Infrastructure Challenges and Issues: A Panel

Nancy Connery, moderator

Consultant, Public Infrastructure

At this juncture, I think it is important to rethink the issue of the infrastructure. It is clearly not at the apex of public attention and policy. It had its day perhaps, and it may yet have another, but right now it is in a quiet phase. I have looked at this phase with some despair at times because I know all of us have worked hard to make public works issues a much more important aspect of public policy. But we know that the facilities and their problems are not going to go away. So, to the extent that we can, this is a good time to take stock.

The issue has become much more textured, I think, since we started 10 or 15 years ago counting up the wish list of things we would like to do or think we should do. It now has many ramifications, some of which were just brought home to us by Dr. Brennan. Our three panelists will provide insights on the challenges and issues in infrastructure finance that lie ahead. Although domestic and international infrastructure requirements differ in both type and degree, the relationship between a healthy infrastructure and economic vitality is universal.



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Financing Tomorrow's Infrastructure: Challenges and Issues Infrastructure Challenges and Issues: A Panel Nancy Connery, moderator Consultant, Public Infrastructure At this juncture, I think it is important to rethink the issue of the infrastructure. It is clearly not at the apex of public attention and policy. It had its day perhaps, and it may yet have another, but right now it is in a quiet phase. I have looked at this phase with some despair at times because I know all of us have worked hard to make public works issues a much more important aspect of public policy. But we know that the facilities and their problems are not going to go away. So, to the extent that we can, this is a good time to take stock. The issue has become much more textured, I think, since we started 10 or 15 years ago counting up the wish list of things we would like to do or think we should do. It now has many ramifications, some of which were just brought home to us by Dr. Brennan. Our three panelists will provide insights on the challenges and issues in infrastructure finance that lie ahead. Although domestic and international infrastructure requirements differ in both type and degree, the relationship between a healthy infrastructure and economic vitality is universal.

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Financing Tomorrow's Infrastructure: Challenges and Issues Domestic Agenda Carol Everett Rebuild America Coalition It is interesting that although the issue of infrastructure investment is on the political back burner right now, a proliferation of new reports is coming out on the subject. I have selected three of these reports to talk about today, reports that offer very different perspectives on the topic but all of which are important to a full appreciation of the dimensions of the issue. I will describe each report quickly, make a few comments, and then offer some final remarks on where we need to go from here. The first report is a congressional report that was released this past January (1995) by the House Committee on Public Works and Transportation (recently renamed the House Committee on Transportation and Infrastructure). This report is entitled simply "National Transportation and Environmental Infrastructure Needs" and takes a fairly traditional approach. The second report was also released in January 1995, "The Case for Public Investment" prepared by the Economic Policy Institute (EPI), a Washington, D.C., think tank. This report takes a macroeconomic modeling approach to the issue of whether our nation should be investing more in infrastructure. The third report was prepared by the U.S. Army Corps of Engineers. It is called ''Living Within Constraints: An Emerging Vision for High Performance Public Works" and incorporates viewpoints from all of the major interest groups concerned with our nation's infrastructure. The three reports are a good follow up to Dr. Brennan's remarks because they bring into high relief the whole question of what we "ought" to be doing as a nation versus what we "can" do. One of my theories after studying these three reports is that where you come out on the infrastructure investment issue has more to do with your initial assumptions about the flexibility of the federal government to solve these problems than about almost anything else.

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Financing Tomorrow's Infrastructure: Challenges and Issues HOUSE OF REPRESENTATIVES REPORT Let me turn first to the House report. To produce this report, the House public works committee used data from industry and government experts and anecdotal from that can be described for the most part as physical or engineering analysis. Based upon this information, the House concluded that "there is a chronic underinvestment in the nation's infrastructure that is threatening our national economy and living standards." The report examines various categories of infrastructure. Major portions of our national highway system are in substandard condition, severely impeding and inhibiting the economic growth and mobility that have been hallmarks of this system. Almost one-fourth of our highways are in poor or mediocre condition; another 36 percent are rated fair. One in five of the nation's bridges is structurally deficient, meaning weight restrictions have been set to limit truck traffic. The nation's transit infrastructure has suffered greatly from a prolonged period of underinvestment that has curtailed service, reduced ridership, threatened the existence of many transit systems, and left substantial needs unmet. Almost one-fourth of the rail transit facilities are in poor condition, and one-fifth of the transit buses must be replaced as soon as possible. In virtually all areas, service levels are inadequate, reducing the mobility of millions of people who depend on public transit. The nation's airport and airway system is steadily becoming more congested. Growth in passenger and air cargo traffic since deregulation in 1978 has been explosive. Passenger traffic is expected to double almost in the next decade, and cargo traffic is growing even faster. Currently, there are unacceptable flight delays at 23 of the nation's major airports. If no improvements are made, 33 major airports will have unacceptable delays by the year 2002. The nation's deep-draft shipping ports, which handle 95 percent of our international trade, face severe access problems on both water-side and land-side. Major ports on all of our coasts have been confronted with serious delays in obtaining dredging permits and other necessary approvals. At the same time, land-side connections have often been ignored because they are not part of a well defined transportation program. As a result, shipments to and from ports face inordinate delays and congestion, often increasing shipping costs. The nation's inland waterways have outdated and antiquated locks and dams that hinder the movement of coal, grain, and other bulk products. Delays in passing through these locks can cause significant increases in shipping costs. In 1990, 10 locks on the inland waterway system averaged more than three hours of delay per barge tow; while many other locks caused lesser delays. With

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Financing Tomorrow's Infrastructure: Challenges and Issues use of the inland waterway system expected to increase each year, delays are likely to increase. Fully 40 percent of the nation's locks are more than half a century old, and one lock on the Kentucky River is 150 years old. Nearly 90 percent of our locks and dams are too small to handle modern barge tows. Our drinking water systems are also deteriorating. Many are using water pipes 100 years old or more. These outdated systems may spring leaks and are subject to widespread contamination. Contaminated water has caused 900 deaths and causes almost one million illnesses every year. In a two-year period, violations of federal drinking water standards were reported in 43 percent of the nation's drinking water systems, which supply water for 43 million people. Our wastewater treatment infrastructure remains inadequate to the task of cleaning up the nation's waters. A third or more of our rivers, lakes, ponds, reservoirs, and estuaries remain polluted, as does almost the entire Great Lakes shoreline. Sewage treatment needs are especially urgent for metropolitan areas trying to remedy the problem of combined sewer overflows and small communities lacking independent financing ability. I know some people in this audience are critical of the needs approach used by the House because, for the most part, it doesn't look at how systems are performing from an outcomes perspective. But I believe at this moment this is the best we can do to provide an overall picture of our nation's infrastructure. And for that reason the House report is invaluable. Okay, so what does the House report conclude? First, national leaders must develop a strategy for meeting our vast transportation and environmental infrastructure needs, establish priorities with the greatest economic and environmental returns, and develop sources of funding. (The report covers a host of financing options but does not come out in favor of one set of strategies or another.) Second, the House report concludes that the infrastructure issue must be elevated to the high level of public visibility that it deserves. (How to do this is something the Rebuild America Coalition has been struggling with for the past eight years.) The House committee believes that higher visibility will help develop a broad national consensus on infrastructure issues and that this consensus can be a springboard for action. Finally, the House report supports establishing a federal capital budget and taking the highway, airport, and waterways trust funds off budget.

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Financing Tomorrow's Infrastructure: Challenges and Issues ECONOMIC POLICY INSTITUTE REPORT In the second report, the Economic Policy Institute (EPI) takes a very different approach from the House public works committee. EPI is interested in spurring the growth rate of family incomes in our country. EPI starts off by saying that "for a quarter of a century following World War II, American families could count on rising living standards propelled by rising real wages. But over the last two decades family incomes have grown hardly at all, and what growth there has been has been a result of more workers per family, not higher wages." EPI asserts that to reverse this slide and ensure a healthy future for America's standard of living, we need to become more productive. The key to boosting productivity is investment, both private and public. To support this thesis, EPI compares infrastructure investment in industrialized nations and finds that the U.S. ranks dead last in terms of infrastructure investment as a percentage of GDP. In 1992, for example, Japan invested roughly three times as much as the U.S. Moreover, EPI says that the value of America's stock of public infrastructure has been decreasing. During the 1960s and 1970s the public infrastructure stock grew steadily, according to EPI, but over the past decade it has fallen without interruption from nearly 55 percent of GDP in 1982 to less than 40 percent in 1992. The EPI report concludes that, "however one measures it, the U.S. is not investing enough in public infrastructure and that we are paying a high price for this practice in terms of declining incomes and opportunities." It goes on to say that "if we do not reverse this trend the price will only rise. We owe much of today's living standards to yesterday's citizens who believed they had a shared obligation to invest in America's future. It is our obligation to our own future and to those who come after us to replenish our nation's capital stock." U.S. ARMY CORPS OF ENGINEERS REPORT The last report I want to discuss was prepared by the U.S. Army Corps of Engineers. The publication date says January 1995, but I believe it was released to the public in September. This report wraps up a three year effort to define a new federal strategy as a component of a broader national strategy aimed at bringing federal programs into better alignment with state, local and private sector needs. It builds on the fine work of the National Council on Public Works Improvement. This is an excellent report and very comprehensive in terms of coverage of the infrastructure topic. My remarks today cannot in any way do justice to its breadth and depth. Because I am running out of time, I am only

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Financing Tomorrow's Infrastructure: Challenges and Issues going to talk about how it approaches the issue of whether America should be investing more in public works infrastructure. In my opinion, this report seems to say that the nation's financial resources are so constrained that it is not productive to discuss what the optimal level of infrastructure investment should be. Yes, the report says, ''public infrastructure investment does matter to economic growth and productivity," but because in reality "there is little, if any, new funding available for increased public works spending anyway," we have "moved beyond arguments over whether America is truly underinvesting in public works, or whether public investment really matters to the economy." Following this line of thought, the report concludes with recommendations for maintaining what we have better, focusing on demand management and low cost solutions. This report sees a much reduced financial role for the federal government than the first two reports do. CONCLUSION Getting back to the theory I presented at the beginning of my talk, I believe the world views described in these three reports are natural extensions of the organizations they represent. For example, EPI's focus on a federal solution is logical for an organization whose mission is to think broadly about national economic problems but has no implementing authority. I also find it reasonable that the House recommends a more conservative federal role than in the past now that Congress is arguing over a smaller and smaller discretionary budget and feels increasingly powerless faced with a budget deficit problem of seemingly insurmountable proportions. The Corps, on the other hand, is a federal agency. I am only guessing here, but I expect the range of solutions that it can envision is somewhat restricted by what is currently acceptable to the administration. It would, therefore, make sense that the Corps sees the nation's options as pretty constrained right now—more constrained than EPI or Congress. So, where should we go from here? In my opinion, all of these world views are important to understanding the full complexity of the infrastructure investment question and need to be carried forward into an effort to achieve a consensus on a national infrastructure investment strategy. And how should we go about developing a consensus on a national infrastructure investment strategy? A first step would be to update the National Council on Public Works Improvement report card, which rated America's infrastructure performance in "Fragile Foundations." This will be a difficult undertaking, if it is to be done right, but we need a way of communicating to the American public how this

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Financing Tomorrow's Infrastructure: Challenges and Issues nation is doing in terms of moving people and goods, disposing of our wastes, and providing safe drinking water. "Doing this right" will mean utilizing the path-breaking research findings of the National Research Council on measuring and improving infrastructure performance. After that, I think we need to convene a national conference that brings together all of the players at the national, state, and local levels, including the private sector. Everyone seems to know that the rules are changing in Washington, but what the new rules mean for the different players in the infrastructure delivery partnership are not clear. I believe a conference would do a great deal to clarify roles and provide guidance on how to sift through the various infrastructure financing options.

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Financing Tomorrow's Infrastructure: Challenges and Issues International Perspective Frannie Humplick World Bank The information I will be reporting on comes from a World Bank report that came out last year. Assuming that the public sector will be limited in its ability to finance infrastructure in the future and that, therefore, we have to look at alternatives outside the public sector, I will not look at government infrastructure funds or municipal funds because those are still options in public investment. In terms of scale, developing countries at present are spending about $200 billion a year as a group on infrastructure. About 90 percent of that investment is financed by the public sector, either through tax revenues or by borrowing in ways that the public sector mediates. What is interesting is that infrastructure investment in developing countries is a large fraction of public investment and also of total investment. The share of infrastructure as part of total investment is between 20 and 30 percent, depending on whether the country is a low-income or a middle-income country. As a share of public investments, the percentage is even higher—more than 30 percent and, in some cases, up to 60 percent. This is an interesting trend because, with two exceptions, in developing countries infrastructure investments have been continuously privatized. The exceptions are road infrastructure, which has largely remained in the public sector, and power generation in countries with limited energy resources where most generation and transmission have remained in the public sector. Water supply and other areas of infrastructure have been provided by lower levels of government and, in some cases, the private sector. Public investment in infrastructure covers mostly road and energy infrastructure. The infrastructure problem, internationally as well as domestically, has a number of characteristics. The first one is maintenance. When we talk about infrastructure, $200 billion a year is invested in new capital or the major

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Financing Tomorrow's Infrastructure: Challenges and Issues rehabilitation of existing capital. Not usually included are expenditures on maintenance or operating costs, which come under the current budget. To show you what the scale of the problem is, I will use a ratio developed by the International Monetary Fund from our projects around the world for macroeconomic and planning purposes. The ratio is called the "r coefficient," which is the ratio of maintenance and operating expenditures to initial investment of capital expenditures annualized. Depending on the type of infrastructure, there is a huge change in the importance of capital versus recurrent expenditures. So when we talk about financing, it is important to distinguish between financing of the initial, major works and annually recurring expenditures. Some categories of expenditures have a higher ratio of recurrence to capital investments. These include buildings in education and health and, within the category of roads, feeder roads, which are more maintenance intensive than higher technology roads like paved roads and state roads in general. The second issue is that foreign financing is an important component of the infrastructure investment problem. At present, about 12 percent, $24 billion a year, is foreign financing of the infrastructure investment. As I mentioned earlier, most of that goes to transportation and energy projects. Another issue is public guarantees. The share of commercial financing of infrastructure over time has declined, even when it is publicly guaranteed. Figure 1 shows the stock of dispersed lending to infrastructure in billions of U.S. dollars over time. The upper block shows the total disbursement, and the lower block is publicly guaranteed private investment, which has declined. Even though people are talking more about private participation, real private flows are not coming in yet. In fact, they seem to have been declining in comparison to the total need. This raises an important problem of financing. If it is true that the private sector is not very interested in financing infrastructure, what can be done to increase it? The last characteristic of this problem is demand, which is projected at $200 billion a year and is going to grow. It is already growing in three types of countries: countries that have just come out of macroeconomic adjustment, newly industrialized countries that are going through periods of rapid growth and have, at the moment, very congested infrastructure systems, and countries that are rapidly urbanizing. When you think about these three characteristics, you find they include almost the entire world, with very few exceptions. So the demand is certainly going to grow. Why are we talking now about infrastructure financing? I want to go quickly through the advantages and disadvantages of the way infrastructure is financed at the moment, which is basically through public borrowing. Among the advantages, especially in developing countries, is that the government is sometimes the only credible entity in the country. For this kind of investment,

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Financing Tomorrow's Infrastructure: Challenges and Issues FIGURE 1 Publicly guaranteed private loans have fallen. Note: The loans are for electricity, gas, water, telecommunications, and transportation. Source: Adapted from World Development Report 1994 (The World Bank, 1994). the government must play a role to establish credit worthiness. The second advantage is that governments can usually borrow at low rates, partly because of the certainty of repayment. A disadvantage of government financing is that governments are usually more lax than the private sector in terms of financial discipline because they can always raise taxes or transfer funds to meet financial constraints. Another disadvantage is that the government is not as efficient, partly because of the lack of financial discipline, but for other reasons as well, like overextension or the fact that civil servants of the infrastructure do not own the facilities for which they are responsible. Thus, there are inefficiencies, and these inefficiencies make government financing costly, even though borrowing may be at a lower rate than for the private sector. This puts a strain on government budgets, which is a real disadvantage. A third disadvantage is that maintenance is usually neglected when the government is responsible for provision, at least in developing countries. I am not certain about the domestic experience, but I think it can be said that maintenance usually suffers. That is because the infrastructure is provided up front, paid for indirectly, generally by taxation, so users do not have a true sense of the cost. Maintenance is neglected because users do not have a sense of ownership of the infrastructure.

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Financing Tomorrow's Infrastructure: Challenges and Issues The overriding issue is that government financing is usually the best way to balance equity and efficiency issues. So the challenge becomes how to take advantage of the government but use the private sector to offset some of the elements that at the moment are disadvantages, the first one being financial discipline. I am going to go over nine alternatives for financing infrastructure in order of increasing risk-sharing by the private sector. Bringing in the private sector is a question of keeping the advantages of government provision while allowing the private sector to take risks it normally would not take in order to make financing infrastructure feasible. Among the options are: specially negotiated contributions joint public/private companies formal joint ventures service delegation leasing concessioning transferring responsibilities to the private sector participation by users privatization The first alternative, specially negotiated contributions, are contributions negotiated once. The private sector brings in certain types of financing to put an infrastructure project together. Some countries have created mixed companies of joint public and private investment. There are formal joint ventures where the public and private sectors enter into formal contracts for one-time projects. Service delegation (the fourth alternative) is the transfer by government of planning and management responsibilities to private agents. The service is contracted out to the private sector, but the government keeps public ownership. There are various forms of transferring responsibilities to the private sector—participation, when users are given responsibility for financing and managing the infrastructure, and privatization, when there is a total transfer of ownership to the private sector. These options differ in a number of ways, who owns the infrastructure at the end of the day, for example, which varies from the public sector to mixed ownership to completely private ownership. Another difference is who is responsible for planning. As you can see in figure 2, this varies depending on the option. In the area of financing, the government could transfer responsibility but keep financing in the public sector for the efficiency of operations and to maintain the advantages of government borrowing and flexibility. The same arrangements can be made for operation and maintenance. I will describe these

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Financing Tomorrow's Infrastructure: Challenges and Issues product or service. What do private sector entities do with the knowledge or technology asset? They obtain market share. Market share is really the final determinant of whether or not you have been successful. And in today's global economy, the market share is not just domestic but global—capturing the product and service end-user markets on a world wide basis. Clearly, in the construction industry, every major U.S. firm operates globally. The growth markets are not just in the United States. They are all over the world. Think of the tremendous physical infrastructure challenges in the former Soviet Union. There are similar challenges and opportunities in China. I will mention one that I have become a little familiar with, the Three Gorges Project. I do not know if any of you are familiar with this major initiative now under way in China. U.S. construction firms are very interested in the initiative and eager to participate in it. At the moment, however, I think we are the only advanced industrial democracy that is not moving forward with any government support for such participation. Even the Canadians, who like to think of themselves as far more environmentally oriented than we are, have strongly endorsed the Three Gorges Project and are providing direct financing subsidies to their major construction firms. Right now the Export-Import Bank is not able to do that for American firms because of guidelines from the White House. I mention this as an example of a global market and the importance of the market share beyond our own backyard. NATIONAL TECHNOLOGY INNOVATION SYSTEM What are the elements of the national technology innovation system? The first element is the human resource base. A nation needs skilled, educated people. That is obvious, but it is of great concern to the United States. Even though we spend more money on education per pupil, per capita, than any other country in the world, many of us feel that the quality and the delivery of our national public education system are sorely wanting. I will share a few very sad statistics. There are more school administrators in New York City than in all of France. There are more school administrators in New York State than in the entire European community. Anyone who has small children knows that, even if you live in purportedly affluent parts of the country, first grade classes are now held in trailers. There are just not enough resources to do the things we all took for granted growing up in a time when all these national financial resources did not go into education. That is not clearly an infrastructure issue in the sense that you have been talking about, but I put the human resource base as the primary element for an innovation system.

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Financing Tomorrow's Infrastructure: Challenges and Issues Second, there is the technology asset. Fundamental new knowledge, technology know-how, and other R&D assets are necessary but insufficient for commercial technology utilization. Technology owners who hold a proprietary position today through a limited monopoly granted by the patent system or trade secret protection are not guaranteed to reap the economic benefits of the commercial uses of their technology. The technology asset, as I envision it, really is the starting point in the race to attain early market entry and market dominance. Physical infrastructure is the third building block in a national innovation system. This includes everything from the quality, sophistication, and ease of transportation systems to the constructed environment in the broadest sense. Since leaving the government, I have had the opportunity in the last few years to do some technology work in the former Soviet Union. I think we all remember the days when you could visit Moscow and not see any cars. It is now virtually impossible to get to a meeting on time in Moscow unless you budget an hour-and-a-half to get to your appointment. This is true in places like Bangkok as well. Therefore, if you are trying to conduct any sort of business, the physical transportation infrastructure is absolutely critical to efficiency. Transportation systems are going to be profoundly driven by the use and deployment of advanced technology, like the intelligent vehicle highway system (IVHS). The smart systems that are being demonstrated right now in test beds in various parts of the country will not only afford the United States leadership in terms of new products and services we can deploy and new markets we can tap, but also in terms of tremendously enhancing our own environment for conducting business. A nation's capital formation and allocation system are absolutely critical for innovation. This is the most important building block we have to deal with right now. In order to remain competitive, firms must acquire capital to pay for innovation, production, capacity, and global marketing. Businesses and government share certain concerns, but they do not agree on the ways and means of achieving the optimal system for capital formation and allocation. Indeed, some economists now say the United States has an innovation-hostile capital formation and allocation system. It is not that we do not have lots of capital. We have billions of dollars in capital. The problems are where the capital goes, for what purposes, and what results it gives to the society at large and business in particular. I will explain this in more detail. The next building block is the regulatory framework. I would rank the existing framework with the current capital formation and allocation system as a profound disincentive to our ability to have a world-class national innovation system. The regulatory environment in which firms operate at home and abroad heavily influences their decision-making. This covers everything from the types

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Financing Tomorrow's Infrastructure: Challenges and Issues of business protection, or lack of it, to intellectual property rights and product liability. Competition policy, better known as antitrust policy, and directives often regulate what a firm may develop at home and abroad. The set of laws and complex regulations embedded in the government procurement and acquisition system currently regulate private sector suppliers to the government. I am sure many of you are familiar with that morass. Indeed, there are many major U.S. firms that will not even participate with government customers because of the problems associated with the acquisition system. For example, Motorola chose not to supply the government with mobile radios during Desert Storm because they had to guarantee, as one of the regulations in the acquisition system, that nowhere else in the world were mobile radios being sold for a penny less than the Department of Defense was paying. Motorola obviously could not guarantee that. So where did we procure our mobile radios? Japan. The international trading system is a critical enabling factor for national innovation. A firm's early entry into and penetration of key global markets is determined by its ability to participate fully and equitably in the global trading system and, in parallel, to obtain relief from trading systems that subsidize or protect infant or targeted industries, that force mandatory cross-licensing or technology transfers, or that commit a host of other anti-trade sins. When I was in the White House Office of Science and Technology Policy during the Reagan administration, I was on the periphery of the famous Kansai Airport negotiation with Japan because I was working on a lot of Japanese-related technology trade issues. The Japanese fought against doing anything to provide transparency in the bidding process for our construction companies. I have not followed the issue since, but somebody told me that the United States is not a player in that process, in spite of a trade agreement, because of a whole set of non-transparent cultural issues that have worked collectively to keep us out of that market. I would add that the Three Gorges Project is another example of a project in which U.S. companies have not been able to participate because our own government has not being willing to put our firms on an equal footing with foreign competitors by giving them access to the Export-Import Bank and supporting them in other ways. Reciprocal access to international investment opportunities is another building block in a national innovation system. The international economy and the globalization of R&D, finance, and manufacturing currently offer firms investment opportunities abroad. Nations that do not adopt reciprocity in international investment flows are really creating an entry barrier to their home markets. For example, if you compare the direct foreign investment figures of both the United States and Europe vis-à-vis Japan, you would be shocked. Per capita, there is almost no American direct foreign investment in Japan.

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Financing Tomorrow's Infrastructure: Challenges and Issues American firms do not really have the opportunity to invest in and acquire Japanese assets. Even in the more sensational cases where investors and companies have acquired majority ownership of shares in Japanese firms, they have not been able to exercise any corporate governance because of informal barriers. On the other hand, the United States and Europe have a fairly open reciprocal international investment flow and can participate in each other's economies. The industrial structure for innovation is another key factor. This is a very important point. The industrial structure in which a firm conducts its primary innovation activities has a profound effect on time to market and market penetration. Today in the United States we have a very interesting situation. Many of our most advanced technology assets are developed or incubated in fragile, capital-starved entrepreneurial firms that are vulnerable to premature failure—particularly if a company is in a small or scattered industry or in a new industry, in which the ability to share information, costs, and risks are limited. On the other hand, if you look at technology that is incubated in or through partnerships with larger, more vertically integrated industries, you often see some very innovative things occurring where producers and end users across multiple applications pool their resources and risks to develop and commercialize technology. Let me give an example from the construction industry. The construction industry obviously has a tremendous need for the most advanced flexible materials. These types of materials are being developed in the aerospace industry, in the auto industry, in our national laboratories for defense purposes, and by sporting goods manufacturers. You could envision a case of a number of vertically integrated teams with players from all of those industrial sectors who have a common interest in, say, developing or using advanced ceramics. They would not have any antitrust problems. They would not be concerned about pooling their crown jewels because they are in different business lines. But they could have a way to get to the market faster and more quickly with cost-effective products through those synergies and links, than if they tried to team up with their direct competitors in a traditional horizontal consortium. In a horizontal consortium, competitors rarely share critical information. They help each other get to a common point, and then they go off and compete. In a vertical teaming relationship, they can share their proprietary crown jewels. If you look at the strategies used by some of our foreign competitors who get to the market in many industries on a cycle time much faster than U.S. firms, you find that they are pooling and sharing risks and costs across industrial sectors and multiple product lines.

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Financing Tomorrow's Infrastructure: Challenges and Issues Business management and manufacturing practices also profoundly affect innovation. As you know, in this country we pioneered what is known as the Tailoris Mass-Production System. We also pioneered many of the current management practices that are increasingly viewed as hindrances and disincentives to early market entry and penetration. Horizontal, cross-functional teaming relationships are increasingly replacing rigid, hierarchical, or inflexible organizational structures. The Malcolm Baldridge Quality Awards have played a big role in helping change cultures of firms that need relationships among their supplier networks. In the traditional, hostile relationship, firms go out every year and rebid their supplier network rather than working with them to upgrade their capability, and vice versa. And the whole new world of virtual manufacturing, or integrated computer manufacturing, is having a profound effect on U.S. firms. I had the pleasure last year of visiting Motorola's new manufacturing facility in Phoenix, which produces satellites for the Iridium communications network. Experts consider this manufacturing facility one of the most advanced. Rather than building each satellite from the ground up, they have a system in which the satellites are all built concurrently. The Japanese deserve tremendous credit for pioneering and utilizing many of the most advanced manufacturing techniques. This also relates to how they treat their workers and labor. They do not have the hostile management/labor relations we have in the United States. To many of us working in the competitiveness arena, the greatest obstacles to the involvement of workers in management decisions are the traditional labor unions because participation takes away from their power structure. The National Labor Relations Board has had suits brought by labor unions. For instance, a big labor union brought a suit against DuPont for having self-managed work teams in the factory because they eliminated labor shop stewards. All of these factors comprise a holistic national innovation system. Evidently, nations provide the primary staging platforms for commercial innovation. Collectively, we need to look at the system of incentives and impediments for each of these factors and decide what we can do as a country to create incentives and break down disincentives. We need to optimize our system for the next century, which requires us to create wealth and skilled jobs here in the United States based on our leadership in science and technology and our skilled human resource base. I believe that the United States is at a turning point. If we do not begin to develop both a national innovation system and a systemic approach, our leadership in science and technology is going to create more accessible raw material for our foreign competitors to use. I will share with you an anecdote on that.

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Financing Tomorrow's Infrastructure: Challenges and Issues I was involved very intensely in the late 1980s and early 1990s with the Japanese on technology issues. They used to refer to our universities as their raw material suppliers. They saw our universities as creating the knowledge and technology assets that they converted into products and sold back to us. We were negotiating a very difficult intelligent manufacturing systems initiative. One of the Japanese negotiators from MITI said the following to me, and he really sort of let the cat out of the bag, which we already knew. However you structure this, he said, as long as this is an R&D project, we are going to clean your clocks because you do not have the capacity to take this and get it to market ahead of us. So we want all these programs to be R&D oriented. We want access to your knowledge, creativity, people, and institutions. We will take that back and deploy it through our system, which has a better capital formation process that does not impede our businesses through regulatory problems. Every single trade regulation or trade policy is geared to support and help Japanese manufacturing entities at home and abroad. With our management business structures, we do not waste time on management labor problems. We do things collectively. So, go ahead, focus all our projects on R&D. We will contribute a little money, but we are going to be the ones who produce the product and services that come out of it. I will throw in a political comment here regarding the government not supporting grants to companies to create more commercial industrial technology. I would say that unless the federal government and Congress begin to deal with capital formation and allocation and clean up the regulatory mess, we will just be creating more raw material for our competitors. FINANCING INNOVATION What should we do about the financing environment for innovation? Banks and venture capital firms no longer play a role. The reason for that, again, is regulatory, compounded by culture. At one time in our country, banks played a major role. Then in 1933, we passed the Glass-Steagall law in the aftermath of the Depression and the stock market crash. This law makes it illegal for banks to own shares of industrial enterprises or to be involved in security underwriting. Therefore, banks play no role in what many believe to be the most critical phase of technology incubation and financing through equity participation. They are only involved in debt financing of major corporations. Venture capital firms played a very important role back in the 1970s and 1980s in the creation of Silicon Valley, the semiconductor and biotech industries. Their role is increasingly changed now. They no longer invest in seed or early stage financing because the growth potential of their investment is

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Financing Tomorrow's Infrastructure: Challenges and Issues very uncertain. It is too hard to predict the outcome to justify the risks. They really want a very clearly defined exit strategy, and they are really only looking at a three-year to five-year window. Start-up companies do not want to go to the venture capital list unless they are absolutely desperate. Venture capital firms will take all your equity, put in a management team, and keep you on starvation rations because they have to manage for the fact that out of their investment portfolio only 30 percent of their ventures have any chance of success. So they take huge returns from that 30 percent to balance the 70 percent that fail. What should we do? We clearly need to redirect capital allocation through tax reform. You have read about flat taxes. Moving from a consumption-oriented tax system to a savings-oriented tax system is something most policy groups that have been looking at tax reform advocate. It is a question of what the transition is. Let me just mention a couple of things that, collectively, could make a profound difference. The R&E tax credit has been a primary incentive for increasing corporate investment in R&D. However, it has never been made permanent, and the credit base structure has made it applicable only to a few firms. So one important recommendation is to make that tax credit permanent, so every year you know that you will be able to take advantage of it. Then change the base so everybody, as opposed to only a few companies, is eligible for the R&E credit. Another interesting idea is to provide a 20 percent credit to encourage collaborative R&D ventures in the United States. I talked earlier about the need for pooling and teaming. The tax system could be a neutral way to encourage that, as opposed to giving direct grant subsidies to individual firms. What is nice about doing a lot of these incentives through the tax system is that everyone would be eligible. With direct subsidies of specific firms, even if you pour $10 billion into grant programs for commercial technology development, there would still be a lot of companies that would not get them. And where do you draw the line on the governments role in terms of picking up the risks and rewards of private sector innovation? It is much cleaner, neater, fairer, and more comprehensive to do these things through the tax system and concentrate our tax resources on creating a broad infrastructure and base of knowledge through basic and strategic research that is mission-driven. It is also incredible that at this stage of our history we are still dealing with a capital gains tax. We are the only advanced industrial country in the world with a punitive capital gains tax structure. Everybody else—the Europeans, the Japanese—has gotten rid of this structure. We have allowed ourselves to treat this as a rich/poor issue. All the facts and statistics show that this is not the case. The idea that a reduction in the capital gains tax would reward the rich is a political canard. Every business study says the one thing they would like is to reduce the capital gains tax. What we have now is double taxation. You pay at both the individual and the corporate level, and this is a

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Financing Tomorrow's Infrastructure: Challenges and Issues huge disincentive for investment. It favors debt bias over equity in our tax code. You can deduct debt from your taxes, but you cannot take advantage of equity. Equity investments drive growth. Thus, we need to eliminate the double taxation of individual and corporate investment income in order to increase the availability of investment capital and reduce costs. We also have a treasury regulation that provides a complete incentive for our companies to do their R&D overseas. We could change this with an Executive Order (the Bush and Clinton administrations have tried). I think Wall Street is protecting itself and not looking at the good of the country. The regulation is fairly detailed and complex but is in the tax code. If you want to get tax benefits from R&D, you must do it overseas. Now, do we want to have our R&D done overseas, away from our platform of innovation? No. So we should get rid of that treasury regulation. It will cost a little bit of money, but the benefits for productivity will be huge. We should also get rid of Glass-Steagall. It is obsolete, and we need all of our financing sources participating in innovation. REGULATORY OBSTACLES In regard to regulatory structures, I want to mention a few quick items. The regulatory framework is really a case of huge national resources going into something that has nothing to do with productivity. Let me give you some statistics collected by the National Association of Manufacturers in a wonderful little booklet describing what manufacturing means to the American economy. U.S. firms spend about $65 billion responding to government environmental regulations. They spend another $55 billion responding to health-related regulations and $55 billion on legal services. The statistic mentioned earlier, that we spend approximately $170 billion collectively on R&D, represents money that goes into productivity. The rest does nothing to add to our wealth or create jobs. Clearly, we want regulations to protect our families, ourselves, and society at large. The issue is balance. Most experts on the regulatory regime think we have gone too far and allowed regulation to become a disincentive. I will share with you just one area where regulation is now very negative—product liability. The product liability system varies from state to state. It has neither rhyme nor reason and is driven by the Trial Lawyers Association. Awards given to plaintiffs have no caps, and this is a nightmare. In terms of its impact on innovation, I will refer you to the literature. In fact, the National Research Council (NRC) did one of the best studies on product liability reform and its relationship to innovation.

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Financing Tomorrow's Infrastructure: Challenges and Issues DuPont used to be a major material supplier of medical devices. When you want to have access at some point in your life to certain types of medical devices, the United States may no longer manufacture medical devices (within the next 10 to 20 years). As a result of the product liability system, even if a manufacturer's materials had nothing to do with the cause of an injury, and even if the materials they sold to an end-use manufacturer were totally modified by that end-use manufacturer, the manufacturer can still be held totally liable. Because awards have no caps, a company could be wiped out. DuPont said, ''Why should we do that?'' So here we have the quandary of our government spending lots of money on R&D in advanced materials for, among other reasons, medical application. And yet we do not have any companies that are going to commercialize the applications because of product liability laws. So who is going to benefit from that taxpayer investment in the new materials that lead to a whole new generation of products? We will not. I am giving you that as an example of how these issues are linked. You cannot look at one in isolation from the others. Antitrust is also a very important issue, but when the laws and regulations were originally set up, antitrust legislation had a different purpose than it has now. We still have an antitrust system with a philosophical basis from the 1920s, when we were concerned about competition between Ohio and Indiana, not competition between the United States and a global environment. The Justice Department, as we speak, has issued "Antitrust Guidelines and Innovation Policy." In a nutshell, first they look at the type of R&D a firm does. If a firm conducts R&D that could lead to something that could keep another company out of a market, the Department of Justice will initiate antitrust action. That is anti-competitive behavior. I always thought that doing R&D was to give a firm an advantage over competitors—that was one of the reasons you invested in it. So we have moved antitrust way upstream. Look at the implications of this for new industries, such as those emerging around the national information infrastructure. You see in the announced mergers and acquisitions of companies a reorganization that will alter the current industrial structure, but it will not take you to this national information infrastructure. AT&T is divesting. Cable computer telecommunication companies are reorganizing in order to get the bits and pieces they need to participate in whatever this new industry is going to be, both in manufactured products and in the software and service end. Yet the Justice Department is looking at all of those potential acquisitions and mergers from a traditional 1920s antitrust perspective. Similarly, whatever you think about Microsoft, whether they are the thousand-pound gorilla or not, as an American citizen I was very upset that our government went, on its own, to the European Community Commission, to the

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Financing Tomorrow's Infrastructure: Challenges and Issues gentleman in charge of antitrust policy, to initiate talks about how Microsoft should be busted up in Europe. Why do we want to bust up one of our leading companies in Europe? I do not know. Microsoft is one of the few companies, an exception to all the losses we accrue from intellectual property, from which we are getting a lot of money back. Antitrust is a critical issue relating to innovation. Our foreign competitors have totally different policies. The Japanese have never brought an antitrust suit against a Japanese company, ever. ROLE OF THE NATIONAL LABORATORIES The construction industry is a user of technologies developed by others. That is not necessarily bad as long as they are involved up front with the producers of their innovation stream. I think one of the ways to move quickly but still avoid antitrust concerns is to catalyze some vertically integrated teaming relationships on both the producer and the user side. You are not going to be threatened by people who make certain types of sporting equipment, and you are going to have a lot of needs in information technologies, too, managing inventory and all of that. One thing that I would recommend to this industry is that they go to the national laboratories and take the time and effort to see what they have. There is no question that the laboratories are developing a lot of things of tremendous value to this industry. The construction industries could get in on the ground floor—maybe in some of the consortia that are formed—and participate in a way that gives them some proprietary capabilities to move forward. I am sure there are trade associations in this industry that I am not knowledgeable about, but they could put together a lot of structures to get together with the federal laboratories and also the universities. Cutting across the industrial sector is an innovative way to do this. When I was in the Commerce Department, we found out about the intelligent vehicle highway system initiative (IVHS). This was a classic example of government operation. The Department of Transportation was acting in isolation. I reached out to Transportation and the R&D people, and we did some interagency work on it. But in that project there was going to be a tremendous need for advanced displays, and the flat panel display industry is so important as an enabling technology in the chain. Since the IVHS was a government mission, we suggested building in a procurement need to stimulate our fragile entrepreneurial advance display manufacturers, but Transportation turned their backs on that. So all the displays that are being used are from Japan, which to me was upsetting, unnecessary, and counterproductive.

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Financing Tomorrow's Infrastructure: Challenges and Issues If you look at things as part of a system as opposed to looking at each piece in isolation, you begin to see where you can fit things in and how they are related. I give the Japanese real credit for doing that in almost everything they do. The Council on Competitiveness has not looked at the movement of goods from city to city in a coherent way. Some companies, as I recall, Frito-Lay, Inc., won the Malcolm Baldridge Award for an incredibly sophisticated transportation movement and inventory system that uses technologies in a service sense. I think that this board in the NRC (BICE) could make a tremendous contribution by looking at that kind of issue and getting a study out on it. I could tell you that Los Alamos National Laboratory, where I am on the board, has a very innovative initiative in the transportation arena with the Department of Transportation. They are looking at the whole traffic control system in Albuquerque as a test bed. Detractors question why a weapons laboratory is interested in transportation. Los Alamos makes, designs, and manages the nuclear weapons process, but they also bring to the table advanced computational simulation capability, which is unique and can help our economy. They are working with a number of major construction firms. The board might want to take a team out to look at that because they are doing a lot in transportation. CONCLUSION In conclusion, these are the points I have tried to make this morning. You can have a tremendous human resource base, and we need to work on that. You can be the leader in science and technology. You can be at the forefront of developing every new innovative technology that is going to drive new product services and create whole new industries. But if you do not embed those assets in an innovation environment that provides incentives for getting products and services to the market quickly in terms of quality, price, and market penetration, all of this will be for naught. What we need to do, what we can do, is be the staging platform for world leadership in science and technology and its utilization.