By: Gary P. Pisano, Harvard Business Review
Following up on his pledge to provide greater support for manufacturing in his State of the Union address, President Obama has announced a proposal to cut the effective tax rate for manufacturers to 25%.
A number of economists howled against this so-called “industrial policy” and criticized the president’s singling out manufacturing for “special treatment” — something they say no industry should get. But the reality is that special treatment has always been a fact of life, and it would be naive to think that’s suddenly going to change. The industries that now receive special treatment include:
Agriculture, which receives massive government subsidies.
Universities, which enjoy tax-exempt status and significant direct subsidies through government research grants.
Health care, which receives a huge tax break (employer-sponsored health care plans are paid for with pre-tax dollars).
Housing, which is generously subsidized (largely through the tax deductibility of mortgage interest, which stimulates demand for homes as well as loans from banks.)
Private equity, which enjoys a15% tax rate on carried interest. (If the tax rate on profits in manufacturing were capped at a 15% marginal rate, manufacturing in this country might look a lot more attractive.)
By subsidizing other industries so generously, we have tilted the scales away from manufacturing. Thus, the decline of manufacturing is not completely a result of “natural” market forces.
There are some popular arguments for government action to revive manufacturing that I don’t buy. One is that it is somehow more valuable to make real (tangible) things than provide less tangible services. That’s silly.
Another is that the “rebirth” of manufacturing will suddenly solve America’s jobs problem. That’s wishful thinking. Manufacturing now accounts for only about one in 10 American jobs. A major reason for the decline in manufacturing employment in recent decades is the huge increases in the productivity of American factories. With those productivity gains likely to continue (a good thing), it is hard to imagine how manufacturing could ever return to its glory days, when it employed about a quarter of the U.S. workforce.
The Case for Special Treatment
That said, there are some compelling reasons the government should give manufacturing special treatment:
Lowering the trade deficit. It may be true that we value homes and health care just as much as we value iPhones and high-definition TVs, but there is a big difference between them in terms of trade. Homes and health care can’t be exported, while manufactured goods make up about 80% of world trade. If Americans want to keep consuming foreign-made consumer electronics, cars, and clothing, then we need something to sell in return. And one look at the trade deficit ($558 billion in 2011) clearly indicates we don’t have as much as our foreign competitors to sell in return. To make up the difference, we just borrow.
Sure, with improvements in information technology and communication, some services are becoming more tradable and that creates opportunities for the U.S. But let’s not kid ourselves. These services will also find themselves in a run for their lives. Indian companies, for instance, are already doing quite well exporting services like software development, technical support, and back-office processing to America.
Strengthening the industrial base. Remember, too, that many high-value-added services are often closely connected to manufacturing and can be delivered only locally. Production engineering is hard to do without a factory (it’s like being a cook without a kitchen). And if you do not have local plants, you don’t need to employ highly skilled technicians to maintain equipment.
Suppliers of production equipment also tend to cluster near manufacturing (the countries with the highest production of machine tools — Germany, Japan, China, and Italy — tend to have strong local manufacturing bases). It’s no surprise, therefore, that semiconductor-equipment suppliers are moving more of their R&D to Asia to be closer to the hubs of semiconductor production.
Retaining R&D. In many contexts, R&D and production are tightly integrated, and they need to be co-located. In the 1960s and 1970s, American consumer-electronics companies started outsourcing their manufacturing to Asia. But by the 1990s, the R&D had migrated there as well. This tight connection between R&D, innovation, and production is present in sectors like biotechnology, advanced materials, and nanotechnology. If we lose manufacturing, R&D eventually follows.
The Right Policies
Supporting American manufacturing does not mean, as many critics assume, advocating an industrial policy of “picking winners,” subsidizing dying industries, or protectionism. These tactics have never proved effective.
Instead, the government should focus on creating the right conditions for manufacturing to thrive. Actions it should take include the following:
Funding basic and applied scientific research in advanced manufacturing technologies. Such a model of government funding has been extremely effective in creating world-leading IT and biomedical sectors in the U.S.
Supporting training and education. Factory work today requires much more brain than brawn. It is knowledge work. Ironically, American manufactures often cannot find workers with the technical and vocational skills required in today’s sophisticated manufacturing operations. Government support of vocational education and community college technical programs is vital to making America an attractive place to invest in manufacturing.
Saving manufacturing is not about some nostalgic return to the past. Manufacturing is a critical component of the American ecosystem for innovation and can be an important part of the knowledge economy. To let it erode would be a grave mistake.