[Economic Report of the President (2012)]
[Administration of Barack H. Obama]
[Online through the Government Printing Office, www.gpo.gov]


Improving the Quality of Life Through Smart Regulation, Innovation, Clean Energy, and Public Investment

Recent years have seen an unprecedented number of official
efforts to improve, develop, and implement new measures of the quality
of life and economic performance. Much of the groundwork for these efforts
was laid in two important National Research Council reports. Nature's
Numbers, published in 1999, considered how to expand the national
income accounts that track the country's economic activity to properly
take into account the environment and natural resources. Beyond the
Market, published in 2005, proposed ways to integrate nonmarket activity
into the accounts.
This work has implications for economic policy. Carefully designed
regulations can promote economic growth and improve the Nation's
quality of life. Water pollution, for example, can cause illness and
destroy the livelihood of fishermen and others who rely on a healthy
ecosystem to earn a living. Pollution, as Robert Kennedy noted, does
not subtract from the gross domestic product. Appropriately balanced
efforts to restrict harmful pollution can improve economic performance
along with the health and safety of Americans.

The theme of this chapter is that, properly measured, both economic
growth and the Nation's well-being can be increased by smart regulation,
innovation and public investment in such fields as medical research,
clean domestic energy and transportation infrastructure.


For more than a century, the United States has been a world
leader in protecting the health and safety of its citizens through
well-chosen regulations. Fuchs (1998 and 2010) attributes gains in
life expectancy prior to World War II to improvements in "nonmedical
factors: nutrition, sanitation, housing, and public health measures."
For example, in response to yellow fever and cholera outbreaks caused
by water pollution, the Rivers and Harbors Act of 1899 gave the Army
Corps of Engineers the authority to regulate the discharge into
waterways of "refuse matter of any kind or description." Similarly,
public health concerns about unsanitary meat packing conditions and
patent medicines containing narcotics gave rise to the Pure Food and
Drug Act of 1906, which authorized the Food and Drug Administration
(FDA) to inspect food and drug products and regulate their sale.
In 1900, roughly one in every 200 Americans was addicted to narcotics
found in patent medicines (DOJ n.d.). Following the disclosure
requirements in the Pure Food and Drug Act, sales of patent
medicines containing those substances fell by nearly a third
(Musto 1999).
As society evolves and technology changes, such basic protections
afforded to citizens through regulation are updated and improved.
Today, the water pollution controls provided for in the Rivers and
Harbors Act have been incorporated into more expansive provisions in
the Clean Water Act of 1972 and the Safe Drinking Water Act of 1974,
which enable the Environmental Protection Agency (EPA) to promulgate
regulations with the goal of making U.S. waters safe for drinking,
swimming, and fishing. Similarly, the Pure Food and Drug Act of 1906
was amended by the Food, Drug, and Cosmetic Act of 1938 to give
the FDA the authority to require evidence of safety for new drugs
and to tighten food quality standards. It was amended again in 1962
to require manufacturers to prove drug effectiveness (Randall 2001).
Most recently, the Food Safety Modernization Act of 2010 further
improved the safety of food sold in the United States by, among
other provisions, giving the FDA the authority to directly issue
mandatory food recalls, requiring food processors to have plans in
place for addressing safety risks, and requiring importers to verify
food safety.
Measuring the benefits of regulations for the quality of life is
a formidable task. Some forms of regulation have a positive effect
on economic growth, for example, by improving the health and vitality
of the workforce, by promoting stable and efficient operation of
financial markets, by speeding the adoption of energy-saving
technologies, by improving educational outcomes, or by upgrading the
operation of the transportation system. Much of the benefit from
those types of regulations eventually translates

into increases in GDP. In other cases, such as the protection of
the National Park System, safeguards against invasive species, or
cleaner lakes for swimming and fishing, the benefits of regulation
help the economy, but are less easily charted in the national
accounts. For example, increased tourism or higher returns to
commercial fishing resulting from cleaner water would be
reflected in GDP, whereas the public's increased appreciation of
that cleaner water would not be.\

Designing Smart Regulations
On January 18, 2011, President Obama issued Executive Order
13563, "Improving Regulation and Regulatory Review," which lays out
a balanced approach to regulation--to protect the health and safety
of the American people in a way that maximizes net benefits to
society, that uses the best information available, and that avoids
unnecessary or overly burdensome requirements. The President called
for an agency-wide review to reduce burdensome regulations.
Underlying that approach is a belief that a smart, effective
regulatory system depends on careful analysis of costs and
benefits, both before and after regulatory action, including an
informed public discussion. The Executive order directs the Office
of Information and Regulatory Affairs (OIRA) of the Office of
Management and Budget (OMB) to provide oversight, transparency, and
discipline for executive agencies in the regulatory process, and
coordinates that interagency review of rulemakings to ensure that
regulations are consistent with applicable law. The net benefits
of regulations finalized in 2011 are expected to be at their
highest level in the last 10 years. And monetized savings from
the retrospective review of regulations called for in the new
Executive order are likely to exceed $10 billion over the next five
Many of those regulations are intended to improve the quality of
life by correcting market failures that lead to unsafe living or
working environments. Effective regulations put into place rules that
correct for significant market failures and thus achieve greater
social benefits. "Smart regulations" are those that maximize the
net benefits of a regulatory action to society. Benefit-cost analysis
attempts to quantify and assign dollar values to the various
effects of a regulation, which can be used to determine how it can
reach its goal in the most efficient manner--that is, how it can
generate the largest net benefits (the difference between total
benefits and total costs) to society. Such information is useful
for both policymakers and the public, even when economic efficiency
is neither the only nor the overriding public policy objective, as
in the case of protecting privacy.
Benefit-cost analysis is used to estimate likely future benefits and
costs of a proposed regulation, but it can also be used to
"look back" at existing

regulations, based on evidence about the actual, realized benefits
and costs of those regulations. Such retrospective analyses can be
used both to improve existing regulations and to better evaluate new
Smart regulations thus seek to use the best information available
in order to maximize net benefits by setting regulatory stringency at
the most efficient level--the point at which the incremental benefits
are equal to the incremental costs. For example, even though the
marginal costs of seat belt standards increased over time
(front-seat shoulder and rear-seat lap belts were mandated for cars
in 1968 and for light trucks and vans in 1971, and three-point belts
were required in the mid-1970s), those costs were far outweighed by
the corresponding number of lives saved per year by seat belts
(DOT 2004; Kahane 2004). The buckle-up laws of the mid-1980s raised
the number of lives saved by wearing seat belts to 6,000 a year by
1988-90, and subsequent increases in belt use raised the annual
number of lives saved to more than 15,000 in each year from 2003 to
2007. All together, between 1975 and 2009, seat belt regulations
saved an estimated 268,000 lives (Kahane 2004; DOT 2009). (For
another example of how benefit-cost analysis works, see Economics A
pplication Box 8-1.)

Smart Regulations in Practice
Benefit-cost analysis has long been used to evaluate regulations
within the Federal Government. For example, the Flood Control Act of
1936 declared that "the Federal Government should improve or
participate in the improvement of navigable waters or their
tributaries including watersheds thereof, for flood-control
purposes if the benefits to whomsoever they may accrue are in
excess of the estimated costs, and if the lives and social security
of people are otherwise adversely affected."
The use of benefit-cost analysis in evaluating Federal
regulations has become widespread since 1981, when President Reagan
issued Executive Order 12291, formally requiring that "regulatory
action shall not be undertaken unless the potential benefits to
society for the regulation outweigh the potential costs to society
and that regulatory objectives shall be chosen to maximize the net
benefits to society." President Clinton issued Executive Order 12866,
which focused OIRA oversight on "significant" rules and increased
transparency. As noted earlier, President Obama issued Executive
Order 13563, which reaffirms the principles in Executive Order
12866 and outlines a regulatory strategy to support continued
economic growth and job creation. In particular, Executive Order
13563 offers new directions for regulatory review, including a
requirement that agencies "use the best available techniques to
quantify anticipated present and future benefits and costs as
accurately as possible" while authorizing consideration of "values
that are difficult or impossible to quantify, including equity, human
dignity, fairness, and distributive impacts."

Based on the quantified benefits and costs in current
regulations, smart regulations are generating the highest level of
net benefits for U.S. citizens in the last decade. In calendar year
2011, the Administration completed 740 regulatory reviews, 336 of
which were interim final or final rules from executive agencies. Of
the interim final and final rules reviewed, 18 percent were
"economically significant," meaning that they are anticipated to
have an effect on the economy of more than $100 million in any given
year. Those economically significant rules are expected to result
in $15 billion in costs and $116 billion in benefits annually
(in 2001 dollars). Over the past three calendar years, the annualized
net benefits of completed rules have totaled about $155 billion.
In 2011 alone, annualized net benefits totaled more than $101
billion. Those figures reflect an estimate of not only purely
monetary savings, but also an estimate of the monetary value of
prevented deaths, illnesses, and injuries. Figure 8-1 shows the
benefits and costs of regulations, which are detailed in the
agencies' Regulatory Impact Assessments for each economically
significant rule and summarized annually in OMB's annual
Regulatory-Right-to-Know report to Congress.
Data and estimation methods have improved substantially over
time, as have modeling tools for projecting a regulation's effect
into the future. For

Improving the Quality of Life through Smart Regulation,    | 235 Innovation, Clean Energy, and Public Investment

Economics Application Box 8-1: Comparing Benefits and Costs
How do policymakers determine whether a regulation is a smart
regulation? For example, in 2007, the Department of Transportation
(DOT) decided to require that all new passenger vehicles weighing
less than 10,000 pounds be equipped with electronic stability control
(ESC) systems, which reduce crashes by improving braking in critical
situations when the driver is beginning to lose control. This rule
will increase the fraction of new vehicles with ESC from 29 percent
in 2006 to 100 percent in 2012. How did the DOT decide this was a smart
First, the DOT identified what is arguably a market failure: a
relatively affordable technology existed that lowered the risk of a
crash, but it was not being offered by some manufacturers and, when
offered the choice, many consumers declined. This market failure was
caused by asymmetric information (drivers purchasing a vehicle could
not fully assess the protection afforded by ESC systems) and by a
negative externality (consumers purchasing a car without an ESC system
did not fully account for the risks of a crash to others).
Second, the DOT then examined the likely costs and benefits of
equipping all passenger cars and light trucks/vans with ESC by
model year 2012. Approximately 17 million vehicles will be subject
to this regulation; however, DOT estimates that as of 2011,
manufacturers would have installed ESC in 71 percent of their fleet
absent the rulemaking. Therefore, both the benefits and costs were
calculated by raising ESC installation from that baseline of 71
percent to 100 percent. The benefits of the rule include reductions
in fatalities, injuries, property damage, and travel delays, all
resulting from fewer accidents. To monetize those benefits, the DOT
multiplied the total number of loss-of-control crashes by the average
effectiveness of ESC systems and found that 67,00091,000 crashes
would be avoided each year. Using historical accident data, DOT
estimated that a decline of 67,000 crashes would reduce total
annual fatalities by 1,547 and decrease total annual injuries by
The monetary value of those benefits depends on the discount
rate, that is, on how much benefits in the future are worth today
(a high discount rate implies that people discount the future more
and thus any benefits that accrue in the future would be valued
less today). At a 7 percent discount rate, the reduction in injuries
and fatalities translates into $6.4 billion in benefits; at a 3
percent discount rate, those benefits are $8.0 billion, as the
Box Table shows. To determine the noninjury component of benefits,
the DOT multiplied the individual unit costs for travel delays and
property damage by the 67,000 crashes that would be prevented by the
rule, yielding $247 million in benefits at the discount rate of
7 percent.
Annual Costs and Benefits by Discount Rate Millions of 2005 dollars

The DOT determined that production costs would rise by between
$111 and $479 for each affected vehicle, depending on whether the
vehicle was already equipped with anti-lock braking systems, a
necessary component of ESC. The expected costs of the standard above
the baseline total $985 million. Because the average weight of
passenger cars is expected to increase by 2.1 pounds as a result of
the new equipment, the lifetime fuel use of those vehicles is
expected to go up by 2.6 gallons. At discount rates of 7 percent
and 3 percent, the total additional fuel costs are $21.8 million
and $26.8 million, respectively. Summing vehicle and fuel costs gave
the total costs of the regulation: about $1.0 billion. Net benefits,
then, are the difference between total costs and total benefits, or
between $5.6 billion and $7.3 billion each year for the lower range
of accident prevention.
/a/ For further discussion of market failures and automobile safety
standards, see Mannering and Winston (1995), Arnould and Grabowski
(1981) and Viscusi and Gayer (2002).
/b/ The appropriateness of including private benefits net of private
costs in a benefit-cost analysis varies from rule to rule. By
including private net benefits-- the value of reducing injuries and
fatalities of the consumers minus the purchase cost of the
technology--the DOT is making the implicit assumption that consumers
have made a suboptimal purchasing decision (one of the market
failures being addressed by the regulation). However, if consumers
do not face an information problem, a traditional approach would
assume that consumers have made the purchasing decision that
maximizes their welfare. If this were the case, it would be
inappropriate to include those private net benefits in the
analysis. For further discussion, see Gayer (2011).

example, the health benefits from reducing different air pollutants
over different time periods and populations have been estimated
by epidemiologists using air quality monitoring data and various
health endpoints (EPA 2011a). Improvements in computing power and
data records now allow air quality modelers to forecast the effects
of regulatory actions on future air quality under different
scenarios. Combining those estimates allows policymakers to weigh
the expected health results of a given air quality regulation with
the expected costs associated with the controls required by the rule.
A peer-reviewed study by the EPA using the Criteria Air Pollutant
Modeling System estimated that the Clean Air Act prevented more than
160,000 premature deaths, 54,000 cases of chronic bronchitis, 130,000
non-fatal heart attacks, and 1.7 million cases of asthma
exacerbation between 1990 and 2010. Those adverse health outcomes
could have led to 86,000 emergency room visits for respiratory
problems, 3.2 million lost school days, and 13 million lost work
days (EPA 2011b).
Some health benefits from Clean Air Act regulations will likely
raise economic growth indirectly and over time through intermediate
factors. For example, a healthier population will arguably be a
more productive one, a change that can be measured in improved
labor productivity. A growing consensus has identified certain of
those intermediate drivers of growth, including increased human
capital, capital investment, research and develop ment, economic
competition, physical infrastructure, and good governance. Some
evidence strongly suggests that regulations promoting educational
attainment may improve human capital accumulation, thereby increasing
economic growth over time (for example, see Cohen and Soto 2007).
Other studies show a positive link between increased life expectancy
and economic growth. A survey of the existing literature on health
and economic outcomes (Bloom et al. 2004) finds in cross-country
analysis that a one-year increase in life expectancy generates a 4
percent increase in economic output, controlling for other
variables. Similarly, Murphy and Topel (2006) find that progress
made battling various diseases after 1970 added about $3.2 trillion
a year to national wealth.

Retrospective Analysis
The prospective benefit-cost analysis that goes into crafting
smart, efficient regulations is necessarily fraught with
uncertainty. Prospective analysis requires that the costs and
benefits of a regulation be identified and quantified before
(ex-ante) the regulation is implemented. Only after a

regulation has gone into effect can its actual (ex-post) effects
become known (see Data Watch 8-1).
Changes in technology often make pollution abatement cheaper.
For example, the actual costs to utilities of the cap-and-trade
system for sulfur dioxide allowances set up by the Clean Air Act
Amendments of 1990 were much lower than had been predicted.
Scrubbing technologies turned out to be more efficient at removing
sulfur dioxide from emissions, and power plants were able to blend
a higher percentage of cheaper, low-sulfur coal than had initially
been assumed. Moreover, the benefits of reducing sulfur dioxide
emissions have since been found to be much larger than originally
thought. As a result, subsequent regulations for utilities have
tightened controls on those emissions.
Similarly, during the 1970s, automobile technologies were
improved by new pollution standards. Regulators were phasing lead
out of gasoline, and again the costs of the regulation were
overestimated and the benefits underestimated. Lead impairs brain
development in children and has been linked to serious health
problems in adults such as hypertension, heart attacks, and
premature death (Lovei 1998). Concern about high blood lead
concentrations in the U.S. population led the EPA to begin in 1974
to phase in a stringent standard reducing the amount of lead allowed
in the gasoline supply. Subsequent studies found that the annual
benefits of banning lead in gasoline would be more than $6 billion
(in 1983 dollars), but would cost around $500 million a year
(Schwartz 1985). Harrington, Morgenstern, and Nelson (1999) note
that those costs may have been overstated, but that it was difficult
to disentangle the effects of a phase-out of leaded gasoline from
the much larger effect of changes in oil markets around that time.
Research also found that the benefits of lowering lead exposure were
greater than initially thought. The EPA's 1985 benefit estimate
implied that reducing mean blood lead concentrations in the
population by 1 microgram per deciliter (or 1 (ig/ dl) was worth at
least $3.5 billion a year (Schwartz 1994). By 1994, however,
researchers were finding that a reduction of 1 (g/dl in mean blood
lead concentrations resulted in much greater benefits than earlier estimates--as high as $17.2 billion a year (1989 dollars)
(Schwartz 1994). The phase-out of leaded gasoline was completed in
1995; by then the average blood lead concentration was
approximately 2.3 (g/dl, down from more than 15 (g/dl in the early
1970s (Weaver 1999).

Data Watch 8-1: The Value of Information--the PACE Survey
One of the few data sources for benchmarking costs of air and
water pollution controls is the Pollution Abatement Costs and
Expenditures (PACE) survey, which recently has been funded by the
Environmental Protection Agency (EPA) and administered by the Census
Bureau. from 1973 to 1994, the PACE survey was administered annually
to nearly 20,000 manufacturing and mining facilities and electric utilities. Since 1994, because of resource constraints, the Census Bureau has
conducted this survey only twice (for 1999 and 2005). To estimate the
overall regulatory burden facing American manufacturers, the PACE
survey collects data on overall pollution abatement expenditures
by manufacturers for treatment, prevention, recycling, and disposal,
rather than trying to allocate costs to specific regulations. It is
the only survey that measures environmental compliance costs at both
the individual and aggregate levels (Ross et al. 2004).
Pollution equipment expenditures have fallen over time, on average
accounting for 7 percent of all investments made by manufacturing
industries in the early 1990s and 4 percent in 2005. There is
considerable variation in spending across industries, but given that
pollution levels (and the negative externalities associated with
pollution) also vary by industry, that is neither surprising nor
necessarily suboptimal.
The EPA has used PACE data to estimate the cost of both past and
proposed regulations (see for example, Gallaher, Morgan and
Shadbegian 2008). Academics have used the data set to investigate
the relationship between EPA regulations and economic outcomes. For
example, Levinson (1999) used the PACE data to develop a new index
of state environmental compliance costs. Similarly, Shadbegian and
Gray (2005) examined the relationship between of pollution abatement
and productivity. And Becker (2005) found expenditures on
environmental compliance for small facilities differ from larger

"Look-Back" Initiative
President Obama's Executive Order 13563, issued in 2011,
directed executive agencies to conduct retrospective reviews of their
regulations to determine whether any of the agencies' regulations
should be modified, streamlined, expanded, or repealed. This Executive
order was followed by Executive Order 13579, which called on
independent agencies to conduct such retrospective reviews to the
extent possible. Look-back exercises enable regulatory agencies to
learn whether they can increase net benefits by modifying existing
regulations, expanding regulations, or even eliminating existing
regulations that may turn out to be ineffective or duplicative.

Incorporating ex-post benefits and costs of regulations is the
key goal of the new Executive order requiring agencies to conduct
retrospective reviews of their regulations. In the past, agencies
have undertaken such reviews in certain situations but only on an
ad hoc basis. The new Executive order aims to improve regulatory
analyses by providing a formalized process for incorporating new
information into regulations and for gaining insight into the costs
and benefits borne by the private sector in practice.
The President's regulatory look-back initiative has produced more
than 500 reform proposals, detailed in 26 agency plans, and monetized
savings from this review are likely to exceed $10 billion over the
next five years. A number of recent actions eliminate or streamline
unjustified or excessive regulations, and the Administration has put
in place an improved regulatory system that will generate more
current and accurate information on regulatory costs and benefits.
Moreover, pursuant to Executive Order 13579, issued in July 2011,
some of the major independent regulatory agencies have also issued
preliminary retrospective review plans for public comment.  Five
examples illustrate the effectiveness of the look-back initiatives.
First, the Occupational Safety and Health Administration (OSHA),
has announced a final rule that will eliminate redundant reporting
burdens; the regulation is expected to save employers 1.9 million
hours and $40 million annually. OSHA also plans to finalize a rule
projected to result in more than $585 million in savings each year
by making U.S. hazard classifications and labels consistent with
other nations.
Second, since the 1970s, the EPA has treated milk as "oil"
subject to regulations designed to prevent oil spills. In response
to feedback from the agriculture community and the President's
Executive order, the EPA recently concluded that the rules
placed unjustifiable burdens on dairy farmers and decided to exempt
milk from those regulations. That exemption will save the dairy
industry, including many small businesses, as much as $148 million
per year.
Third, to reduce burdens on railroads, the Department of
Transportation has proposed to refine its requirements for tracks
that are to be equipped with positive train controls. This equipment
can automatically control a train in emergency circumstances,
reducing the risk of an accident. The potential refinements would
eliminate the need for costly wayside components and mitigation
measures along as much as 10,000 miles of track where they are not
needed for safety. The initial 5-year savings are expected to be as
high as $335 million, with total 20-year savings of up to $778

Fourth, the EPA has proposed to eliminate a requirement for air
pollution vapor recovery systems at local gas stations in many
states, on the ground that modern vehicles already have effective
air pollution control technologies. The anticipated annual savings
from eliminating the requirement are estimated to be as high as
$87 million.
Fifth, the Health and Human Services Department has proposed or
finalized several rules that reduce regulatory burdens and
restrictions on doctors and hospitals and that are expected to save
more than $5 billion over the next five years.
There are many other look-back efforts--in all, the initial round
of retrospective proposals is expected to eliminate millions of hours
of required paperwork for individuals, businesses, and State and
local governments and to save billions of dollars.

Improvements in Everyday Life
Every time Americans drive a car, take a breath, swim in a lake,
or take a medication they are benefiting from regulations. As noted,
such improvements in quality of life often show up in national
accounts only as a fraction of their total benefit to society.
For example, although the growth and size of the pharmaceutical
industry are reflected in GDP, the value of assurances given to
the U.S. public that the medicines they are taking have been tested
and verified to be effective and safe goes far beyond the measured
value of that sector to the national economy.
Similarly, the Clean Water Act and its associated permitting
requirements have reduced effluent discharge into U.S. streams,
lakes, and estuaries. Putting a price tag on the benefits of being
able to swim, fish, and boat in those bodies of water is difficult.
Regardless of the value, some of those benefits (for example,
increasing expenditures on fishing equipment and recreation) will show
up in a calculation of GDP, while many others (such as reducing the
level of fecal coliform in the water) will not. The EPA estimates the
benefits of reducing discharge of conventional pollutants to U.S.
rivers and streams to be approximately $11 billion annually
(Bingham et al. 2000).
The EPA's Superfund program, which identifies, investigates,
and cleans the Nation's most contaminated hazardous waste sites,
has also improved public health. Since 1980 the Superfund program
has prevented millions of people from being exposed to hazardous
substances by requiring protective and containment measures and the
removal from industrial sites of many millions of tons of material
contaminated with toxic chemicals such as lead, arsenic, mercury,
and benzene (EPA 2011c). Studies have shown that Superfund cleanups
have lowered the risk of acute poisoning, improved infant health,
and decreased the risk of cancer (Currie, Greenstone, and

Moretti 2011; and EPA 2011c). Those improvements are generally
not captured well in GDP for any given year.
Even though smart regulations can impose restrictions on the
private sector, as Figure 8-2 illustrates, the resulting benefits
do not come at the cost of prosperity or sacrifices in U.S.
standards of living. Over a period of decades, air quality has
improved while the economy has grown; indeed, the demand for clean
air and water has risen along with income across countries (see for
example, Grossman and Krueger 1995; and World Bank 1992). Even
though those benefits do not show up directly in GDP measures,
they are consistent with increases in conventional
(albeit incomplete) measures of growth. Per capita GDP has shown
substantial growth between 1980 and 2010, rising by 65 percent,
while at the same time per capita emissions of criteria pollutants
(lead, carbon monoxide, sulfur dioxide, nitrogen oxides,
particulate matter, and ozone) have declined by nearly 75 percent.
Similar achievements have been made in other areas as well.
The number of fatalities on U.S. roads per million vehicle miles
traveled (VMT) has declined by 67 percent between 1980 and 2010,
while VMT per capita increased by 44 percent, reflecting the
effectiveness of road and vehicle safety regulations.

Innovation, loosely defined as the introduction of a new or
improved product, service, or process, is the primary source of
long-run increases in productivity and human welfare (Grossman and
Helpman 1991). When new ideas are integrated into the economy, they
offer new possibilities for both production and consumption.
Innovation comes in two general forms: process and product
innovation. Process innovations involve new or improved methods of
production or distribution, often as firms seek to reduce costs.
The cost savings are reflected in conventional accounting statistics
as greater productivity. Over time, rising productivity drives the
growth in the amount of output that the economy can produce.
By contrast, product innovations introduce new or improved products
or services into the marketplace. As noted, consumers benefit from
product innovations in ways that conventional accounting statistics
do not adequately measure.
Although there is no perfect measure of the importance of
innovation to an economy, by many measures innovation has played
an increasingly important role in the U.S. economy in recent decades.
For example, the industries classified by the OECD as "knowledge-
and technology-intensive" have steadily increased as a share of the
U.S. economy, from 34 percent of GDP in 1992 to 40 percent in 2010,
according to the National Science Foundation (2010; 2012).

Private-sector competition is the primary driver of innovation.
Firms in innovative industries must continually work to improve
their products or increase their efficiency to avoid losing market
share to competitors. Businesses that successfully invest in
innovations are rewarded in the marketplace. Incentives for
businesses to invest in innovation are often less than optimal
from the perspective of society as a whole, however, primarily
because the innovator may not be able to capture all of the benefits
generated by the innovation. The positive spillovers from innovation
mean that the private returns from innovation will often be less
than the social returns, particularly when it comes to basic research.
Private firms have limited incentive to conduct basic scientific
research from which they generally can capture only a small fraction
of the value that emerges from that research. As a result, private
markets may lead to underinvestment in basic science and limited
diffusion of scientific advances.
Because private incentives to invest in innovation are often
inadequate, public-sector support for innovation has important
benefits. Government can promote innovation in many ways. By operating
a well-functioning system of intellectual property rights, the
government can help innovators earn returns commensurate with the
social value of their innovations. Government can increase investment
in innovation through research and development (R&D) expenditures,
both by direct funding and by tax

incentives. It can facilitate the commercialization of innovations
by removing barriers that prevent the private sector from
transforming inventions into marketable products. It can provide
infrastructure necessary for innovation, for example by allocating
spectrum to support the growth of wireless broadband, itself an
important platform for innovation in mobile devices, applications,
and services. The government can also target innovation initiatives
to areas of key public importance, including education, health care,
and energy. This section of the chapter discusses these issues and
describes some of the Federal Government's current efforts to
promote innovation in the U.S. economy.

Measuring Innovation
Innovation's crucial role in economic growth and welfare has
prompted efforts to improve the tools to measure it. One longstanding
approach to measuring innovation is to infer that any economic growth
not attributable to additional capital and labor must be due to some
sort of "technical change." This so-called "Solow residual" approach
(Solow 1957), however, leaves unanswered many questions about the
nature of the technical change.
Data on patenting activity can provide a useful, if imperfect,
measure of innovation. Although many innovations are kept secret to
preserve competitive advantage, many others are made public through
patent filings. The innovations for which patents are granted vary
greatly in their significance, however, and a raw count of patents
cannot account for these differences. Moreover, increases in patent
activity over time may be attributable, at least in part, to more
aggressive patenting of marginal innovations rather than increases
in innovation itself (Hall and Ziedonis 2001). To address these
limitations, studies of innovation have often relied on measures
of patent citations. For example, the number of times a firm's
patents are cited by other patent applications is more closely
correlated with the firm's market value than is the raw number of
patents it holds (Hall et al. 2001).
New measurement efforts have focused on the funds allocated to
R&D within the economy. Historically, R&D has been treated as an
intermediate input to the production process and is therefore excluded
from GDP estimates. Beginning in 2013, the GDP estimates produced by
the Bureau of Economic Analysis (BEA) will include R&D under the
category of investment, increasing measured GDP. Spending on R&D is
large and growing; if the new definition had been in effect earlier,
current-dollar GDP in 2007 would have been, on average 2.7, percent
higher, and R&D would have accounted for 6.3 percent of real GDP
growth between 1998 and 2007.

In addition, to help improve understanding of the role of R&D
in fostering innovation, the Census Bureau and the National
Science Foundation (NSF) have introduced the Business R&D and
Innovation Survey. This new survey combines firm-level data on
R&D expenditures with measures of new or improved products or
processes and patenting and licensing activity. The first group
of 40,000 for-profit firms was surveyed in 2009, and some
preliminary findings have been reported. For example, the NSF reports
that companies that invest in R&D exhibit far higher rates of
innovation than other firms (Boroush 2010).
Measuring innovation is particularly challenging in the growing
medical care sector. For example, medical science has established
that aspirin--an old and inexpensive product--can substantially
reduce heart attack risk. Patients have seen enormous benefits from
that scientific advancement, but those benefits are not captured by
estimates of GDP. The National Institute on Aging has sponsored
research on the development of national health accounts that would
gauge the population's health status and measure how medical care
and other factors affect health.

Intellectual Property Rights and Patent Reform
Innovation is spurred in part by the desire to reap rewards
for developing new products and services that people will value
The central purpose of intellectual property (IP) rights, which
include patents, trademarks, and copyrights, is to promote
innovation by giving IP owners the right to exclude others from
making use of their novel product or service. Well-designed IP
rights enhance the private returns to innovation and bring them
closer to the social returns, thereby increasing the incentives
to invest in socially valuable innovation. As President Lincoln
famously said, the patent system "added the fuel of interest to the
fire of genius" (Edwards 2006).
The United States has long had a robust system of IP rights.
In fact, one of the powers explicitly given Congress in the
Constitution is "To promote the Progress of Science and useful
Arts, by securing for limited Times to Authors and Inventors the
exclusive Right to their respective Writings and Discoveries."
In recent years, however, many observers have raised concerns about
the U.S. patent system. For example, the Federal Trade Commission
(FTC 2003) describes concerns that the patent system has failed to
keep up with the challenges posed by the growth of the
knowledge-based economy. Similarly, the National Academy of Science
(NRC 2004) describes unease among academics and practitioners
that "the escalation in the number of patents, possibly encouraged
by a lowering of the threshold to their

acquisition, was creating thickets of rights that could impede
innovation." Shapiro (2008) sees the core problem as being that,
in some circumstances, "the patent system predictably provides
excessive rewards to patent holders." The opportunity for
excessive returns can arise when patents are issued for
technologies that are not genuinely novel or when a patent
covers a small component of a complex product that allows the
patent's owner to extract royalties disproportionate to the
incremental value of the component. Some empirical evidence
suggests that, at least in certain industries, greater patenting
activity has in fact led to reduced R&D intensity (Hunt and
Bessen 2004).
To address concerns about the performance of the patent system,
President Obama, on September 16, 2011, signed into law the America
Invents Act, the most significant reform of U.S. patent law since
1952. By allowing third parties to provide the patent office with
additional information that may be helpful in assessing the novelty
of an invention for which a patent application has been filed,
the new law will reduce the number of improperly issued patents
and thus increase "patent quality." The law will also reduce
unnecessary litigation by creating new ways of resolving patent
disputes more quickly and cheaply, allowing inventors to invest
with more confidence in the validity of their IP rights while
reducing the drag on innovation caused by improperly granted
patents. The law will also reduce wait times for patent applicants
by giving the U.S. Patent and Trademark Office more resources to
reduce the backlog of applications and by creating a
"fast-track option" for time-sensitive patent applications such as
those from fast-growing startups or entrepreneurs seeking venture
capital. Last, the new law will harmonize the American patent
system with patent systems in the rest of the world by adopting
a "first inventor to file" system. This change will make the U.S.
system more efficient and predictable, allowing innovative
entrepreneurs to market their products more easily in the United
States while simultaneously exporting them abroad.

Private and Public Investments in R&D
R&D is a critical driver of innovation. Investments aimed at
creating new knowledge or applying existing knowledge in new ways are
often a necessary precursor to developing new or improved products
or processes or entire new industries. Although innovative activities
extend far beyond conventional R&D, and innovations arise in
industries that perform little R&D as such, investing in R&D is
generally an important element of innovative activity.
A large body of research confirms that investments in R&D
increase productivity growth (CBO 2005). Other research demonstrates
that the social returns to R&D investment are generally substantially
greater than

the private returns. For example, Nordhaus (2004) concludes that
"only a minuscule fraction of the social returns from technological
advances over the 1948-2001 period was captured by producers,
indicating that most of the benefits of technological change are
passed on to consumers." (See also Hall, Mairesse, and Mohnen 2009;
Bloom, Schankerman, and Van Reenen 2010; and Jones and
Williams 1998.) These findings support the conclusion that R&D
investments often have important positive spillover effects that
prevent private firms from fully capturing the benefits of their
innovations, thus giving them inadequate incentives to invest
in R&D. In addition, Hall (2002) finds evidence that capital
market imperfections may lead to underinvestment in R&D even in
the absence of these spillovers. In short, economics research
provides persuasive support for a robust government role in
promoting R&D.
The United States is a world leader in R&D investments. With
an estimated $400 billion in public and private expenditures in
2009, the United States invested more in R&D than China, Japan,
and Germany combined. Moreover, R&D spending as a share of the
U.S. economy has been increasing in recent years, with the
ratio of R&D spending to GDP reaching nearly 2.9 percent in
2009, the highest since the 1960s. During that interval,
however, the composition of U.S. R&D spending shifted dramatically.
During the 1950s and 1960s, the majority of total R&D expenditures
was federally funded; today nonfederal sources predominate. Private
industry investments have consistently accounted for about 90
percent of all nonfederal R&D expenditures.
Despite the increasing role of private-sector investment in R&D,
public support for R&D remains critically important, particularly
in basic research, which aims to expand scientific knowledge and
thus does not generally have immediate commercial applications.
Private firms can thus find it especially difficult to capture
the benefits that stem from this research, and the positive
spillover effects of basic research can be especially large.
For example, NSF-funded basic research into the principle of
nuclear magnetic resonance ultimately led to the development
of magnetic resonance imaging (MRI) machines, a medical
imaging technology that has significantly improved diagnosis
for cancer and other conditions. Not surprisingly, the Federal
Government is a strong supporter of basic research. In 2008,
while the Federal Government accounted for only 15 percent of
U.S. development expenditures and less than one-third of
applied research expenditures, it accounted for nearly 60
percent of the Nation's basic research expenditures.
Overall, the Federal Government provides substantial support
for R&D. In 2009, when the Recovery Act helped Federal R&D spending
reach 1.18 percent of GDP, the U.S. Government invested a greater
share of GDP

in R&D than did the government of any other OECD country. Even in
other years, the U.S. Government's R&D investments relative to GDP
have substantially exceeded the OECD average. Although this largely
reflects U.S. dominance in military R&D (national defense has
historically accounted for more than half of Federal R&D
expenditures), many defense-related innovations ultimately have
significant benefits in the private sector. Research into
communications networks by the Defense Advanced Research Projects
Agency, for example, ultimately led to the emergence of the
Recognizing the importance of R&D for innovation, in April
2009, the President set the goal of devoting more than 3 percent
of GDP to R&D, both public and private--a share that surpasses
the record of almost 2.9 percent set in 1964 at the height of
the space race. In its effort to reach this goal, the
Administration has supported large increases in Federal R&D
funding. The Recovery Act's investment of $18.3 billion in
research funding was part of the largest annual increase in R&D
funding in U.S. history. The President's Fiscal Year 2013 Budget
has proposed additional support for science and basic research,
making progress toward the goal of doubling funding for three key
basic research agencies--the National Science Foundation, the
Office of Science in the Department of Energy, and the National
Institute of Standards and Technology. A particular success story
is the Small Business Innovation Research (SBIR) and Small Business
Technology Transfer (SBTT) programs, competitive programs that
provide about $2.5 billion annually to the most promising research
projects at small firms. From 2002 to 2006, about one-fourth of
the "top 100" innovations selected by R&D Magazine came from
companies that had received an SBIR grant at some point in their
history. Recognizing the importance of continuing these successes,
on December 31, 2011, President Obama signed a bill reauthorizing
the SBIR and SBTT programs for the next six years.
In addition to direct Federal funding for R&D, the
Administration has promoted incentives to support private R&D
investment. The Research and Experimentation tax credit, for
example, enacted in 1981, provides a tax credit based on
qualified research expenses to encourage businesses to increase
their investments. Subsidizing this activity through the tax
system allows the private sector, rather than the government,
to choose the research projects and the method for conducting the
research. Recent studies show that the credit is a cost-effective
way to encourage research spending (U.S. Treasury 2011). On
September 8, 2010, the President proposed to expand and simplify
the credit and to make it permanent; that proposal is also included
in the President's FY 2013 Budget. The proposal will further enhance
private firms' incentives to invest in research and will provide

businesses with assurance that the credit will be available for
the duration of long-term research projects.

An important stage in the process of innovation is
commercialization of new technologies. New inventions and new
knowledge alone will have little effect on economic welfare
unless they are converted into marketable products or processes
that change how firms do business. One obstacle to realizing the
economic benefits of innovation is the difficulty in transferring
new ideas from universities and Federal laboratories to the
marketplace. For example, recent empirical studies point to
substantial frictions attributable to licensing costs and show
large gains in innovation when these frictions are reduced
(Williams 2010). Other researchers have found that universities
often adopt technology transfer policies that constrain the volume
of innovations brought into the marketplace (Litan, Mitchell, and
Reddy 2007).
As the President announced in January 2011, one of the goals
of the Administration's "Startup America" campaign is to foster
innovation by increasing the rate of technology transfer.
Since then, the Administration has announced a number of
initiatives in support of this goal. In October 2011, the President
issued a Presidential Memorandum directing the heads of Executive
departments and agencies to take action to accelerate technology
transfer and commercialization of Federal research in support of
high-growth businesses. The National Center for Advancing
Translational Sciences at the National Institutes of Health assists
biomedical entrepreneurs by identifying barriers to commercialization
and speeding development of new drugs and diagnostics.
The Administration's National Bioeconomy Blueprint lays out a
number of steps designed to advance biological research innovations,
including reforms to speed commercialization and open new markets.
The NSF's Innovation Corps program is a public-private partnership
that will connect NSF-funded researchers with private-sector mentors
who will help to transform the results of scientific research into
commercially successful technologies. The Department of Energy (DOE)
launched a program called "America's Next Top Energy Innovator,"
which offers startup companies low-cost and streamlined procedures
for licensing new energy technologies patented by DOE labs.
Together, the Administration's "lab-to-market" initiatives will
encourage universities and government research centers to streamline
their technology transfer procedures, support additional
government-industry collaboration, and encourage the
commercialization of novel technologies flowing from research
programs--in short, they will facilitate the commercialization
phase of the process of innovation.

Wireless Broadband and Spectrum Policy

Information and communication technology (ICT) is vitally
important to the U.S. economy. A large body of research has linked
economic growth in recent decades with ICT expansion. For example,
Roller and Waverman (2001) estimate that one-third of the growth in
per capita GDP in 21 developed economies from 1970 to 1990 is
attributable to investments in telecommunications infrastructure.
Similarly, Bloom, Sadun, and van Reenen (2007) note that the great
majority of growth in U.S. productivity since the mid-1990s has been
in sectors that either intensively use or produce information
Wireless broadband is a form of ICT that can transform many
different areas of the American economy by providing a platform for
innovation, in areas ranging from media-rich consumer products to
health care and education technologies. Much of the investment
necessary to realize the potential of wireless broadband will come
from the private sector. According to the Census Bureau, total
capital spending by wireless telecommunications carriers has
exceeded $20 billion in each year since 2000 (U.S. Census Bureau
2011). Public support is necessary in some important areas,
including developing a nationwide wireless broadband network for
public safety and extending wireless broadband services into rural
communities, both of which are discussed in this chapter in the
section on infrastructure. Another important way that the government
can help to support the growth of wireless broadband is by making
more spectrum available, both for licensed and unlicensed use. With
the proliferation of smartphones, tablets, and other mobile devices
with Internet access, mobile data traffic has been growing
tremendously, more than doubling between 2009 and 2010, and industry
forecasters expect data traffic to continue to grow rapidly (Cisco
2011). To accommodate this surging demand, wireless carriers will
need access to additional spectrum.
In early 2011, President Obama introduced his National Wireless
Initiative. The proposal aims to nearly double the spectrum available
for wireless broadband in the next 10 years by freeing up 500
megahertz (MHz) of spectrum currently allocated to other uses. Some
of this spectrum will be shifted away from Federal Government uses,
in part by finding ways to make more efficient use of the remaining
Federal and shared spectrum. Any changes in the use of Federal
spectrum will be designed to ensure that there is no harmful
interference with public safety needs or other critical public uses
of the spectrum. Doubling the spectrum for wireless broadband will

\4\ Jorgenson et al. (2008) estimate that ICT accounted for 59 percent of productivity growth during 1995-2000 and 38 percent during 2000-2006. Most recently, Brynjolfsson and Saunders (2010) conclude that most U.S. productivity growth since 1995 can be attributed to ICT.

also require changes in commercially licensed spectrum. Shifting to
wireless broadband a portion of the spectrum now licensed for
over-the-air television broadcasting will yield substantial economic
benefits. To ensure that commercially held spectrum is reallocated
efficiently and that the economic benefits are widely shared, the
Administration supports using "voluntary incentive auctions" to
guide the reallocation. These auctions will allow existing licensees
to receive a portion of the auction proceeds in exchange for
voluntarily making their spectrum available for wireless broadband.
The auctions will also generate substantial revenues for the U.S.
Treasury, providing support for important goals, including deficit
reduction, R&D for emerging wireless technologies, and a nationwide
interoperable wireless broadband network for public safety.


In his State of the Union address, President Obama, noted that,
"This country needs an all-out, all-of-the-above strategy that
develops every available source of American energy. A strategy that's
cleaner, cheaper, and full of new jobs." The President has outlined
goals that will set the United States on a path toward lowering its
dependence on oil and developing cleaner domestic energy sources
that reduce emissions of air pollutants. Those include goals to
continue focusing on increasing responsible domestic oil and gas
production, to reduce foreign oil imports by a third by 2025, and to
increase the share of electricity generated from clean energy
sources--including nuclear power, natural gas, clean coal, and
renewables like wind and solar--to 80 percent by 2035.
The President has outlined a Blueprint for a Secure Energy
Future to guide the Nation's transition to a clean and secure energy
economy. While the market provides key signals that greatly
influence energy production and consumption decisions, energy
markets are subject to market failures, so the government has an
important role to play in guiding the mix of energy supplies and
uses that is best for the Nation. The government also has a role
to play in increasing energy security, reducing air pollution,
promoting clean energy through investments in innovation and
infrastructure, and establishing rules of the road that promote a
cleaner and more secure energy future.

Enhancing Energy Security

The short-run demand for energy is relatively inelastic, so
consumers will bear the brunt of sudden, unexpected energy supply
disruptions in the form of price increases, causing them to reduce
their consumption of other goods and services, or reduce savings.
Elevated global energy prices can, in turn, slow economic growth.
Promoting the development of alternative energies and energy-
efficient technologies reduces the economy's vulnerability to
international energy supply shocks and improves energy security.
Oil consumption per thousand dollars of real GDP has fallen by
about half since 1980 (from almost one barrel per thousand dollars
of GDP in 1980 to about 0.5 barrel per thousand dollars of GDP in
2010). Despite progress in reducing the "petroleum intensity" of
the economy, vulnerability to increases in the global market price
of crude oil remains. We can improve energy security by lowering
demand for petroleum and by increasing the supply of domestic
conventional and alternative energy.

Reducing Demand

During the past year, the Administration has pursued a course
that reduces demand for petroleum. In November, EPA and DOT
proposed new fuel economy standards for vehicle model years
2017-2025, building on the successful programs for the 2011 and
2012-2016 model years. These standards will save consumers money at
the pump, dramatically reduce the Nation's dependence on oil, and
increase investment in new technologies and new manufacturing here
in the United States. Under the proposed rules, fuel economy
standards from the DOT, greenhouse gas (GHG) emission standards
from the EPA, and State of California regulations will be harmonized
and auto companies will be able to rely on well-defined regulatory
targets to help steer their investments in producing advanced
vehicles. Annualized costs of the rule are expected to be between
$6.4 billion and $10.6 billion; annualized fuel savings are expected
to range between $20.3 billion and $26.7 billion (2009 dollars).
Additional annualized benefits from improved health, greater energy
security, and lower GHG emissions are expected to range between $5.4
billion and $6.4 billion. Taken together, the fuel economy standards
proposed for model years 2011-2025 are projected to reduce oil
consumption by over 2.2 million barrels per day by 2025, and save
consumers $1.7 trillion in fuel costs.
The President has also proposed a new tax incentive to offset
half of the incremental cost of dedicated alternative-fuel commercial
vehicles, such as natural gas and electric trucks, for a five-year
period. In addition, the President has proposed transforming the
individual tax credit for consumers who purchase advanced vehicles
into a rebate.

Increasing Domestic Energy Supplies

The Nation has pursued strategies to safely increase domestic
energy sources. As part of this focus, the President is committed to
advancing the responsible production of domestic oil and natural gas
resources. Thanks to higher domestic production and lower imports,
dependence on foreign oil is being reduced. In 2010, for the first
time in over a decade, the United States relied on net imports for
less than half of the oil we consumed; in 2011, import dependence
declined even further, to 45 percent. Since 2007, the United States
has been the leading natural gas producer in the world.
To help ensure safe and responsible development of abundant
natural gas resources, the Administration is taking a number of
steps, including: exploring home grown technologies and methods to
improve safety and environmental performance of shale gas
production; encouraging greater use of natural gas in
transportation; and requiring disclosure of chemicals used in
hydraulic fracturing on public lands. As Box 8-1 describes, the
development of unconventional oil and gas deposits across the
United States illustrates how American enterprise and innovation
in horizontal drilling and hydraulic fracturing, combined with
government-supported research, have unlocked vast new domestic oil
and gas resources.
The United States has also increased the amount of ethanol and
biodiesel blended into the nation's fuel supply. In 2011, ethanol and
bio-diesel production in the United States were estimated by the U.S.
Energy Information Administration (EIA) to be roughly 14 billion
gallons and 920 million gallons, respectively (EIA 2012). That
represented about 10 percent of U.S. gasoline demand and 2 percent
of diesel demand for 2011. In March 2011, the President set the goal
of breaking ground on at least four commercial-scale cellulosic or
advanced bio-refineries over the next two years, and we are on track
to exceed that goal. In addition, the Administration announced a
partnership between the Departments of Agriculture, Energy and the
Navy to invest in multiple domestic commercial or pre-commercial
scale bio-refineries to produce advanced "drop-in" biofuels,
substitutes for diesel and jet fuel.

Reducing Emissions

The Administration has taken historic steps to address air
pollution from stationary sources such as aging coal-fired power
plants. The Mercury and Air Toxics Standard (MATS) regulation
announced by the EPA in December, for example, will reduce emissions
of sulfur dioxide, mercury and other toxic air pollution and
generate between $27 billion and $80 billion in net benefits
annually by improving people's health.
In addition, to create a market for innovative technologies
that will encourage the deployment of clean energy and the benefits
that come with it, such as reduced emissions of air pollutants and
greenhouse gases, the President has proposed a Clean Energy Standard
A CES works by giving electric power plants clean energy credits
for electricity they generate from clean energy. Utilities that serve
retail customers are responsible for making sure they have enough
clean energy credits to meet their target. Utilities that generate
more clean energy than needed to meet their target can bank their
extra credits for later use, or sell them to other companies. Under
the President's proposal, the target would increase over time, so
that by 2035, 80 percent of the country's electricity would be
generated from clean sources. This flexible approach would harness
private-sector incentives to minimize the cost of generating
electricity from clean energy sources.
Because of cleaner power plants, greater use of alternative
fuels, and more energy-efficient vehicles, buildings, and appliances,
EIA (2012) expects per capita emissions of carbon dioxide in the
United States to fall over time, by an average of 0.8 percent a year
between 2010 and 2035.

Supporting Clean Energy R&D and Infrastructure

Public investments in innovation and infrastructure are critical
to solving the twin objectives of increasing energy security and
reducing GHG emissions. Private-sector investment in energy R&D and
infrastructure will be less than optimal because the positive
externalities from such investments prevent private firms from fully
capturing the benefits. Support for innovation is a key piece of the
Blueprint strategy, which involves creating markets for clean
technologies that are ready to deploy and funding cutting-edge
research to deliver the next generation of technologies. In
addition, investments in modernizing the energy infrastructure
with advanced technologies will help to increase efficiency and
reduce waste. Innovation and adoption of new technologies will be
critical to improving energy efficiency and shifting the Nation's
energy use toward low-carbon energy generation.
Among the DOE offices that provide support for clean energy
innovation is the Advanced Research Projects Agency-Energy (ARPA-E),
an organization modeled after the Defense Advanced Research Projects
Agency. ARPA-E provides funds to develop advanced energy technologies
that reduce energy-related emissions and increase energy efficiency,
focusing on transformational energy research that the private sector
by itself is unlikely to support. The Obama Administration funded
ARPA-E for the first time with $400 million as part of the Recovery
Act. This funding, along with subsequent appropriations, has been
used to support about 180 projects, including technologies for
plug-in electric vehicles, batteries that convert wind power into
a steady power source, and microorganisms that produce liquid
biofuels from sunlight and carbon dioxide. The President's Fiscal
Year 2013 Budget proposes $350 million in new funding for ARPA-E
to continue

Box 8-1: Developing Domestic Energy: Shale Gas and Shale Oil

Shale gas and shale oil (also known as "tight" oil) are deposits
trapped inside formations of fine-grained sedimentary rocks, or shale.
As recently as a decade ago many of these deposits were viewed as
uneconomical to extract. Now they are being profitably extracted,
leading to a boom in production from these unconventional oil and
gas deposits.
The President has been clear about the importance of domestic
oil and gas production, including the central role responsible
natural gas development will play in our energy future, increasing
energy independence, and supporting jobs.
The percent of new wells directed to shale gas and oil deposits
surged from 13 percent in 2005 to 57 percent in 2011. That dramatic
increase is in large part due to rising energy prices in the early
2000s, which made it profitable for oil and gas companies to pursue
higher cost reserves. But it is also due in part to R&D investments
made by the Department of Energy (DOE). Between 1978 and 1992, the
DOE invested about $137 million in the Eastern Gas Shale program,
which helped develop and demonstrate directional and horizontal
drilling technology.
Horizontal drilling allows multiple wells to be completed from
one drilling pad by drilling vertically for several thousand feet
and then drilling horizontally. Hydraulic fracturing pumps water,
chemicals and sand into the well to fracture the surrounding rock,
releasing trapped natural gas and oil, allowing more gas and oil to
be captured (see figure). From 2006 through 2010 the average annual
growth rate of shale gas production was 48 percent. By 2035 shale
gas is expected to make up 49 percent of total U.S. natural gas
production, up from 23 percent in 2010 (EIA 2012). Increased supply
has caused wholesale natural gas prices to fall more than 75 percent
from their peak in October 2005 through October 2011. This led to a
67 percent drop in prices charged for natural gas used to generate
electricity and a 34 percent decline in residential natural gas
Domestic oil production also grew in 2009 and 2010, in part due
to horizontal drilling methods. That growth helped improve America's
energy security. We reduced our imports of crude oil, from 10.1
million barrels per day in 2005 to an estimated 8.9 million barrels
per day in 2011. EIA (2012) projects that domestic oil production
will continue to increase through 2020. We are also exporting more
refined petroleum products than ever: between the first half of 2009
and the first half of 2011, exports of mineral fuels and oils jumped
150 percent, an increase valued at more than $35 billion (see
Chapter 5). In addition, the United States is at the forefront of
exporting extraction technologies and related services to other
countries interested in tapping their own unconventional oil and
gas reserves.
This expansion of natural gas and oil production has also
supported jobs for thousands of Americans. Bureau of Labor
Statistics (BLS) data show that oil and gas extraction and drilling
services jobs have grown by 100,000 between 2005 and 2010, with
much of that increase tied to horizontal drilling for shale gas and
oil. The industry also indirectly supports many more jobs, including
jobs associated with the transportation, processing, and distribution
of oil and natural gas products. Furthermore, downstream industries,
such as the chemical and plastics sectors that use natural gas as an
important input, benefit from the expanded supply of natural gas.
Such tremendous growth also comes with the responsibility to
develop these new resources safely. A number of concerns have been
raised regarding the potential adverse environmental impacts
associated with current shale gas extraction practices, particularly
the use of hydraulic fracturing. The Obama Administration is taking
a number of steps to ensure that the United States can realize the
economic benefits of its natural gas resources in a an
environmentally responsible way. An important part of this effort
consists of targeted research coordinated between the DOE, the
Department of the Interior, and the Environmental Protection Agency
to assess and address potential impacts of natural gas and oil
development using hydraulic fracturing and to identify innovative
ways to reduce adverse environmental impacts. For example, the DOE
is actively involved in research exploring improved methods to
treat the water used in shale gas extraction so it can be reused or
disposed of safely. The Administration is committed to ensuring
that natural gas and oil extraction will be pursued in a prudent
manner that is safe for the environment.


to support breakthrough clean energy research in areas such as solar
energy, energy storage, carbon capture and storage, and advanced
An important part of the effort to transition to a clean energy
future is the "SunShot Initiative" announced by the DOE in February
2011. This initiative supports innovation to reduce the cost of
solar energy by 75 percent by 2020, making unsubsidized solar energy
cost-competitive with other forms of energy. Achieving the goal will
require major innovations in the ways solar technologies are
conceived, designed, manufactured, and installed. SunShot is
investing in solar technology and manufacturing improvements and
working to reduce installation and permitting costs. According to
DOE (2011) analysis, by reducing the cost of solar electricity to
about six cents per kilowatt hour, SunShot has the potential to
increase the share of electricity generation from solar photovoltaics
to 15 percent by 2030.
As the United States transitions to a clean energy future, an
important way to improve energy efficiency, reliability, and security
is to upgrade the electricity transmission and distribution
infrastructure to make greater use of advanced technology and to
incorporate real-time communications, monitoring, and control
systems. Transforming the electricity infrastructure into a "smart
grid" could lead to substantial cost savings and efficiencies, help
avoid blackouts, and improve the integration of renewable energy
sources on the grid. The Recovery Act included $4.5 billion in grid
modernization investments, matched by contributions of more than
$5.5 billion from the private sector. Building on these investments,
the Administration announced a number of new initiatives to support
the development and deployment of smart-grid technologies, including
$250 million in loans to deploy smart-grid technology in rural areas
under the Rural Utility Service. In June 2011, the White House
released a report by the National Science and Technology Council, "A
Policy Framework for the 21st Century Grid: Enabling Our Secure
Energy Future," outlining policy recommendations that build on
existing smart-grid investments to foster continued modernization
of electricity infrastructure.
In addition to efforts to support smart grid development, the
Administration has announced efforts to improve Federal coordination
and ensure timely review of proposed renewable energy projects and
transmission lines through the formation of two interagency Rapid
Response Teams, one for transmission and one for renewables. The
Rapid Response Team for Transmission is focused on seven pilot
project transmission lines which cross through 12 states. These
projects were selected from lists produced through independent
stakeholder processes. When built, these seven pilot projects
will help increase electric reliability and integrate renewable
energy into the grid. The agencies participating in the Renewable
Energy Rapid Response Team have all made significant strides toward
the deployment of renewable energy through the development of
better government processes to issue permits for renewable energy


As emphasized, energy infrastructure is critical for developing
our domestic clean energy potential. Infrastructure also includes
transportation systems like roads, railways, ports and airports;
information and communications networks; and schools, parks, and
other public facilities. As economic activity grows, the
infrastructure that supports it must grow as well. Moreover,
physical infrastructure deteriorates over time and requires
ongoing investment for maintenance. If investments to maintain,
upgrade, and expand infrastructure do not keep pace with the growth
in demand, the result is congestion: too many hours sitting in
traffic or in an airplane stalled on the tarmac, too many dropped
calls, slow Internet connections. Such disruptions impose
substantial economic costs through wasted time and resources and
diminished quality of life. As a result, efficient infrastructure
investments can have a significant positive impact on economic

The State of the Nation's Infrastructure

The value of the U.S. transportation capital stock steadily
increased from 2004 to 2009, reaching more than $6 trillion in 2009
(the most recently reported year). The greatest percentage increase
in mileage for any mode of transportation from 2004 to 2009 was in
light transit rail track, which increased by 24 percent, followed by
commuter rail track, which increased by 10 percent. At the same time,
the overall condition of many parts of the Nation's transportation
infrastructure remained disappointing. In 2008, nearly 21 percent
of urban interstate highways and 35 percent of urban collector roads
were in poor or mediocre condition, according to the Bureau of
Transportation Statistics. Moreover, in 2009 nearly 71,200 bridges--
more than 10 percent of all U.S. bridges--were rated as structurally
The current disappointing state of transportation infrastructure
is partly reflected in rising levels of congestion on many parts of
the transportation system, particularly urban roadways. According to
the Texas Traffic Institute's (TTI) Urban Mobility Report, traffic
congestion in urban areas in 2010 accounted for 4.8 billion hours of
travel delay and 1.9 billion gallons of wasted fuel, for an aggregate
congestion cost of more than $100 billion, an increase of more than
25 percent over 2000 in constant (inflation-adjusted) dollars
(Schrank, Lomax, and Eisele 2011). If current trends continue, TTI
projects that the total cost of congestion in U.S. urban areas could
grow by a further 32 percent in real terms by 2015. These estimates
likely understate the real effects of congestion on welfare because
they do not take into account the reduction in quality of life that
results from additional time spent commuting. Studies of how
individuals experience the activities of daily life have found that
commuting is among the least enjoyable and most stressful (Kahneman
et al. 2004, Stutzer and Frey 2004).
The U.S. electricity grid is also showing signs of strain, with
investment in capacity generally lagging behind growth in demand.
According to the DOE (2008), growth in peak demand for electricity
has exceeded transmission growth by almost 25 percent every year
since 1982. Power outages and interruptions have become more frequent
and are now affecting more consumers. The DOE reported that 41
percent more outages affected 50,000 or more consumers in the second
half of the 1990s than in the first half, and the average outage
affected 15 percent more consumers. By 2008, power outages and
interruptions cost Americans an estimated $150 billion each year.
Broadband is another important category of infrastructure where
the United States faces significant investment needs. Described by
the Federal Communications Commission as "the great infrastructure
challenge of the early 21st century" (FCC 2010), broadband's growth
over the past decade has been substantial. Thanks to significant
investments by telecommunications and cable companies, 95 percent of
the U.S. population had access to wired broadband service in 2010,
and industry analysts project that by 2013, wireless providers will
offer such service to about 94 percent of the population. (Atkinson
et al. 2011). At the same time, many households, particularly in
rural areas, continue to have Internet access only at much slower
speeds. As discussed, perhaps the most significant challenge to the
Nation's broadband infrastructure is the threat of growing
congestion on wireless networks.
Overall, evidence is growing that the United States has been
under-investing in many kinds of infrastructure. For example, the
Nation invests annually approximately 2 percent of GDP on
infrastructure, compared with 9 percent and 5 percent, respectively,
for China and Europe. In addition, compared with other OECD
countries, Americans are relatively dissatisfied with their local
public infrastructure systems, according to the Gallup World Poll.
Americans' satisfaction with public transit ranks 25th out of 32
OECD nations, and satisfaction with roads and highways ranks 17th
out of 32. Many observers, including the American Society of Civil
Engineers (2009), have concluded that the United States faces a
substantial need for infrastructure investment over the next five
years. Although the optimal level of infrastructure investment is
difficult to quantify precisely, the evidence strongly suggests
that the United States has not been investing adequately to meet
future infrastructure needs.

Government and Private Sector Roles in Infrastructure

In the United States some kinds of infrastructure, including
most roadways and public transit systems, are typically owned and
financed by government; other kinds, such as freight railways and
telecommunications networks, are largely privately owned. In part,
these patterns of ownership reflect historical accident. In choosing
how much public support for infrastructure to provide and how to
finance it, the United States, like other nations, faces questions
about how best to balance the roles of the public and private
sectors in infrastructure investment. Two key economic principles
are whether it is costly or difficult for a private owner or
investor to earn a return by monetizing access to the network,
through tolls or user fees, and whether important positive
spillover benefits from infrastructure investment would prevent
private investors from fully capturing the overall economic
benefit, even if there were a dedicated revenue stream from users.
The most important potential positive spillover effect is that
many infrastructure investments improve economic efficiency,
increase productivity, and promote rapid economic growth. Through
these effects, as a large body of research has shown, investments
in infrastructure can substantially improve the long-run performance
of an economy. For example, Munnell (1992) reviews the evidence on
infrastructure investment and economic growth and concludes that,
"in addition to providing immediate economic stimulus, public
infrastructure investment has a significant positive effect on
output and growth." Gramlich's (1994) review of the same research
cautions that the rates of return on investments vary widely across
different types of infrastructure and highlights the need for
policies that direct public investment toward projects with the
highest social return. More recent studies have found further
evidence that public infrastructure investment often offers
considerable returns, in some cases higher than those from private
capital investment. This research is reviewed in a U.S.
Treasury-CEA report (2010).
In addition to their long-run benefits on economic growth and
productivity, investments in infrastructure can also provide
short-run benefits during times when economic resources are
underutilized, by supporting employment in construction and in
materials production. These short-run effects depend on the state
of the overall economy. When the economy is operating at or close
to its full potential, the new employment generated by infrastructure
projects generally requires diverting workers from other productive
activities, and the expenditure of public funds may similarly
divert funds from other investment opportunities. Certain
infrastructure investments may still be justified during such times,
but the opportunity costs of diverting economic resources from other
activities reduce the net benefits of such investments.
By contrast, today the economy is gradually recovering from the
most serious economic crisis since the Great Depression and is
operating significantly below its full potential, with unemployment
still unacceptably high. In 2011, over 1.8 million workers in the
construction industry were jobless, with an industry unemployment
rate of 16.4 percent. In these circumstances, public infrastructure
projects create net jobs for workers. With excess capacity widely
available in the economy, increased public spending on construction
materials and increased private spending by newly hired workers are
unlikely to divert goods or materials from other uses. Similarly,
with interest rates exceptionally low, there is little risk that
Federal investment will crowd out private investment, and more
infrastructure investments will yield a positive rate of return.
Moreover, State and local governments, which typically fund a
significant portion of infrastructure spending, have been forced to
cut back on spending because of revenue shortfalls since the
recession of 2007-09. Recent macroeconomic research confirms the
intuition that the expansionary effect of Federal investment
spending is likely to be significantly greater during times of
substantial slack in the economy. For example, Auerbach and
Gorodnichenko (2010) find that expansionary fiscal policy is
substantially more effective during recessions than during
expansions. Overall, with so many resources sitting idle, the
opportunity costs of using those resources for infrastructure
investment are greatly reduced. Moreover, postponing necessary
infrastructure investments until after the economy has rebounded
would have the undesirable effect of occupying productive resources
just when the private sector needs them most.

Financing Infrastructure Investments

Government funding for infrastructure draws on a number of
different sources, including Federal disbursements of Highway Trust
Fund revenues and State and local issues of municipal bonds. Recent
years have seen increased interest in alternative financing
mechanisms that may expand the pool of available capital and
improve the efficiency of project selection. A common theme in
these alternative approaches is the goal of attracting more private
capital for direct or indirect investment in transportation
infrastructure. Increased reliance on the private sector to
finance transportation infrastructure investments can help increase
funding for those investments and may also improve the efficiency of
project selection and drive greater returns on investment. For
example, to attract private financing, many projects incorporate a
dedicated revenue stream, often from user fees or other forms of
usage-based pricing. Because these revenue streams link investment
returns directly to user demand, they can help to guide capital
toward the most efficient projects. In general, innovative
financing mechanisms can engage the private sector in
infrastructure investments with important public benefits. In
particular, this chapter considers three innovative approaches to
private-sector engagement: public-private partnerships, particularly
in the area of rail freight; Build America Bonds (BABs) as an
alternative to municipal bonds that can attract new sources of
private funding into the market for financing infrastructure
projects; and a National Infrastructure Bank that has the potential
to leverage private capital into projects of national significance.
Public-Private Partnerships. In the United States, most
investment in freight railway infrastructure is privately financed,
because it is largely owned by the rail carriers themselves.
However, even in a network based on private ownership, important
public benefits can be realized through investments that improve the
flow of freight across the railway network. The benefits of diverting
freight efficiently from trucks to rails, for example, include
reduced highway congestion, greater safety, and reduced pollution.
Public-private partnerships between State and Federal agencies and
the rail carriers can be an efficient way to promote such
investments. For example, the Chicago Region Environmental and
Transportation Efficiency program is a public-private partnership
between the U.S. Department of Transportation, the State of
Illinois, the City of Chicago, Metra commuter rail, and Class I
railroad companies. The partnership, formed to develop and implement
a set of multimodal infrastructure improvements to untangle
congestion choke points in the Chicago transportation hub,
involves significant financial cooperation between the private
railroad industry and public government entities.
Build America Bonds. Introduced in 2009, BABs are taxable bonds
for which the U.S. Treasury Department pays a direct subsidy to the
issuer to offset borrowing costs for public capital infrastructure
projects. These bonds can function as an attractive alternative to
municipal bonds, which deliver a borrowing subsidy only indirectly
through the Federal tax exemption to investors for interest
earnings. BABs appeal to a broader class of investors than
tax-exempt municipal bonds, including nonprofits, pension funds,
and many other institutional investors. Since the inception of the
program in April 2009, BABs have had a very strong reception from
both issuers and investors. They have supported more than $181
billion of financing, in 2,275 transactions in all 50 states, the
District of Columbia, and two territories, for new public capital
infrastructure projects such as schools, bridges, and hospitals.
An empirical study by the Treasury Department (2011) found that
State and local governments that issued BABs realized considerable
savings relative to the cost of issuing tax-exempt bonds. The study
also found that expanding the BABs program would lead to continued
savings on borrowing costs for State and local governments. Although
the initial program expired at the end of December 2010, the
President's Fiscal Year 2013 Budget has proposed extending the program
for two years at a subsidy rate of 30 percent and extending it
permanently thereafter at a revenue-neutral subsidy rate of 28
percent. The Administration has also proposed expanding the program
to include a broader range of eligible municipal projects.
National Infrastructure Bank. Another new approach to increasing
private-sector participation in infrastructure investment is a
National Infrastructure Bank, as President Obama has proposed as part
of the American Jobs Act. The proposed bank would help increase
overall investment in infrastructure by attracting private capital to
co-invest in specific infrastructure projects and would help improve
the efficiency of infrastructure investment by relying on a merit-
based selection process for projects. To ensure substantial leverage
of private capital, the bank would finance no more than 50 percent of
the total costs of any project. It would fill in an important gap in
the Nation's infrastructure funding system by focusing on projects of
national or regional significance, whose effects cross over state and
jurisdictional lines. Such projects are often at a disadvantage under
current financing mechanisms, including state-level infrastructure
banks and bonds issued by State and local governments. As a result,
the National Infrastructure Bank would be a valuable complement to
existing sources of funding and would improve the efficiency of
U.S. infrastructure investment.

Recent and Current Federal Infrastructure Initiatives

Infrastructure investment has been an important priority
throughout the Obama Administration. As discussed above, the
modernization of the electricity grid is a key element of the
effort to transition to a clean energy future. This subsection
reviews some of the Administration's other recent and current
initiatives to support infrastructure investment.
Transportation. The Recovery Act of 2009 provided over $48
billion to fund transportation infrastructure investments. In 2010,
the Federal Highway Administration announced that it had finished
obligating more than $26 billion of that amount for 12,000 road,
highway, and bridge projects, and in June 2010, President Obama
visited Columbus, Ohio, to commemorate the breaking of ground on
the 10,000th such project. The Recovery Act also provided funds
for investments in the Nation's air and sea transportation
infrastructure, including $1.3 billion to construct new runways and
improve air traffic control facilities and equipment, as well as more
than $18 billion to support transit and high-speed rail. Many of
these and other recently completed transportation infrastructure
investments have already produced substantial economic benefits
for the American people, including increased flows of traffic in
congested areas, improved highway safety, expansion of public
transit service into new communities, and rehabilitation and
maintenance of aging infrastructure.
Despite these substantial achievements, there is still a
pressing need to revitalize America's infrastructure networks.
Recognizing this need, President Obama has proposed $50 billion
in immediate investments in transportation infrastructure as part
of the American Jobs Act. The proposal includes investments to
speed up the permitting process, to make highways safer and more
efficient, to repair and modernize public transit systems, to
improve intercity passenger rail service and airports, to develop
high-speed rail corridors, to support innovative multi-modal
transportation programs, and to modernize the air traffic system
by investing in the Next Generation Air Transportation System, or
NextGen. The President also supports a robust renewal of surface
transportation programs, now scheduled to expire on March 31,
2012, to keep existing and planned transportation projects moving
Broadband. The Recovery Act provided $7.2 billion to upgrade
the Nation's broadband infrastructure, including $4.7 billion for
broadband infrastructure programs at the Department of Commerce's
National Telecommunications and Information Administration (NTIA)
and $2.5 billion for the Department of Agriculture's Rural Utilities
Service (RUS) to expand broadband access in rural areas. These two
programs together received more than 3,800 applications requesting
more than $52 billion in support for potential projects in all 50
states and territories. When the final awards were announced in
September 2010, NTIA had awarded approximately $4 billion for 233
projects throughout the country. The funds will support the
construction or upgrade of approximately 120,000 miles of
broadband infrastructure and will improve broadband access for
approximately 24,000 community institutions, including schools,
libraries, and health care facilities. In addition, RUS has awarded
more than $3.5 billion in grants and loans for 320 broadband
projects, which will provide broadband access for 2.8 million
households and 364,000 businesses in rural areas.
As part of the National Wireless Initiative, the President has
called for investment in a state-of-the-art nationwide wireless
broadband network for public safety communications. Developing and
deploying such a system would help enable interoperability at the
national level, making first responders more effective when they are
called on to cross jurisdictional lines. An interoperable network
would also reduce the costs of the assorted interoperability
measures now being used, ranging from swapping radios to using
Internet-based gateways to patch together noninteroperable systems.
Moreover, deploying a single nationwide network would realize
important scale economies, eliminating duplicative operating and
maintenance costs and enabling public safety entities to obtain
commercially supplied devices and equipment at substantially lower
cost than they can today. Finally, with clear, nationwide standards
that help make public safety communication systems interoperable
across jurisdictions and vendors, software and hardware developers
will find it more economical to invest in innovative public safety
devices and applications, further enhancing the effectiveness of
first responders.


Through smart regulation, innovation, promotion of clean
domestic energy, and public investment, the Federal Government helps
Americans every day, improving safety and health, laying the
groundwork for technological breakthroughs, and putting into place
the infrastructure that facilitates commerce and travel and raises
productivity. The benefits of these activities are not fully
reflected in standard measures of economic activity such as GDP, but
they do significantly improve the quality of life and our economy.
Jan Tinbergen (1976), the first winner of the Nobel Prize in
economics, commented that, "progress in our understanding can only be
based on our push for measurement of phenomena previously thought to
be non-measurable." Spurred by the creation of new measurement
techniques and the need to improve conventional measures of
well-being, several recent official efforts have aimed at
expanding the boundaries of measurement of the quality of life. As
this year's Economic Report of the President suggests, further
innovation and advances in measurement through improvements to
traditional economic indicators and the development of new
indicators of societal well-being will help bring about further
improvements in the Nation's quality of life and the economy.