Kauffman Index of Entrepreneurial Activity

The Kauffman Foundation recently released its 2009 Index of Entrepreneurial Activity. The report covers trends in entrepreneurship from 1966 to 2008. The index shows a rather steady level of business formation:

In 2008, an average of 0.32 percent of the adult population, or 320 out of 100,000 adults, created a new business each month. This business-creation rate translates into 530,000 new businesses being created each month during the year. The entrepreneurial activity rate increased only slightly from 2007, when it was 0.30 percent. Over the past twelve years, the business creation rate fluctuated between 0.27 percent and 0.32 percent.

However, within that steady sate there are dynamic changes. For example, the rate of low-income potential new business is different than high-income potential business:

Low- and medium-income potential business-creation rates generally decreased when economic conditions were strong, whereas high-income-potential business creation generally increased. When economic conditions worsened, high-income-potential entrepreneurship rates generally decreased and low- and medium income- potential entrepreneurship rates increased.

Thus, the rate of formation of low income potential business declined in the late 1990’s and has increased recently. Likewise, the entrepreneurship rate among those with less than a high school education declined in good economic times and rose in bad. And, not surprising, the highest rates of entrepreneurship were in construction.
Entrepreneurial activity was also different by region:

New-business-creation rates are highest in the West and South. From 2007 to 2008, the largest increase in entrepreneurial activity occurred in the West (0.37 percent to 0.42 percent). Entrepreneurial activity rates also increased in the Northeast (0.26 percent to 0.29 percent) and South (0.31 percent to 0.33 percent), whereas entrepreneurial activity rates declined in the Midwest (0.25 percent to 0.23 percent).

According to analysis of the data by RealClear Politics, the top ten entrepreneurial cities are:

Atlanta
Phoenix
Riverside, CA
Los Angeles
Miami
New York
San Francisco
Dallas-Fort Worth
Houston
Washington, DC

Since I’m based in DC, it would good to see that it made the list. I suspect, however, that this would not be true in previous years.

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Manufacturing and services – part 2

In a posting over a year ago, I discussed the fusion of manufacturing and services as a characteristic of the I-Cubed Economy – using Rolls Royce as an example. Rolls Royce gains a great deal of its revenues for servicing its products. The two are inseparable: High quality servicing requires that RR make the product (in order to understand it). The result is a complete customer package:

“They aren’t selling engines, they are selling hot air out the back of an engine,” says an investment analyst.

A recent story in the Economist on Oracle’s take over of Sun (Mr Ellison helps himself) illustrates the same point in the IT sector. The story describes the dynamics of the industry:

Since the early 1990s the industry has resembled a cake made of horizontal layers of technology, with each layer dominated by a few companies. Cisco, for instance, provided most of the networking gear. Sun and HP sold servers. Oracle was the leader in databases. IBM’s mainstay was services. SAP, a German giant, ruled in business software.
This structure is now collapsing as the industry’s heavyweights move into each other’s layers. HP bulked up its services division by buying EDS, for example, and has also moved more into networking. Cisco will soon start selling servers, and has formed an alliance with several smaller hardware and software firms to build, in effect, a data centre in a box. The industry is, in other words, going back to its past, when it was dominated by a few integrated companies that tried to do it all.
This is, in part, a consequence of the industry’s maturity: to keep growing, firms have to invade each other’s markets. In addition, customers increasingly prefer to buy integrated systems from one vendor, rather than doing the plumbing themselves. New technologies such as virtualisation and “cloud computing” are also blurring the boundaries between the industry’s layers. A server can now easily switch between being a computer, a storage device or a router (a box that directs network traffic). For computing to become a utility, which is the promise of the cloud, a data centre cannot be a hotch-potch of boxes cobbled together from different vendors, but must be tightly integrated.

The Oracle purchase of Sun fits with that dynamic:

Taking over Sun, he [Larry Ellison] said this week, provides Oracle with all the pieces to put together systems that reach from “application to disk”. Oracle’s engineers are already brainstorming about how to build “industries in a box”–complete computer systems that come fine-tuned for, say, banking or retailing.

In other words, Oracle will fuse hardware and services into one customer service application.
Another good example of the fusion of services and manufacturing in the I-Cubed Economy.

Tax Havens and intangibles – update

In follow up to my posting yesterday, it looks like the Obama plan sidesteps the issues I raised. As the New York Times reports:

The most widely used tactic not covered by the plan is known as transfer pricing, which multinational corporations employ routinely to reduce the taxes they owe to the United States by keeping their profits offshore in low-tax or no-tax havens.

The story goes on to say:

As part of the tax code, the tactic allows corporations, typically Fortune 500 companies like Wal-Mart, Exxon Mobil and General Electric, to reduce their United States taxes by calculating the prices they charge on goods and services transferred between their global divisions.
While corporations are supposed to compute those costs as if they had been assessed between independent, neutral entities, and to pay any taxes owed on them — the top rate is around 35 percent — corporations often fudge the numbers to their advantage, according to senior analysts.
In other words, corporations routinely abuse the tactic to minimize their taxes by undercharging or overpaying their foreign subsidiaries for goods and services.
With the Obama plan closing other loopholes, corporations are “now going to get crazy with their transfer pricing,” said Lee Sheppard, a commentator for Tax Analysts, a trade publication.

Much of the commentary on the proposal has been skeptical – pointing out the possible negative competitiveness implications (for example, see New York Times, Wall Street Journal, Washington Post). Much of the speculation is that this is part of the larger budget battles. Robert Reich notes that is can be a strategic move to both create a bargaining chip for corporate support on health care and a way to make the deficit hawks come to the table on the costs of health care reform (by proposing a way to pay for health care via the tax haven crack down).

My own sense is that this is more an opening salvo in a future tax reform battle. By laying down this marker early, the Administration is beginning the positioning for that fight. If I am right, then tax reform might be on the agenda sooner rather than later. At that time, I hope the issue of transfer pricing — including of intangibles — is back on the table.

Patent Reform notes

The Kaufman Foundation’s Policy Dialog on Entrepreneurship has a good piece on Patent Reform and Our Innovation Economy — including a fact sheet on reform proposals. As they state:

The existing system contains deficiencies that are worrisome from the perspective of entrepreneurship. While patents for new inventions provide a strong incentive for people to both create and publicize their intellectual property, patent laws are increasingly cumbersome.

Their two reform principles flow from that analysis: “(1) patents should only be provided for truly non-obvious inventions; and (2) consistent with the first objective, the procedures for contesting patents should entail minimum cost.” I would agree.

On another note on patents, the Economist recently ran a story on Intellectual Property in China. That story notes how Chinese firms have taken to patent enforcement:

Since 2006 more patent lawsuits have been filed in China than anywhere else, even litigious America. Most pit domestic firms against each other, but in recent years foreigners have found themselves on the receiving end too. In December Samsung, a South Korean conglomerate, was ordered to pay compensation to Holley, a Chinese telecoms firm. The recent victories and lucrative awards will open the floodgates to more suits, predicts Tony Chen of Jones Day, a law firm.

Increased use of patent lawsuits by the Chinese is a trend I wrote about in earlier postings a couple of years ago. The Economist goes on to note:

Chinese firms are also increasingly seeking patents abroad, a sign that they plan to protect their technology when exporting it to rich countries. They won 90 patents in America in 1999 but last year they received 1,225. That is still relatively few–IBM, an American technology giant, receives around 3,000 a year–but it is increasing quickly. Because it takes three to five years to issue a patent, the number issued to Chinese firms is expected to soar soon. The quality of patents issued in China is also improving. Revisions to the patent law that take effect in October strengthen the requirement for a patent’s novelty, bringing it up to global standards. Stronger patents are easier to enforce, opening the door to more lawsuits

As I warned before, patent lawsuits are a game that two can play. And the Chinese are likely to play it very well. Which makes the second principle in the Kaufman Foundation fact sheet mentioned earlier — procedures for contesting patents should entail minimum cost — that much more important.

Tax havens and intangibles

Later this morning, President Obama and Treasury Secretary Geithner will outline their new proposals for cracking down on offshore tax havens. According to the Wall Street Journal:

It aims to change the legal treatment of offshore subsidiaries and structures that companies have used to avoid not only U.S. taxes, but taxes in other developed countries as well.
In addition, the administration will strive to tighten rules that have encouraged thousands of Americans to open offshore bank accounts in an effort to duck U.S. taxes. The plan would increase information reporting and tax withholding as well as penalties, and make it harder for foreign account-holders to win cases in court. The administration promised new enforcement tools to crack down on tax-haven abuse.

It is unclear from the preliminary news reports whether the proposals will also target the issue of transfer of intangible (specifically patents) to low tax countries. As we noted in our report, Intangible Asset Monetization: The Promise and the Reality, companies can transfer 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.
However, as recently as 2006, then IRS Commissioner Mark Everson complained to a Senate subcommittee that:

Taxpayers, especially in the high technology and pharmaceutical industries, are shifting profits offshore through a variety of arrangements that result in the transfer of valuable intangibles to related foreign entities for inadequate consideration.

In other words, they 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.
By the way, this concern over internal transfer pricing is at the heart of many corporate tax issues.
As we note in our report, 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 and to ensure that the incentive went to new licensing activities only.
In conjunction with such a tax incentive, the problem of tax havens should be addressed. Transfer pricing mechanisms and cost sharing arrangements need to prevent those transfers that, as the IRS describes, are “for inadequate consideration.” The issue (some would say the abuse) of “passive investment companies” should also be handled.
The notion of tax havens and loopholes is often a matter of perspective. One person’s loophole is another person’s incentive. However, there is a growing concern that the tax code has become overly complex and that rates could be lowered in conjunction with the elimination of certain specific provisions. Any such tax reform, including the possibility of closing loopholes currently applied to intangibles and lowering the tax rate on royalties, should be looked at very carefully in the context of the impact on the creation and utilization of intangible assets

From some of the press reports, this appears to be in part the strategy that the Obama Administration wants to use — tighten up the overseas tax havens to raise funds to pay for other business tax incentives, such as the R&D tax credit.
We will see if it extends to other areas of taxation of intangibles as well.

Is reconstruction innovation?

The MIT Sloan Management Review has a new article on The Profit-Making Allure of Product Reconstruction. As they describe it:

Reconstruction, which covers a continuum of activities from recycling to refurbishing to remanufacturing, allows companies to sell goods at lower prices than if they were to assemble nearly identical new products. In most cases, the prices of remanufactured products are 50 to 75% lower than those of new ones. Despite lower prices, however, reconstruction provides customers with high-performance goods.

Normally, such activities would not necessarily be considered as “innovation.” One of the most standard metrics of innovation is amount of sales from new products (see OECD’s Oslo Manual: Guidelines for Collecting and Interpreting Innovation Data, 3rd Edition). Even the broad definitions of innovation (see earlier posting) emphasis the “newness” of the activity or product.
From that point of view, recycling and refurbishing are not innovation. As defined by the article, “Recycling is the process by which a used product is broken down into its constituent parts, which are then used in the manufacturing of new products,” and “Refurbishing is the process by which a product is restored to its original condition, without modification, so that it can be used for the same purpose as initially intended.” Neither of these activities results in new (i.e. different) products.
On the other hand, according to the article, “Remanufacturing is the process of completely disassembling a used product, repairing or replacing worn or obsolete components and adding enhancements.” That last part, “adding enhancement” would make this innovation under the standard definitions.
But even here, the article makes clear that the motivation of a customer to use a reconstructed product is often times the desire to avoid having to do something new — i.e. an upgrade. So, reconstruction is essentially a non-innovative solution. In fact, it is an innovation avoidance strategy. It keeps the old tech going while shunning the new.
Well, let’s take a different view of innovation — from the process point of view. The idea of recycling, in and of itself, is an innovative idea. What can be more innovative than turning what was a waste product into a source of raw materials? The old mindset was from earth-to-earth — i.e. from mine or farm to garbage landfill. Recycling is a totally different mindset based more on a circular product life-cycle approach. It wasn’t just the technology (i.e. the electric arc furnace) that made the steel minimills so innovative. It was the massive use of scrap as the primary raw material. Yes, scrap has always been a raw material. Generations of church bells were melted down to make cannons. But the rise of recycling as a standard mode of operation is an innovation in the post-WWII consumerist economy. The mere fact that there is an article in the MIT Sloan Management Review touting the idea shows how novel the concept still is.
Refurbishment is also an innovative idea for many. Product design long ago went from the idea as repair to the concept of replacement as the standard mode of product maintenance. Refurbishment and remanufacturing are an innovative way of changing the maintenance process once again. Rather than repair on site, refurbishment and remanufacturing uses the replacement process with a previously repaired product. For example, the copier is not fixed in the office, but replaced with an identical model that has been refurbished (repaired) previously. The copier is then taken to a repair/refurbishment location to be fixed up for another customer. The customer doesn’t get back its old “fixed” product; the customer gets a “new” version of the same product.
Thus, viewed as a process innovation, reconstruction is clearly an innovative idea — at least for some.
This raises yet another question about defining innovation. Is it still “innovation” if people have been doing it for a long time. For example, refurbishing and remanufacturing copy machine has been a standard part of the industry for many years. The formation of a new copy refurbishing company would not be considered an innovative undertaking. Yet another steel scrap yard or paper recycling plant would not be innovative. But recycling restaurant grease into bio-fuel is an example of innovation.
So the key to answering the question original question posed in the title of this posting comes down to “where” and “when.” Implementing these ideas in places where they have not been used before is process innovation. In the end, it is still the “newness” of the activity that counts. And judging “newness” is a subjective activity: new to the world, new to my neighborhood, new to me? At what point does it stop being innovation and start becoming replication?
Our standard innovation question is tied to “new to the firm.” So if the local diner installs a dishwashing machine (to replace the hand washing), that counts as innovation. Does it also count as innovation if they add a “patty melt” to the menu? It is a new product for them. What if they switch to a tex-mex format? Then all of their sales would be coming from “new products.”
These are the types of issues we need to grapple with, if the concept of innovation has any meaning at all from a public policy point of view. The goal of policy is to create incentives and remove barriers to innovation. That requires knowing what innovation is, and is not. Otherwise, innovation becomes such an open-end phrase that it can be used to justify anything – and therefore helps nothing.