February 2010 Archives

As I anticipated in an earlier posting, today the BEA revised its estimate of 4Q GDP. What I got completely wrong was the direction -- my bad. GDP grew by 5.9% -- revised upward from the earlier estimate of 5.7%. I had thought the number would have been revised downward because of the worse than expected trade data. As it turned out, upward revisions in private inventory investment and nonresidential fixed investment were more than enough to overcome any downward revision due to the increased trade deficit and the lower than expected consumer spending.

So, I take it back -- the economy really was doing well in the 4th quarter of last year. Let's see if we can sustain that growth and if we see an improvement in the employment numbers.

By the way, I will make another prediction: don't read too much in to next week's employment data. The survey was taken in the middle of the snow storms which may skew the data.

A story in today's Wall Street Journal (In Italy's Mills, a New Spin) on the fashion industry highlights the role of manufacturing in an intangible-intensive, innovation-driven economy.

"If we lose the Italian mills, we lose the creativity needed for fashion," says Sal Giardina, an adjunct professor of textiles at New York's Fashion Institute of Technology. "Fabrics are the common denominator of fashion. From birth to death, we are never more than three feet away from a textile product."

Much has been said about this high value-added strategy. As I have noted before, manufacturing is an intellectual capital dependent activity. A key part of that IC is the supply-chain relationship. The need to have production and design closely linked is something that a number of technology industries re-learn every few years. As the article illustrates, it is important in any industry with short product life cycles -- such as fashion.

The article also points outs the countervailing forces:

Yet consumers have been demanding cheaper clothes, and one way retailers have achieved these improvements is by pressuring apparel manufacturers to lower prices by more than 20% for each of the past two seasons. Many have done so by moving more production to China, Sri Lanka, Thailand and other low-labor-cost regions of the world.

How these two forces play out will determine the fate of many industries -- and the fate of many national economies.

Here is a quick take on three interrelated items worth reading:

Greg Tassey's paper Rationales and mechanisms for revitalizing US manufacturing R&D strategies outlines the importance of manufacturing to a technology-based economy and a new economic framework for policy.

The Geography of Innovation describes the role of regional innovation clusters and how to promote them.

The Power of Place 2.0 summarizes 10 policy ideas for "creating jobs, improving technology commercialization, and building communities of innovation."

All three are built on the central concept that innovation and intangibles (including knowledge) drive economic growth -- the concept that also is at the core of Athena Alliance and our notion of the I-Cubed Economy.

Gary Pisano of the Harvard Business School has a new working paper on The Evolution of Science-Based Business: Innovating How We Innovate. First of all, Pisano differentiates between technology-based and science-based businesses. Technology-based businesses, like software and electronics, develop and apply existing science. Science-based businesses, such as biotech, must engage in developing new science. That difference makes science-based businesses far more risky - since the science may or may not pan out:

Science‐based businesses are at the frontier of knowledge. Technical failure is the norm, not the exception. What is known pales in comparison to what remains to be discovered.

. . .

Thus, not only might the financial costs of exploration be high, but critical technical uncertainties may not be easily or quickly resolvable early in the development process. And, even if an organization can resolve those uncertainties through research, there is no guarantee the resulting intellectual property will be appropriable. "Deeper understanding" may be critical to further development, but it is generally not patentable.

That fact of "science" limits how such science-based businesses can raise capital. After discussing the limits of venture capital and capital markets, he offers this discussion of IP monetization:

An alternative or complementary strategy for a firm to raise capital for its R&D is to "monetize" its intellectual property. That is, rather than trying to develop a whole product and earning revenues on product sales, the company essentially licenses out the project to another firm. Such licensing has become a huge part of the R&D world in most technology intensive industries. There are literally thousands of R&D agreements and licensing deals that occur every year. One of the chief benefits of intellectual property monetization is that it enables firms to manage risks. It also enables firms with complementary capabilities to access know‐how.

Monetization of intellectual property is not a new phenomenon. Firms have licensed intellectual property for more than a century. However, the extent of this IP monetization appears to have grown dramatically in the last few decades. Since science‐based businesses rest on intellectual capital, it stands to reason that markets for know‐how will play an ever more important role in the future. However, we must also understand that monetization of IP has limits as a device for creating the required integration.

Market mechanisms work best when the relevant "modules" of knowledge are clearly defined. Thus, modularity facilitates collaboration (Teece 1982). This is one reason Open Source projects like Linux have been so successful. The modular architecture of Linux enables thousands of software developers from around the world to make contributions without ever having to talk to each other directly or to meet face to face. The IP monetization approach is often predicated on an assumption that the IP in question is a discrete module or asset that can be bought and sold. However, as mentioned earlier, in science‐based contexts, the immaturity of the underlying knowledge base makes it less likely for modularity to exist. This suggests that achieving the required integration through licensing and the market for‐ know will fall short in science‐based contexts.

I'm not sure he has completely grasped the role of IP monetization. In some industries, such as electronics, the licensing process is one of integrating modules. But in biotech, the process seems to have two other roles: division of labor and capital formation. The division of labor function of licensing spreads the work among several organizations, specifically between the new drug development and approval process and the production and marketing processes. Licensing (and sale) of biotech IP also functions in the timeless manner of swapping long term revenues for upfront capital. Licensing and other forms of IP monetization use the revenues from the previous science-based success to fund the next scientific gamble. Thus, it may be perfectly suited to the high risk nature of these types of businesses.

Ultimately Pisano argues that these science-based endeavors require new organizational models -- based on a view from Alfred Chandler that "it is hard to think about technological innovation as anything but tightly intertwined with organizational and institutional innovation." As he notes:

Science‐based businesses in biotech and elsewhere have 'borrowed' many elements of organizational technology (venture capital financing, use of the public equity markets for liquidity, monetization of intellectual property, etc.) that have been used, often successfully, in other technology contexts such as electronics and software. However, as argued above, science‐based sectors create novel organizational challenges around the simultaneous need to manage risk, integrate cross knowledge bases, and leverage cumulative learning. Addressing these challenges calls for new "organizational technology."

Here I would completely agree. But I would not limit the observation to only science-based businesses. Most innovation-based businesses (whether new science-based, based on existing science, or non-technological) face the same three challenges of risk, multiple knowledge bases, and learning. We can look to science-based businesses for clues to the emerging organizational models. But those models, I would argue, will end up being widely applicable in the I-Cubed Economy.

Here is an interesting excerpt from the UK's Ministry of Defense look at the future: Global Strategic Trends Out to 2040:

Success in future conflict, especially against adaptive and agile adversaries, will require a shift away from kinetic to influence activity, underpinned by a greater understanding of the enemy. This understanding will require more emphasis on intelligence gathering, cultural awareness, individual and collective training, and focused comprehensive approaches.

By "kinetic", they mean firepower. In other words, the old industrial age method of warfare -- which General Nathan Bedford Forrest characterized as "Get there firstest, with the mostest" -- is giving way to an intangible based model.

And speaking of financial innovations, here is an example of a recent one -- created by the government. David Wessel's column in the Wall Street Journal (A Stimulus '09 Success Story) explains how this innovation in state and local financing came about:

In 2009, the driving force wasn't fairness or tax reform. It was an emergency. The bond market was closed to most cities and states. Many institutional investors weren't buying, and firms that had been insuring shaky municipal borrowers were imploding. An urgent need to draw new investors to buy muni bonds gave birth to the taxable, federally subsidized "Build America Bonds."
The experiment worked. It helped revive the muni-bond market, keeping local construction projects going. Last year, $64 billion in Build America Bonds were issued in 45 states, about 20% of all muni offerings; this year will be bigger.
Wall Street and U.S. Treasury estimates show that, after the federal subsidy, muni issuers of Build America Bonds save between one-quarter and one-half percentage point on borrowing costs versus issuing tax-exempts. That's $1.25 million and $2.5 million annually on a $500 million bond issue. New York's Metropolitan Transportation Authority figures it saved $46 million over the life of a $750 million Build America Bond issued last spring.

The result is not just a revitalization of the muni bond market but a shift in the market toward a type of financial product that everyone seems to think is a better way to finance state and local governments. As Wessel notes, "Sometimes, the system works."

Amen to that.

As work continues on financial reform legislation (see for example today's New York Times story), one of the elements that is still a hotly discussed issue is some form of review of financial innovations. Proposals for a Financial Product Safety Commission or a Consumer Financial Protection Agency seem to be gaining ground after stalling (see a recent Washington Post story).

Behind this debate is the question of whether financial innovation is positive or negative. Bob Litan at Brookings recently posted a essay In Defense of Much, But Not All, Financial Innovation. He is responding to the critique of many -- including Paul Volcker -- that innovation in the financial sector has been damaging. Litan scores a number of innovations, such as home equity credit lines, money market funds, and adjustable rate mortgages as positives. He also scores asset-backed securities as a positive, but he recognizes the dangers especially with the "originate-to-distribute" (OTD) model. As he notes:

The challenge is how to fix securitization so that it continues to provide the consumer benefits of the added funds it brings to lending without having the workout disadvantages just described, and especially without becoming so complex and opaque that it distorts asset markets. . .

This is an example of his general approach toward financial innovation:

If we want more useful innovations in the future - as I believe we should - we should not generally apply the precautionary principle to finance. But we should stand readier to correct abuses when they appear and not let destructive financial innovations wreak the kind of economic havoc we have unfortunately just witnessed.

In a piece last year in the Financial Times Robert Shiller makes different point:

New products must have an interface with consumers that is simple enough to make them comprehensible, so that they will want these products and use them correctly. But the products themselves do not have to be simple.

So Shiller is arguing for careful up front design of the products, whereas Litan is advocating a quick response to problems as they emerge.

I think there is merit in both approaches. There are financial innovations we wish to promote as socially beneficial -- microloans as an example. Such innovations can be designed in a way as to keep them from going bad. And mechanisms put in place to catch them if they do.

As I've noted before the point is to understand when an innovation goes beyond its useful sphere. We generally thing of a rose as a desirable plant. But a rose growing in the middle of a wheat field is probably better characterized as a weed.

Our trick in revamping the financial system is to build a mechanism that can tell the difference between a rose and a weed -- and know when a rose has become a weed.

Today's New York Times is running an op-ed (An Order of Prosperity, to Go: Exports of Services Can Save Our Economy) that shows how hard it is to get it right on export promotion. The author asserts -- and I would agree -- that exports of services have dramatically grown in recent years and that the US has a competitive edge in many services exports. Unfortunately, the idea touted in the headline that services exports can solve our trade and economic problems is just nonsense. As I have demonstrated earlier, our services surplus is too small to overcome our goods deficit. And while we are currently competitive in services trade, most other nations are rapidly beefing up their capabilities. According to one report, over 30 countries have active programs to promote services exports (although I don't know how many of these are really travel and tourism promotion activities - travel and tourism being a major part of our services trade).

What is really troubling with this op-ed, however, is its complete laissez faire economic view. The only thing the author argues for is more trade agreements: "the best thing the administration can do is reduce impediments to trade and then get out of the way." Such a policy is guaranteed to result in one outcome -- the loss of our current competitive position in services trade and an ultimate switch from a surplus to a deficit.

We have seen the movie before starring "Advanced Technology Products". The US once had a small, but meaningful surplus in these high-tech areas. It was touted that this surplus would overcome our deficit in our low-tech goods. One can almost recall the headline: "High-tech exports will save the economy." The reality turned out very differently. The last monthly surplus in Advanced Technology Products was in June 2002 and the last sustained series of monthly surpluses were in the first half of 2001.

We need an active government policy of promoting all types of exports. Service exports are important and contribute to reducing the deficit. That part of the argument the op-ed got right. But services are not enough. And simply "get the government out of the way" of services exports is a recipe for decline -- just like it worked in high-tech. Why would we ever want to go down that road again?

A couple of recent newspaper stories on manufacturing caught my attention regarding what may be the future of manufacturing in the US. There is this story in the New York Times (Detroit Auto-Parts Suppliers Branch Out to Other Industries) which explains:

In September, for instance, NTR, a solar energy company from Ireland, awarded contracts to two Detroit-area auto suppliers, including the race-car engine developer McLaren Performance Technologies, to make components for thousands of SunCatcher solar dishes.
"It should be no surprise we went to Detroit," says Jim Barry, NTR's chief executive. "The standard of manufacturing in the automotive industry is extraordinarily high, and that is the only place you can find such a concentration of skills."

And there a story in the Wall Street Journal (Radical Shifts Take Hold in U.S. Manufacturing) about how capital investment in industries has shifted. One part of that article was especially telling:

A large chunk of semiconductor production takes place abroad, but many companies still prefer to produce in the U.S., particularly if their manufacturing entails little human labor or is highly complex. Being close to the U.S.-based design centers of major chip users like computer maker Dell Inc. and consumer-electronics maker Apple Inc. also can be an advantage.
"This is a kind of manufacturing that will make sense to do in the U.S. for a long time to come," said Tim Peddecord, chief executive of privately held memory-module producer Avant Technology, which recently opened a new 50,000-square-foot plant in Pflugerville, Texas. The new plant will boost the company's capacity to 800,000 modules a month from 500,000.

Both stories illustrate that the key is building on the existing strengths of the industries intangible assets -- in these cases, the worker skills and the relationship with customers/suppliers. As I've noted before, we need to explicitly incorporate intangibles and intellectual capital into our manufacturing strategy. - - - By the way, the New America Foundation talking points on manufacturing outline why it is important to the US economy -- including for maintaining our innovative capacity. Worth the read.

In the State of the Union, President Obama pledge to "double our exports over the next five years." A week ago, Commerce Secretary Locke announced the details of the National Exports Initiative. The trade data released earlier this week showed exports in 2009 totaled $1.55 trillion. Doubling exports would take it to $3.1 trillion (based on the 2009 export level -- $3.6 trillion based on 2008 export levels).

How do we get to the level of $3.1 trillion exports in 2014? Goods exports were about $1 trillion in 2009. All services export were about $500 billion. Business services are about $230 billion. Travel and passenger fees (essentially tourism) are about $125 billion combined. Royalties are $83 billion. Other transportation services (essentially freight transportation) are $45 billion. Government payments and military contracts are just over $27 billion.

Increasing exports of goods is the key. For example, if you have only a 50% increase in goods exports to $1.5 trillion, you would have to increase services exports 3 times to gain the other $1.5 trillion. And of those services, it would be mainly business services and tourism that would have to provide the bulk of the increase. Transportation services will grow only as fast as export and imports of goods increase. To get to $1.5 trillion in services exports would require a 4 fold increase in business services and tourism.

In its best year in the last two decades, tourism grew by a little over 16%. If it would match that rate, total exports from tourism would reach over $260 billion by 2014. Far short of a 4 fold increase - but more than doubling. However, the average before the recession was closer to 4.5%. Reaching the goal of doubling this export would require matching the largest growth rate in recent years - an unlikely prospect.

Between 2004 and 2008, goods exports increased about 12% a year. At that rate over the next few years, exports of goods would increase to just under $1.9 trillion - short of a doubling. But the average for the decade and half before the recession was under 7%. Maintaining that average rate would leave us well short of the goal of doubling the level of goods exports by 2014.

Before the recession, growth in intangibles -- business services exports and royalty payments received -- was about 10%. That would take us up to $370 billion of business services and $135 billion in royalties by 2014 - well short of doubling. So, while exports of intangibles have been the fastest growing area in the past decade and half, they are not enough to reach the goal of $3.1 trillion in 2014.

Thus, meeting Obama's goal of doubling exports by 2014 will require a sustained push to increase our exports even beyond the recent high rates found for a few years in the mid part of the last decade. Every category will have to grow at about 15% per year.

The chart below shows what would be needed (military contracts and transfers are assumed not to increase).
Exports of intangibles can play a role in meeting that overall goal. But the real contribution of intangibles will be to strengthen manufacturing and the export of goods. As I have noted before, intellectual capital and intangible assets are just as important for manufacturing as for any other sector. Baking IC and intangibles into a manufacturing strategy (see earlier posting) is absolutely critical to reaching the trade and exports goals the President has set of our nation.


By the way, doubling the level of exports could eliminate the trade deficit. Imports are currently around 17% of GDP (has grown over the past two decades from around 10% in the 1980s). OMB forecasts GDP in 2014 in current dollars is about $18.5 trillion. Assume that ratio holds steady, imports in 2014 will be $3.1 trillion. Thus, a combined a policy of holding imports at the current level of GDP with a growth of exports might make economic sense. Such an import policy, however, would require a policy to reduce oil imports, i.e. an energy policy. But that is a discussion for another time.

Today's press coverage of international trade news had an interesting take. For example, look at these excerpts from two stories in the New York Times:
Trade Deficit Widened in December

Rising demand for foreign goods in the United States caused the trade deficit to widen more than expected in December, the government said Wednesday, suggesting that American businesses and consumers were growing more confident about spending.

Healthy Jump in Chinese Exports Points to Recovery in World Trade:

China said Wednesday that its exports climbed 21 percent in January from a year earlier, while imports surged 85.5 percent, the latest sign that world trade is starting to recover from the global financial crisis.
. . .
Imports in January rose impressively, in line with economists' expectations, because imports a year ago were so weak. Many Chinese export factories nearly stopped buying raw materials then as their orders dried up, but they have been restocking since late spring.

In other words, a return to the "old normal" of Chinese production for US consumers as the engine of economic activity. Where is the evidence of the so-called "new normal" of sustainable economic growth?

As Kelly Evan in the Wall Street Journal (U.S. Losing Edge on Export-Led Growth) points out, "U.S. export growth is running up against a Big Fat Greek Problem."

The widening reflects faster growth in imports than exports at year-end, an unwelcome side effect of the U.S. economic recovery. It also is a reminder that export-led growth, which nations are pursuing as a path out of recession, is easier said than done.
President Barack Obama has called for a doubling of U.S. exports over the next five years to help narrow the trade deficit and spur economic growth. The quickest way of doing so is a weaker dollar, which makes U.S. goods and services cheaper in the global market.
But lately, the dollar is moving in the other direction. Worries over the fiscal health of Greece and other nations have dogged the rival euro currency, which hit an eight-month low on Tuesday before closing a few cents higher.

In the 1980's, America - with public and private sectors working together - confronted our economic competitiveness issues. A number of programs and activities were started, such as the Manufacturing Extension Partnership, that continue to this day. But it was recognized that any of these sectoral and micro-economic policies needed to be anchored in a sound macroeconomic base. For the past few decades, one key component of that base have been out of whack: currencies.

Confronting the current issues -- specifically the US-China currency issue -- is one of the toughest tasks ahead. There are many reasons why China will resist these efforts -- based on legitimate over its own economic prosperity. And there are many reasons why some in the US are reluctant to confront the problem.

But unless and until we do, there will be no "new normal." The old normal will reassert itself -- at a lower level of prosperity. And we will all be in the position of just waiting for the next economic crisis. That is a situation which benefits no one: neither the US or China. Which is why will we need to working together to solve the problem.

BEA's trade data for December showed an unexpected increase in the deficit, up to $40.2 billion from November's revised $36.4 billion. Our trade surplus in intangibles also went in the wrong direction as well, declining slightly by $68 million (chart one). Exports of business services declined, while imports increased. Royalties exports (payments received) and imports (payments out) both increased, with exports running slightly higher than imports. Revisions to last month's data show that, contrary to previous analysis, exports of business services increased in November.

Chart 1


Our worsening goods deficit continues to completely overwhelms our intangibles surplus (chart two). The overall decline was in our trade balance was completely due to a surge in petroleum imports. Exports and imports of non-petroleum goods increased, but balanced out leaving the deficit in non-petroleum goods basically unchanged (chart three).

Chart 2


Chart 3

Overall, 2009 saw a decline in our intangibles trade surplus - dropping to $135 billion from $145 billion in 2008. Exports took the biggest hit, declining by almost 3.6%. Imports were generally steady with a minor decline of about 0.9% (See chart four). Total trade in intangibles declined by 2.6% - although the percentage of intangibles that makes up the total US trade rose dramatically (see chart five). The reason for that spike is the fall off of total trade last year, not anything to do with intangibles.

Chart 4


Chart 5

The good news is that our deficit in Advanced Technology Products decreased markedly in December, down to $4.9 billion from November's $8.3 billion. In part, the improvement was due to higher exports and lower imports of information and communications technologies. Exports of aerospace technologies also surged, indicating that the improvement might be only short-term. And BEA and the Census Bureau note that exports were over stated by $500 million because of non-disclosure requirements. The last monthly surplus in Advanced Technology Products was in June 2002 and the last sustained series of monthly surpluses were in the first half of 2001.

One final point: as I noted in my earlier posting about the 4thQ GDP numbers, the GDP estimates are likely to be revised based on new trade data. We now have that data -- and it is worse than expected. So look for the GDP number to be revised downward.


Note: we define trade in intangibles as the sum of "royalties and license fees" and "other private services". The BEA/Census Bureau definitions of those categories are as follows: Royalties and License Fees - Transactions with foreign residents involving intangible assets and proprietary rights, such as the use of patents, techniques, processes, formulas, designs, know-how, trademarks, copyrights, franchises, and manufacturing rights. The term "royalties" generally refers to payments for the utilization of copyrights or trademarks, and the term "license fees" generally refers to payments for the use of patents or industrial processes. Other Private Services - Transactions with affiliated foreigners, for which no identification by type is available, and of transactions with unaffiliated foreigners. (The term "affiliated" refers to a direct investment relationship, which exists when a U.S. person has ownership or control, directly or indirectly, of 10 percent or more of a foreign business enterprise's voting securities or the equivalent, or when a foreign person has a similar interest in a U.S. enterprise.) Transactions with unaffiliated foreigners consist of education services; financial services (includes commissions and other transactions fees associated with the purchase and sale of securities and noninterest income of banks, and excludes investment income); insurance services; telecommunications services (includes transmission services and value-added services); and business, professional, and technical services. Included in the last group are advertising services; computer and data processing services; database and other information services; research, development, and testing services; management, consulting, and public relations services; legal services; construction, engineering, architectural, and mining services; industrial engineering services; installation, maintenance, and repair of equipment; and other services, including medical services and film and tape rentals.

For those of you not in the Washington area, you may be wondering about the weather here. This is the view from the back and front of the snowbound house. And there is another foot on the way. And yes, those are cables down in the back. So far, we have not lost power, cable or telephone. So as long as my internet connection is up, expect to see continued regular postings to the Intangible Economy. After all, it will all melt away in a month or two.

Business Week is running a special report on The Value of Design. There are a number of good pieces in the report. Let me pick out one that I think crystallizes the way design is important. This is from Dave McClure's article The Value of Design to Startups:

Design and marketing aren't just as important as engineering: They are way more important. ...
Addictive User Experience (Design) and Scalable Distribution Methods (Marketing) are the most critical components of success in consumer Internet startups, not Pure Engineering Talent.

"Addictive User Experience" -- I like that. When I used to teach, I would talk about irrepressible functionality ---giving consumers something they didn't think they needed but now can't live without. The classic case being the TV remote. Addictive User Experience is a level beyond that. And McClure is absolutely right: it is a process for design, not engineering.

We have a lot of government programs to spur engineering teaching and research. Yet, if we believe McClure, design is a least just as important. So where are our programs in design teaching and research?

The President's FY2011 budget announced last week includes two proposals to change tax law as it relates to the transfer of intangible assets (from the Treasury Departments' General Explanations of the Administration's Fiscal Year 2011 Revenue Proposals aka The Green Book). The proposals go to the issue of companies transferring their intellectual property to subsidiaries located in countries where the royalty income is tax at a low rate or not taxed at all. The parent company "sells" the IP to the subsidiary and then pays royalties to that subsidiary for the use of the IP. The key question is the fair market value of that transfer. US law requires that the transfer be valued at the same level as if it was an arms-length transaction between two independent entities. The parent would then pay US taxes on that income. There is concern that companies are low balling the value of the IP, "selling" it cheaply so as to minimize the amount of US taxes they have to pay on the income from those sales. The US loses in two ways, the tax on the income from the sale and the tax on the income from the royalties.

The specific proposals from the Green Book are:

TAX CURRENTLY EXCESS RETURNS ASSOCIATED WITH TRANSFERS OF INTANGIBLES OFFSHORE

Current Law
Section 482 authorizes the Secretary to distribute, apportion, or allocate gross income, deductions, credits, and other allowances between or among two or more organizations, trades, or businesses under common ownership or control whenever "necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses." The regulations under Section 482 provide that the standard to be applied is that of unrelated persons dealing at arm's length. In the case of transfers of intangible assets, section 482 further provides that the income with respect to the transaction must be commensurate with the income attributable to the intangible assets transferred.

Reasons for Change
The potential tax savings from transactions between related parties, especially with regard to transfers of intangible assets to low-taxed affiliates, puts significant pressure on the enforcement and effective application of transfer pricing rules. There is evidence indicating that income shifting through transfers of intangibles to low-taxed affiliates has resulted in a significant erosion of the U.S. tax base.

Proposal
Under the proposal, if a U.S. person transfers an intangible from the United States to a related controlled foreign corporation that is subject to a low foreign effective tax rate in circumstances that evidence excessive income shifting, then an amount equal to the excessive return would be treated as subpart F income in a separate foreign tax credit limitation basket.
The proposal would be effective for taxable years beginning after December 31, 2010.

- - -
LIMIT SHIFTING OF INCOME THROUGH INTANGIBLE PROPERTY TRANSFERS

Current Law
Section 482 permits the Secretary to distribute, apportion, or allocate gross income, deductions, credits, and other allowances between or among two or more organizations, trades, or businesses under common ownership or control whenever "necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses." Section 482 also provides that in the case of any transfer of intangible assets, the income with respect to the transaction must be commensurate with the income attributable to the intangible assets transferred. Further, under section 367(d), if a U.S. person transfers intangible property (as defined in section 936(h)(3)(B)) to a foreign corporation in certain nonrecognition transactions, the U.S. person is treated as selling the intangible property for a series of payments contingent on the productivity, use, or disposition of the property that are commensurate with the transferee's income from the property. The payments generally continue annually over the useful life of the property.

Reasons for Change
Controversy often arises concerning the value of intangible property transferred between related persons and the scope of the intangible property subject to sections 482 and 367(d). This lack of clarity may result in the inappropriate avoidance of U.S. tax and misuse of the rules applicable to transfers of intangible property to foreign persons.

Proposal
To prevent inappropriate shifting of income outside the United States, the proposal would clarify the definition of intangible property for purposes of sections 367(d) and 482 to include workforce in place, goodwill and going concern value. The proposal also would clarify that where multiple intangible properties are transferred, the Commissioner may value the intangible properties on an aggregate basis where that achieves a more reliable result. In addition, the proposal would clarify that the Commissioner may value intangible property taking into consideration the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative to the controlled transaction undertaken.
The proposal would be effective for taxable years beginning after December 31, 2010.

The first proposal seems to be an attempt to strengthen the enforcement capabilities. The second is similar to a proposal made last year (see earlier posting). However, last year's proposal called for the valuation of the intangible "at its highest and best use, as it would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts." In other words, a market transaction. The new proposal is to value the intangibles "taking into consideration the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative." I'm not sure that what really means, but I think it might be a movement from a market transaction based valuation method to to an income-based method.

As I noted back then, this proposal contain three components: an expansion of the definition of intangibles; dealing with the issue of transfer of multiple intangible properties; and, a valuation issue. The valuation issues I just mentioned -- market based versus income based.

The second component goes to the power of the IRS Commissioner under Section 482 to place his/her own value on a transfer whenever "necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses." The proposal would allow the Commissioner to value the intangible on an aggregate basis. This appears to go after the well-know issue that portfolios on intangibles are more valuable than the individual items taken separately. This issue is also tied to the market valuation issue -- as the current rules of using income appear to require tying the income to each specific intangible.

The third component would expand the definition of intangibles include workforce in place, goodwill and going concern value. It is also, at least to me, attacking a very different issue than the other two. Those three intangibles are essentially "whole-enterprise" assets. They can not be split off from the enterprise. As such, they are generally not transferred from entity to another as individual components like a patent or a trademark could be.

Thus, the issue of international transfer pricing is different in this case. It is about transferring control of the enterprise to a foreign owner. This is a slightly different "loophole" the IRS has been going after. Beginning 2007, the IRS has defined workforce in place as an intangible asset for purposes of what is called Section 936 Exit Strategies (see Industry Director Directive on Section 936 Exit Strategies # 1 and Industry Director Directive on Section 936 Exit Strategies # 2). These are specific transactions having to do with the restructuring of companies who had gained tax credits for operating in Puerto Rico as those credits have been phased out. The classification of workforce in place as an intangible asset made such a transfer a taxable event. Not surprisingly, this is view as a very controversial move. (For more information see the KPMG write up The Transfer of Workforce in Place to a Foreign Corporation.) It appears that this latest proposal is an extension of that same principle -- that all asset transfers should be subject to taxation -- to all transactions.

Our previous report, Intangible Asset Monetization: The Promise and the Reality, pointed out that taxation is an important policy tool that has not yet fully come to grips with the rise of importance of intangibles assets. For example, we have long advocated the expansion of the R&D tax credit into a knowledge tax credit by incorporating tax incentives for investments human capital as well as research. As part of a review of the intangibles and taxation, we suggest that it might be time to "explore lowering the tax rate on intangible asset royalties, in conjunction with stricter regulations on international transfer-pricing mechanisms and cost-sharing arrangements and on passive investment companies." The report goes on to say:

Providing a more direct tax incentive to the licensing of intangibles by lowering the rate on intangible asset royalties, such as to the capital gains rate, is a more controversial proposal. This lower rate could be crafted to apply only to royalties for new licenses for a limited time, such as a sliding scale for three years. In crafting such an incentive, safeguards would need to be established to prevent the incentive from being used for simply transferring existing licenses to SPEs [special purpose entities] and to ensure that the incentive went to new licensing activities only.

We didn't have that discussion last year when the Administration made its proposals. Maybe we can this time around.

January's employment data released this morning from BLS showed a welcome trend: the unemployment rate dropped to 9.7%. Not great but going in the right direction -- contrary to economist's expectations. On the other hand, job losses continued (with employment down by 20,000). There had been hope that the economy would begin to create jobs. And revisions to the 2009 data showed a greater job loss than previously reported.

The good news is that the number of involuntary underemployed (part time for economic reasons) and those part time because of slack work both declined dramatically in January. Not to read too much into this, but the trend (as the chart below shows) is in the right direction. Involuntary underemployment essentially peaked in March. As I said last month, this confirms that the fall is over. But the overall numbers point to a slow recovery.

Late last year, I posted a short comment on the Obama Administration's A Framework for Revitalizing American Manufacturing. As I noted then, the Framework recognizes the importance of intellectual capital limits itself to R&D and intellectual property--although the section on worker skills is part of a larger intellectual capital structure. Today, Athena Alliance is releasing a Policy Brief--Intellectual Capital and Revitalizing Manufacturing--which expands the Framework to explicitly incorporate intellectual capital. The following are the paper's recommendations:

Expand the Manufacturing Extension Partnership (MEP) to Boost Intellectual Capital. The Framework appropriately calls for doubling the MEP budget, but the scope of this assistance to manufacturers needs to be expanded to include innovation, new product development, and utilization of intellectual capital. Manufacturing companies have a wealth of intellectual capital that they often do not recognize or manage well. MEP services must include intellectual resource management that covers a broad array of assets, beyond help with intellectual property. The program's budget increase should be used to expand services and staffing in areas such as marketing, finance, and business model development, in addition to new product development and process adoption.

Help Entrepreneurs Manage Intellectual Capital. The Framework specifically cites efforts by the U.S. Small Business Administration (SBA) to provide entrepreneurship training and to foster partnerships with community colleges, universities, and others. It also mentions the U.S. Economic Development Administration (EDA) program of supporting business incubators. But most of these training programs do not explicitly recognize the importance of managing intangible assets and intellectual capital. Programs that support entrepreneurs need to incorporate these topics as part of their activities and impart these essential skills to would-be innovators.

Transform the Baldrige National Quality Program into the Baldrige Quality, Productivity, and Innovation Award. The Framework calls for "facilitating the diffusion of business practice innovations." One way to do this is through the Baldrige program, whose criteria have shifted and broadened over time to focus more on productivity and innovation. This shift, however, has largely gone unheralded. Changing the name--in essence, rebranding the program--would ensure that it rewards not just quality, but also productivity and innovation. The change might also prompt a review of the selection criteria to reflect this broader view.

Increase Worker Training. The Framework rightly calls for increasing federal funding for job training. However, the current system is geared toward assisting workers who have lost their jobs. Just as vital is support for on-the-job training so that workers are able to bolster their current skills, which enhances the competitive edge of employers and improves workers' viability in the marketplace. The important of on-the-job training is heightened in an economic downturn, when companies can easily lose their built-up supply of intellectual capital by laying off workers who may eventually find employment elsewhere.

Funding for on-the-job training could take a number of forms:
•   Direct government funding of training programs, possibly run through the community colleges (as also mentioned in the Framework).
•   A knowledge tax credit to cover employer costs. We already give tax incentives for investments in research and development (R&D) and in machinery. We should also give tax incentives for investments in workers.
•   In a "job-sharing" program. Proposals have been made for a national job-sharing program, where workers would reduce the number of hours worked from full time to part time; for example, from 40 hours to 35 hours a week. The wages saved by the employer would be use to hire additional workers and unemployment insurance funds would be used to pay workers for hours not worked as part of the program. On-the-job training could be included in such programs by requiring workers to spend that time in a training program.

Use IP to Provide Capital. As noted in the Framework, the administration is taking steps to increase the flow of capital to small businesses. Currently, small businesses can raise money based on their physical and financial assets, which can be easily bought and sold, borrowed against, and used to back other financial instruments. But using intangible assets, such as IP, to borrow funds is difficult. Here are some ways the government can free up this type of capital to unleash small business creation, innovation, and growth:

•   Tap SBA loans to fund innovation. SBA underwriting rules should be changed to allow companies to use their IP as collateral on loans. SBA already allows its loan funds to be used to buy intangibles when a new owner wants to acquire a company. Allowing IP to be used as collateral will increase the amount of funds a company, such as one in the high-tech sector, would qualify for.

•   Create an IP-backed loan fund. Other nations have developed special programs to encourage IP-based finance. The U.S. should set up similar programs on a pilot basis, ideally run by the SBA to take advantage of its lending expertise. Technical support could be provided by the SBA's Office of Technology, which already coordinates the Small Business Innovation Research (SBIR) program. The SBA technology office also works with the U.S. Commerce Department's National Institute of Standards and Technology (NIST) on its Technology Innovation Program and has a hand in other federal science- and technology-related initiatives. Such a direct lending program would be a step beyond SBA's current loan guarantee programs--direct lending is needed to jumpstart the process. Once the process of utilizing IP as collateral is fully established, the program could be converted to a loan guarantee structure.

Include Intellectual Capital and Intangible Assets in the Financial Regulatory System. The Framework explicitly points out that financial regulatory reform is necessary to create an environment of stability to promote economic growth and innovation. Yet intellectual capital and intangible assets remain outside of the discussion on financial reform, even though they represent between one-half and two-thirds of aggregate company value. The following methods could be used to bring these assets into the financial regulatory system:

•   Increase disclosure of intangible assets. The U.S. Securities and Exchange Commission (SEC) should be directed to study the barriers to intangible asset disclosure on corporate financial statements; assess past disclosure requirements, such as the 2003 guidance on the Management's Discussion and Analysis (MD&A) section in financial statements; and analyze the merits of a safe harbor for limited disclosure of financial information on intangibles not currently allowed in financial statements. In addition, the relevant federal agencies--the SEC and the departments of Treasury and Commerce--should establish an advisory committee to recommend ways to provide investors with an improved method of assessing the impact intangibles have on the accuracy of a company's financial picture and for supporting industry trade associations' efforts to adopt intellectual asset management and intangible disclosure guidelines for particular industries.

•   Provide information on intellectual capital and bank lending practices. The U.S. Federal Reserve is seeking to strengthen bank supervision practices through the expansion of stress testing to assess the health of individual institutions. As bank regulators undertake these actions, they should be aware of the role and value of intangible assets. The failure to overtly include intangible assets may have the following consequences:

•   Underestimation in the amount of collateral a lending institution has to call on in case of default (and therefore the undervaluation of the underlying loan).
•   Miscalculation of a lending institution's ability to recapture collateral if the lending institution is dealing with an asset it does not understand.
•   Improperly priced loans due to a failure to assign the correct value to the intangible assets or a tendency to apply exceedingly low loan-to-value ratios that are less a reflection of risk than of the institution's lack of knowledge about the performance of intangible assets.
•   Higher capital costs for borrowers, especially those in businesses heavily reliant on knowledge and technology.

Regulatory agencies can take steps to study and collect information on the role of intangibles in the financial system--and to underscore the risks of ignoring them. As they build knowledge in this area, the Federal Reserve and other financial regulatory agencies might consider the following questions:

•   To what extent are lending institutions employing intangible asset as collateral, either explicitly or implicitly?
•   What provisions are there in bank reporting requirements for intangibles?
•   Given that intangible assets can be wrapped up in the catch-all category of a blanket lien on all assets, how can lending institutions determine the value of intangible assets for the purposes of assessing collateral?
•   If intangibles are used explicitly as collateral, what underwriting standards are used and what are the specific valuation standards and loan-to-value ratios?

Promote Better Understanding of Intellectual Capital and Intangible Assets. The Framework mentions intellectual capital using the example of patents and managerial know-how. Yet, as noted earlier, intellectual capital and intangible assets cover a much broader range of categories, including worker skills and knowledge, business methods, organizational structure, and customer relations. There is a need to broaden the understanding of policymakers, business leaders, and the general public on the full scope of intellectual capital and intangible assets and how they function in the marketplace. There are a few ways to widen the scope of knowledge around this subject:

Commission a National Academies' study on intangibles. This was proposed at a June 2008 conference sponsored by the Bureau of Economic Analysis and the National Academies. A broad study of intangibles could include the following components:

•   A survey of efforts in other countries to advance the understanding of intangibles and their role in corporate performance and economic growth, promote financial investments in intangible assets, and foster the utilization of intangibles.
•   An inventory of federally owned intangible assets and an exploration of how to exploit them for economic growth.
•   A list of policy recommendations to accelerate private investment in and management of the types of intangible assets most likely to contribute to growth.

Manage the government's intangible assets more effectively. The federal government is a major investor in intangibles, but we don't have a clear picture of the size or nature of that investment across the agencies. The U.S. Office of Management and Budget (OMB) should build on the current federal budgeting process to engage in a cross-cutting analysis of federal investments in intangible assets. For some time the federal budget, as prepared by the Office of Management and Budget (OMB), has included a capital budget that includes physical capital, R&D, and education and training. The budget documents also include a separate analysis of statistical agencies' funding, which is not included in the investment budget. These and other budget studies already undertaken by OMB can serve as the starting point for a wide-ranging budgetary analysis of federal investments in intangible assets.

When the Obama Innovation Strategy came out last September, I noted the inclusion of a list of possible "Grand Challenges" at the end as setting some major priorities. Today's Federal Register has a the Office of Science and Technology Policy (OSTP) Request for Information on the Grand Challenges:

This Request for Information (RFI) is designed to collect input from the public regarding (1) The grand challenges that were identified in the strategy document; (2) other grand challenges that the Administration should consider, such as those identified by the National Academy of Engineering; (3) partners (e.g., companies, investors, foundations, social enterprises, non-profit organizations, philanthropists, research universities, consortia, etc.) that are interested in collaborating with each other and the Administration to achieve one or more of these goals, and (4) models for creating an ``architecture of participation'' that allows many individuals and organizations to contribute to these grand challenges.

Tom Kalil's posting on the OSTP blog today gives some further information, including links on the National Academy of Engineering's summits on their Grand Challenges for Engineering, university-based Grand Challenge Scholars Program and Expert Labs, a non-profit independent lab affiliated with the American Association for the Advancement of Science.

It will be interesting to see what people come up with in response to the RFI -- and if the solutions to the grand challenges move beyond just technological innovations.

President Obama is scheduled to announce today a program to use $30 billion of TARP funds to increase small business lending (a proposal that the Administration has been floating for some time). According to the Wall Street Journal:

In a briefing Monday, senior administration officials who helped draw up the proposal say that under the program, Treasury would provides capital investments in a swath of the nation's 8,000 banks with assets under $10 billion, which do more than half of U.S. small-business lending.
Banks that increase lending to small businesses beyond 2009 levels would qualify for reduced dividends owed to Treasury on the capital investment. White House economists hope that feature will spur interest in the program among community banks that shunned the original TARP program because of restrictions on the capital and worries that they would be tarred by their competitors as "troubled."

Here is another suggestion they might want to consider to help small business lending: unlock the lending potential of intangible assets. As we have pointed out in a couple of Athena Alliance reports (Intangible Asset Monetization: The Promise and the Realityand Maximizing Intellectual Property and Intangible Assets: Case Studies in Intangible Asset Finance), intangible asset backed lending is growing, but still nascent, means of financing innovation. Currently, companies can raise money based on their physical and financial assets. Such assets can be easily bought and sold, borrowed against, and used to back other financial instruments. But explicitly using intangible assets, such as IP, to borrow funds is difficult. While firms specializing in intangible-based financing are springing up, there are a couple of actions the Administration could take to foster this type of small business lending:

SBA loans to fund innovation. Explicitly change Small Business Administration (SBA) underwriting to allow companies to use their IP as collateral on loans. SBA already allows funds to be used to buy intangibles as part of the acquisition of a company by a new owner. Allowing IP to be used as collateral will increase the amount of funds a high-tech company would qualify for.

Create an IP-back loan fund. Other nations have developed special programs to encourage IP-based finance. A similar program in the U.S. should be set up on a pilot bases. The program could be run by the SBA, to take advantage of their lending expertise. Technical support could be provided by the SBA's Office of Technology, which coordinated the Small Business Innovation Research (SBIR) program and the Commerce Department's National Institute of Standards and Technology (NIST), which runs the Technology Innovation Program along with other science and technology related activities. Such a direct lending program would be a step beyond SBA's current loan guarantee programs. Direct lending is necessary, however, to jump start the process. Once the process of utilizing IP as collateral was fully established, the program could be converted to a loan guarantee program.

As I have noted before, the financial products discussed in this report are some of the most basic financing mechanisms in business, unlike some of the exotic financial vehicles. The innovation is in recognizing the value of intangible assets for corporate finance. Have the SBA enter the market would help regularize the market and set underwriting standards. That would go a long way to making intangible assets a regular and explicit part of the financial system.

My earlier posting on DOE loan guarantees mentioned that the regulations for the program require a "listing and description of assets associated, or to be associated, with the project and any other asset that will serve as collateral for the Guaranteed Obligations, including appropriate data as to the value of the assets . . ." The regulations also require the appraisal of real property to be "consistent with the 'Uniform Standards of Professional Appraisal Practice, [USPAP]' promulgated by the Appraisal Standards Board of the Appraisal Foundation, and performed by licensed or certified appraisers . . ." Standards 9 and 10 of the USPAP covers "business valuation" which includes appraisal of intangible assets, but its usage is not mandatory for government backed loans. Maybe it is time to look at those standards as well.

Here is a tidbit from the New York Times:

The initial discussions indicate a price of over $700 million for the Miramax name and its 700-film library, including films like "Pulp Fiction" and "Shakespeare in Love," which is essentially all that remains of the once-mighty art house label, according to the person, who declined to be identified because of the confidential nature of the negotiations.

Contrast that to the fact that the Pontiac Silverdome just sold for $583,000.

The President has submitted his budget to Congress -- documents are online at the OMB website. Before you get too carried away analyzing all the details (an activity that will consume Washington over the next week -- similar to a shark feeding frenzy), please remember that this is the beginning of a very long process. The process is shown in a nifty graph at the Wall Street Journal. And even that graphic shows the process the way is it supposed to work, with the President signing the appropriations bills and reconciliation bill before October 1. In real life, things often get tied up in continuing resolutions and omnibus appropriations bills.

While not getting into all the details, there is one part of the President's budget that I would like to highlight. Every year, there is an investment budget in the Special Topics portion of the Analytical Perspectives section that includes The analysis includes investments in physical capital, R&D and education and training. Education and training expenditures include aid for higher education through student financial assistance, loan subsidies, the veterans' GI bill, and health training programs, education programs for the disadvantaged and individuals with disabilities, training programs in the Department of Labor, and Head Start. This can be the starting point for a look at how much the federal government invests in intangible assets (see earlier posting). While it is not the complete picture, it does provide some overview (as R&D and education/training are the largest parts of our intangible investments).