of Distribution series with Matt Hopkins demonstrates that the problem is not a lack of R&D spending, either by government or business. Rather we argue that, with the rise of the New Economy business model, the main problem is the failure of U.S. high-tech corporations to invest in the “collective and cumulative careers” which you need if you want R&D spending to result in more high-tech knowledge. Government policy-makers have added to this failure by not recognizing that long-term careers are key to the creation of a world-leading high-tech knowledge base, the subject of our second paper for the Institute’s Distribution project. Just throwing more R&D money at the problem won’t bring you the next breakthrough product.

As I showed in a recent Harvard Business Review article, “Profits Without Prosperity,” the business failure stems directly from the obsession of U.S. top executives with doing massive stock buybacks with the sole purpose of giving manipulative boosts to their companies’ stock prices. This behavior cannot be understood as “short-termism.” It’s really the direct result of the economic incentives inherent in the ample stock options and stock awards that corporate boards of directors, dominated by CEOs, bestow on top executives in order to maximize shareholder value. Neoclassical economists have assured corporate executives that maximizing shareholder value results in the superior performance of their companies and the economy as a whole. In fact, as I have shown in many theoretical and empirical studies, this strategy is ruinous. It undermines innovation and results in income inequity and employment instability.

Over the decade 2004-2013, 75 companies included in 11 high-tech industry categories in the 2013 Fortune 500 list expended $1.1 trillion on stock repurchases and more than half a trillion dollars on cash dividends. The employment practices of these 75 companies are very important to the operation and performance of the U.S. high-tech economy. Yet many if not most of these companies are operating in a “downsize-and-distribute” mode of resource allocation. For the U.S. to remain a world technology leader, this broken business model requires a major overhaul.

LP: A report by the American Academy of Arts & Sciences, “Restoring the Foundation: The Vital Role of Research in Preserving the American Dream,” acknowledges that something is getting in the way of U.S. innovation. Explain the report’s findings and how your own research offers a different perspective.

WL: Yes, the 25 people on the “Committee on New Models for U.S. Science & Technology Policy” in whose names ” Restoring the Foundation” is published are a Who’s Who of the U.S. science and engineering (S&E) community. The report begins with a warning that American research enterprise is at a critical inflection point, and that the decisions made over the next few years will determine the trajectory of American innovation for years to come. Yet the people who signed off on this report show themselves to be more than willing to give business executives a free ride in “restoring the foundation.” The report states that, and I quote, “companies – finding it increasingly difficult to justify such long-term investments in a market environment focused on short-term results – have made it clear that the federal government must continue to be the primary funder of basic research.”

These S&E luminaries take it as a given that “the market environment” makes it difficult for companies to justify long-term investments. That position is unacceptable. For the sake of an innovative economy, let’s change the “so-called market environment” so that high-tech business executives can do their jobs of making the investments in productive capabilities that innovation requires. If the tax dollars of U.S. households are going to fund basic research that is critical to business innovation, then we should expect business executives to allocate corporate profits to complement those government investments. Given what we know about the need for business-government collaboration for investment in the high-tech knowledge base, it will be futile to spend more taxpayer money on funding basic research if business does not do its part in investing in the collective and cumulative learning that is the essence of the innovation process. That means a transformation of the dominant corporate resource-allocation regime from downsize-and-distribute to retain-and-reinvest.

LP: Business executives often argue that lower tax rates for companies and wealthy households are necessary for innovation and entrepreneurship. What do you say to that argument?

WL: They like to repeat this line, but the facts explain why the opposite is actually true. From 2004 to 2013 about 9,000 companies in the Compustat database wasted $6.9 trillion on stock buybacks — that’s equivalent to nearly half their profits. They also spent $7.5 trillion on dividends, the normal way of providing holders of corporate stock with income on their portfolio investments.

The U.S. companies in the S&P 500 Index, which account for over 70 percent of total U.S. market capitalization, did half of those buybacks, representing about 50 percent of their combined profits. In 2012, the average compensation of the 500 highest paid executives on company proxy statements was $30.3 million, with 83 percent from stock-based compensation that incentivizes massive buybacks to manipulate the stock market. And the take-home pay of hedge fund managers, most of it taxed at the low capital-gains rate, makes the outsized remuneration of corporate executives look puny.

Why give tax breaks to people who actively manipulate the stock market, helping to ensure that they remain comfortably ensconced among the 0.1 percent? And why give tax breaks to companies whose profits are used for this purpose? The broken tax regime is part of the problem of concentration of income at the top and the loss of middle-class jobs. It incentivizes value extraction, not value creation. To give more tax breaks to the rich or to the corporations that they control would be utter folly.

LP: How can we change America’s business culture to get more innovation and higher standards of living?

WL: First, we need to rid business of the ideology that companies should be run for the sake of “returning” value to public shareholders. You can’t “return” value created by a company’s productive assets to people who never actually invested in those assets. Taxpayers and workers, on the other hand, do play major roles in investing in the productive capabilities that create competitive products.

You, the taxpayer, do this through government funding of the knowledge base. Employees do it through their on-the-job expenditures of effort. It is highly damaging to industrial innovation and employees’ earnings to run the corporation for the sake of those participants who matter least. Public shareholders are traders in corporate stock, not investors in corporate assets. The actual investors in corporate value creation are households as taxpayers and workers. Let’s run the corporation for them.

LP: If you could give one piece of advice to Apple CEO Tim Cook to position the company for success in the future, what would it be?

WL: That piece of advice would be: stop the stock buybacks.

In October, I wrote a critique of Carl Icahn’s call, in an open letter to Cook, for Apple to do $100 billion in buybacks as a massive tender offer on top of the $51 billion that Apple had repurchased over the previous two years (Joe Nocera of the New York Times featured my arguments in his column, Carl Icahn’s Bad Advice). I then wrote my own open letter to Cook in which I let him know that my research shows that Apple’s buybacks have been a major misallocation of resources.

Just in case he is willing to entertain that piece of advice, I offer him a number of suggestions related to the company’s relations with its employees and society on how Apple might use its profits productively, in ways that are consistent with the company’s innovative business model. These are things like investing in the educational attainments of its employees and letting performance pay do its job of incentivizing employees to invest their skills and efforts in the innovation process. A person like Tim Cook could take the lead among corporate executives in recognizing the debt that is owed to taxpayers for Apple’s profitable products .He should advocate that profitable companies like Apple pay their fair share of taxes, and he should allocate some of Apple’s creative assets – its employees – to making innovative contributions to solving some of America’s greatest social ills, like discrimination, poverty, and climate change. Instead of doing massive stock buybacks, a profitable company like Apple should extend its innovative business model by allocating some of its technological capability to help our society confront the major issues of our times.

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