Cut Mortgage Subsidies and Invest in Innovation

With economic recovery sluggish, what can the federal government do to spark innovation – the historic catalyst for economic growth and productivity?

There are plenty of ideas out there, including ones that are low cost but controversial.

As the McKinsey Global Institute smartly recommended earlier this month,

“Policymakers can support the emergence of new industries by using the power of the government to set standards and to create pricing mechanisms, and by using government purchases to provide early stage demand for new technologies.”

In today’s global economy, however, setting national rules of the road is not sufficient.   Investments matter.  Governments in mature economies must invest in innovation in appropriate ways and at large enough scale to grow jobs in the near term and retool our economy for the long haul.

The real question is: What to invest in and how to pay for it?

I recommend three tiers of national innovation investments:

First, the U.S. needs an entity charged with bringing strategic purpose and direction to federal innovation policy and flexible resources to make that vision a reality.  Presently, responsibilities for innovation policy and investments are divided up among multiple agencies and entities, let alone Congressional subcommittees.  The result is that the whole is less than the sum of the parts.

Rob Atkinson and Howard Wial have proposed a National Innovation Foundation (NIF) to bring together and ramp up the government’s fragmented efforts to boost commercial innovations in fields such as precision manufacturing, information technology, life sciences, clean energy and the environment.

Modeled on successful efforts in Japan, Korea and Finland, the NIF would bring a series of innovation programs that are now isolated and marginalized in separate cabinet agencies under one roof with a budget of $1 to $2 billion per year.  It would also bring national coherence to the myriad state and local efforts underway across the country.

Second, the U.S. needs to invest at scale and in a sustained way in advanced research and development, particularly in emerging sectors like clean energy.

Earlier this year, the American Energy Innovation Council, led by corporate titans like Bill Gates and Jeff Immelt called for an annual $16 billion investment in clean energy innovation ranging from basic energy science and renewable energy to electricity transmission and efficiency.

To drive market creation, the Council urged that funding flow both through ARPA-E (the military-inspired innovation catalyst at the Department of Energy) as well as via a distributed network of Energy Innovation Hubs and Centers of Excellence.

Finally, the U.S. needs to invest at a more granular scale in the interplay between innovation and manufacturing.  Martin Baily recommends consolidating the federal government’s existing manufacturing-related investments into a $15 billion Manufacturing Innovation Fund, which would support loans through a peer-review selection process to companies in the very early stages of new technology development.

To be effective, these investments need to leverage natural regional clusters, the geographic concentrations of interconnected firms and supporting organizations that drive innovation.

In addition, these investments, along with other financing vehicles like a National Infrastructure Bank and a National Green Bank, must offer ways to unleash private capital for productive and sustainable growth.

The price tag for investing in innovation is not cheap.  But there is a way to pay for it.

Smart tax reform provides a path back to sanity.  One way to free up capital for investment would be to stop fueling the bad habits of a failed growth model and a legacy government.

The federal tax code is replete with expenditures that fuel consumption rather than incentives that catalyze innovative and productive growth.

The worst offender by far is the federal mortgage interest deduction.

This deduction is among the most regressive tax subsidies in the U.S. code. It disproportionately benefits high-income households and it largely fails to fulfill its primary purpose of increasing homeownership rates.

According to recent studies, over 70 percent of all U.S. taxpayers receive no benefit from the mortgage interest deduction, and, for those that do itemize their deductions, the tax savings for families making above $250,000 per year are 10 times greater than for households earning closer to median income.

Incredibly, the deduction is projected to grow from $79 billion in the 2010 fiscal year to $144 billion in 2016, according to the Obama Administration’s FY2012 budget.

Under current law, taxpayers are eligible to deduct the interest on mortgages as large as $1 million for first and second homes and an additional $100,000 on a home-equity loan – with no restrictions on how that money can be spent.

The single act of capping the mortgage interest deduction at current levels would save $166 billion over 5 years. This would be more than enough to invest in innovative growth.

For those concerned about the impact on homeownership rates, we should learn from abroad.

The UK gradually eliminated its mortgage interest relief in the 1990s, with no long-term effects on its homeownership rate. Canada does not have a mortgage interest deduction, and has almost the exact same homeownership rate as the United States.

There are many, particularly in the real estate sector, who will resist any effort to scale back the mortgage interest deduction.  But the stakes post-recession are very high.  To grow and prosper, the United States must invest strategically in innovation.

It is time to cut to invest.