Comments to U.S. Trade Representative Regarding Violations and Abuses of Agreements

Nigel Cory July 31, 2017
July 31, 2017


International trade is a crucial enabler for innovative sectors at the heart of U.S. economic competitiveness, including renewable energy, aerospace, life sciences, semiconductors, information communications technology (ICT), and digital content. Trade agreements provide the market access and rules that allow firms in these sectors to maximize their potential to innovate, and in doing so, help drive further improvements in U.S. consumer welfare and standards of living. However, the U.S. government needs to ensure that all counterparties to U.S. trade agreements live up to the commitments they made in signing them.

The U.S. Trade Representative’s (USTR’s) investigation into U.S. trade agreements is a welcome review of the status of U.S. trade agreements, the policies of its trading partners, and whether they’re living up to their side of the agreement. Most U.S. trade partners generally play by the rules. However, as this submission outlines, some U.S. trade partners have violated, abused, and/or discriminated against U.S. firms and their goods and services in contravention of bilateral/regional trade agreements with the United States or in joining the multilateral trading system under the World Trade Organization (WTO). On the latter, China stands out for the way it has systemically broken, ignored, and/or gamed the world trading system to advance its own development, to the detriment of many sectors of the U.S. economy. These unfair trade policies deserve greater scrutiny and action by the U.S. government.

America’s most-innovative sectors deserve to be a central factor in USTR’s investigation as they drive long-term economic growth. The U.S. Department of Commerce reported in 2010 that technological innovation can be linked to three-quarters of the United States’ growth rate since the end of World War II. Technological innovation shapes the entire U.S. economy, as the Information Technology and Innovation Foundation (ITIF) reports in “High-Tech Nation: How Technological Innovation Shapes America’s 435 Congressional Districts.” The U.S. economy is extremely diverse, and different regions specialize in different products and services, but all industries have an opportunity to capitalize on technological innovation to increase their productivity and competitiveness. The role of U.S. trade policy should be to support these firms by ensuring they have clear and fair access to foreign markets.

America’s innovative industries are among the country’s most dynamic and impactful. One recent study found that America’s 50 most-advanced industries (in terms of having the highest research and development (R&D) intensities and highest share of STEM [science, technology, engineering, and mathematics] workers) accounted for 17 percent of U.S. GDP and employed 9 percent of workers. Moreover, those 50 industries employed 80 percent of the nation’s engineers; performed 90 percent of private-sector R&D; generated approximately 85 percent of all U.S. patents; and accounted for 60 percent of U.S. exports. America’s innovation-based, high-tech industries are a vital driver of the country’s traded-sector competitiveness and a key provider of high-wage, high-value-added jobs. Protecting the ability of these sectors to compete fairly on global markets by enforcing trade commitments America’s trade partners have made in multilateral, plurilateral, and bilateral trade commitments should be a paramount objective of the Trump administration’s trade policy.

The Nature of U.S. Innovation Industries

Around the world, countries are competing for market share in high-wage, innovation-based industries. Unfortunately, as this global race for innovation advantage intensifies, many countries have turned to “innovation mercantilism”—a strategy that seeks prosperity by imposing protectionist and trade-distorting policies that tip market scales to expand domestic technology production.

These destructive, “beggar-thy-neighbor” tactics—such as forcing companies to transfer the rights to their technology or relocate their production, research and development (R&D), or data-storage activities—are intended to either replace imports with domestic production or to unfairly promote exports. Countries increasingly are using such innovation mercantilist policies in high-value tech sectors such as life sciences, renewable energy, computers and electronics, and Internet services. To understand how countries can enact policies that detract from U.S. innovation, it’s important to understand the nature of innovation industries and market settings that are needed to maximize innovation.

True innovation industries share four key characteristics in common. First, innovation—the regular development of new products and processes—is central to their competitive success. While all industries, even “traditional” ones, innovate to some extent, true innovation industries are ones where the rapid and regular development of new processes, products, or services—many of them disruptive in nature—is critical to their competitive advantage. For example, biotechnology and semiconductors are innovation industries, as their success depends not on making the current product marginally cheaper, but on inventing the next-generation drug or semiconductor.

A second key characteristic of innovation-based industries is that their marginal costs significantly exceed their average costs. The software industry provides the most extreme example of this. It can cost hundreds of millions of dollars to produce the first copy, but additional software can be produced at virtually no cost. Likewise, the cost to develop a new prescription medicine that gained marketing approval in 2013 reached $2.6 billion. Additional post-approval R&D costs of more than $300 million “boost the full product life cycle cost per approved drug” to close to $3 billion. However, incremental copies of the initial medicine (one more pill off the production line) can be produced at cost. Similarly, it took Boeing almost eight years of development work and more than $15 billion before a single 787 Dreamliner was sold. Total 787 Dreamliner costs have now reached $32 billion. That $32 billion gets built into the cost of every 787. Economists describe such industries as experiencing increasing returns to scale, but not all industries share this characteristic. For example, a study of more than 1,000 European companies found increasing returns to scale for high-tech firms, but decreasing returns to scale for low-tech ones.

Third, innovation industries depend more than other industries on intellectual property (IP), both science- and technology-based IP but also the IP embodied in creative works. For example, software depends on source code; content creators depend on copyrights to protect their work from expropriation; life sciences firms depend on discoveries related to molecular compounds; and aerospace depends upon materials and device discoveries. The challenge, of course, is that intangible capital assets, such as IP, are more easily appropriable than tangible capital assets.

Finally, precisely because innovation industries are so knowledge intensive, they depend upon the unfettered movement of knowledge, information, and data across borders.[viii] That is because creating value in the modern economy increasingly depends upon generating actionable insights from data. For example, 50 percent of global services trade depends on underlying data flows.

These four factors that characterize an industry as an innovation industry—constant innovation, high fixed costs relative to marginal costs, dependence on IP, and dependence on information—have significant ties to globalization and trade, and therefore, to the policies that trading partners enact as part of trade agreements with the United States or as part of the WTO.

Market Conditions Needed to Maximize Innovation

Assessing the impact of trading partners’ trade and economic policies on U.S. innovation also requires an analysis of the three factors that innovation industries depend on to maximize innovation through international trade:

  1. Ensuring the largest possible markets. Firms in many innovation-intensive industries are global because they require scale. For innovation industries with high fixed costs of design and development but relatively low marginal costs of production, larger markets better enable them to cover those fixed costs, so that unit costs can be lower, and revenues for reinvestment in innovation higher. Higher sales allow more revenue to be invested back into generating more innovation. Therefore, trade barriers—such as high tariffs, localization barriers to trade, or restrictions on the ability of service enterprises to compete across international borders—limit scale economies at both the firm and establishment level (a firm being comprised of multiple establishments). Barriers that limit market access by foreign firms—in favor of domestic firms—raise global innovation costs by enabling more firms than necessary.
  2. Limiting nonmarket-based competition. Large markets enable firms to sell more. But if larger markets come with more competitors, total sales per firm can remain the same or even fall. But isn’t this competition good for innovation? In fact, many studies have shown that innovation and competition can be modeled according to an inverted “U” relation, with both too much and too little competition producing less innovation. One study of U.K. manufacturing firms found this relationship. Others, including Scherer and Mukoyama, have found similar patterns. In a study of U.S. manufacturing firms, Hashmi found that too much competition led to reduced innovation in a slightly negative relationship. Normally, markets will not produce an excess number of competitors. But governments often do—through financial bailouts, discriminatory government procurement, or other policies favoring weaker domestic firms. These policies let weak firms remain in the market, drawing sales from stronger firms and reducing their ability to reinvest in innovation.
  3. Ensuring strong IP protections. Firms in innovation-based industries depend on intangible capital, much of it embodied in IP. Strong IP rights spur innovative activity by increasing the appropriability of the returns to innovation, enabling innovators to capture more of the benefits of their own innovative activity. By raising the private rate of return closer to the social rate of return, intellectual property addresses the knowledge-asset incentive problem, allowing inventors to realize economic gain from their inventions, thereby catalyzing economic growth. In addition, as they capture a larger portion of the benefits of their innovative activity, innovating companies obtain the resources to pursue the next generation of innovative activities. However, if competitors can enter and/or remain in the market because they obtain an innovator’s IP at less than the fair market price (either through theft or coerced transfer), they are able to siphon sales that would otherwise go to innovators.

All three factors get to the core challenge for innovation industries: Investment in innovation is uncertain, and therefore higher than normal profits on those innovations that succeed are necessary. Because innovation is about risk and uncertainty, failure is common; for every Apple succeeding with an iPad, there are many IT companies that fail. Moreover, innovation industries face not just loss of market share from competition, but loss of existence. This reality evokes Schumpeter’s dictum that “every piece of business strategy must be understood against the perennial gale of creative destruction.” Innovation industries depend on so-called “Schumpeterian profits”—the profits that arise when firms are able to appropriate the returns from innovative activity. For if firms are assured at best only normal returns on successful innovation, none would undertake the enormous risk of investing in it. Moreover, because innovation is so expensive, higher returns endow companies with the capital to invest more in R&D and other innovation-based activities, perpetuating a virtuous cycle of innovation.