Back to Basics: Research Fueling Innovation

For much of history, profit-making typically meant profit-taking. Wars were fought for land and resources, while men grew rich from subjugating others. Money changed hands, but productivity barely budged. According to economic historian Joel Mokyr, whenever a society managed to raise its standard of living, rent seekers “came either from within the economy in the form of tax-collectors, exclusive coalitions, and thugs, or they came from outside as alien pillagers, mercenaries, and plunderers.”1
Of course, rent-seekers exist to this day, but since the Industrial Revolution, productivity has climbed drastically across the West due to the creative work of a new breed of proft-maker—the innovator. Rather than playing tug of war for limited resources, innovators circumvent those limits by applying their knowledge of the world to devise methods that combine resources more efficiently. Due in large part to their work, real U.S. GDP per capita is more than 30 times higher today than it was in 1800,2 American life expectancy has increased from 46 years in 1900 to about 79 years today,3 and in the developed world, creature comforts abound.

Basic research is the study of fundamentals; its main goal is to advance society’s understanding of the world. For instance, in the 19th century, scientists, such as microbiologist and chemist Louis Pasteur, questioned how diseases are transmitted, and their basic research into the matter led to the germ theory of disease.
Basic research is both a foundation for new discoveries and a guide to innovators that helps keep them from attempting the impossible. Without Pasteur’s work, surgeon Joseph Lister would likely not have searched for an antiseptic that could be used on human tissue and would not have discovered the use of carbolic acid to drastically reduce the incidence of infection during surgery. Isaac Newton might have devoted less of his genius on futile attempts to turn base metals into gold if chemistry had been more advanced.
The value of scientifc knowledge for innovation remains strong to this day. An October 2013 working paper by Frank Lichtenberg4 confirms the value of knowledge accumulation, finding that mortality rates by cancer are strongly associated with the stock of funded research papers published five and ten years earlier. For example, from 1985 to 1999, the stock of published, research-funded papers on lung cancer more than tripled,5 vastly expanding society’s knowledge of the deadly disease that accounts for more than a quarter of cancer deaths.6 Lichtenberg’s analysis suggests that this buildup of knowledge contributed to the 17% decline in lung cancer mortality rates between 1995 and 2009.
While some knowledge comes from the innovator’s  experience in the world, much is discovered through the dedicated activity of researchers. Unfortunately, this activity—the creation of descriptive knowledge—confers little economic value to the creator. Basic research is a classic public good. Once knowledge is discovered, it is impossible to exclude others from using it, and its use by one person does not reduce its availability to anyone else.

Whereas the patent system can reward inventions with temporary monopolies, no such system exists for basic research—neither would such a system be practicable or wise. And though firms can tailor most investment to ensure that a project will be applicable to their business, the potential application of basic research is often diffcult to predict. Businesses have an incentive to invest in applied research and development in their market areas because of the potential for profiting from a new idea. They have little reason, however, to pursue basic research because even if a commercial application is found, it may not be relevant to their market. What is more, a research finding that has applications in one "eld will usually have applications in many others.
Many governments have recognized the importance of knowledge for innovation and use public funds to accelerate its growth. The U.S. government is particularly aggressive in this regard, devoting more money to research and development than any other government in the world. In 2012, the U.S. federal government spent about $131 billion on research and development, including defense-related spending and $60 billion without defense.7 Total (private and public) U.S. research and development spending was almost $420 billion in 2012, compared to $197 billion in China, the second highest-spending country. Outside of the U.S., the rest of the world combined spent around $1 trillion in 2012.8 There is good reason to believe that the U.S. has served as a role model in this area, and the more research undertaken around the world, the better off everyone will be.
Yet, there is good reason to believe that federal research funds in the U.S. are not being spent wisely. Rather than devoting resources to the generation of
descriptive knowledge, the government plays innovator by funding applied research and development. In 2012, only 48% of non-defense federal research and development spending went towards basic research—42% supported applied research and 10% was devoted to development.9 With defense spending included, more than half of all federal R&D spending is devoted to development—but this article does not broach the efficiency of defense spending.
The non-defense R&D allocation makes little sense. Applied research and development does not need funding to the same extent as basic research. Firms spend lavishly on development to create new products and applied research to learn exactly that which is needed to profit. In 2009, U.S. firms spent $197 billion on development and $34 billion on applied R&D.10 Shop floor innovation is not included in these numbers but contributes to many practical advances. Basic research on the other hand, constituted only $16.5 billion (or about 6.6%) of industry research and development investment.11
The case for non-defense development spending is particularly weak. Developing products should be the task of firms and innovators, as the ability to profit from product improvements is high.

There are some indications, however, that applied research could use a subsidy. Applied research is designed to solve practical problems. Lister’s experiments to find an antiseptic for use in surgery is an example of applied research. Today, applied research is conducted widely by firms in pharmaceuticals, semiconductors, communications, and several other cutting-edge industries. The value of applied R&D is well documented with a
recent Econometrica paper by Nicholas Bloom, Mark Shankerman, and John Van Reenen suggesting that applied R&D as a whole is two to four times as valuable to society as it is to the entity that conducted the research.12
Specific innovations can be linked to astounding welfare improvements. For example, according to research by Kevin Murphy and Robert Topel, the benefit of reducing cancer mortality by 1% has been estimated to be worth about $500 billion in present value. They note that, “a ‘war on cancer’ that would spend an additional $100 billion on cancer research and treatment would be worthwhile if it has a one in five chance of reducing mortality by 1% and a four in five chance of doing nothing at all.”13 Both basic and applied research could contribute to such an improvement. 

As optimistic as this return on investment might be, two factors caution against direct government spending on applied research. First, in today’s tight budget climate, government resources should be devoted where government is most needed. The Congressional Budget Office recently released its 2013 Long-Term Budget Outlook, and many fears over debt and deficits were confirmed. The budget deficits have dropped off for a short while, but spending and tax policy are still badly misaligned. Applied R&D is more likely to be paid for by industry than is basic research and less likely to provide the ancillary bene#ts, such as training graduates and developing networks of scientists who are able and willing to collaborate across national and institutional borders, spreading knowledge and inspiring creativity. If there is a limit to how much a society is willing to spend on research, then it’s likely the money is better spent on basic research.

A more subtle reason for focusing on basic research is that government is not well suited to direct applied research. Applied research, by definition, is meant to meet the defined needs of members of society, such as curing disease, generating abundant energy, or paving the way for the next consumer gadget that millions of people decide is worth more than what it costs them. Industry is better suited to identifying which areas are most pressing, because industry has profit to serve as a guide. Moreover, a large body of academic research indicates that industry-funded applied research likely leads to greater productivity gains than government-funded applied research. Rather than fund applied research directly, it would be better to overhaul the notoriously ill-designed and poorly implemented research and experimentation tax credit, as well as reduce regulations that kill that competitive spirit driving applied research and development.

Our nation should undertake a mission to reorganize its federal spending on research and development. Resources should be shifted to basic research in order to grow the stock of knowledge. Regulatory and tax policy should be refashioned to encourage applied research at the firm level. These changes will require careful thinking about difficult problems, such as where to focus basic research funds and how to ensure that the Research & Experimentation (R&E) tax credit is being spent on research rather than product development.
This effort is worthwhile, for spurring the generation of knowledge will feed today’s innovators and help to develop the innovators of tomorrow.