[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]



  IS AMERICA LOSING ITS LEAD IN HIGH-TECH: IMPLICATIONS FOR THE U.S. 
                        DEFENSE INDUSTRIAL BASE

=======================================================================

                                HEARING

                               before the

                      COMMITTEE ON SMALL BUSINESS
                        HOUSE OF REPRESENTATIVES

                      ONE HUNDRED EIGHTH CONGRESS

                             FIRST SESSION

                               __________

                    WASHINGTON, DC, OCTOBER 16, 2003

                               __________

                           Serial No. 108-41

                               __________

         Printed for the use of the Committee on Small Business


 Available via the World Wide Web: http://www.access.gpo.gov/congress/
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                      COMMITTEE ON SMALL BUSINESS

                 DONALD A. MANZULLO, Illinois, Chairman

ROSCOE BARTLETT, Maryland, Vice      NYDIA VELAZQUEZ, New York
Chairman                             JUANITA MILLENDER-McDONALD,
SUE KELLY, New York                    California
STEVE CHABOT, Ohio                   TOM UDALL, New Mexico
PATRICK J. TOOMEY, Pennsylvania      FRANK BALLANCE, North Carolina
JIM DeMINT, South Carolina           DONNA CHRISTENSEN, Virgin Islands
SAM GRAVES, Missouri                 DANNY DAVIS, Illinois
EDWARD SCHROCK, Virginia             CHARLES GONZALEZ, Texas
TODD AKIN, Missouri                  GRACE NAPOLITANO, California
SHELLEY MOORE CAPITO, West Virginia  ANIBAL ACEVEDO-VILA, Puerto Rico
BILL SHUSTER, Pennsylvania           ED CASE, Hawaii
MARILYN MUSGRAVE, Colorado           MADELEINE BORDALLO, Guam
TRENT FRANKS, Arizona                DENISE MAJETTE, Georgia
JIM GERLACH, Pennsylvania            JIM MARSHALL, Georgia
JEB BRADLEY, New Hampshire           MICHAEL MICHAUD, Maine
BOB BEAUPREZ, Colorado               LINDA SANCHEZ, California
CHRIS CHOCOLA, Indiana               ENI FALEOMAVAEGA, American Samoa
STEVE KING, Iowa                     BRAD MILLER, North Carolina
THADDEUS McCOTTER, Michigan

         J. Matthew Szymanski, Chief of Staff and Chief Counsel

                     Phil Eskeland, Policy Director

                  Michael Day, Minority Staff Director

                                  (ii)


                            C O N T E N T S

                              ----------                              

                               Witnesses

                                                                   Page
Sega, Dr. Ronald, Department of Defense..........................     5
Hartwick, Dr. Thomas, Advisory Group on Electron Devices.........     6
Howell, Thomas R., Dewey Ballantine LLP..........................     9

                                Appendix

Opening statements:
    Manzullo, Hon. Donald A......................................    18
Prepared statements:
    Sega, Dr. Ronald, Department of Defense......................    24
    Hartwick, Dr. Thomas.........................................    31
    Howell, Thomas R.............................................    79

                                 (iii)

 
  IS AMERICA LOSING ITS LEAD IN HIGH-TECH: IMPLICATIONS FOR THE U.S. 
                        DEFENSE INDUSTRIAL BASE

                              ----------                              


                       THURSDAY, OCTOBER 16, 2003

                          House of Representatives,
                               Committee on Small Business,
                                                   Washington, D.C.
    The Committee met, pursuant to call, at 11:04 a.m. in Room 
2360, Rayburn House Office Building, Hon. Donald Manzullo 
presiding.
    Present: Representatives Manzullo, Velazquez, Millender-
McDonald, Chabot, Sanchez
    Chairman Manzullo. If we could call the hearing to order. 
Good morning. Welcome to this hearing of the Full Committee on 
Small Business.
    Last year, the Advisory Group on Electron Devices, AGED, A-
G-E-D, presented a remarkable document with interesting 
findings to top officials at the Pentagon. Among other things, 
the group found that ``offshore movement of intellectual 
capital and industrial capability, particularly in micro-
electronics, has impacted the ability of the U.S. to research 
and produce the best technologies and products for the nation 
and the war fighter''.
    Those of you who know me know I have been saying this for 
some time now. Fortunately for America, we have people like Dr. 
Hartwick, who are acknowledged leaders in science and 
technology industry and who volunteer their time to advise us 
of such issues.
    We also have two other distinguished visitors and guests 
and I am really looking forward to their testimony. Please do 
not lose us in the technicals of all of this.
    Ironically, other key authorities in the technology world 
have echoed this message since the AGED briefing. At one of our 
Subcommittee hearings a few months ago, the director of 
Microphysics Laboratory at the University of Illinois, Chicago 
testified that the U.S. military has become almost entirely 
dependent on foreign sources of materials, components and 
production equipment used for the manufacture of night vision 
infrared devices.
    Defense Department witness was unmoved by this and felt no 
threat to supply, even though production was coming from 
France. What disturbs me, however, is that the same French 
company that supplies our military also sells to the Chinese 
and we ask ourselves: How could this not be a significant 
factor in maintaining our tactical edge in war fighting?
    Another example comes from Henry Kissinger, who recently 
stated, ``If outsourcing continues to strip the U.S. of its 
industrial base and the act of getting out or developing its 
own technology, then we will require a careful thought on 
national policy''.
    Friday's front page of the Washington Post Business Section 
headlines read, ``Intel Chairman Says U.S. is Losing Edge''. 
Andy Groves said that, ``The software and technology service 
businesses are under siege by countries taking advantage of 
cheap labor costs and strong incentives for new financial 
investment.''
    ``While some would concede we have already lost our edge in 
manufacturing, what would we do if we lose our leadership role 
in software and services?'' This is Andy Grove saying this, one 
of the founding fathers of the new economy.
    The next quote, because it is the crux of the issue he 
states, ``He is torn between his responsibility to shareholders 
to cut costs and improve profits and to U.S. workers who helped 
build the nation's technology industry, but who are now being 
replaced by cheap labor.''
    He asked for the government to help decide the proper 
balance between the two, otherwise companies will focus only on 
stock price. This is why support for the Crane-Rangel-Manzullo-
Levin bill is so critical. It is one piece of the puzzle that 
helps manufacturing companies decide to keep jobs here.
    Yet another group of advisors has the same concern. The 
President's Council of Advisors on Science and Technology, 
PCAST, recently announced that the Asian semiconductor market 
surpassed the U.S. in 2001 and is expected to further widen the 
gap.
    More strikingly, they found that R&D design capabilities 
are moving overseas, including China, along with the production 
at an increasing rate. One main concern is that ``the proximity 
of research, development and manufacturing is very important to 
leading edge manufacturers.'' It is the link between R&D and 
manufacturing that drives successful innovation.
    The implication for the U.S. then is an acknowledgement 
that our high-tech leadership is not automatic and a loss of 
that leadership, ``would have serious implications for the 
nation's economy and living standards.''
    I wish we had the chairman of this PCAST Subcommittee here 
for this hearing, but George Scalise is in Europe right now 
giving speeches on this very topic. For those of you that do 
not know, Mr. Scalise is also president of the Semiconductor 
Industry Association.
    I can go on with examples, but I will end with this one. A 
recent study by the National Academy states that the 
semiconductor ``plays a crucial role in ensuring U.S. national 
security by allowing it advances in the capability of new 
devices and new applications for national defense. Preserving 
unencumbered access to the world's most advanced technology may 
provide no guarantees, but allowing the nation's technological 
edge or independence to slip away would be hard for future 
generations to understand.'' Mr. Howell was the co-author of 
that study.
    Future generations notwithstanding, here is what I and 
other members of the Committee find hard to understand: About 
three months ago this Committee held a hearing to discuss the 
vulnerability of our defense industrial base, due to offshore 
manufacturing.
    At that hearing, Suzanne Patrick, Deputy Under Secretary 
for Defense Industrial Policy states, ``Despite the downturn in 
the U.S. economy, the defense industrial base is healthy, 
innovative and responsive.''
    She also said that the defense industrial base does not 
need to be revitalized and denied that the U.S. defense systems 
are vulnerable due to foreign dependencies. How is it then with 
so much mounting evidence, that the Defense Department cannot, 
will not acknowledge that our procurement process continues to 
foster an increasing vulnerability and dependency on foreign 
sources?
    That is what we do not understand and that is one of the 
main purposes for this hearing. We look forward to the 
testimony of each of our witnesses.
    [Mr. Manzullo's statement may be found in the appendix.]
    Chairman Manzullo. It is my pleasure to introduce to you 
and yield to our ranking minority member, Congresswoman 
Velazquez----
    Ms. Velazquez. Thank you Mr. Chairman.
    Chairman Manzullo [continuing]. From New York.
    Ms. Velazquez. Thank you.
    Chairman Manzullo. And the Cubs lost and you guys are still 
in.
    Ms. Velazquez. That is right. I am sorry for you.
    Chairman Manzullo. Yes. Thank you.
    Ms. Velazquez. Earlier in the year the Committee looked at 
trends in the technology sector and the challenges facing this 
industry. Sadly we found that many of the existing problems in 
the tech world mirrored those felt by the manufacturing sector.
    This is not surprising, since the manufacturing and 
technology sectors are closely linked. What affects one sector 
will eventually affect the other.
    The research and development that promotes technological 
advancement depends heavily on production. If manufacturing 
jobs are moved overseas, our strong innovation process will 
follow.
    It is unfortunate that this sector, along with the U.S. 
economy, is now suffering, too. In the past two decades small 
businesses have become the dominant employer of high-tech 
innovators and produce 55 percent of all new technological 
developments. However, from January 2002 to December 2002, 
nearly half a million jobs were lost in the technology sector.
    One critical concern for our nation's small tech firms is 
that the environment must be conducive to foster a strong 
domestic defense industry base. Readiness and access to cutting 
edge technology are necessities in regard to the U.S. defense 
industry and our national security.
    As we recently found in the war with Iraq, many times 
Americans do have to turn to foreign countries for assistance 
and as we have experienced with France, it is not always easy. 
That is why the U.S. should not have to depend on countries 
overseas for military assistance. We need to have a secure base 
right here.
    A strong defense base is crucial for U.S. economic and 
military security, yet we are hearing contradictory statements 
about its liability. During a hearing this summer, the 
Department of Defense stated that its current policies do not 
have a negative effect on our economy or threaten our national 
security.
    However, a recent report by the DOD Advisory Group on 
electron devices found the opposite. They reported that the 
outsourcing of the U.S. technology sector has had a negative 
impact on our ability to research and produce the best products 
for our nation.
    The reports said that DOD now has to obtain a majority of 
cutting edge technologies from overseas, giving those countries 
a political and military advantage. The AGED report also claims 
that the Department of Defense must take immediate action to 
preserve our position as a leader in technological advancement 
and to counter the decline of the U.S. electronics and 
technology sector.
    To compliment the report, the President's Council for 
Advisors of Science and Technology, PCAST, Subcommittee on 
Information Technology Manufacturing and Comparativeness 
recently warned that by outsourcing the tech sector abroad, our 
country will risk losing its innovation, strength for design, 
research, development and creation of new products.
    Much of this outsourcing has been in the semiconductor 
industry. This industry is key to the U.S. manufacturing 
sectors' vitality and strength. In 1999, it posted $102 billion 
in sales and accounted for half of the world market. In 
addition, it is the cornerstone of the $425 billion U.S. 
electronics sector.
    Continued outsourcing and decline in the semiconductor 
industry will create a ripple effect. It will eventually leave 
small high-tech firms struggling for business and our nation's 
domestic defense base weak.
    By shifting semiconductor manufacturing overseas, we are 
hindering our nation's role as a leader in technological 
research and development. Today's hearing will us to examine 
how outsourcing these vital sectors are affecting U.S. 
competitiveness.
    The weakening of our technology industry can have 
detrimental affects on both national and economic security. 
Policies need to be in place that would allow not only the 
manufacturing and technology sector to flourish, but also our 
nation's small high-tech firms so that we can remain a leader 
in the world market.
    Thank you, Mr. Chairman.
    Chairman Manzullo. Thank you. We have been advised that 
there will be two votes some time between 11:30 and 12. We are 
going to proceed.
    I am going to give each of the witnesses eight minutes. So 
much information, so little time. Then just bear with us and we 
will have the votes and then we will be coming back for 
questions or concluding testimony.
    Our first witness is Dr. Ronald Sega, Director, Defense 
Research and Engineering, Department of Defense. The confusion 
was, I want to go in the order that the witnesses were listed 
on the list here, because you have a right to follow that order 
on the testimony.
    I had the opportunity to meet with Dr. Sega. He is an 
astronaut. Has been up twice on space shuttles. Long extensive 
background in defense research, academia, government service, 
Ph.D. in electrical engineering, Major General in the Air Force 
Reserves, a tremendous background and we look forward to your 
testimony, Doctor.

 STATEMENT OF DR. RONALD SEGA, DIRECTOR, DEFENSE RESEARCH AND 
      ENGINEERING, DEPARTMENT OF DEFENSE, WASHINGTON, D.C.

    Mr. Sega. Thank you, Mr. Chairman and members of the 
Committee. I appreciate the opportunity to appear before you 
today.
    As Director of Defense Research and Engineering, I have 
oversight responsibility of the Department's investments in 
basic sciences, applied research and technology development and 
demonstration programs. These research and development 
activities are performed by universities, government 
laboratories as well as by small, medium and large businesses.
    The over arching guidance of the Department of Science and 
Technology investment strategy is a collaborative product of 
the Office of the Secretary of Defense, the Joint Staff, our 
Combatant Commanders, Military services and the Defense 
agencies that have been developed in a direct response to the 
needs of our war fighter.
    Advanced electronics are critical to the Department. In 
fact, it is one of the 12 major elements of the Defense 
technology area plan and one of the ten major research areas of 
the basic research plan, which I could go into later.
    In FY 2003, the Department invested $678 million in 
electronics S&T and $106 million in electronics basic research. 
When combined with our related S&T investments for sensors and 
electronic warfare, this investment totaled approximately $1.9 
billion. Overall this funding was nearly 20 percent of the 
Department's total S&T investment for FY 2003.
    I would like to now touch briefly on some external sources 
of information used by the Department of Defense. 
Recommendations from various groups, such as the Defense 
Science Board, Navy Research Advisory Committee, Army 
Scientific Advisory Board, Air Force Scientific Advisory Board, 
National Research Council, JASONs and the Advisory Group on 
Electron Devices (AGED) are important sources of information 
for us.
    On a routine basis, leaders from industry and industrial 
professional organizations, in fact Mr. Scalise was in our 
office here within the last month, these are spanning small 
business to large corporations, meet with my staff and me to 
discuss their plans and provide the recommendations on where 
technology opportunities and challenges may exist.
    We also obtain input from leading experts and academia, 
various professional societies, trade groups, industry 
associations as we strive to remain more informed as to the 
state-of-the-art and emerging S&T trends. Inputs from all of 
these sources are important in formulating the Department's 
S&T's strategy to meet war fighter needs.
    Key to defense technology leadership is an innovative and 
robust science and engineering work force within our defense 
laboratories and those that support the defense base. I will 
talk a little bit more about them.
    There has been one office that we have added to the office 
of Director of Defense Research and Engineering since I have 
been there and that is the Deputy Under Secretary Defense for 
Laboratories and Basic Sciences. The individual is not only of 
Laboratories, but also my Deputy, DDR&E and that is Dr. John 
Hopps. Where is Dr. Hopps?
    He is responsible for the oversight of our laboratories, 
basic sciences, university programs and work force that we will 
now into the future. Extensive background in academia at Ohio 
State, research at Draper Labs, National Science Foundation 
background and recently provost at Morehouse.
    This is an area of tremendous importance to me personally 
and to the Department of Defense. We are making important 
investments, new investments in secondary and undergraduate 
science and engineering education in order to help ensure an 
adequate national S&E work force for DOD needs.
    We have increased the Department's graduate fellowship 
stipends and number of awards in order to attract the best and 
brightest U.S. scientists and engineers. Additionally, we are 
working to make employment opportunities within our 
laboratories more attractive to the nation's most talented 
scientists and engineers.
    Many new educational initiatives that I just mentioned are 
electronics related. Our secondary and undergraduate curriculum 
initiatives emphasize material science and engineering, fields 
that are critical to the technology advances in electronics.
    For example, a new undergraduate research initiative, in 
that initiative we are making investments in a leveraged, 
collaborative program with the Semiconductor Research 
Corporation, with a focus in electronics.
    Another component of our undergraduate research efforts is 
being made in collaboration with the National Science 
Foundation in the research experiences for undergraduate 
program.
    In closing, I appreciate the opportunity to come before you 
to relate to you our commitment to retaining U.S. leadership in 
those sciences and technologies that are critical to 
maintaining our war fighting superiority. Thank you, Mr. 
Chairman.
    [Dr. Sega's statement may be found in the appendix.]
    Chairman Manzullo. Thank you, Doctor. Our next witness is 
Dr. Thomas Hartwick, high technology specialist for commercial 
and aerospace business. Been in the business for 45 years. That 
is your bio.
    Hands-on experience, strategic planning, involvement in 
numerous professional activities, numerous boards including 
IMEC, very extensive background professionally, including 
business and education, academia.
    It is a real honor also to have you with us today, Dr. 
Hartwick and we look forward to your testimony.

  STATEMENT OF DR. THOMAS HARTWICK, CHAIR, ADVISORY GROUP ON 
                    ELECTRON DEVICES (AGED)

    Mr. Hartwick. Thank you, Mr. Chairman.
    Chairman Manzullo. If you could pull the mike down and 
closer to your mouth there.
    Mr. Hartwick. How is that?
    Chairman Manzullo. That sounds good. Thank you.
    Mr. Hartwick. Mr. Chairman, Ms. Velazquez, my name has 
already been stated. I am a self-employed, high-tech guy. I 
will give you the high-tech view.
    My background roughly splits up like this: I spent the past 
decade serving on boards and committees in the public and 
private sector. I fly on a lot of airplanes from coast to 
coast. I am tired.
    The four previous decades I spent in aerospace general 
management in research, project management, strategic planning, 
manufacturing, running a P&L organization, which is a very 
painful experience.
    The testimony is solely my own, but I believe it fairly 
represents a broad cross section of the professional and 
business high-tech community, both in private and public 
sectors.
    I represent only myself today. My main message today from 
the high-tech community is that we believe immediate government 
action is needed to address the offshore manufacturing problem. 
That is our point of view.
    My focus here is on high-tech business, because as has 
already been stated by the Chairman and Ms. Velazquez, it is 
the core of new DOD systems and entirely new mega-billion 
dollar industries, like chips or television.
    The high-tech community is most worried about the national 
trend for break up of clusters. I call these enterprise centers 
to be clear. I coin a new phrase and define it as a complexity 
of university, small business and manufacturing entities. So 
they form together a working relationship. The movement of 
manufacturing plants offshore breaks up these clusters and 
destroys the infrastructure for new business and new products.
    In the past, this has occurred over a very long time 
period. For television, it took 40 to 50 years until all the 
plants around Chicago closed their doors. For flat panel 
displays about 20 to 25 years before active matrix LCD's went 
overseas.
    For chips, ten to 15 years and we are seeing it 
accelerating now. My point is, the time keeps getting shorter. 
So for new technologies, we do not have that much time.
    Without enterprise centers to nucleate and nurture a wide 
variety of small businesses, foreign companies eventually 
dominate the business and new product development is 
constrained and that is our fear.
    Let me explain. In creating new products, there is a 
sequence of events. You first have to innovate. That is the 
conceptual part where the light bulb goes off. Then you have to 
design and do a prototype fab. But you have to establish the 
manufacturing process to create that device. If you do not, 
then you cannot produce items for sale.
    If these steps are constrained within a single company, 
like was done in much of the end of this century, it is okay. 
It works. If it is confined within the enterprise center, the 
system works.
    If you do not do this, then the inventions often end up on 
the cutting room floor, because you cannot manufacture them. 
That is our concern.
    Sure, some businesses can employ remote design and we hear 
a lot of talk about virtual companies and remote design, but 
those are now generation devices. They are not cutting edge, 
new devices that nucleate entire industries.
    This is all anecdotal information and it does not 
accurately capture what I call the pervasive and insidious 
nature of enterprise center break ups. I think it takes more 
detailed analysis to really understand them and to understand 
the impact, particularly the time cycle and then to create a 
national strategy to prevent future loss. It is like the 
Titanic. You have to get on the problem early, in order to get 
a desired result.
    I worry about that for new technologies like 
nanotechnologies, you have probably heard about and MEMS 
technologies, this is a MEMS product from our Sandia Labs, if 
you would like to see it. A little chip that is really a 
machine. These are the technologies that are most fragile right 
now.
    National security Products parallel this commercial 
development, except for two differences. The first difference 
is that product security is difficult to maintain. Classified 
products are important to the national security enterprise and 
we must maintain that classification. It is difficult to do in 
a foreign environment.
    Now we have most of our chips made offshore and the 
government is hard pressed to ensure future supplies of cutting 
edge technology. Second, the cutting edge technology that we 
use in government designs are difficult to produce on demand in 
a commercial plant. Why? Because the commercial plant runs 
product to create profit and if you just run a few products for 
the government, then you interrupt the production lines and it 
does not work. So there are two reasons why defense is 
different.
    The Advisory Group on Electron Devices has cited these 
issues and they have called for prompt action. Special 
arrangements can be made with domestic suppliers, but these are 
band-aid solutions, which our government can put in place for 
the time being. We need a long-term national strategy to 
reverse the trend. It is the trend that is important.
    Other examples of technologies that might fit in this 
category are MIMICS, these are microwave chips that fit in your 
cell phone. Everybody has. We dominate this industry now, but 
it could go offshore if we are not careful and uncool night 
vision devices are becoming more of a commodity today.
    My message is: It is time for action in the U.S. to prevent 
this foreign dominance and it cannot be from the standpoint of 
big business or small business or national security. It has got 
to be complete solution that meets all needs.
    I humbly submit, I guess that is the proper way to phrase 
it, two suggestions. I think we need an enterprise study. Mr. 
Howell here and the Academy has turned out a big report like 
this. I have another one in my briefcase that is the same size 
and these studies try to teach us that we have a problem.
    I know we have a problem and I believe we need studies to 
quantify the problem and prioritize the areas that actions need 
to be taken on.
    The second suggestion is a keep one strategy as a band-aid 
approach. I think we would be derelict in our duties if we did 
not ensure at least one on-shore manufacturing organization to 
handle each of these technologies, both now and into the 
future. I advocate a keep one strategy.
    Thank you very much. I appreciate the ability to express 
these views. I will take any questions you have. Thanks.
    [Dr. Hartwick's statement may be found in the appendix.]
    Chairman Manzullo. Thank you. Our next witness is Thomas 
Howell, with Dewey Ballantine, an international trade group. He 
is an attorney, a long history of being involved in major trade 
cases and disputes and we look forward to your testimony.

STATEMENT OF THOMAS R. HOWELL, PARTNER, DEWEY BALLANTINE, LLP, 
                        WASHINGTON, D.C.

    Mr. Howell. Thank you, Mr. Chairman. I should say that I am 
appearing to you today as a co-author of this National Academy 
study and I am speaking on my own behalf and not on behalf of a 
client or on behalf of the Academy.
    U.S. high technology manufacturing is moving offshore. Let 
me illustrate that with a few figures, based on semiconductor 
consumption. The semiconductors are the ubiquitous core of 
high-tech machinery and a rough bench mark of where high-tech 
manufacturing is occurring can be gleaned by looking at what 
parts of the world semiconductors are being consumed. So in 
other words, where are they being actually insert into systems.
    As recently as 1997, the U.S. accounted for 33 percent of 
global shipped consumption. That meant one-third of all the 
devices were being put into high-tech systems right here in the 
United States. Asia Pacific accounted for 22 percent. Now Asia 
Pacific does not include Japan. That is China and the 
surrounding countries, but not Japan.
    Five years later, by 2002, those ratios had completely 
reversed. Asia Pacific consumed 36 percent of the world's 
chips. The United States 22 percent.
    By 2005, the U.S. share is going to shrink to 18 percent 
and Asia Pacific's share will grow to 40 percent and is 
accelerating.
    That shift has been driven by China. As recently as 2000, 
China accounted for only seven percent of global chip demand. 
Two years later in 2002, that figure had more than doubled, to 
15 percent and that is still increasing.
    Currently, the U.S. industry in terms of production of 
chips leads. We have 50 percent of the world's market and 77 
percent of all U.S. owned semiconductor manufacturing is still 
located right here in the U.S., but the trend, as we know, is 
not favorable.
    The capital investment in new facilities in the U.S. is 
dropping as a share of world investment. The capital equipment 
shipments to sites in the U.S., such as semiconductor 
production equipment, right now account for only about 25 
percent of the world's shipments. The investment is declining 
here and it is increasing abroad. That is the offshore trend 
that we are all concerned about.
    The challenges that are emerging to U.S. leadership in 
microelectronics are in all cases government driven. This is 
not just an evolution of factor advantages in other countries. 
These reflect deliberate foreign policies. They take two forms 
I could call leadership and close-followership strategies.
    Japan and the European Union are pursuing leadership 
strategies. They are aimed at overtaking the United States in 
microelectronics technology. They are putting a lot of money 
into big joint R&D projects aimed at developing leading edge 
commercial technologies.
    Interestingly too, in both Japan and Europe the governments 
are putting a lot of money into building state-of-the-art fabs 
within their own geographic zones. In Japan, the project is 
called the All Japan Foundry Project. In Europe, there are 
government funded state-of-the-art fabs in France and Germany 
that will keep some state-of-the-art manufacturing capability 
there and there is significant government money going into 
those foundries.
    More interesting and more of a challenge to us are what I 
would call a close-followership strategy. That is where 
governments abroad do not seek to overtake the U.S. leadership 
in technology, but instead to integrate the operations of their 
own industries with those of our companies.
    Taiwan was the most successful practitioner of this 
strategy, but it is now being emulated by Malaysia, Singapore, 
Thailand, Israel and most significantly China.
    The reason close-followership is more of a challenge is 
actually the functions these countries are assuming in our own 
production processes are being offshore and that is what is 
drawing our manufacturing overseas.
    At least in semiconductors, this movement offshore is not 
being driven by comparative costs. The fact is there is not 
much of a labor cost component to manufacturing in this 
industry. The cost differentials between manufacturing chips in 
the U.S. and chips in China or Taiwan are not that dramatic. 
Other factors are at work.
    I will just cite a few of them. First, there is the advent 
of foundries. The capital costs and the risks associated with 
investing in state-of-the-art semiconductor manufacturing have 
become staggering. They are prohibitive for all but a handful 
of companies.
    It costs now two to three billion dollars to build a state-
of-the-art fab and it is going to cost ten billion, 15 billion 
as we move ahead technology.
    The foundry model has enabled foreign countries to say 
essentially do not worry about those costs and risks. We will 
assume those ourselves. We will make the chips for you. You 
give us your designs. You give us the technology and we will do 
it all here. All you have to do is pay a service fee.
    The practice began in Taiwan, but it is now spread to 
Singapore, Malaysia, Israel and most recently China. More and 
more U.S. semiconductor firms are fab-less. That means they 
outsource all their designs to foundries in Asia. Others are 
fab-lite, which means they are using foundries as a significant 
part of their total production.
    Significantly, I am not aware of a foundry anywhere in Asia 
that does not enjoy significant government support, although 
those things are being built with either government equity 
participation or with large loans from government banks and in 
some cases both.
    Then there is tax policy. The most successful foundries in 
the world are in Taiwan. TSMC and UMC, they control currently 
about two-thirds of semiconductor foundry manufacturing. The 
government of Taiwan has implemented taxes which ensure that 
those companies essentially pay no taxes. They operate at a 
tax-free environment year-after-year.
    In fact, reflecting accumulated credits during most recent 
years, TSMC has a higher after tax income than a pre-tax income 
reflecting the accumulation of tax credits from prior years. 
China is basically copying this policy now, virtually identical 
in its own high-tech zones in China.
    There are incentives to individuals. One of the key 
advantages that TSMC and USMC in Taiwan enjoys is they can 
attract and hold many of the best and brightest quality 
managers and engineers. One important factor here is the tax 
treatment of individual compensation. The people that work for 
these companies receive stock or stock options and 
compensation. It is taxed at par value, which could be like one 
Taiwan dollar; whereas the market value may be $100 or many 
multiples of the face value.
    The only tax they pay is on that face value and when they 
sell those, exercise the option to sell the stock, there is no 
capital gains tax. That is pure income to them.
    In the competition for skilled managers and engineers, 
those companies have a dramatic edge, because they can offer 
really the opportunity to get rich quickly working there. 
Significantly, China is replicating this policy as well on a 
larger scale in China.
    Finally, there is China's preferential value-added tax. In 
2000, the Chinese government established a preferential rate of 
value-added tax, which basically said that while any imported 
device must pay a 17 percent VAT at the border upon entry into 
China, anything that is domestically manufactured in the 
semiconductor industry or designed, pays an effective VAT of 
only three percent.
    So in other words, the differential VAT operates like a 
tariff and as a result, many foreign investors have rushed into 
the Mainland to establish fabs inside of China to take 
advantage of this tax preference.
    At present, roughly 20 Taiwan owned fabs have begun 
operation or are under construction on the Mainland. They are 
all foundries and they are taking advantage of this VAT 
preference. All these factors are combining to produce a shift 
in investment to Asia and within Asia to China.
    It is a problem for us. The prospect of this manufacturing 
is moving to China means that ultimately the design function 
will migrate as well. There is a gravitational pull being 
exerted now by the shift of manufacturing and ultimately, the 
university infrastructure that is needed to support the whole 
infrastructure.
    My recommendations are first that the U.S. government 
should enforce the WTO commitments China has made against their 
preferential value added tax. We ought to consider in our own 
tax policies the tax holidays that are available abroad and we 
should significantly increase federal spending on university 
based R&D here to keep the talented people and cutting edge 
research going on within our own borders.
    Thank you.
    [Mr. Howell's statement may be found in the appendix.]
    Chairman Manzullo. So much information. I have several 
questions, but before that, Dr. Sega, could you take one or two 
minutes and explain to the folks here what you did in our 
office? The four departments that you explained that are 
involved in your organization. I want the folks here to get a 
broader understanding of the exact nature of the position that 
you hold. Could you do that for us?
    Mr. Sega. Yes.
    Chairman Manzullo. You introduced one of your----.
    Mr. Sega. Yes, and one of those was the Laboratories and 
Basic Sciences. This is within the Office of Director of 
Defense Research and Engineering and we have the oversight over 
the basic, applied and advance research.
    The second office is Deputy Under Secretary Defense for 
Science and Technology. Dr. Charlie Holland has the oversight 
of that office.
    The third is that of Advance Systems and Concepts. The 
Deputy Under Secretary Defense is Sue Payton and there is a 
Director of Plant and Programs, Mr. Al Schaffer and we also 
have in the office oversight of DARPA and the director is Dr. 
Tony Tether.
    Chairman Manzullo. Then how many people work under you?
    Mr. Sega. In the range of 40.
    Chairman Manzullo. Okay. I needed that so we could get a 
broader understanding of the depth of what you are involved in.
    We have a couple of lines here going at the same time. Dr. 
Sega who is in charge of the core research and then at the same 
time talking about the core research, a lot of the components 
of it are coming from overseas.
    I guess my question to you, Dr. Sega, in terms of what you 
do, do you get involved in the source of supplies, studies, 
materials, et cetera as Director of your department?
    Mr. Sega. No, sir, I do not.
    Chairman Manzullo. So that is outside your field?
    Mr. Sega. Yes, it is.
    Chairman Manzullo. I guess my question here would be and I 
appreciate that, my question here would be to the other two 
witnesses. To what extent is our military capability imperiled 
by the off-shoring of the semiconductor industry?
    We have heard a lot of numbers, but in terms of what that 
converts to for military preparedness. Dr. Hartwick, do you 
want to take a stab at that?
    Mr. Hartwick. I would suggest that we are not imperiled 
today. I cannot speak for the Department of Defense and AGED, 
because I am representing only myself, but the context of our 
work was in the trends in the future.
    The trends are clear and the breaking of the linkage 
between the fine research that is done in Dr. Sega's 
organization and ultimately getting that device or product into 
a manufacturable state is our concern.
    Currently, we have enough on-shore facilities, but that is 
rapidly changing. So the point is, the rapidity of the change 
and what it means three and four years from now.
    To build a new military system takes anywhere from five to 
ten years. You must act now in order to prepare yourself for 
these changes. That is our concern and that was the concern of 
our forum that you have cited.
    Chairman Manzullo. What do you do? Mr. Howell, you have 
some tremendous insight and studies as to what the foreign 
nations are doing, but where do we go from there? At what point 
do we lose critical mass?
    Mr. Hartwick. Yes.
    Chairman Manzullo. And then what do you do about it?
    Mr. Hartwick. The organizations that are going to hurt 
first are the ones that really require cutting edge technology, 
that is the surveillance intelligence agencies. They hurt 
first. They must put band-aid solutions on this.
    They must make deals to have government product in the case 
of chips run in the same manufacturing lines as commodity 
chips. The government must ante up, because they are 
interrupting the flow of high profit commodity chips on these 
lines. The government, near term, must make deals, band-aid 
solutions to ensure we have that product coming through three 
and four and five years from now.
    Chairman Manzullo. Ms. Velazquez?
    Ms. Velazquez. Thank you, Mr. Chairman. Mr. Hartwick, an 
article published by Manufacturing and Technology News on May 
16, 2003 stated that the AGED panel was told to stop briefing 
military officers, other government agencies and Congressional 
staff on the conclusion of its report. Can you confirm if this 
occurred?
    Mr. Hartwick. Yes, it did occur.
    Ms. Velazquez. Why do you believe it did?
    Mr. Hartwick. I do not have any idea.
    Ms. Velazquez. Can you expand a little bit more on that?
    Mr. Hartwick. We had a turnover of management with Dr. 
Sega's shop at that time. I believe that that may have had an 
influence on that decision. From my perspective, each briefing 
that we gave in briefing our results was extremely well 
received. We only briefed when we got a briefing request. We 
solicited no briefings.
    Each briefing was well received. I was puzzled by the 
directive to stop briefing just as you are.
    Ms. Velazquez. That directive came from?
    Mr. Hartwick. It came from Dr. Eisenstadt, who is a third 
tier down from Dr. Sega.
    Ms. Velazquez. Mr. Sega, do you have any comment on that 
question?
    Mr. Sega. The briefing that I received and unfortunately it 
was a brief time because of a delay in an airplane I believe on 
the 19th of November of last year from Dr. Hartwick, was the 
result of a forum that was conducted.
    In fact, I was the keynote speaker at the forum. A good 
exchange of folks and ideas and so forth at the meeting and the 
briefing was presented to me. There is some great content in 
the briefing.
    Now, we need to make a decision on these briefings whether 
that they are as the AGED process is a direct report of 
industry group to me whether or not the advice being provided 
for making planning and policy kinds of determinations, whether 
the document is for official use only, is classified, is to go 
through a formal release process.
    To go through a formal release process in the Department of 
Defense, then it is submitted per the Directorate of Freedom of 
Information and Security Review in the department and is 
cleared for open publication and then one goes forward.
    During our meeting, the next step was to visit with Mr. Al 
Schafer, who heads up the office of plans and programs and take 
a look at this information and see where we should go from it.
    It has good information in it. It was not annotated if you 
will as a briefing. It did not have references.
    Ms. Velazquez. Dr. Sega----.
    Mr. Sega. What the decision----.
    Ms. Velazquez. You got the report a year ago, right?
    Mr. Sega. Yes. What it is, is the document is an official 
use only document. It is not cleared for public release.
    Ms. Velazquez. Why is it not cleared for public release?
    Mr. Sega. It was my determination.
    Ms. Velazquez. Who paid for it?
    Mr. Sega. Excuse me? I did.
    Ms. Velazquez. The government.
    Mr. Sega. Yes. It is historically not unusual for some of 
AGED reports and I do not know if we have that here, to be for 
official use only. The purpose of the advisory group is to 
provide advice. It is roughly half-and-half government folks 
and those that are from outside of the Department of Defense, 
but are acting in a government consultant status to provide 
advice.
    Ms. Velazquez. Okay.
    Mr. Sega. In terms of being able to present it to staff, to 
Congress and official use only forum, that from my perspective, 
that was always fine.
    Ms. Velazquez. Are you trying to tell me that you never 
released reports?
    Mr. Sega. We never cleared it for open, unlimited 
distribution. That is a correct fact.
    Ms. Velazquez. Are you planning to release the report?
    Mr. Sega. No.
    Ms. Velazquez. Why is in the report that you do not want 
the public to know or members of Congress?
    Mr. Sega. The----.
    Ms. Velazquez. The report basically is a call for action. 
It is a national plan of action to counter the decline of U.S. 
electronics manufacturing and technology.
    Mr. Sega. As I said, the recommendations and the 
observations and there are many of which are very, very good 
and we have applied those and taken actions on many of those. 
The group provides advice, in this case to the Director of 
Defense Research and Engineering. Distributing of the 
information is found in this government product, an official 
use only basis and we had those restricted to AGED reports in 
the past to government agencies and contractors.
    It is providing good advice to us. Now without annotation, 
without references and without a dissenting thing of reviews, 
it is key to have it briefed by somebody, if you will and 
provide the appropriate caveats and provide additional 
background.
    By itself, we felt that it was not appropriate to 
distribute it for unlimited distribution.
    Ms. Velazquez. I do not get it. I just do not understand 
why after a year and cleaning it up you cannot release this for 
public consumption or even for us, members of Congress. We 
legislate.
    Mr. Sega. Yes. It is absolutely fine. Official use only 
documents are provided and they have been provided.
    Ms. Velazquez. Okay.
    Mr. Sega. This document in particular to Congress and 
staff. It is only the unlimited distribution that has been 
restricted and it never went through the clearance process for 
doing that, because it was determined to be more appropriate as 
an official use only document.
    Ms. Velazquez. Doesn't it pose a national security problem?
    Mr. Sega. We classify things----.
    Ms. Velazquez. Dr. Sega, from a security standpoint, are 
there any domestic industries that the Department of Defense 
believes the U.S. needs to protect?
    Mr. Sega. The question you asked is outside of the purview 
of the Director of Defense Research and Engineering. If I can 
give you an example of an area once identified of a shortage, 
where we do have oversight, one of those is in terms of Title 
III.
    Let me give you two examples of the Defense Reduction Act 
Title III. Gallium Arsenide is an electronic device and it is 
used in military applications, such as radars and smart weapons 
and electronic warfare systems. Under the stressing performance 
environments associated with these systems, it provides an 
advantage in terms of speed, power consumption, performance, 
reliability, not achieved in the silicon-based technology.
    This is an example from the past. The Department supported 
the development of Gallium Arsenide technology for a number of 
years, even before there was a significant commercial 
application. When it became apparent that the long-term 
viability of U.S. wafer supply base was in doubt, the 
Department established the program under Title III of the 
Defense Reduction Act.
    Ms. Velazquez. Okay. Now----.
    Mr. Sega. During the 1990's--can I--no?
    Ms. Velazquez. That is good enough. I just would like to 
ask you: After hearing from the other two witnesses, have you 
revised any of your opinions on the state of the defense 
industrial base in this country?
    Mr. Sega. The purview of my job is to look at the science 
and technology base. We are concerned about bringing forward 
the best technology for the war fighter.
    We stay in close contact and I think it is important to do 
that from day one all the way through the lifetime of a weapons 
system with the users, the acquisition community, which is the 
part that involves manufacturing and industrial base and with 
those in logistics. So technology, acquisition, logistics and 
users are working together to make this effective from day one 
all the way through and different parts have a lead at 
different times through a weapons system's lifetime.
    So we get that information from them. It is a collaborative 
area, but it is not one that I have responsibility for.
    Ms. Velazquez. Mr. Howell. Dr. Howell. Mr. Howell.
    Mr. Howell. I am a Mister.
    Ms. Velazquez. Yes. Would you like to comment on that?
    Mr. Howell. Most of my work has been on the civilian side 
of microelectronics and I do not know the ins and outs of the 
military applications that have been given. The original 
question I think was when do we reach a tipping point where our 
national security begins to be jeopardized by the offshore 
movement of manufacturing.
    I think that different people can have different answers to 
that, but I think the tipping point may be and this is not just 
my view, I think it is the view of many people in the 
community, it is when the best graduates from schools, graduate 
schools of electronics and integrated circuit design and so on, 
find that the opportunities are not here any more. The best 
opportunities for the best people are abroad and they start 
moving abroad.
    At that point, it becomes very hard to retain the 
capability that we need really in this sector. I do not know 
how that ripples down exactly to the military sphere, because I 
know that generally it takes so long to design and insert these 
kinds of devices into military systems and it would take a 
number of years before that would reverberate into the security 
area, but it would if it is a long-term trend.
    I think right now the state-of-the-art manufacturing is 
here. The best design talent is here. The best universities 
are----.
    Chairman Manzullo. Let me interrupt you. Did you have a 
comment you wanted to make, Dr. Hartwick?
    Mr. Hartwick. No, I am fine.
    Chairman Manzullo. Okay. Let me conclude here because we 
have to go vote. We have been holding a series of hearings on 
the nature and state of our manufacturing base in this country.
    I find the testimony of each of you to be intriguing, yet 
extremely distinctive. You are talking essentially in I don't 
want to say three different spheres, but I would like to do is 
to work with the three of you.
    I think we all agree here that we have to begin to 
formulate policy to make sure that the United States keeps its 
cutting edge technology, has the ability, but to keep that here 
at home. I think the three of you agree with me on that.
    You come from three different perspectives. Three different 
backgrounds. If you would be willing to work with us, as part 
of I don't want to call it a national manufacturing strategy, 
but we are seeing comments from people like Andy Grove from 
Intel, who is just begging this Congress for leadership in 
order to make sure that we maintain these strategic advantages 
at home. It has been an extremely thoughtful testimony and I 
appreciate it very much.
    Did you have a question you want----.
    Ms. Millender-McDonald. Mr. Chairman, thank you so much. I 
had a classified meeting on transportation so I was running 
here to try to listen to these distinguished panelists and I 
know that the topic is extremely critical, especially to 
California, given the Silicon Valley and its demise.
    Because of the HB-1 bill that we presented, I am very 
concerned as to whether we are losing advantage in terms of 
technology. Again, if there is an opportunity for us to have 
conversation with them, I would be happy to be a part of that.
    Chairman Manzullo. Did anyone want to comment on the HB-1? 
Dr. Hartwick? Anybody?
    Mr. Hartwick. I don't know what the HB-1 is.
    Ms. Millender-McDonald. It was providing----.
    Chairman Manzullo. You could tell they are definite field 
sciences.
    Ms. Millender-McDonald. It was to accord persons coming in 
from other countries to do high-tech jobs here in the United 
States, because of a lack of personnel for those types of jobs, 
especially those coming in from India.
    That is what that bill suggests. While we passed that bill, 
I was very concerned about that, given that we should have had 
someone here in the United States who could----.
    Mr. Hartwick. I would like to respond, if I may.
    Chairman Manzullo. Sure.
    Mr. Hartwick. First off, I would be delighted to work with 
whoever it is that wants to get this problem solved.
    Chairman Manzullo. Well, it is the four of us now.
    Mr. Hartwick. I am with you. I would suggest that there is 
more than three spheres. You see three spheres represented 
here. There is an education sphere. There is a big business and 
a small business sphere. The spheres are multiple and the very 
problem we have is that they do not talk with one another.
    Ms. Millender-McDonald. Here. Here.
    Mr. Hartwick. It is time to get them all together.
    Chairman Manzullo. That is why we are here. You know what? 
We have to terminate the talk, because we have to exercise our 
Constitutional obligation to vote.
    Thank you for coming. The hearing is adjourned.
    [Whereupon, at 12:00 p.m., the Committee meeting was 
adjourned.]

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