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Measuring Capital in the New Economy
Measuring Capital in the New Economy
Measuring Capital in the New Economy
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Measuring Capital in the New Economy

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As the accelerated technological advances of the past two decades continue to reshape the United States' economy, intangible assets and high-technology investments are taking larger roles. These developments have raised a number of concerns, such as: how do we measure intangible assets? Are we accurately appraising newer, high-technology capital? The answers to these questions have broad implications for the assessment of the economy's growth over the long term, for the pace of technological advancement in the economy, and for estimates of the nation's wealth.

In Measuring Capital in the New Economy, Carol Corrado, John Haltiwanger, Daniel Sichel, and a host of distinguished collaborators offer new approaches for measuring capital in an economy that is increasingly dominated by high-technology capital and intangible assets. As the contributors show, high-tech capital and intangible assets affect the economy in ways that are notoriously difficult to appraise. In this detailed and thorough analysis of the problem and its solutions, the contributors study the nature of these relationships and provide guidance as to what factors should be included in calculations of different types of capital for economists, policymakers, and the financial and accounting communities alike.
LanguageEnglish
Release dateFeb 15, 2009
ISBN9780226116174
Measuring Capital in the New Economy

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    Measuring Capital in the New Economy - Carol Corrado

    Index

    Preface

    This volume contains revised versions of most of the papers and discussions presented at the Conference on Research in Income and Wealth entitled Measuring Capital in the New Economy, held at the Federal Reserve Board in Washington, D.C., on April 26–27, 2002. It also contains some material not presented at that conference.

    Funds for the Conference on Research in Income and Wealth are supplied by the Bureau of Economic Analysis, the Bureau of Labor Statistics, the Census Bureau, the Federal Reserve Board, and Statistics Canada. For this conference, additional financial support was provided by the National Science Foundation under grant SES-0137120. We are indebted to these organizations for their support.

    We thank Carol Corrado, John Haltiwanger, and Daniel Sichel, who served as conference organizers and editors of the volume. We also thank the Federal Reserve Board for hosting the conference and the NBER staff and University of Chicago Press editors for their assistance in organizing the conference and editing the volume.

    Executive Committee, April 2005

    John M. Abowd

    Susanto Basu

    Ernst R. Berndt

    Carol A. Corrado

    Robert C. Feenstra

    John Greenlees

    John C. Haltiwanger

    Michael J. Harper

    Charles R. Hulten, chair

    Ronald Jarmin

    J. Bradford Jensen

    Lawrence F. Katz

    J. Steven Landefeld

    Brent R. Moulton

    Mark J. Roberts

    Matthew Shapiro

    David W. Wilcox

    Introduction

    Carol Corrado, John Haltiwanger, and Daniel Sichel

    Carol Corrado is chief of the Industrial Output section in the Division of Research and Statistics at the Federal Reserve Board and a member of the executive committee of the Conference on Research in Income and Wealth. John Haltiwanger is professor of economics at the University of Maryland, a research associate of the National Bureau of Economic Research, and a member of the executive committee of the Conference on Research in Income and Wealth. Daniel Sichel is assistant director in the Division of Research and Statistics at the Federal Reserve Board.

    The views expressed in this introduction are those of the authors and should not be attributed to the Board of Governors of the Federal Reserve System or other members of its staff.

    As the new economy has developed, intangible assets and high-technology investments are playing an increasingly important role.¹ These developments have raised many important questions about measurement, including how to treat intangible assets in economic accounts and whether we are accurately measuring newer, high-technology capital. Economic researchers, data providers, and policy analysts are interested in answering these questions because the answers can lead to better assessments of the economy's long-run pace of economic growth and rate of technological advance, as well as to improved measures of national wealth.

    In April 2002, the Conference on Research in Income and Wealth (CRIW) of the National Bureau of Economic Research (NBER) held a conference at the Federal Reserve Board in Washington, D.C. The purpose was to develop new results in capital measurement and to explore their practical implications for the measurement community. This volume includes the papers presented at the conference, the discussants’ remarks, and summary remarks of some of the key conference participants. The papers and comments have undergone review and, in some cases, substantial revision since their presentation at the conference.

    The themes of the conference and this volume concern the challenges of how to measure physical capital accumulation and the contribution of intangible assets in an economy that is increasingly dominated by high-technology capital and undergoing change brought about by advances in information technology. Just as Griliches (1994) argued that the fraction of output that is difficult to measure has been growing over time, we argue that the fraction of capital that is challenging to measure has been growing over time as well. Growth of high-tech capital has been extremely rapid in recent decades, and although data are sparse, the growth of intangible capital appears to have been rapid as well.

    Substantial attention has already been devoted to some of the measurement challenges regarding high-tech assets. For example, the focus on measuring real investment in computers and on studying the prices of semiconductors for computers has been considerable. Less attention, however, has been devoted to the measurement of the asset accumulation process for high-technology communications capital and for computer software capital; the latter is a major type of intangible asset that the Bureau of Economic Analysis (BEA) has only recently included in its capital accounts. This volume devotes needed attention to the measurement of communications equipment and software capital.

    This volume also devotes substantial attention to the measurement of intangible assets not now on the national balance sheet. Relatively little is known about the precise size of these assets, although recent work points to the potentially large magnitude of business spending on intangibles (Nakamura 2001; Lev 2001). Moreover, an extensive literature documents the profitability of business spending on research and development (R&D) and employer-provided training, suggesting that one can broadly argue that intellectual capital, organizational capital, human capital, and human resource practices are crucial assets of successful firms in today's economy (Hall 2000, 2001a,b; Lev 2001).

    A growing body of research also emphasizes the complementarities between investment in high-tech capital, including software capital, and the creation of intangibles in the form of network externalities (Shapiro and Varian 1999) and organizational and firm-specific human capital (Bryn-jolfsson and Hitt 2000). Such complementarities likely exist both in dotcoms and in large manufacturing establishments, although the nature of the complementarity likely differs substantially across sectors and businesses. Although much work remains to be done in this literature, these types of intangible capital and their interaction with other forms of capital also receive considerable attention in this volume. Indeed, the desire to better understand this interaction is a key reason the conference focused on the challenges of measuring capital quality and intangibles. As noted above, these measurement challenges are similar in that their importance and relevance have grown with the spread of information technology. They are very distinct, however, in the questions addressed: Are we capturing technological change in our price measures for high-tech assets? versus How should we determine the boundary between what is investment and capital and what is not? Accordingly, the papers in this volume address diverse measurement issues.

    Without a doubt, some of the measurement issues highlighted here are controversial. The flourishing U.S. economy of the late 1990s—especially its booming stock market—has been partly responsible for generating the interest in better measuring and understanding the role of capital quality and intangibles in our modern economy. Indeed, a sizable literature attempts to determine how much of the gap between the market value of corporate securities and the value of corporate capital at replacement cost can be explained by intangibles. Although several papers in this volume are skeptical about using market valuations to measure intangibles, the perspective that important inferences about firm performance can be drawn from market valuations receives support in this volume. At the same time, other papers in the volume offer alternative strategies for measuring intangibles based on spending or earnings data.

    We recognize that it is vital to incorporate the perspective of the accounting community in addressing the measurement issues highlighted in this volume. One challenge is that even if a widespread consensus forms on the need to develop and improve measures of intangible capital, the measurement difficulties and the need for transparency in business accounting yield an inherent tension. Moreover, business accounting practices are currently undergoing scrutiny that stems from questionable accounting practices by some firms; often such practices are connected to the treatment of intangibles in business accounts. Although these developments raise a new set of challenges, we believe that it is essential to continue moving down the road toward a better understanding and fuller recognition of intangibles.

    At the conference and in this volume, the issues highlighted in this introduction are addressed from a wide variety of perspectives and approaches. In the remainder of this introduction, each paper in the volume is summarized. The summaries are not exhaustive, as the papers speak for themselves, and some perspective is provided on how the papers fit together, given the objectives of the conference.

    An Overview of the Papers

    The first paper in the volume, Measuring Capital and Technology: An Expanded Framework, provides guidance on what components of business spending should be included in measures of capital investment. Carol Corrado, Charles Hulten, and Daniel Sichel present an intertemporal model that defines capital investment as follows: Any outlay that is intended to increase future rather than current consumption should be treated as investment. Thus, spending on a host of intangibles—computerized databases, R&D, new copyrights and licenses, brand equity, and improved organizational structures—should, in principle, be counted as investment in economic accounts. The authors use their framework to identify and measure the components of business capital spending on intangibles. They find that, by the late 1990s, business fixed investment in intangibles may have been as large as investment in traditional equipment and structures. They indicate further that a significant portion of this investment is excluded from the existing investment figures in U.S. national income and product accounts (NIPAs) and suggest that a move to recognize intangible capital might alter our understanding of the factors determining economic growth.

    The next few papers explore conceptual and measurement issues for intangible capital. Jason G. Cummins in A New Approach to the Valuation of Intangible Capital raises both conceptual and measurement issues about the market valuation approach to measuring intangible capital that has appeared in the recent literature. In the market valuation approach, intangible capital is measured as the gap between the market value of a corporation's securities and the replacement value of its physical assets. Cummins takes a different conceptual and empirical approach. He models intangibles within an adjustment-cost framework and then exploits data from analysts’ forecasts of earnings to test his approach and framework. Compared with the market valuation approach, Cummins's approach finds a substantial, but much smaller, valuation of intangible capital.

    In The Valuation of Organizational Capital, Baruch Lev and Suresh Radhakrishnan take a different approach in measuring what they call organizational capital. They define organizational capital as the knowledge and structure used to combine inputs, such as physical capital and labor, to produce goods and services. Some businesses have more of this organizational capital than others—that is, they are able to produce more or more-valuable goods and services with a given amount of physical and human capital. Using this conceptual framework, Lev and Radhakrishnan develop alternative measures of organizational capital. The primary approach is to measure organizational capital as a residual, much like total factor productivity. Lev and Radhakrishnan test the information content of these measures of organizational capital by considering how financial markets value them.

    In Intangible Risk, Lars Peter Hansen, John C. Heaton, and Nan Li raise further questions about using financial market data to infer measures of intangible capital. They point out that drawing inferences about intangible capital from stock market returns must consider risk or offer some competing interpretation for the heterogeneity in stock market returns. Put differently, asset valuations reflect beliefs about not only the future prospects for firms but also the riskiness of the implied cash flows. Taking risk into consideration, they present evidence that important differences exist between the risks associated with investments in traditional measured capital and those associated with intangible capital.

    Other papers explore alternative direct measures of the factors that either compose or are closely connected to intangible capital. The first group focuses on human capital and human resource practices. The growing role of intangibles is conjectured to be linked to an increasing role of firm-specific human capital and associated human resource practices. That is, the tacit knowledge of employees is a key intangible asset, and successful businesses are those that manage the accumulation of such assets well through their human resource and organizational practices. For this important and difficult area of inquiry, the volume includes two papers.

    In the first paper, The Relation among Human Capital, Productivity, and Market Value: Building up from Micro Evidence, John M. Abowd, John Haltiwanger, Ron Jarmin, Julia Lane, Paul Lengermann, Kristin Mc-Cue, Kevin McKinney, and Kristin Sandusky explore new micro-based measures of human capital and the connections among human capital, productivity, and market value. Well established in the literature is that traditional human capital measures (for example, education) are important factors in production and that traditional measures capture only a small fraction of what we think of as human capital. Using newly developed, longitudinal, employer-employee matched data, the authors construct new, comprehensive measures of human capital and look at the connection between the new human capital measures and firm performance. Interestingly, but perhaps not surprisingly, the new measures help account for the observed variation in labor productivity across businesses. Even more interesting is that the new human capital measures also help account for the variation in market valuation across businesses after controlling for observed physical assets. The latter finding suggests that human capital is closely connected to intangible capital.

    In their paper Measuring Organizational Capital in the New Economy, Sandra E. Black and Lisa M. Lynch explore these closely related issues but use a different approach. Rather than focusing on the differences in human capital across businesses, Black and Lynch focus on the observed differences in human resource practices (including training) across businesses. Of course, the latter may have an effect on and interact with the differences in human capital across businesses, but the focus here is on the differences in the management of human capital across businesses. These authors review the burgeoning recent literature in this area and argue that human resource practices appear to be quite important in accounting for observed differences in firm performance. Moreover, the authors discuss recent related findings that the returns from the adoption of advanced technologies are improved by the adoption of state-of-the-art human resource practices.

    Industrial R&D has long been seen as one of the key factors underlying the differences in the products and processes across businesses. In other words, R&D has long been viewed as one of the critical factors determining the growth in total factor productivity. However, measuring R&D capital and its effects on firm performance is inherently difficult. One of the major challenges is having the appropriate data to capture the full effects of R&D on firm performance. In his paper Pharmaceutical Knowledge-Capital Accumulation and Longevity, Frank R. Lichtenberg takes a fresh look at these difficult issues in the pharmaceutical industry. Using rich micro-level data on the development of new drugs and data on the effects of such new drugs on human longevity, Lichtenberg generates novel results on the returns from R&D. In so doing, he raises several questions about the existing methods that are used to measure R&D capital and its effects on business performance.

    Barbara M. Fraumeni and Sumiye Okubo in their paper R&D in the National Income and Product Accounts: A First Look at Its Effect on GDP look at related issues, but from the top down instead of the bottom up. Fraumeni and Okubo discuss the data collected on R&D expenditures in the U.S. economy. They discuss how an R&D capital stock could be constructed for the U.S. NIPAs, and then they examine the relationship between their measures and existing GDP. This paper is important in its own right, but it is also important because it fulfills one objective of the conference—which was to spur consideration of how measuring intangible capital may change the existing statistics. Fraumeni and Okubo offer direct guidance on this subject.

    The next set of papers explores measurement issues for what might be called high-tech capital. High-tech capital is inherently difficult to measure because accurate measurements of quality change and of depreciation are particularly difficult. Tremendous progress has been made in the measurement of certain high-tech products such as computers and semiconductors. The focus of this set of papers is on the areas of high-tech capital in which progress has been slower—in particular, communications equipment and software.

    In Communications Equipment: What Has Happened to Prices? Mark Doms uses unique, newly developed data to study price and quality change for communications equipment. He found a high pace of quality change in communications equipment, particularly for the components used to create and provide business computer networks, such as high-end routers, switching equipment, and fiber optic equipment. The estimated pace of quality change is not as dramatic as that for computers and semiconductors but is still quite rapid and faster than official statistics suggest. Doms also points the way for improving the measurement of real output, prices, and productivity growth in this important industry by offering new ways of classifying its highly diverse components.

    One relatively recent change is that software is now treated as an investment good in the NIPAs. This change is important conceptually and has had significant implications for the national accounts. Treated as an investment good, software now contributes to the aggregate capital stock, and the difficult issues of measuring quality change and depreciation for capital goods must now be addressed for software. In Information-Processing Equipment and Software in the National Accounts, Bruce T. Grimm, Brent R. Moulton, and David B. Wasshausen carefully document the measurement of high-tech assets in the national accounts, including the current treatment of software. The paper goes beyond summarizing the new treatment of software, however. The authors discuss the limitations and difficulties associated with the new methodology, outline areas in which the BEA hopes to make future progress, and discuss recent changes in the methods the BEA uses to measure information-processing equipment.

    The remaining papers cover areas that bridge more than one of the aforementioned topics. Growth of U.S. Industries and Investments in Information Technology and Higher Education by Dale W. Jorgenson, Mun S. Ho, and Kevin J. Stiroh explores the connections among productivity growth, human capital investment, and information-technology investment at the industry level. Much has been made of the contribution of information technology to the rapid and accelerated pace of productivity growth in the late 1990s. This paper uses industry-level data to explore the contribution of information technology at a more disaggregated level. Also, much has been made in the literature about skill-biased nature of the information-technology revolution. The rise in the demand for skilled workers in the past few decades and the associated changes in wage inequality have been the subjects of much research and debate. Using the growth accounting methodology that Jorgenson helped pioneer, the authors explore how all of these factors interact at the industry level. Their findings confirm the important contributions of both information technology and investment in human capital (via higher education) to productivity growth. Moreover, the paper raises several issues about measurement. In particular, the lack of comprehensive and integrated industry accounts makes the empirical exercises in this paper challenging, and the authors provide a useful perspective on the ways the official statistics could be improved along these lines.

    Finally, W. Erwin Diewert in Issues in the Measurement of Capital Services, Depreciation, Asset Price Changes, and Interest Rates provides a unified framework for the measurement of capital that addresses many of the issues and topics covered in the volume. Diewert reviews the standard methods for measuring capital, examines a range of alternatives for the treatment of depreciation, and explores the role of quality change and how intangible assets stocks could be measured. He uses this unified framework to discuss the pros and cons of the alternatives statistical agencies might face from both a conceptual and a practical point of view. In the context of the other papers in the volume, Diewert provides direct guidance on the various reasons for the difficulty in measuring intangible assets and high tech capital.

    Conclusion

    As in past NBER and CRIW conferences, this one stimulated a rich discussion by experts in the areas covered by the volume. For many of the published papers, the discussants’ comments are also included. These comments provide useful perspectives on the papers themselves and on the relevant broader issues. In addition, the conference included two panel discussions that provided important perspectives on the issues of the conference. The first panel assessed private-sector approaches to accounting for intangible assets and included Martin Baily, Ed Bersoff, Janamitra Devan, and Baruch Lev. The second roundtable discussed next steps for the measurement community and included Brian Kahin, Frederick Knicker-borcker, Randall Kroszner, Steven Landefeld, Marilyn Manser, and Larry Slifman.

    The volume includes written remarks by noted contributors to the related literature who also participated actively in the conference. After welcoming remarks by Martin Feldstein and introductory remarks by Alan Greenspan, Robert Hall discussed his provocative work on the use of the stock market valuations to measure intangible capital. His remarks, published in this volume, offer an interesting perspective, especially in light of the sharp declines in stock prices in recent years. Besides presenting his paper on organizational capital, Baruch Lev participated actively in the panels and discussion, relating the perspectives of the accounting profession on the measurement of intangible capital. As discussed earlier, incorporating the perspective of the accounting profession is important, and his remarks are published in the volume. Finally, the volume includes written remarks by Erik Brynjolfsson and Loren Hitt. They have been active contributors to the literature on the measurement and contribution of intangibles to productivity, firm performance, and growth. One of the special features of this work is the initiation, supervision, and analysis of private surveys on these topics, yielding a unique perspective on these issues.

    Not surprisingly, no overall consensus emerged from the conference. Because capital measurement issues are difficult and the debate is ongoing, this lack of consensus is consistent with the conference tradition. The statistical, research, and policy communities will be grappling with the difficult issues in measuring capital for some time to come—and the problems associated with defining and measuring intangible capital and measuring high-tech capital will be at or near the top of the list. We believe that the papers in this volume will help define the issues, stimulate debate on these topics, and generate advances in both theory and practice.

    Indeed, an area of agreement at the conference was that the statistical agencies could use satellite accounts as a repository for the new measures being developed for some components of intangibles (for example, R&D capital and human capital). We hope that the statistical and research communities will use the rich insights presented here in this way and in other ways for years to come.

    The conference organizers and attendees thank those who made this conference a success and the NBER and CRIW volume possible: the National Science Foundation and the NBER and CRIW for financial support; the Federal Reserve Board for hosting the conference; and the NBER, especially Helena Fitz-Patrick, for assistance in compiling this volume.

    References

    Brynjolfsson, Erik, and Loren Hitt. 2000. Beyond computation: Information technology, organizational transformation, and business performance. Journal of Economic Perspectives 14 (4): 23–48.

    Griliches, Zvi. 1994. Productivity, R&D, and the data constraint. American Economic Review 84 (1): 1–23.

    Hall, Robert. 2000. E-capital: The link between the stock market and the labor market in the 1990s. Brookings Papers on Economic Activity, Issue no. 2:73–118.

    —. 2001a. The stock market and capital accumulation. American Economic Review 91 (5): 1185–1202.

    —. 2001b. Struggling to understand the stock market. American Economic Review Papers and Proceedings 91 (2): 1–11.

    Lev, Baruch. 2001. Intangibles: Management, measurement, and reporting. Washington, DC: Brookings Institution Press.

    Nakamura, Leonard. 2001. What is the U.S. gross investment in intangibles? (At least) one trillion dollars a year! Federal Reserve Bank of Philadelphia Research Working Paper no. 01–15.

    Shapiro, Carl, and Hal Varian. 1999. Information rules. Cambridge, MA: Harvard Business School Press.


    1. We use the term new economy broadly to encompass the ongoing changes in the economy, particularly those related to information technology.

    1

    Measuring Capital and Technology

    An Expanded Framework

    Carol Corrado, Charles Hulten, and Daniel Sichel

    Carol Corrado is chief of the Industrial Output section in the Division of Research and Statistics at the Federal Reserve Board and a member of the executive committee of the Conference on Research in Income and Wealth. Charles Hulten is professor of economics at the University of Maryland, chairman of the Conference on Research in Income and Wealth, and a research associate of the National Bureau of Economic Research. Daniel Sichel is assistant director in the Division of Research and Statistics at the Federal Reserve Board.

    We thank Ed Prescott and Barry Bosworth for helpful comments on an earlier draft. The views expressed in this paper are those of the authors and should not be attributed to the Board of Governors of the Federal Reserve System or other members of its staff.

    Edward C. Prescott is a senior monetary advisor at the Federal Reserve Bank of Minneapolis, the W. P. Carey Chair in economics at Arizona State University, a research associate of the National Bureau of Economic Research, and a 2004 Nobel Laureate in Economics.

    1.1 Introduction and Background

    The last two hundred years have witnessed dramatic gains in the standard of living in the United States, driven by the technological innovations introduced by the Industrial Revolution and carried forward by the evolution of technology since then. This evolution is reflected both in the development of new products (electric lighting, automobiles, open-heart surgery) and in the improved efficiency of production processes (the assembly line, just-in-time inventory controls, computer-aided design). Growth economists have undertaken the important task of quantifying these developments and of sorting out the relative importance of the factors that drive sustained increases in real output. This effort has increased in recent years with the debate over the new economy and the question of whether living standards will continue to rise at the accelerated pace of the late 1990s.

    The sources of growth model has been the main empirical tool in tracking and explaining growth trends. This model, developed in the 1950s and 1960s by Solow (1956, 1957, 1960), Kendrick (1961), Denison (1962, 1964), Jorgenson and Griliches (1967, 1972), and others, allocates the growth rate of measured output to the growth rate of labor and capital inputs, each weighted by their share of output, and a residual factor associated with the efficiency with which output is produced from a given set of inputs (total factor productivity, or TFP). A large academic literature has evolved using this framework, reviewed recently in Hulten (2001), and TFP has become an official statistic produced regularly by the Bureau of Labor Statistics (BLS). An updated version of the BLS decomposition is shown in the upper half of table 1.1, which indicates that output per hour worked rose about 1.25 percentage points per year faster since 1995 than it did during the period of lackluster growth from 1973 until then. These figures have lent support to the new economy view about prospective growth trends.

    Although great progress has been made in applying the sources-of-growth framework to the analysis of economic growth, doubts have nevertheless been raised about our ability to understand and measure fully the fundamental sources of growth. For example, despite several decades of rapid technological advance in information technology, one of the originators of the sources-of-growth model, Robert Solow, famously remarked in 1987 that you see the computer revolution everywhere except in the productivity data (Solow 1987). Alan Greenspan observed about ten years later that many services industries displayed implausibly negative trends in measured productivity despite being among the top computer-using industries.¹ Also, Nordhaus (1997) concluded from his analysis of the history of lighting that official price and output data miss the most important technological revolutions in history. The recent debate over the accuracy of the consumer price index (CPI) has raised similar questions: Studies have shown that the failure to capture the full effect of improvements in product quality and the benefits of new goods and services created an upward bias in the CPI of more than 0.5 percentage point (Lebow, Roberts, and Stockton 1994; Advisory Commission to Study the Consumer Price Index 1996; Shapiro and Wilcox 1996) and implied a corresponding downward bias in the rate of increase in the consumption component of total real output.

    Some of the foregoing concerns can be traced to problems inherent in the data used to study economic growth, but many key data concerns have been addressed in relatively recent work at the major statistical agencies. These include, among others, the renewed emphasis on quality change in the measurement of prices at the BLS, the capitalization of software expenditures by the Bureau of Economic Analysis (BEA), and the expanded coverage of service industries by the Census Bureau. However, no parallel theoretical advance has emerged, within or beyond the sources-of-growth framework, to guide further empirical advances and tell us what we need to know to understand economic growth in the new economy.

    The first goal of this paper is to expand the conceptual framework of the sources-of-growth model by linking it to a variant of the standard model of intertemporal choice developed in Hulten (1979). In the expanded framework, the determination of what expenditures are current consumption and what are capital investment is governed by consumer utility maximization, and any outlay that is intended to increase future rather than current consumption is treated as a capital investment. When this deferred-consumption rule is applied to one of the most important new economy questions—whether business intangible outlays and knowledge input should be expensed or capitalized in national accounting systems—an unambiguous answer is obtained: there is no basis from the consumers’ point of view for treating investments in intangible capital differently from investments in plant and equipment, or tangible capital.²

    We then turn to the question of how much difference the theoretically appropriate treatment of intangible capital might make to the productivity estimates shown in table 1.1. Competing approaches have emerged in the current literature on the measurement of intangibles. One prominent approach uses the value of securities, primarily stocks, to infer the quantity of intangible capital held by U.S. corporations to help interpret recent changes in productivity (R. Hall 2000, 2001a,b).³ Our work, however, follows another branch of the literature. Rather than appealing to the stock market, we pull together disparate pieces of spending data and related evidence to gauge the plausible magnitude of the additional business investment (and thus gross domestic product [GDP] and output per hour) if expenditures on intangibles, or knowledge capital, are treated symmetrically with investments in traditional fixed capital. The estimates we develop build on the studies by Nakamura and others who have examined the undervaluation of measured business investment and capital in the late 1990s (Nakamura 1999, 2001, 2003; Brynjolffson and Yang 1999; Brynjolffson, Hitt, and Yang 2002; McGratten and Prescott 2000), as well as earlier work sponsored by the Organization for Economic Cooperation and Development (OECD; OECD Secretariat 1998).

    Our effort differs from previous work, however, by applying the theoretical classification and accounting principles that follow from the expanded framework we introduce in the next section. Not only does this framework lead us to cast a wider net to identify the possible components of business investment in intangibles, but it also leads us to distinguish spending flows that generate relatively long-lasting revenue streams from those whose returns dissipate too quickly to count the associated asset as fixed capital. The latter consideration has not been an explicit aspect of others’ efforts to gauge the plausible undervaluation of business investment. We also are careful to separate assets that are already included in the national accounts from those that are not.

    All told, our framework for the economic measurement of capital suggests that, if business intangibles are fully recognized in national accounting systems, the move will significantly change measures of economic activity. We estimate that business spending on long-lasting knowledge capital—including intangibles broadly—grew relative to other major components of aggregate demand during the 1990s. As a result, our estimates show that, by the end of the decade, business fixed investment in intangibles was at least as large as business investment in traditional, tangible capital. When the unrecognized portion of this spending is viewed in relation to existing measures, our framework portrays the U.S. economy as having had higher gross private saving and, under plausible assumptions, fractionally higher average annual rates of change in real output and real output per hour, particularly from 1995 to 2002.

    1.2 Theory

    1.2.1 The Production Function Approach to Growth Accounting

    Contemporary growth accounting is organized around the concept of the aggregate production function. Aggregate real output is assumed to be related to inputs of labor and capital via an aggregate production function, with provision for changes in the productivity of the inputs. When efficiency change has the Hicks-neutral form, the production function can be expressed as

    where Qt denotes real output, Kt and Lt are capital and labor, and At is an index of the level of TFP. In econometric studies of growth, the production function is given a specific parametric form, and the parameters of F (·) are then estimated using a variety of techniques. In the index-number (non-parametric) approach of Solow (1957) and Jorgenson and Griliches (1967), the growth rate of output is equal to the shared-weight growth rates of labor and capital:

    (The g terms are growth rates, and the s terms are factor shares.) Under constant returns to scale and marginal-cost pricing, Solow showed that the factor shares are equivalent to output elasticities, and the term gA was associated with a shift in the production function in equation (1) (illustrated as the move from a to c in figure 1.1), while sKgK + sLgL was a movement along the function (c to b in the figure). Each item in equation (2) can, in principle, be estimated from national accounting data, except for the growth rate of TFP, gA, which must be inferred as a residual—Abramovitz's famous measure of our ignorance.

    The sources-of-growth equation is the basis for the estimates in table 1.1, which are expressed in labor-productivity terms: gQ gL = sK (gK gL) + gA.⁴ The estimates in this table highlight the slowdown in productivity growth in the early 1970s and the pickup in the mid-1990s. The table also reveals the important role played by TFP in these swings in productivity growth. The acceleration in labor productivity since 1995 has generated the new economy view that the U.S. economy has entered an era of higher productivity growth. As can be seen in the table, the 1.25 percentage point improvement in labor productivity growth after 1995 was driven both by a pickup in TFP and by the increased capital deepening of information technology (IT) equipment and software.⁵

    The potential importance of investment in intangible assets is borne out by the lower panel of table 1.1, in which the sources of growth estimates exclude the effect of capitalized software (i.e., they exclude investment in software as a component of both output and capital input). Here the pickup in labor productivity growth is seen to be only about 1 percentage point, about one-quarter percentage point less than when software is included.

    These results for software point to the potential importance of capitalizing other intangibles, like R&D. In the treatment shown in the upper panel of table 1.1 (the part taken from the BLS release), R&D is added as a memo item explaining a portion of the residual; it does not play an explicit role as a capital input. Unfortunately, the traditional sources-of-growth framework treats capital and labor inputs as determined outside of the framework and therefore does not provide guidance as to whether to treat R&D as a memo item or as an investment good and thus as part of output. This problem is addressed in the following section by embedding the sources-of-growth framework in a more complete dynamic model in which investment decisions are made explicit. Our extended framework shows that no basis exists for treating intangible capital differently from traditional forms of fixed capital. Indeed, the asymmetrical treatment of the two types of capital could have the effect of suppressing some of the most dynamic factors driving economic growth.⁶

    1.2.2 Capital in a Complete Model of Economic Growth

    The sources-of-growth model, derived from the production function as illustrated in figure 1.1, evolved as a period-by-period analysis of the factors determining output along the growth path of an economy. This model treats capital as predetermined and cannot fully describe the growth process because saving and investment are choice variables in a complete model of growth. Not only is this choice dimension important because it determines the quantity of capital available at each point in time, but it also determines what should be counted as capital. The answer to the question of whether intangibles should be treated as capital is therefore a matter of embedding the production function-based sources-of-growth analysis in a larger model of economic growth.

    Several options are available in this regard: the neoclassical growth model, the endogenous growth model, and optimal-growth theory. The latter is the most suitable because it deals directly with consumer saving behavior. We will therefore work with the variant of this model used in Hulten (1979) to endogenize capital in an expanded growth-accounting framework. Following standard intertemporal capital theory, we assume that optimal consumption in each period is determined by the maximization of an intertemporal utility function U(C1,…, CT) subject to (a) the constraints of the technology represented by the production function in equation (1); (b) the capital accumulation equation expressed in its perpetual inventory form as

    where δ is the rate of depreciation; (c) the constraint that the production of consumption and investment goods cannot exceed total output in any period

    (this expression also serves as the annual product and income account of the economy portrayed by this model, which for simplicity is assumed closed); (d) the exogenously given initial and terminal quantities of capital, Ko and KT; and (e) the initial level and paths of labor input and TFP (and thus gL and gAdetermines how output is divided between the production of consumption and investment goods and therefore is relevant to how intangibles ought to be treated.

    For purposes of exposition, we can restate the constraints on the optimization in a more compact form.⁸ The production function Ct + It = AtF (Kt, Lt), the initial and terminal stocks of capital K0 and KT, the accumulation condition Kt = It + (1 − δ)Kt−1, and the paths of At and Lt, can be expressed in equivalent form as

    This is the intertemporal production possibility frontier, which indicates all combinations of the consumption vector {C1,…, CT}, including the optimal vector, that are possible given the vector of labor input, technology levels, and the initial and terminal stocks of capital. This form of the constraint reveals the endogenous role of capital in the growth process. Capital largely disappears when the constraints are expressed in this form, and it disappears altogether if the initial and terminal stocks of capital happen to be zero.

    The solution to the intertemporal optimization problem is shown graphically in figure 1.2 for the case of two time periods. The feasibility constraint Φ is represented by the curve AB, and the intertemporal utility function U(C1,…, CT) is represented by the curves UU and U'U'. The optimal consumption plan is represented by the point a, and this point defines the maximum wealth of the economy. The line WW indicates the level of this wealth and has the form

    In equation (6), the nominal rate of discount, i, is assumed to be constant over time for simplicity of exposition, and the initial and terminal stocks of capital are set to zero. The optimal point, a, is an explicit function of labor input and level of technology in each period. Capital is implicit in the optimal solution, because A C1 units of consumption are forgone in period 1, and the resources freed up by this abstinence are used to make capital goods, which are then used up in production in period 2. Capital is, in effect, an intermediate intertemporal good.

    The relative roles of capital formation and technical change can be explored using the following thought experiment: What would have been the outcome had technology not increased from AB’ to AB, with labor held constant? The production possibility frontier in the case of zero technical change is shown as the curve AB’, and the optimal solution as b. The effect of capital formation on the optimal consumption plan (in the absence of technical change) is represented by the notional jump from A to b, and the effect of technical change (including the effect of the induced capital accumulation) as the jump from b to a. The latter is the wealth effect of technical change much discussed in recent years, but note that it arises only from unexpected increases in the level of technology. Expected increases in technology are already embedded in the long-run consumption plan of the optimizer (that is, Ct is invariant to expected technical change).

    1.2.3 Implications of the Intertemporal Framework for Defining and Measuring Capital

    The simple intertemporal framework of figure 1.2 has an important implication for the treatment of intangible capital in a set of economic accounts. Figure 1.2 makes clear that any use of resources that reduces current consumption in order to increase it in the future (for example, the movement along AB from the point A on the horizontal axis to the optimal point a) qualifies as an investment. Figure 1.2 thus argues for symmetric treatment of all types of capital; that is, in national accounting systems, investments in knowledge capital should be placed on the same footing as that of investments in plant and equipment. This requirement is of rather broad scope. It includes all investments in human capital (not just outlays by government and not-for-profit institutions on education), research and development expenditures, and indeed any expenditure in which a business devotes resources to projects designed to increase future rather than current output, whether it is intangible or tangible.

    Financial accounting practice continues to ignore this principle, and national income and wealth accounting is only just beginning to incorporate it into practice. Of course, many practical difficulties arise in implementing the symmetry principle, and these difficulties are one reason that financial accountants prefer to expense intangibles. Much intangible capital investment occurs within the company, household, or government unit that has the intellectual property right to the capital, and no arm's-length valuation of the investment exists. Moreover, the appropriability of property rights and the spillover of externalities also present problems. However, practical difficulties do not invalidate the underlying theoretical principle of symmetry. From a conceptual standpoint, it does not matter at all whether an asset is self-constructed or not, nor does the presence of externalities or market pricing power matter in the theoretical framework of figure 1.2: the intertemporal utility function is based on the final result of the production process—consumption. The consumption possibility frontier Φ(·) incorporates all externality effects, monopolistic market structures, and self-constructed assets. No theoretical basis exists for treating one type of capital differently from another simply because one type is harder to measure accurately.

    Some of the practical difficulties will become apparent in section 1.3 of this paper, in which we attempt to estimate the magnitude of some of the main types of business intangible investments. However, before turning to this task, we will review some of the main implications of our theoretical analysis for national economic accounting.

    1.2.4 Implications of Symmetry for Economic Accounting

    The symmetry principle implies that the production function, as formulated in equation (1), is an incomplete representation of the production possibilities of an economy and must be expanded to accommodate the input and output of intangibles. Written in implicit form, the expanded production function can be expressed as

    where investment in intangibles is denoted by Nt; the accumulated stock of intangibles (adjusted for depreciation) is denoted by Rt; distinguishes it from the term in equation (1). The intertemporal production possibility frontier also must be reinterpreted in terms of the expanded concept of capital and correctly specified efficiency term.

    , is added to the left-hand side of the GDP identity, equation (4).

    , is added to the right-hand side of equation (4). When both the user cost value and the investment value of intangibles are included in GDP, the national accounting identity becomes

    refer exclusively to tangible capital, whereas the U.S. national accounts include some intangibles in Itdenotes the user cost of tangible capital input when intangibles are recognized as in equation (8). It differs from the corresponding user cost in equation (4), which may include income from intangible capital. The two user costs are connected by the expression

    , must be added to the conventional GDP identity in equation (4) to arrive at the correct expression in equation (8); this raises the issue of where this additional value of output should appear on the right-hand (income) side of equation (8).

    , appear on the income side of the accounts? The answer is that intangible investments are reflected as retained earnings that are uncounted in the conventional framework. Specifically, because intangibles are expensed in the conventional framework, they are subtracted from revenue to get earnings. Because intangibles would not be subtracted from revenue in the expanded framework, retained earnings are higher than in the conventional frame-work.⁹ Thus, the symmetry principle is not just about uncounted output, but also about uncounted income accruing to capital.

    . The rate of saving and investment and the relative shares of capital and labor in GDP are also affected. Labor's share in the old view is sL = (pLL)/(pLL + pKKwhen intangibles are recognized as asset. (For ease of exposition, time subscripts have been dropped, and the asterisk is used to denote the true income share.) The two shares are related by a factor of proportionality

    . Since both the old and new shares must sum to one, capital's income share must be larger when intangibles are recognized as being capital. Put differently, the new view includes the return to these forms of investment.

    , and the mismeasured share is sC = (pCC)/(pCC + pII. Consumption's share is smaller when intangibles are treated as capital, implying that the rate of saving and investment is correspondingly higher. This result is relevant in light of concerns about the low rate of saving in the U.S. economy: existing measures of saving exclude much of the investment in knowledge capital that defines the modern economy.

    1.3 The Scale of Business Investment

    In this section, we first identify and group the items commonly thought to represent private business spending on intangibles. We next review the available data sources and develop estimates of outlays on intangibles for three periods chosen to illustrate the growth in intangibles in the 1990s. The intertemporal model is then used to guide the determination of which (or what portion) of the items we have identified as business intangibles should be categorized as business fixed investment in national accounting systems.

    1.3.1 Identifying and Estimating Business Spending on Intangibles

    As illustrated in table 1.2, we group the various items that constitute the knowledge capital of the firm into three broad categories: computerized information, innovative property, and economic competencies. The table indicates, in general terms, what type of knowledge capital is included in each broad group and how each type is currently treated in the NIPAs.¹⁰ The major component of computerized information, computer software, already is included as business fixed investment. The other components, which include the knowledge acquired by businesses in their development of new or improved products, processes, or economic competencies, are not generally recognized as assets of the firm in the U.S. NIPAs or in other national accounting systems.

    Table 1.3 presents estimates of the size of outlays by businesses on these broad categories of intangibles. As indicated by the numbered rows of the table, these estimates have been built from nine types of intangible assets that have been identified and grouped according to our three basic categories. The table summarizes the availability of data that can be used to measure business spending on each item and then presents our spending estimates for the late 1990s, that is, from 1998 to 2000; spending rates for periods five and ten years earlier also are shown to help illustrate trends by detailed asset type during the decade.¹¹ In the discussion that follows, we review the data sources for each item and assess how the available information can be used to broaden measures of business investment to more fully encompass each of the categories of knowledge capital shown in table 1.2.

    Computerized Information

    Computerized information reflects knowledge embedded in computer programs and computerized databases. When computer software was recognized in the NIPAs in 1999, the move captured the estimated costs of software created by firms for their own use as well as purchases of prepackaged and custom software. The own-account estimates were developed from detailed occupational data on employment and wages in private industry, in conjunction with an estimate (50 percent) of the average time spent by individuals in the relevant occupations on software development (Parker and Grimm 1999). This method of estimating investment, though imprecise, is consistent with the framework of figure 1.2: Some uses of employee time (development) are investments, other uses are inputs to current production. Spending in this category thus reflects the current NIPA computer software estimates (which averaged more than $150 billion during 1998-2000) plus a small figure (about $3 billion) for computerized databases, an item not capitalized in the NIPAs. Spending on computerized databases is estimated from the Census Bureau's Services Annual Survey (SAS).

    The recognition in the NIPAs of computer software as investment generally has been met with acceptance and praise. During the work leading up to the introduction of software in the accounts in 1999 and in subsequent work by the BEA and others, important lessons have been learned about how to handle the possible double-counting from bundling of assets as well as issues related to own-account production.¹² Because intangibles are often bundled with fixed assets (e.g., Brynjolffson, Hitt, and Yang 2002) or constructed on own-account, the lessons learned from software should be quite valuable as efforts to measure other intangibles move

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