How Wall Street and the Tax Code Discourage Disruptive Innovation

by Daniel O'Connor on March 19, 2013

According to Clayton Christensen, the Harvard Business School professor who originated the concept of “disruptive innovation” and still remains the most-prolific researcher in the field, America’s current brand of capitalism is not finely tuned to produce the disruptive innovations our economy needs for economic and employment growth.

As Christensen argues in the Bloomberg interview featured above in this blog post, “the way financial leaders measure profitability, it appears like investing in innovation is not profitable.”

The gist of his argument: the tax code coupled with the prevailing financial “wisdom” incentivize short-term investments in sustaining and efficiency-enhancing innovation, but discourage long-term investments in empowering innovations that facilitate disruption and create new markets.  Unfortunately, empowering innovation is the most vital category of innovation for long-term core economic growth and job creation.

So, why is this important to the average American?  Well, in short, it helps partially explain the jobless recovery, as according to Christensen:

Disruptive innovations create almost all of the net jobs in the economy…

[Currently, most companies are] investing to make good products better or invest in innovations that make companies more efficient, and those things on average reduce jobs in the economy and don’t create growth.

In a well-functioning economy, sustaining innovations make existing products better and are useful for maintaining the current economic trajectory.  They do not create significant new growth.  Efficiency-enhancing innovations focus on making current goods, services or business models cheaper and more efficient.  Walmart is a classic example of this type of innovation.  The negative side of efficiency-enhancing innovations is that they actual result in job losses.  The good part of efficiency-enhancing innovations is that they are free of capital to be invested elsewhere — preferably in empowering innovations that contribute to future economic growth.

So, to recap, a well-functioning economy has a delicate balance of three types of innovation.  Empowering innovations create new markets and jobs, sustaining innovations make existing products and services better and sustain the current economic trajectory and efficiency-enhancing innovations free up capital from existing markets to reinvest in empowering innovations that promise to grow the economy and drive core economic growth.

Unfortunately, Christensen argues, we have not seen the correct balance of the three types of innovation — especially since the financial crisis and subsequent rebound, which has largely been propelled by productivity gains (aka efficiency-enhancing innovation).  According to Christensen, the financial and investment sectors have focused on efficiency-enhancing innovation because the gains are recognizable in the short-run and they produce the best results for financial managers focused on ratio-denominated measures of financial performance — notably Return on Net Assets (RONA), Internal Rate of Return (IRR), Earnings Per Share (EPS) and Gross Margin Percentage.

When ratios are used to measure profitability, there are two ways to improve growth.  Either grow the numerator (generate more income from current assets), or shrink the denominator (shrink pool of assets).  Because growing the numerator is more difficult in the short run, incentives encourage managers to shrink the denominator and outsource assets.  This is good for profitability in the short term, but disastrous for long-term innovation and growth.  Unfortunately, according to Christensen, this creates a positive feedback loop that makes efficiency-enhancing innovations appear more profitable than investing in disruption:

As [capital managers] invest in efficiency innovations they create or emancipate more and more capital, but then what they do is invest it in continued investments in efficiency innovation, so we are just awash in capital.  The cost of capital is zero, yet they continue to measure profitability in measures that just aren’t relevant anymore.

To illustrate his point, Christensen details the story of the once mighty McDonnell Douglas:

The story of McDonnell Douglas, however, provides a cautionary tale. The DC3 was its warrior. McDonnell Douglas made everything in the DC3. But its return on assets was low. So with each of the subsequent airplane models they outsourced more, until the company outsourced everything with the DC10.

McDonnell Douglas stopped making things, but instead became an assembler of sub-systems. RONA increased to about 60 percent. The company reduced its assets because it no longer made components. But when customers needed spare parts, they went to the suppliers of McDonnell Douglas rather than McDonnell Douglas itself. Although “profitable” by one definition, once the company had sold the DC10 there was no ongoing cash flow sufficient to do a DC11.

So misaligned short-term incentives, similar to the misaligned incentives at the heart of the financial meltdown that pushed managers to take excessive risks in the name of short-term performance, often cause managers to forego empowering investments that can lead to disruptive innovations, because in the short term they are simply costs on the balance sheet with no associated returns or profits.

A great example of this myopic short-term bias in the high-tech space comes from the Bloomberg interview with Christensen, when Erik Schatzker, one of the Bloomberg anchors, asked Christensen about Amazon:

You celebrate Amazon as an innovator, yet Amazon makes almost no money relative to the volume of revenue it brings in.  At what point do these innovations begin to turn into real margins, because thats Amazon’s problem.

Amazon might be the technology world’s best example of a commitment to long-term disruption; however, it has chronically low margins (which actually can be a competitive advantage).  If Amazon’s managers were short-sighted and wanted to maximize their returns on the capital in the short term, they never would have invested in building their revolutionary cloud computing business.  In fact, Amazon is continually investing in new, disruptive products, which is why many argue that it has a better future than Apple even though the Cupertino company has much higher profit margins.  Although this contention is open to debate, one thing is for sure–if Amazon had taken the McDonnell Douglas approach a decade ago, it never would have invested the money in what is becoming the core of its business and, instead, would likely have remained a first generation e-commerce company with weak future prospects, albeit one with higher margins for a short period of time.

Although Christensen’s diagnosis is disheartening, he does have at least one suggestion.  Rework the tax code to encourage long-term investments that produce disruptive innovation:

Our current tax code encourages this kind of migratory capital. If you put money in a company for 366 days, investment returns count as tax-favored long-term capital gains. I would prefer to see the tax code restructured so that taxes on capital gains declined on a scale over a much longer period. Migratory capital would disappear if, when you left money in a company for a period of something more like 6-8 years, there might even be no tax on your gain. Such treatment would encourage capital to invest in empowering innovations, not flip in and out of sustaining and efficiency innovations.

Christensen also reminds us that the cost of capital — at least in the U.S. — is at record lows, which is exactly when we should be eschewing ratio-based assessments of capital performance and investing in long-term growth.  Given the current mess around the inartful spending cuts in the sequester and the stalled debate around tax reform, it is unlikely that such a tax change could make it through clogged Congress.  However, lawmakers concerned with future growth and employment should take Christensen’s advice to heart.  Disruptive innovation — from the Model T to the PC — has driven the US economy over the last century of record growth.  It is important not to lose sight of this as our economy matures and our policymakers search for ideas to keep the U.S. economy competitive for generations to come.

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