Stephen Ezell on Innovation Matters

Bridges vol. 41, October 2014 / OpEds & Commentaries

By Stephen Ezell                                                                                                                       

Ezell

Leveraging ICTs to Bolster European Productivity and Economic Growth

Europe trails the United States across many dimensions with regard to the production and application of information and communications technologies (ICTs). In fact, only nine of the top 100 ICT companies worldwide have headquarters in Europe and, of the top 30 global IT services and software companies, only four have their headquarters in Europe. But while most focus on Europe’s lag in ICT-producing industries – that is, industries producing semiconductors, computers, mobile phones, tablets, entertainment consoles, or other electronic devices – the greater concern for Europe is how much it trails the United States in ICT usage and adoption. This is because, at the economy level, more than 80 percent of the benefits of technology come from its consumption, while just 20 percent come from its production. In fact, a major reason why European productivity levels trail those of the United States is that European enterprises, governments, and other organizations trail their American counterparts in ICT investment, usage, and adoption. This article examines the economic literature that attributes lagging European productivity growth in part to inferior ICT investment and usage, discusses several recent policy decisions that have held back ICT usage and application in Europe, and offers several policy recommendations to bolster European productivity growth through ICT.

Higher productivity growth is the sine qua non of economic growth: It is the principal way that economies grow. For most of the post-War period, European productivity grew significantly faster than that of the United States; but after 1995, that trend reversed, as ITIF writes in Raising European Productivity Growth Through ICT. In fact, from 1980 to 1995, labor productivity in EU-15 countries grew at almost 2.4 percent annually compared to the United States’ 1.4 percent growth; but from 1995 through 2013 European labor productivity has grown at about 1 percent annually, compared to America’s nearly 2 percent. As a result, the labor productivity gap in the European Union (EU) relative to the United States widened by 10 percentage points between 1995 and 2013: from 89 percent to just 79 percent of US levels. This represents a missed opportunity, for if the EU-15 nations had maintained their 1980 to 1995 productivity growth rate until 2013, their annual GDP would be 16 percent larger today, with their economies collectively more than €1.6 trillion greater than their current €10.6 trillion level. Likewise, if productivity growth had not accelerated in the United States after 1995 but remained at its average annual growth levels from 1980 to 1995, US annual GDP would be 17 percent smaller, or $2.8 trillion lower than it is today.

Productivity increases stem from a variety of factors, but the principal one is use of more and better “tools” by producers: in other words, the use of more and better machinery, equipment, and software. And in today’s knowledge-based economy, the tools that are most ubiquitous and most effective in raising productivity are ICT-based. These digital tools are more than simply the Internet, although that itself drives growth. They include hardware, software applications, and telecommunications networks, and increasingly tools that incorporate all three components, such as computer-aided manufacturing systems and self-service kiosks.

Thus, ICT has become the modern economy’s key driver of productivity growth, which explains why nearly all scholarly studies since the mid-1990s have found positive and significant effects of ICT on productivity. Indeed, as research performed in 2011 by Oxford Economics confirms, ICT generates a higher return to productivity growth than most other forms of capital investment. In fact, ICT workers contribute three to five times more productivity than non-ICT workers. ICT’s impact on productivity works through two particular channels. First, ICT increases labor productivity in ICT-using industries by making labor produce more or work more efficiently. Second, ICT makes physical capital become more productive. Put simply, ICT is “super capital” that has a much larger impact on productivity than other forms of capital.

Thus, a principal reason why the European Union has demonstrated lower productivity growth than the United States since the emergence of the Internet age is that it has had lower productivity gains from ICT. In fact, OECD data show that, from 1985 to 2010, ICT capital contributed 0.53 percentage points to the average annual GDP growth rate in the United States (and 0.56 percentage points in the United Kingdom), but only 0.32 percentage points in France, 0.28 in Italy, and 0.27 in Germany (see Figure 1). Similarly, a 2011 report from Coe-Rexecode found that while ICT contributed 37 percent of US GDP growth between 1995 and 2008, it contributed 32 percent in Germany and just 26 percent and 27 percent, respectively, in France and the United Kingdom.

Figure 1: ICT contribution to average annual GDP growth rate, 1985-2010

Narrowing the focus to productivity growth, van Welsum, Overmeer, and van Ark found that ICT contributed 1.3 percentage points to the average annual growth rates of labor productivity in the United States between 1995 and 2007, but only 0.7 percentage points in the EU-15 (64 percent and 57 percent of total labor productivity growth, respectively). Furthermore, a recent OECD report, The Impact of ICT on Productivity and Growth, finds that the ICT contribution to value-added total factor productivity (TFP) growth from 1996 to 2007 was significantly higher in the United States than in EU countries.

There are at least five key reasons why Europe has not generated as much productivity growth from ICT as the United States has: lagging ICT investment, limited impact of ICT in Europe’s services sectors, excessive regulations and barriers to ICT-based enterprises and applications, onerous taxes, and weaker broadband deployment policies.

First, European firms simply do not invest as much in ICT as firms in the United States do, with that gap widening over time. In fact, whereas in 2000, EU-based firms invested about 80 percent as much as the United States in ICT as a share of total capital investment, by 2011 that ratio had declined to 57 percent. This is unfortunate, because higher levels of ICT investment drive higher productivity growth. As Cardona et al. find, firm-level analyses provide “solid evidence that over the last two decades an increase of ICT investment by 10 percent translated into higher output growth of 0.5–0.6 percent,” regardless of the country studied. Over time, these differential investments have contributed to a much deeper stock of ICT capital in the United States than in Europe. In fact, from 1991 to 2007, ICT capital stock – the total accumulated ICT investment – tripled in Germany, Italy, and Spain, reaching 6 percent of total capital stock; but in the United States (and the United Kingdom), it quintupled to 14 percent.

Taken as a whole, economists view US ICT investment as a key reason why the United States has maintained its place at the “technological frontier” as one of the most productive countries. The effectiveness of greater ICT capital investment in the United States suggests that additional ICT investment in Europe is likely to have significant benefits as well. As Strauss and Samkharadze argue in ICT Capital and Productivity Growth, “US productivity has outgrown the EU-15 mainly because of stronger ICT capital deepening and faster progress in productive efficiency.”

A second reason explaining why Europe hasn’t gotten the same productivity boost from ICT as the United States is the limited impact ICTs have had in Europe’s services sectors. In fact, from 1999 to 2009, US services sector productivity grew by 32 percent, while it grew just 21 percent in Germany and 20 percent in Holland. To be sure, some European countries, such as Norway, Poland, and the United Kingdom, have seen greater labor productivity growth in services than the United States over that period. But in total, from 1995 to 2007, EU private sector services productivity grew only one-third as fast as it did in the United States, primarily due to the greater deployment and usage of ICT in America’s service sectors.

Third, the diffusion of ICT adoption, usage, and application in Europe has been significantly slowed by a number of policy and regulatory promulgations – stretching back at least two decades – that have slowed, impeded, and inhibited not only the growth of ICT-based digital industries in Europe, but also the use of ICT by non-ICT enterprises such as those in the financial or hospitality sectors. For example, Dutch bank ING was the first bank in the world to introduce online banking, but Dutch regulators, fearing the impact online banking would have on employment (i.e., tellers) – introduced laws that slowed the introduction of online banking and compelled ING to first launch its service in the United States, not Europe.

Unfortunately, similar reactions to innovative, ICT-based business models and innovations persist across Europe today. For example, France’s Culture Minister has attempted to portray Amazon.com’s free shipping of online orders – a business model innovation – as “a strategy of dumping.” And a bill just unanimously approved by France’s lower house of Parliament would effectively force online booksellers to sell at higher prices than brick-and-mortar stores by banning any seller from applying government-related discounts to the cover prices of books that are shipped to readers. Similarly, Germany has become the first country to ban Uber Pop, a ride-sharing car service based on a smartphone app, across its entire territory.

Elsewhere, Europe’s revised Privacy and Electronic Communications Directive places much stricter restrictions on online behavioral advertising than those that exist in the United States. In analyzing the impact of the directive, Avi Goldfarb and Catherine Tucker found that if European online advertisers reduced their spending on online advertising in line with the reduction in effectiveness resulting from stricter privacy regulations, “revenue for online display advertising could fall by more than half from $8 billion to $2.8 billion.” More broadly, the European Center for International Political Economy (ECIPE) finds that, if fully enacted, the European Data Privacy Directive would reduce EU GDP by 0.35 percent, in even the most conservative estimate.

Meanwhile, the recent European Court ruling guaranteeing a “right to be forgotten” – allowing Web users to request Internet companies to remove links from search queries associated with their names, even if those results are factually accurate – will impose significant costs not only on search engine giant Google, but also on smaller European and American search competitors. Moreover, while it’s one thing if the European Commission asserts a “right to be forgotten,” it’s quite another when the EC attempts to extend this policy to other nations by extending the “right to be forgotten” beyond the country code top-level domain (e.g., Google.fr for France) to the top level domains used by other parts of the world (e.g., Google.com). Likewise, calls to create a “Europe-only cloud” for cloud computing services would only add unnecessary costs to the global provision of ICT services and unnecessarily impede the global flow of digital information. Such policies, which seek to limit access to best-in-class global ICT resources to protect and grow Europe's ICT industry, are unlikely to do anything other than raise ICT costs and, by extension, discourage ICT adoption in the rest of the European economy.

High taxes imposed on digital industries provide a fourth reason why Europe has fallen behind the United States in ICT industries. For example, Europe’s higher consumption taxes have a clear impact on prices for ICT equipment: A recent cross-country study found that for Apple’s iPad, an average 14 percent of the purchase price went to taxes, but in European countries the percent going to taxes ranged from 16 to 19 percent. While these taxes are sometimes justified as “luxury” taxes, in fact most ICT goods are not luxury goods, but rather are “pro-sumer” capital goods that spur productivity. Even worse are proposals to enact specific taxes on digital companies, such as the French Digital Economy Minister Fleur Pellerin’s call to enact an EU value added tax on certain online cultural goods and services. But as The New York Times notes in “Au Revoir, Entrepreneurs,” France’s insistence on imposing onerous digital taxes has only contributed to a massive migration of French digital entrepreneurs from France to England.

One final reason why America has gotten more of a productivity bump from ICT turns out to be stronger broadband Internet penetration, in part a result of differing policy approaches. Here, we are lucky to have something of a natural experiment, with the European Union and the United States undertaking contrasting broadband policies. The United States was fortunate to have previously encouraged widespread deployment of two separate pipes into homes (copper and coaxial), allowing for policies focused on intermodal, facilities-based competition. The European Union, on the other hand, has generally relied on regulations that treat broadband more or less as a utility, allowing new entrants to lease incumbents’ facilities at wholesale cost. While it can be difficult to generalize appropriate policy considering particular historical complexities of each countries’ or region’s ICT development, recent data strongly indicate that the United States has seen stronger investment and more extensive build-out of high-speed access networks. As Christopher Yoo and John Chestnut found in U.S. vs. European Broadband Deployment: What Do the Data Say?, the United States has achieved 82 percent coverage with networks of 25 Megabits per second (Mbps) or greater compared to only 54 percent coverage in the European Union. Given the market fragmentation many European markets have seen with service-based competition, it is likely that these policies have played a significant role in this coverage disparity.

To be sure, as written extensively by the Information Technology and Innovation Foundation, America’s policies supporting ICT adoption, diffusion, and deployment are far from perfect. Countries around the world must learn from one another's best practices. Yet the evidence seems clear that Europe has fallen behind the United States in the impact that information and communications technologies make on European productivity and economic growth. Too often, European policy makers want to focus on bolstering Europe’s ICT-producing (i.e., ICT-manufacturing) industries at the expense of ICT-using enterprises, because they fear the creative destruction that ICT usage can bring. To remedy this, European policy makers should enhance incentives (such as investment tax credits) to increase ICT capital investment by European firms, embrace ICT-based business models and digital innovation even when they disrupt existing industries, and significantly loosen their regulatory hold on the information and communication technology sector.

Stephen Ezell is a senior analyst with the Information Technology and Innovation Foundation (ITIF), a Washington, DC-based technology and economic policy think tank, where he focuses on science, technology, innovation policy, and trade issues. He is the coauthor with Dr. Robert Atkinson of Innovation Economics: The Race for Global Advantage (Yale, September 2012). Ezell came to ITIF from Peer Insight, an innovation research and consulting firm he cofounded in 2003 to study the practice of innovation in services industries. He holds a B.S. from the School of Foreign Service at Georgetown University, with an Honors Certificate from Georgetown’s Landegger International Business Diplomacy program.