Few would argue that America’s business fortunes rise and fall on its ability to put ideas to work and then bring them to market. William Lazonick, professor of economics at the University of Massachusetts Lowell, and Matt Hopkins, research associate at the Academic-Industry Research Network, have investigated what has gone wrong in America’s approach to innovation in recent years.

In this Q&A, which was first published at the Institute for New Economic Thinking’s blog, Lazonick shares findings from two recent papers that are part of the Institute’s project on the Political Economy of Distribution. He explains why successful companies like Apple need to make fundamental changes to the way they allocate resources and stop throwing away America’s most valuable asset for future innovation — you.

The Q&A below has been edited slightly from it’s original form for clarity.

Lynn Parramore: Let’s talk about where high-quality, low-cost technology products actually come from. Who pays for the research that goes into creating a product like the iPhone?

William Lazonick Professor and director of the University of Massachusetts Center for Industrial Competitiveness and president of the Academic-Industry Research Network

The iPhone didn’t just magically appear out of the Apple campus in Cupertino. Whenever a company produces a technology product, it benefits from an accumulation of knowledge created by huge numbers of people outside the company, many of whom have worked in government-funded projects over the previous decades. Öner Tulum, a researcher at the Academic-Industry Research Network (theAIRnet), has shown how all of the technologies in the iPhone — things like touch-screen technology, GPS, and so on — originated with government spending, funded by taxpayer money.

That’s why a company like Apple should be using a substantial portion of its super-profits to support government investment in the next generation of innovation. Instead, the company runs an entire division devoted to finding ways to avoid taxation.

Parramore: Your work shows how the process of developing high-tech products has changed in recent decades and how the fruits of success are distributed. Who is reaping the rewards of high-tech innovation in today’s economy?

Lazonick: If you were an employee in the “Old Economy” business model that was dominant in high-tech companies coming into the 1980s, you got to share in the success of innovation through a stable job, salary increases and retirement security. Under a “retain-and-reinvest” allocation regime, a company reinvested profits in your capabilities and worked to keep your valuable human assets. You, then, would contribute to innovation by engaging in collective and cumulative learning about the company’s proprietary technologies, many of which had been developed in its corporate research labs. The pay of top executives was largely tied to the gains shared with the mass of salaried employees. IBM in the mainframe era is a prime example; through the 1980s the company had an explicit policy of “lifelong employment,” bragging that it had never laid off an employee involuntarily since 1921.

IBM in the mainframe era is a prime example; through the 1980s the company had an explicit policy of “lifelong employment,” bragging that it had never laid off an employee involuntarily since 1921.

When “open systems” came along in the 1980s, exemplified by IBM’s PC with its Microsoft operating system and Intel microprocessor, things changed. Older employees who were skilled and versed in a company’s proprietary technologies got pushed aside in favor of younger workers with the latest open-systems skills. Old Economy companies now had to compete for talent with “New Economy” startups that used stock options to convince high-tech workers to give up secure employment with the established companies.

In the name of shareholder value, these executives could avoid the uncertain process of investing in people, the source of all innovation. At the same time, companies started doing massive stock buybacks, a practice sanctioned by the Securities and Exchange Commission in 1982, in order to jack up stock prices.

In this new regime, executive pay became increasingly stock-based, rewarding top executives for the company’s stock-price performance, no matter how it was achieved. Top executives began to embrace a new and strange ideology: a company should be run not for its products and employees, but for its shareholders, even though these shareholders merely bought and sold stock and contributed nothing to the success of the company. Executives got quick boosts to company profits by laying off experienced, and more expensive, employees.

In the early 1990s, the Old-Economy icon IBM led the way in transforming from “retain-and-reinvest” to “downsize-and-distribute.” Sadly, over the past two decades, this has become the dominant resource-allocation regime among US companies, high-tech and otherwise. My detailed research at the industry and company levels shows that this financialized mode of doing business has helped to concentrate income among the top 0.1 percent, and it has led to the ongoing erosion of middle-class employment opportunities in the US.

Parramore: You’ve noted a growing consensus that America is falling behind other countries when it comes to innovation and technology. How did this happen, and how do your findings tell a different story from what is commonly believed?

A growing number of academic studies are concluding that there is an “innovation crisis” in the US.

A growing number of academic studies are concluding that there is an “innovation crisis” in the US. In the Old Economy, decades of research collaboration between government agencies and business enterprises put in place the infrastructure and knowledge base that has permitted companies like Netflix, Facebook, Uber and Airbnb to emerge as dominant players. But other nations are starting to catch up and even take the lead in developing the most advanced technologies. In 2007, researchers in France and Germany shared the Nobel Prize in Physics for the scientific discoveries that made possible the iPod and countless other digital devices.

So what is the US doing wrong? Some point to a decline in government R&D spending as a consequence of the end of the Cold War. Others view the problem as a lack of business R&D spending because of a financial-market environment that results in “short-term” thinking on the part of corporate executives. But research on investment in the high-tech knowledge base that I have done with Matt Hopkins demonstrates that the problem is not a lack of R&D spending, either by government or business. Rather we argue that, with the rise of the New Economy business model, the main problem is the failure of US high-tech corporations to invest in the “collective and cumulative careers” which you need if you want R&D spending to result in more high-tech knowledge. Government policymakers have added to this failure by not recognizing that long-term careers are key to the creation of a world-leading high-tech knowledge base, the subject of our second paper. Just throwing more R&D money at the problem won’t bring you the next breakthrough product.

As I showed in a recent Harvard Business Review article, “Profits Without Prosperity,” the business failure stems directly from the obsession of US top executives with doing massive stock buybacks with the sole purpose of giving manipulative boosts to their companies’ stock prices. This behavior cannot be understood as “short-termism.” It’s really the direct result of the economic incentives inherent in the ample stock options and stock awards that corporate boards of directors, dominated by CEOs, bestow on top executives in order to maximize shareholder value. Neoclassical economists have assured corporate executives that maximizing shareholder value results in the superior performance of their companies and the economy as a whole. In fact, as I have shown in many theoretical and empirical studies, this strategy is ruinous. It undermines innovation and results in income inequity and employment instability.

Over the decade 2004-2013, 75 companies included in 11 high-tech industry categories in the 2013 Fortune 500 list expended $1.1 trillion on stock repurchases and more than half a trillion dollars on cash dividends. The employment practices of these 75 companies are very important to the operation and performance of the US high-tech economy. Yet many if not most of these companies are operating in a “downsize-and-distribute” mode of resource allocation. For the US to remain a world technology leader, this broken business model requires a major overhaul.

Parramore: Business executives often argue that lower tax rates for companies and wealthy households are necessary for innovation and entrepreneurship. What do you say to that argument?

Lazonick: They like to repeat this line, but the facts explain why the opposite is actually true.

From 2004 to 2013 about 9,000 companies in the Compustat database wasted $6.9 trillion on stock buybacks — that’s equivalent to nearly half their profits. They also spent $7.5 trillion on dividends, the normal way of providing holders of corporate stock with income on their portfolio investments. The US companies in the S&P 500 Index, which account for over 70 percent of total US market capitalization, did half of those buybacks, represented 54 percent of their combined profits — an astonishing development.

These people are far less interested in creating value over the long run than in extracting it for themselves over the short run through stock market casino games.

In 2013, the average compensation of the 500 highest paid executives was $32.2 million, with 84 percent from stock-based compensation that incentivizes massive buybacks to manipulate the stock market. Yet these highest paid corporate executives may actually be jealous of the $1 billion pay packages of the biggest hedge-fund activists who are the chief financial cheerleaders for doing buybacks to boost stock prices. These people are far less interested in creating value over the long run than in extracting it for themselves over the short run through stock market casino games.

Hedge-fund managers, of course, have much of their income taxed at the corporate tax rate, while most corporate executives lobby for lower tax rates for themselves and their companies.

Why give tax breaks to people who actively manipulate the stock market? Why are we helping to ensure that they remain comfortably ensconced among the 0.1 percent? And why give tax breaks to companies whose profits are used for this purpose, instead of something useful? The broken tax regime is part of the problem of inequality. It incentivizes value extraction, not value creation. To give more tax breaks to the rich or to the corporations that they control would be utter folly.

Parramore: How can we change America’s business culture to get more innovation and higher standards of living?

Lazonick: First, we need to rid business of the ideology that companies should be run for the sake of “returning” value to public shareholders. You can’t “return” value created by a company’s productive assets to people who never actually invested in those assets. Taxpayers and workers, on the other hand, do play major roles in investing in the productive capabilities that create competitive products.

You, the taxpayer, do this through government funding of the knowledge base.

Employees do it through their on-the-job expenditures of effort. It is highly damaging to industrial innovation and employees’ earnings to run the corporation for the sake of those participants who matter least. Public shareholders are traders in corporate stock, not investors in corporate assets. The actual investors in corporate value creation are households as taxpayers and workers. Let’s run the corporation for them.

Parramore: If you could give one piece of advice to Apple CEO Tim Cook to position the company for success in the future, what would it be?

Lazonick: That piece of advice would be: stop the stock buybacks.

In October, I wrote a critique of Carl Icahn’s call to Tim Cook for Apple to do $100 billion in buybacks as a massive tender offer on top of the $51 billion that Apple had repurchased over the previous two years. My research shows that Apple’s buybacks have been a major misallocation of resources.

There are plenty of ways Apple could improve relations with employees and society and use its profits productively in ways that are consistent with the company’s innovative business model.

Apple could invest in the educational attainments of its employees and let performance pay do its job of incentivizing employees to invest their skills and efforts in the innovation process. Tim Cook could take the lead among corporate executives in recognizing the debt that is owed to taxpayers for Apple’s profitable products. He should advocate that profitable companies like Apple pay their fair share of taxes, and he should support the efforts of employees who can make innovative contributions to solving some of America’s greatest social ills, like discrimination, poverty, and climate change. Instead of doing massive stock buybacks, a profitable company like Apple should “think different” about innovation by deploying some of its technological capability to help our society confront the major issues of our times.

The views expressed in this post are the author’s alone, and presented here to offer a variety of perspectives to our readers.