The first presidential report to Congress on manufacturing, Alexander Hamilton's 1791 Report on Manufactures, was a classic; it shaped American industrial policy for 150 years. The latest report, the Report to the President on Ensuring American Leadership in Advanced Manufacturing published last month by the President's Council of Advisors on Science and Technology (PCAST), shares many similarities. Both reports recognize that manufacturing leads to economic strength and to innovations. Hamilton recommended tariffs; the latest report recommends new incarnations of President Reagan's successful SEMATECH consortium as well as a cut in the corporate income tax.  Although it represents a step in the right direction, the new report does not go far enough.

The recently issued report was put together by PCAST, a prestigious group assembled by President Obama, including top academic and business leaders such as Craig Mundie, Chief Research and Strategy Officer of Microsoft, and Eric Schmidt, Executive Chairman of Google. Their report was based upon a workshop in which they heard testimony from leading manufacturers and innovation experts.

The resulting report shows some good understanding of the decline of the U.S. manufacturing sector. It shows some good understanding of what has worked to encourage innovation in the past. It makes some good recommendations regarding cutting the U.S. corporate income tax, But its economic recommendations do not go far enough, and it could perhaps do with taking a page from Hamilton. 

Decline of the U.S. Manufacturing Sector

The report notes the overall decline in American manufacturing shown in red in the following graph from the report, but just seeks to reverse the decline in hi-tech manufacturing, shown in blue:

It dispels many myths. For example, it rejects the commonly held misconception that the declines in U.S. manufacturing are simply due to wage rates being lower abroad:

The loss of U.S. manufacturing leadership and jobs is not solely an issue of lower relative labor costs abroad. Strong evidence that labor costs are not the key factor is that the United States is lagging behind in driving innovation in manufacturing not just relative to low-wage nations, but also relative to nations such as Germany and Japan. Both countries make high-quality goods that command pre­miums in the marketplace. In 2003, Germany surpassed the United States in total export value, with key exports in machinery, vehicles, chemicals, and metals and manufactures. (Although in 2009, China surpassed Germany to become the world's leading exporter, Germany still leads the United States.) Moreover, the skills and talents of workers -- rather than the cost of labor -- appears to matter most to companies deciding where to locate their manufacturing operations: The 2010 Global Manufacturing Competitiveness Index, a study based on the input of 400 CEOs and senior manufacturing executives worldwide, showed access to talented workers was the major driver of a country's competitiveness in attracting manufacturing, above the cost of labor and materials. The report also predicted the U.S. would slip in this competitiveness ranking by 2015. This is despite the fact that BLS data showed in 2007 that U.S. compensation for manufacturing workers was lower than the average for Europe and the rate for 16 other countries.

It also rejects the idea that America can be a research and development country without factories. It points out that after factories move abroad, research and development (R&D) often follows.

The Nation's loss of manufacturing leadership is not limited to factory jobs; there are also concerns that we are losing leadership in R&D employment and investment related to manufacturing. R&D activity linked to manufacturing is moving offshore to access emerging global markets, and to respond to global competition for talent and the growing supply of scientists and engineers abroad. This is occurring as other countries are increasing their R&D intensities. Over the past several years, spending by U.S. firms on R&D outside the United States has grown at three times the rate of their domestic spending. In the most recent employment statistics from the National Science Foundation's Division of Science Resources Statistics, three industries -- all of them in the manufacturing sector -- reported U.S. domestic R&D employment as a percentage of worldwide R&D employment as below 70%: communications equipment, semiconductor and other electronic components, and motor vehicles, trailers, and parts. In the last of these industries, domestic R&D employment was only 55% of the global total in 2008. At the same time, many of the nation's approximately 280,000 small and mid-size firms do not have the option to offshore R&D, and struggle to compete with foreign firms.

Without factories or R&D centers, Americans lose the infrastructure needed to produce innovations. The main focus of the PCAST report is upon innovation and what the U.S. government can do to encourage it.

How to Encourage Innovation

The report recommends that $500 million be spent to encourage innovation, modeled upon President Reagan's SEMATECH consortium which saved the American integrated circuit industry. Here is a description from the report of what happened:

The Federal government has also used public-private partnerships as a vehicle to advance key tech­nologies. The SEMATECH consortium of the late 1980s and early 1990s, for example, was a partnership between DARPA [Defense Advanced Research Projects Agency] and 14 U.S.-based semiconductor manufacturers, in response to the fact that Japan had captured a large portion of the integrated circuit memory chip market, and was poised to capture the majority of that market. This was viewed as a risk to national competitiveness and national security. SEMATECH, which matched $500 million in Federal government spending with equivalent industry spending over 5 years, advanced precompetitive research on the technology needed for next-generation chips. It also funded a test integration facility for tool and equipment suppliers in the semiconductor industry, allowing for prototyping of innovations in chip technology through direct contact between suppliers and the major companies in the consortium.

In his June 25 radio and Internet address, President Obama ran with this idea, though he neglected to give Reagan credit. He recommended that money be spent to create infrastructure that would promote innovation in advanced manufacturing. He said:

(T)his week, we launched what we're calling an Advanced Manufacturing Partnership. It's a partnership that brings our federal government together with some of America's most brilliant minds and some of America's most innovative companies and manufacturers.

Their mission is to come up with a way to get ideas from the drawing board to the manufacturing floor to the marketplace as swiftly as possible, which will help create quality jobs, and make our businesses more competitive. But they also have a broader mission. It's to renew the promise of American manufacturing. To help make sure America remains in this century what we were in the last - a country that makes things. A country that out-builds and out-innovates the rest of the world.

However, while the President is talking the talk about strengthening manufacturing, it isn't clear whether he is willing to walk the walk, particularly when it comes to a key question only partially addressed in the report:

How to Ensure that  Innovations be Produced in U.S.

Ensuring that new innovations will be produced in the United States and benefit the American economy is a huge problem. In fact, the report notes that many of the inventions developed in the U.S. in the past are currently being produced abroad. This statement appears in Box 1 of the report:

Research and innovation are essential, but alone they do not ensure a successful manufacturing sector. This is a sample of technologies and products with both commercial and defense applications invented in the United States and now produced primarily abroad:

• Laptop computers,
• Solar cells
• Semiconductor memory devices
• Semiconductor production equipment such as steppers
• Flat panel displays
• Robotics
• Interactive electronic games
• Lithium-ion batteries.

The report notes that the problem is not due to a lack of academic education, it is largely due to the lack of the kind of education that comes from learning by doing:

(T)he United States no longer has the knowledge, skilled people, and supplier infrastructure required to produce light-emitting diodes for energy-efficient illumination, components for consumer electronic products like the Kindle e-reader, or advanced displays for TVs, computers, and handheld devices such as mobile phones. (See Box 1.) With respect to batteries, the United States had also lost its lead in manufacturing. (The recent Recovery Act provided $2.4 billion for advanced battery and electric drive component manufacturing, demonstrations, and infrastructure development, which should allow advanced batteries and components for plug-in and hybrid vehicles to be manufactured in the U.S. rather than be imported). Companies in Asia now design nearly every U.S. brand of cell phone and laptop computer, except for Apple. This transfer of knowledge and manufacturing capacity may have national security implications as well, increasing the risk of counterfeit or malicious components in critical security systems. New U.S. companies continue to emerge in new technology sectors, but many keep costs down, access emerging markets and high-skilled workers, and satisfy their investors by locating their facilities abroad, usually in Asia-instead of creating jobs at home.

It Recommends Cuts in the Corporate Income Tax

In order to keep these innovations in the United States, the report recommends that the marginal rate of the U.S. corporate income tax be reduced and that an already-existing R&D tax credit be reworded so that it specifically applies to manufacturing R&D:

RECOMMENDATION 2: IMPROVE TAX POLICY

The Federal Government should:

• Reform corporate income taxes, to bring the marginal tax rate in line with other OECD countries, as advocated by President Obama in his 2011 State of the Union address. This will create stronger incentives to locate manufacturing plants in the U.S. and help eliminate the disincentive to repatriate profits, and instead, draw companies to use them to employ U.S. workers.
• Extend the R&D tax credit permanently and increase the rate to 17%, as advocated in the Presidents' Strategy for American Innovation and FY2012 budget request. Knowing that the credit will persist will encourage firms to lengthen their time horizon for R&D investments. The rules governing the tax credit should also be examined to make clear that R&D on manufacturing processes qualifies for the credit.

The PCAST report recommends lowering the corporate tax rate from the current 35% to about 25%, the level of most European countries and of Rep. Paul Ryan's House Budget Plan. But many countries have corporate income tax rates below that. For example, Ireland's corporate income tax rate is just 12.5%. Presidential candidate and former Minnesota Governor Tim Pawlenty has recommended that the U.S. Corporate Income Tax rate be reduced to 15%. He argues, correctly, that lowering the corporate income tax would jumpstart American economic growth.

During the 2008 presidential elections, former Arkansas Governor Mike Huckabee went even further. He recommended reducing the corporate income tax to zero by substituting the FairTax (a sales tax) for the payroll taxes as well as both the personal and corporate income taxes. The FairTax is border adjustable, which means that it is paid on imports but excluded from exports, so it doesn't prevent domestic investment decisions.

Another possibility would be to replace the corporate income tax with a value-added tax on goods (since goods are involved in international trade). Almost all of America's trading partners already have a value-added tax of at least 15%. Like the FairTax, the value-added tax is border adjustable which means that it is paid on imports but excluded from exports and so doesn't prevent domestic investment.

Yet another possibility would be to integrate the corporate income tax and the personal income tax, exempting all income which is reinvested while taxing only income that is consumed. This strategy was most recently proposed in 1995 by Senators Nunn and Domenici as part of their Unlimited Savings Account (USA tax) proposal.

Cutting the corporate income tax is indeed an excellent idea. Bringing it in line with the European countries would definitely be a step in the right direction, but it would be just a baby step. Why not reduce it much further? The higher the corporate income tax, the less corporations will invest. A zero corporate income tax would lead to maximum investment.

The Report Fails to Deal with Mercantilism

There is, however, a larger blind spot in the report.  The report does not suggest anything that would prevent foreign governments from practicing mercantilism in order to steal our industries. The more that we would innovate, the more they would steal. Back in Reagan's time, when Japan was the main culprit, a Republican President opposed mercantilism. President Reagan not only launched SEMATECH to defend the integrated circuit industry from Japanese predations, but he also required that Japan reduce its car exports to the United States, which forced the Japanese companies to build auto factories in the United States where they continue to benefit the American worker.

The current leadership of both parties in Washington advocates unilateral free trade, even though more and more of our trading partners practice mercantilism. Take Mexico for example. Despite NAFTA, Mexico, copying China, now manipulates the dollar-peso exchange rate so that it runs trade surpluses with the United States. The Federal Reserve reported that Mexico had spent 3.64% of its GDP on currency manipulations between September 2009 and September 2010. The Obama administration raised no objections. Mexico is even using tariffs on American products (25% duty on U.S. cheese, 20% duty on U.S. wine, 15% duties on U.S. fruit and fruit juices, 15% duties on U.S. pencils and pens, 10% duties on U.S. shampoo, hair spray, tooth paste and deodorant, and 10% duties on U.S. dog and cat food.) to gain access to America's internal trucking industry, and President Obama is capitulating to its demand.

Or take South Korea. Due to its non-tariff barriers, we import about 700,000 cars each year from South Korea, while they only import about 6,000 from us. Presidents Bush and Obama have negotiated so-called "free trade" agreement with them which lets them continue to manipulate non-tariff barriers and the dollar-won exchange rate in order to continue running trade surpluses with us. The Federal Reserve reported that South Korea spent 4.24% of its GDP on currency manipulations between September 2009 and September 2010. Yet Congress is preparing to ratify a "free trade" agreement with South Korea that doesn't prohibit currency manipulation and doesn't require balanced trade. According to one analysis, it will cost the United States 159,000 jobs during the first seven months after ratification.

But Mexico and South Korea are pikers compared to China. The Chinese government manipulates currency exchange rates and places tariff and non-tariff barriers on American products, so that American companies have to locate in China if they wish to sell to China's growing markets. But in order to locate factories in China, American companies are required to share their technology with Chinese competitors, and that's just one of the ways China steals their technologies. UC-Irvine economist Peter Navarro, author of the new book Death by China, writes:

The most potent of China's "weapons of job destruction" are an elaborate web of export subsidies; the blatant piracy of America's technologies and trade secrets; the counterfeiting of valuable brand names like Nike and Chevy; a cleverly manipulated and grossly undervalued currency; and the forced transfer of the technology of any American company wishing to operate on Chinese soil or sell into the Chinese market.

Why should American companies devote time and money to innovations that will soon be stolen by China? Obviously, the United States needs to require balanced trade as potential Republican Presidential candidate Governor Sarah Palin now recommends. Then, when the Chinese government excludes products made in America from its markets, it would be excluding Chinese-made products from American markets. American companies would be able to locate their factories in the United States, where they could protect their technology, and still have access to China's markets. Until the U.S. requires that trade be balanced, any innovations produced in the United States will soon be manufactured abroad.

We recommend that the United States adopt our WTO-legal scaled tariff whose duty rate would be regularly adjusted with each individual country with which we run a trade deficit. The tariff rate would be individually adjusted to our trade deficit with each country, rising as the trade deficit becomes worse, falling as the trade deficit improves, and disappearing when trade reaches balance or goes into surplus. The scaled tariff would force our trading partners to take down their barriers to American products in order to reduce our duty on their products.

And the scaled tariff would not be a budget buster, quite the contrary. It would generate federal government revenue equal to about half of the U.S. trade deficit (which is currently $563 billion per year). The infrastructure for innovation proposed by PCAST could be funded while still leaving 499/500th of the new revenue generated to help balance the federal budget.

Unlike a general devaluation of the dollar, the scaled tariff only applies to countries with which we have large trade deficits. It would not affect our trade with countries, such as Canada, which don't place barriers upon American products and don't manipulate exchange rates.

For the 200 years after 1791, when Hamilton submitted his Report on Manufactures to Congress, America's growing manufacturing base produced growing prosperity. Our manufacturing, even more than our armed forces, won both World War II and the Cold War.  PCAST has done our country a service by bringing attention to our declining manufacturing sector which is resulting in our declining capacity for innovation.

Its solutions aren't bad either. It reached back to the Reagan administration and found a successful model of how the federal government can help with innovation. As far as taxation is concerned, it recommends exactly what Congressman Paul Ryan's House Budget Plan recommends on corporate income taxes.

The only problem with PCAST's report is that it does not go far enough to make sure that innovations invented in the United States are manufactured and developed in the United States. In order to do that, we recommend that the United States enact a modern version of Hamilton's successful tariffs, a trade-balancing scaled tariff.

The authors maintain a blog at www.idealtaxes.com, and co-authored the 2008 book, Trading Away Our Future: How to Fix Our Government-Driven Trade Deficits and Faulty Tax System Before it's Too Late, published by Ideal Taxes Association.