Will Business-Toxic Environment Poison Silicon Valley Innovation?

The world is full of pseudo-Silicon Valleys — private and public attempts to re-create California’s high-tech mecca. But they have achieved only pale copies of an original that remains the undisputed cradle of innovation.

Historic leaders like Hewlett-Packard and Intel have stayed there, and more recent giants like Google, Facebook and Twitter cluster around the pioneers. The Valley’s economy attracts one-third of all venture capital invested in new U.S. businesses — 39% in 2009, though the $7 billion made it a slow year. A new startup launches every working day. Some will emerge as the next Google or Intel.

But Silicon Valley faces a serious threat in the form of the fiscal and regulatory earthquakes that have put California on the verge of becoming a failed state.

Measured by per-household state and local government spending, California ranks third in the nation, behind Alaska and New York. The state government is trying desperately to squeeze money out of any profitable activity to meet the crippling costs.

Further, California continues to impose onerous regulations on the private sector. High taxes and stifling regulations give companies a strong incentive to move elsewhere.

Forty years ago, when Silicon Valley began to expand and soon came to dominate the high-tech universe, most of its companies were manufacturing enterprises, producing microchips and computers right on the spot. No longer. Starting in the 1980s, Valley firms began moving away from production to concentrate on inventing new products and services.

Many companies have outsourced most of their manufacturing to factories in countries like China, India, and Taiwan — places with lower wages and high production quality.

Was so much outsourcing necessary? Jason Clemens, research director for the Pacific Research Institute in San Francisco, one of California’s few free-market think tanks, acknowledges that countries like Taiwan offer a powerful “pull” factor for shifting manufacturing to East Asia.

But there has been a major “push” factor too, Clemens argues: the Golden State’s excessive income and property taxes and its web of regulations, which, he believes, have driven up outsourcing. As Berkeley-based journalist Francis Pisani puts it: “Outsourcing is the only answer to taxes and regulations.”

California has piled every imaginable burden on businesses: Minimum-wage laws are among the highest in the country, and health and safety regulations are among the strictest. Cities like San Francisco and San Jose require businesses to offer employees health insurance. Labor laws are extremely union-friendly. Environmental policies drive up energy costs. And on and on.

Small firms have the toughest time in this business-toxic climate. A recent study by Sanjay Varshney, dean of the College of Business Administration at California State University in Sacramento, estimates that the cost of state regulations in 2007 reached an average of $134,122 per small business — the equivalent of one job lost per company.

And it’s not just the small guys: Google, which uses colossal amounts of electricity, is building its data centers in other states or abroad, where energy is much cheaper.

Outsourcing has allowed local entrepreneurs and would-be entrepreneurs to remain as creative as ever — for now. The Valley continues to attract innovators and risk-takers who’ve brought “permanent revolution” to the Valley, Pisani says.

After the microchip, the PC, and the Internet, Silicon Valley entrepreneurs might have rested on their laurels. But the innovation hasn’t stopped. Smart phones inaugurated a new era of personal nomadic devices. Now comes Apple’s iPad.

These dazzling products have opened a new frontier for the software industry — the seemingly infinite world of digital applications, or “apps,” for mobile gadgets. Relatively cheap to launch and not requiring heavy investment or sophisticated equipment to create, apps could be invented anywhere, Pisani says.

But it so happens that most of them are still created in Silicon Valley — or in other parts of the Bay Area that can offer cheaper rents. It is invaluable, Pisani explains, to be “not farther than one hour’s drive from Palo Alto and Sand Hill Road,” where all the venture capitalists work.

Outsourcing has encouraged that creative spirit not just by keeping costs down but by bringing Silicon Valley firms into daily contact with other cultures. As a result, Valley entrepreneurs recruit engineers in Africa, Asia, Europe and South America. A permanent two-way flow of people, products, and services unites the Valley with hundreds of regions across the planet.

But Silicon Valley entrepreneurs, recognizing the benefits of this cross-fertilization, express frustration with current immigration law. The federal government’s annual cap on H-1B visas — issued to professionals working in certain fields, many of them high-tech — is absurd, says Hank Nothhaft, CEO of Tessera, a firm in the field of semiconductor miniaturization.

“Asian students are not allowed to stay in the U.S.,” he says. “After they get a degree, they have to return to India or South Korea, where they become our competitors.”

Given California’s harsh business climate, it’s remarkable that entrepreneurs still flock to Silicon Valley, Sonia Arrison wryly observes. She’s a Pacific Research Institute scholar with a reputation for being a high-tech prophetess. “It’s a trade-off,” she said. “If you leave the Valley, you lose a lot.”

The cost of doing business in the state is rising, but outside the Valley it remains more difficult to find venture capital and recruit brilliant students.

Innovation still tends to happen first in Silicon Valley. Even the sclerotic, near-failed state of California hasn’t yet stifled the extraordinary energy of this unique place. A good thing, because California’s economic recovery — and America’s — will depend heavily on its continued vibrancy.

• Sorman is a contributing editor to the Manhattan Institute’s City Journal. This article is adapted from the spring 2010 issue.

Nothing contained in this blog is to be construed as necessarily reflecting the views of the Pacific Research Institute or as an attempt to thwart or aid the passage of any legislation.

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