Bridging the Innovation Valley of Death | Commentary
Is Wall Street’s influence in corporate boardrooms killing America’s innovation future? There’s a good case to be made that it is, and that it’s getting worse. But Congress can do something about it when it rewrites the tax code.
Just a few weeks ago, the Senate Finance Committee released more than 1,400 policy recommendations it had received. There’s one more it should consider: changing the rules on capital gains and stock options. Here’s why.
In the heady days following the end of World War II as the baby boomers were just emerging on the scene, American exceptionalism was at its zenith. AT&T, Chrysler, Ford, DuPont, GE, GM, Hewlett-Packard, IBM, RCA, Texas Instruments, Westinghouse, Xerox — the list is far too long to enumerate — were not only iconic corporate names, they were also powerhouses of research and development. The transistor, the laser, power steering, xerography, color TV, large-scale integrated circuits, high-speed computers and Teflon all trace their origin to industrial R&D of that era.
It was a time when American corporations did not expect their laboratory discoveries to contribute to next year’s bottom line. They could afford to invest for the longer term. And the most successful of them did. The research they supported was mostly use-inspired and applied. But corporate leaders had the patience to wait for the financial benefit that would accrue.
Today, patient capital is a rarity in boardrooms, and the impatience has a lot to do with Wall Street expectations. There is no doubt American culture has changed: unlike Tom Brokaw’s “Greatest Generation” of the ’40s and ’50s, the “Me” generation of today demands instant satisfaction. But changes in the tax code, growth of electronic trading and lower fees for buying and selling stock have had a dramatic effect, as well.
In 1960, the top marginal tax rate was 91 percent, and the long-term capital gains rate was 25 percent, a differential of 66 percent. Back then, trading commissions were relatively high, and eight years was the average time shareholders kept their stock.
Today, the top marginal tax rate is 39.6 percent and the long-term capital gains rate is 15 percent, a differential of 24.6 percent. Today, moreover, trading commissions are relatively low, and the average holding period is just four months.
The net result is what former Rep. Vernon J. Ehlers, R-Mich., called the “valley of death” in the 1998 congressional science policy study, Unlocking the Future. Ehlers used the term to describe a market failure that chokes off long-term applied research needed to transform scientific discoveries into marketable products.
Corporate leaders have always kept an eye on their company’s stock price, but nowadays they’re fixated on it. And for good reason: Executive compensation depends on it. Invariably, bonuses are tied to it, and most executives receive a good chunk of their pay in the form of stock options. Here’s all you need to know about them.
Options have value only when the “strike price” (usually the fair market price of the stock at the time the options are issued) is lower than the stock price at the time the owner sells them. The faster the stock price rises, the sooner the options become valuable. And though executives may be required to hold their options for a period of time before exercising them, the “vesting period” is usually relatively short.
Under current tax and regulatory structures, there is little incentive for corporate executives to take a long-term view of their company. How their company’s stock will perform during the next few quarters matters much more than what their company’s profits will be like five years hence.
Norman Augustine, retired CEO of Lockheed Martin, the big defense contractor, knows from personal experience how Wall Street punishes a company that looks long term. Augustine, an engineer, understood the importance of R&D, and shortly after he took over Lockheed’s helm, he laid out a sound five-year investment plan. As a result, the stock price took an instant nosedive. It was a lesson he says he has never forgotten.
Today, Augustine, who left Lockheed in 1997, suggests crafting new capital gains tax policies — longer vesting and holding periods — that provide strong incentives for corporate executives and ordinary shareholders to retain their stock for periods of up to a decade. Only in that way, he argues, will corporate America invest in desperately needed long-term R&D.
Without Augustine’s strong tax medicine, it will be up to the federal government to bridge the valley of death. And that is often a tough pill to swallow in Washington.
Michael S. Lubell is the Mark W. Zemansky Professor of Physics at the City College of the City University of New York and director of public affairs of the American Physical Society.