The importance of getting the statistics right – 2

Apropos my earlier posting (and the recent news that GDP grew rather than declined in the 1Q 4Q), the Upjohn Institute is hosting a conference today and tomorrow on another measure issue: Measuring the Effects of Globalization. Papers range from how we (mis)measure manufacturing to how we don’t measure intangibles — and are available on the website. As these papers show, once again, not getting the statistics right has policy implications.

The importance of getting the statistics right

This posting follows on my previous posting on interesting insights from the OECD Knowledge-Based Capital conference. In his presentation at the opening session, Steve Landefeld, Director of the US Bureau of Economic Analysis (BEA) raised a core question: does R&D (S&T) raise growth? Or put another way, do we know what drives economic growth?
Landefeld points out that the original formulation of the “technology” or “knowledge” portion of the growth equation was Solow’s residual. It was what was left over after capital and labor were accounted for. The label “technology” was hung on that residual. In reality, the residual includes many items not just S&T. After years of economic and statistical analysis, there is still 40% of the residual that we don’t understand (a point that Chuck Hulten also made in a later presentation). (For an overview, see also my 1998 paper, Technology and Economic Growth)
Landefeld pointed out the importance of trying to understand what drives growth — that 40% we don’t understand. Without that understanding, we can get policy (technology policy, tax policy, macroeconomic policy) wrong. One example is monetary targeting. He noted that if the monetary target is one half of 1% lower growth than is could be over the next ten years, this results in a cumulative reduction of $5.8 trillion in GDP, roughly the size of the hit on the value of household real estate assets during the housing crisis.
Let me explain that point further. The Federal Reserve is charged with setting monetary policy balancing two factors: economic growth/employment and inflation. The trade-off between the two was at center stage at the recent Congressional testimony by Fed Chairman Bernanke. Monetary targets are based on how fast the economy can growth without triggering inflation. That the potential non-inflationary growth rate of the economy — the “speed limit” as Alan Blinder called it a few decades ago — is based on productivity growth. If the productivity growth projections are off because we don’t understand what all the factors that drive productivity growth, then our monetary targets will be off. Nor — as I pointed out in that 1998 paper — can we design effective policies to raise productivity growth if we don’t understand all the factors.
Those factors are simple. They are all the investments in intangible assets that we have not been able to measure — either as inputs, outputs or impacts. Hence, getting the statistic right on intangible is not just an academic exercise. Without the right data, we are trying to navigate by looking in the rear view mirror. Always a dangerous activity.

UK technology targets

I’m catching up on the OECD’s Knowledge-Based Capital conference earlier this month (click here for the conference website including a link to the video of sessions). (Side note: this conference is part of the project that was kicked off at the conference on New Building Blocks for Economic Growth which Athena Alliance organized in 2011 – see our conference report, my conference observation paper, my “take-away” presentation and links to other documents including videos of Fed Chairman Ben Bernanke’s keynote address and the opening panel).
At the opening session, David Willetts, the UK Minister for Universities and Science spoke about the role of government. While he talked about the need to reduce regulations and making sure government doesn’t get in the way as befits a Conservative Party MP, he also argued for a positive role. In addition to funding support for R&D he mentioned was looking at the U.S. SBIR program, DARPA, use of procurement to promote specific technologies and the use of prizes.
But his focus was on helping technologies, not companies. In a paper published in January, Willetts outlined Eight Great Technologies that the UK should promote:
  • big data
  • satellites
  • robots and other autonomous systems.
  • synthetic biology.
  • regenerative medicine
  • agricultural technologies
  • advanced materials
  • energy storage.
These are not a random list of technologies but an interconnected set with one leading to the other. Satellites feed into “big data” which helps drive autonomous systems. Synthetic biology is the parallel to IT and is closely tied to regenerative medicine and agricultural technologies. Advanced materials is parallel to synthetic biology and energy storage is an application of advanced materials.
I do find the grouping a little strange in its mix of broad areas and specific applications (e.g. advanced materials and energy storage; big data and satellites/robots; synthetic biology and regenerative medicine/agriculture). An unstated strategy here appears to be to find a big area of research, explain why the UK can play in this area and then look for some application areas where the UK might have a competitive/commercial advantage.
It is interesting that Willetts includes a short set of scenarios that highlight different paths development of the technology could take. In the False Dawn, the technology never develops to commercial scale. Transmutation means it goes off in a different direction. Under Gone abroad the technology takes off elsewhere. It’s here but it isn’t ours means that there are companies in the UK reaping the benefits of commercialization but they aren’t UK owned companies. The more successful scenario is We have grown big new companies ala Rolls Royce and Vodafone where the UK is home to more top 500 companies. The final scenario is We are purveyors of R&D to the world where the UK is the world’s R&D lab.
It is also interesting to note that Willetts seems to be getting some push back from other conservatives. For example, a piece in The Spectator (“David Willetts looks back to the future for economic growth”) accused him of trying to revive failed policies of the past of picking winners and losers. Willett argues that the policy is one of picking general purpose technologies, not specific companies as in the past. There is even an explicit comparison to “Ronald Reagan’s Small Business Research Initiative.” But to these critics, the difference between picking companies and picking technologies is irrelevant.
We will have to see how this new technology strategy plays out politically in the UK. In any event, the technology list is interesting in and of itself.
By the way, the U.S. has been doing similar studies. One example that ties together many of the same technologies (IT, synthetic biology and materials) is the STPI Emerging Global Trends in Advanced Manufacturing report (see earlier posting for a summary).

From trade to economic harmonization

In last night’s State of the Union address, President Obama called for the start of negotiations on a Trans Atlantic Partnership — essentially a free trade agreement with the European Union. Interestingly, just hours before, the two top Senator’s with jurisdiction over trade matters sent the top trade negotiator a letter warning how difficult those talks would be. As reported in today’s Washington Post, the letter from Senate Finance Committee Chairman Max Baucus (D-MT)and ranking member Orrin Hatch (R-UT) outline the many difficult issues that the agreement would have to tackle, ranging from pharmaceutical testing to genetically modified foods to intellectual property protection. I could throw in a few they didn’t mention such as aerospace subsidies, tax havens and data privacy.
This list of issues illustrates a major point: trade talks aren’t about trade anymore, at least not the way we used to think about trade. These partnership agreements are about economic harmonization — having the same economic rules and regulations. There is lies the difficulty. Do the US and the EU really want the same regulations? Whose regulations are better?
As I’ve pointed out before, trade entered a new era in 1994 with the inclusion of TRIMS (Trade Related Investment Measures), TRIPS (Agreement on Trade-Related Aspects of Intellectual Property Rights) and GATS (General Agreement on Trade in Services) in the Uruguay Round. These moved trade negotiations past tariffs and at-the-border issue to internal economic and regulatory policies.
The problem with the shift to economic harmonization is that the old dynamics of negotiations don’t work. During my Senate staff career, I was involved in the beginning and the end of the Uruguay Round. When we finally passed the implementing legislation, I mused out loud that I thought this would be the last global round of trade negotiations. None of my colleagues agreed – and some of the old hands seemed taken aback at such heresy. They argued that you can only get an agreement by linking everything in a big package. (In diplomacy – this is known as “linkage.”)
Almost two decades later, I still think I am right. Linkage doesn’t work the way it used to. In previous negotiations, the focus was on tariff reduction. I’ll reduce my tariffs on steel if you reduce your tariffs on autos. This allowed for a win-win (from economists point of view) situation that pushed for lower and lower tariffs. Everyone agreed that the end point was lower tariffs. The question was how to get there.
In the new talks, it is unclear how the trade-offs work, and in what direction the dynamics points. I’ll lower my tariffs on steel if you increase your copyright protection to 100 years? I’ll allow you to subsidize your aircraft industry if you don’t ban my genetically-modified beef? I’ll decrease my agricultural subsidies if you reduce regulations on investment banking?
We don’t have any agreement on what the end point should be. We have a general idea – “open economies” – but we differ dramatically on what that means and on the specifics.
Thus my unease with large multi-issue, multilateral negotiations such at the Trans Atlantic Partnership. I’m not sure we understand the trade-offs any more. And I’m not sure what we really want to accomplish in any one specific area [less regulation on the financial sector or more regulation?]. Rather, as I’ve argued before, we may have to approach each of these economic regulatory issues separately – possibly in separate forums, such as the OECD and the G20. Yes, this being a negotiation, there will be linkage. But the complex web of links will not become so great as to bring the entire structure down. And it will allow all parties to clearly focus on a specific issue not the trade-offs — leading, one would hope to a better outcome.

Senators go after intangible transfer pricing issue

Yesterday, Senators Levin (D-MI) and Whitehouse (D-RI) introduced the Cut Unjustified Tax Loopholes Act (CUT Loopholes Act), S. 268 — see the press release, the bill summary and Senator Levin’s floor statement.
While the bill goes after a number of tax provisions, of special note is the provisions on intangible. As the bill summary states, one provision:

ends transfer pricing abuses by taxing immediately excess income to foreign affiliates receiving U.S. intellectual property, limiting income shifting through U.S. property transfers offshore, and tightening the rules related to the valuation of “goodwill” and other intangibles.

The bill is the outgrowth of hearings of the Permanent Subcommittee on Investigations, chaired by Senator Levin last year on “Offshore Profit Shifting and the U.S. Tax Code.”
While I’ve not yet see the exact text of the bill, those provisions sounds very similar to provisions that the Obama Administration has put forward in their previous budgets (see earlier postings). I expect that the forthcoming budget to once again include this provision.
The language and explanation of the 2012 Obama proposals from the Treasury Department is as follows:

Current Law
Section 482 authorizes the Secretary to distribute, apportion, or allocate gross income, deductions, credits, and other allowances between or among two or more organizations, trades, or businesses under common ownership or control whenever “necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.” The regulations under section 482 provide that the standard to be applied is that of unrelated persons dealing at arm’s length. In the case of transfers of intangible assets, section 482 further provides that the income with respect to the transaction must be commensurate with the income attributable to the transferred intangible assets.
In general, the subpart F rules (sections 951-964) require U.S. shareholders with a 10- percent or greater interest in a controlled foreign corporation (CFC) to include currently in income for U.S. tax purposes their pro rata share of certain income of the CFC (referred to as “subpart F income”), without regard to whether the income is actually distributed to the shareholders. A CFC generally is defined as any foreign corporation if U.S. persons own (directly, indirectly, or constructively) more than 50 percent of the corporation’s stock (measured by vote or value), taking into account only those U.S. persons that own at least 10 percent of the corporation’s voting stock.
Subpart F income consists of foreign base company income, insurance income, and certain income relating to international boycotts and other proscribed activities. Foreign base company income consists of foreign personal holding company income (which includes passive income such as dividends, interest, rents, royalties, and annuities) and other categories of income from business operations, including foreign base company sales income, foreign base company services income, and foreign base company oil-related income.
A foreign tax credit is generally available for foreign income taxes paid by a CFC to the extent that the CFC’s income is taxed to a U.S. shareholder under subpart F, subject to the limitations set forth in section 904.
Reasons for Change
The potential tax savings from transactions between related parties, especially with regard to transfers of intangible assets to low-taxed affiliates, puts significant pressure on the enforcement and effective application of transfer pricing rules. There is evidence indicating that income shifting through transfers of intangibles to low-taxed affiliates has resulted in a significant erosion of the U.S. tax base. Expanding subpart F to include excess income from intangibles transferred to low-taxed affiliates will reduce the incentive for taxpayers to engage in these transactions.
The proposal would provide that if a U.S. person transfers (directly or indirectly) an intangible from the United States to a related CFC (a “covered intangible”), then certain excess income from transactions connected with or benefitting from the covered intangible would be treated as subpart F income if the income is subject to a low foreign effective tax rate. In the case of an effective tax rate of 10 percent or less, the proposal would treat all excess income as subpart F income, and would then phase out ratably for effective tax rates of 10 to 15 percent. For this purpose, excess intangible income would be defined as the excess of gross income from transactions connected with or benefitting from such covered intangible over the costs (excluding interest and taxes) properly allocated and apportioned to this income increased by a percentage mark-up. For purposes of this proposal, the transfer of an intangible includes by sale, lease, license, or through any shared risk or development agreement (including any cost sharing arrangement)). This subpart F income will be a separate category of income for purposes of determining the taxpayer’s foreign tax credit limitation under section 904.
The proposal would be effective for transactions in taxable years beginning after December 31, 2012.
Current Law
Section 482 authorizes the Secretary to distribute, apportion, or allocate gross income, deductions, credits, and other allowances between or among two or more organizations, trades, or businesses under common ownership or control whenever “necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.” Section 482 also provides that in the case of transfers of intangible assets, the income with respect to the transaction must be commensurate with the income attributable to the transferred intangible assets. Further, under section 367(d), if a U.S. person transfers intangible property (as defined in section 936(h)(3)(B)) to a foreign corporation in certain nonrecognition transactions, the U.S. person is treated as selling the intangible property for a series of payments contingent on the productivity, use, or disposition of the property that are commensurate with the transferee’s income from the property. The payments generally continue annually over the useful life of the property.
Reasons for Change
Controversy often arises concerning the value of intangible property transferred between related persons and the scope of the intangible property subject to sections 482 and 367(d). This lack of clarity may result in the inappropriate avoidance of U.S. tax and misuse of the rules applicable to transfers of intangible property to foreign persons.
The proposal would clarify the definition of intangible property for purposes of sections 367(d) and 482 to include workforce in place, goodwill and going concern value. The proposal also would clarify that where multiple intangible properties are transferred, the Commissioner may value the intangible properties on an aggregate basis where that achieves a more reliable result. In addition, the proposal would clarify that the Commissioner may value intangible property taking into consideration the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative to the controlled transaction undertaken.
The proposal would be effective for taxable years beginning after December 31, 2012.

What I want to hear in the State of the Union – 2013 edition

According to press reports, the President’s State of the Union address on Tuesday will focus on the economy and the middle class. Pundits are noting the difference with Obama’s Inaugural Address, but I would point out the different purpose of each occasion. I would point out that the State of the Union usually includes economic issues, as the economy is a major part of the state of the union.
Last year’s State of the Union also focused on the economy. Before that speech, I pointed out what I would like to hear in the President’s remarks. Here is an updated version:

America is coming back from a devastating economic recession. The recovery of the economy is taking hold. But our job is not done yet. Recovery must be followed by sustained growth and improved economic competitiveness.
We’ve faced this challenge a number of times before. And every time, America has risen to the occasion. But confronting today’s economic challenges requires understanding what is different about our economy today — and crafting tools that fit this new environment in which we find ourselves.
Today, while manufacturing is coming back to the United States, it is different from the manufacturing that left our shores. It is leaner and smarter — requiring higher levels of workers skills. To keep our competitive edge requires fostering an educational enterprise that can provide the constantly changing skills required in a knowledge- and information-intensive economy.
We now see the fusion of manufacturing and services where companies provide solutions not just products. Customization, speed, and responsiveness to customer needs are the keys to success in this new environment. And as the linkage between goods and services grows, we are seeing international competition in services once thought immune to such challenges.
In confronting these new challenges, we cannot rely on simply repeating the policies of the past. We need a combination both new and old solution.
For example, basic research helped sustain America’s economy growth in the 20th Century. But basic research is not enough. It is one part of a larger mix that fuels the economy. We moving to a post-scientific economy where, to quote Dr. Christopher Hill, former Vice Provost for Research at George Mason University, “the creation of wealth and jobs based on innovation and new ideas will tend to draw less on the natural sciences and engineering and more on the organizational and social sciences, on the arts, on new business processes, and on meeting consumer needs based on niche production of specialized products and services in which interesting design and appeal to individual tastes matter more than low cost or radical new technologies.”
Education needs to move from the classroom to the living room. Life-long learning should not be a slogan but an ingrained part of everyday life. And as important as STEM is, our economic future is not solely in the hands of our scientists and engineers. Our future prosperity rest on raising the skills and knowledge level of everyone. Productivity no longer comes just from new machines, but from new ways of organizing work. And as Professor Jamie Galbraith once said “American competitiveness depends at least as much on style, design, creativity and art – and especially on the liaison between technology and art.”
And let us be clear. The manufacturing jobs of our father and grandfather are not coming back. But we can create the manufacturing jobs for our children and grandchildren. We cannot — we will not — compete on the basis of a race to the bottom where wages and living standards are lowered to keep jobs from moving elsewhere. We can – and will — compete based on raising the knowledge content of our products — both goods and services.
Government can play a major role in innovation and the development and diffusion of new products. But, innovation policy needs to catch up to the innovation process.
In crafting a new policy, we must recognize three points:
 • the innovation model has changed,
 • it’s all about people and organizations, and
 • technology plays multiple roles.
First, we all need to recognize that the innovation model has changed. It is not the linear process of flowing from basic research to final product that sticks in everyone mind. It is a network process. There are many points on the network where innovation can come from. We have used a number of terms to try to describe parts of the new model: “open innovation,” “user-driven innovation,” and even “design thinking.”
It is also not solely about technology. Technology remains an important component. But, as noted earlier, social innovations, marketing, finance, design and business models are also key sources of innovation as well.
Suffice it to say that innovation policy needs embraced this broader concept.
Second, innovation is about people and organizations. Skills, not just education, are critical. Likewise, both tacit and experiential knowledge, not just codified and science-based knowledge, are also important. In order to put those skills and knowledge to proper use, organizational structure comes into play. The old hierarchical systems of the industrial age are no longer adequate or appropriate. New adaptive organizations which encourage innovation are needed. What we use to be called “High Performance Work Organizations” are needed to effectively utilize worker skills and knowledge.
Finally, any innovation policy needs to understand that there are multiple roles for technology. Technology can be a driver of innovation, a tool of innovation, and even sometimes not all that that relevant to innovation. As a driver, the creation of new technology is a major source of innovation – the kind we normally think of when we use the word “innovation.”
But technology is also a tool in the innovation process. Technology as innovation tool works in two ways. One is innovation as the absorption and utilization of technology. For example, the iPod contained no new technology. It utilized the technology in a new way. The other is technology as an enabler. This is especially true in the information technology (IT) area, where IT allows for a myriad of new applications and innovations.
Take the analogy of the railroad. The marrying of the steam engine to a carriage on iron rails brought about far reaching changes in many difference areas. The railroads spurred on development of a number of other industries, most notably the steel industry. They changed opened up vast new markets and changed the retail and wholesale industries. They even gave rise to new management practices and the shift from ownership capitalism to managerial capitalism.
And sometimes technology plays a very minor role in innovation, if at all. Which was more important in creating the American suburbs: the automobile, Levittown or the 30 year mortgage? One was technological; one was design; one was financial. All were important. As a nation we need to recognize and promote multiple forms of innovation.
So here are some policies I plan to put forward. The new demand driven model innovation shows that government procurement and regulations can drive innovation. Government as a demanding customer can create the “thin opening wedge” — new products and services that have a specialized use. Once that specialized use is established, the product or service can be refined and adopted to a broader customer base. The demanding customer in fact becomes a co-creator. Smart regulations can serve the same function by creating demanding customers.
Here is another example of how we can expand our thinking on innovation. We have a program to create and fund Engineering Research Centers (ERCs) in a number of areas. We should create one for design thinking. We should expanding the ERC model to funding research on and demonstration of new business methods and organizational mechanisms as part of our “Catalyze Breakthroughs for National Priorities” element of the innovation strategy. And we should fund more organizationally-focused challenges, such as the famous DARPA “Red Balloon” challenge.
These are but few of the types of new policies we will pursue — beyond the status quo and conventional thinking that government should confine itself to basic research, education and infrastructure. That might be uncomfortable for some to hear. But it is where we need to go if we are to restore long term economic prosperity in this highly competitive global economy.

December trade in intangibles – and annual

Remember that big jump in the trade deficit for November that BEA reported last month? Well, things might have been a little better than normal in December. This morning, the BEA said the December trade deficit was $38.5 billion (compared to November’s revised figure of $48.6 billion). Exports were up by $3.9 billion over November and imports down by $6.2 billion. The best part of this news is that the December deficit was the smallest all year and the goods deficit was the smallest all year at $56.2 billion. In fact, it is the smallest deficit in almost 3 years: January 2010 was smaller. In fact, other than the dramatic decline of the trade deficit in the summer of 2009 at the height of the Great Recession, one has to go back to 2002 to find sustained deficits as low. The improvement in the deficit was due in large part to a decrease in the petroleum trade deficit (see chart below). The deficit in non-petroleum goods returned to it more normal level after surging in November.
By the way, the November revisions and the better than expected December report will likely cause a major revision upward in the 4th quarter GDP number released last week. Economists estimates for the trade deficit ranged from $42.3 billion to $48 billion.
For the year, the overall trade deficit was down slightly to $540.4 billion compared to $560 billion in 2011 but substantially up from the $494.7 billion deficit in 2010.
Our trade surplus in intangibles also improved in December (it has actually dropping in November). Exports of business services rose faster than the increased import, resulting is a higher surplus in business services. However, royalty payments (imports) great faster than royalty receipts (exports), so the surplus in royalties was down slightly. As a result, our overall surplus in intangibles grew by $157 million to $14.5 billion.
A dramatic drop in the Advanced Technology Products (ATP) deficit also helped. The ATP deficit declined to just under $5.4 billion in December — a drop of over half from November’s almost $11.8 billion. A large decrease in information & communications technology imports and an increase in aerospace exports accounted for much, but not all, of the improvement. The last monthly surplus in Advanced Technology Products was in June 2002 and the last sustained series of monthly surpluses were in the first half of 2001.
Intangibles trade-Dec12.png
Intangibles trade-2012.png
Intangibles and goods-Dec12.png
Intangibles and goods-2012.png
Oil good intangibles-Dec12.png

Note: we define trade in intangibles as the sum of “royalties and license fees” and “other private services”. The BEA/Census Bureau definitions of those categories are as follows:

Royalties and License Fees – Transactions with foreign residents involving intangible assets and proprietary rights, such as the use of patents, techniques, processes, formulas, designs, know-how, trademarks, copyrights, franchises, and manufacturing rights. The term “royalties” generally refers to payments for the utilization of copyrights or trademarks, and the term “license fees” generally refers to payments for the use of patents or industrial processes.

Other Private Services – Transactions with affiliated foreigners, for which no identification by type is available, and of transactions with unaffiliated foreigners. (The term “affiliated” refers to a direct investment relationship, which exists when a U.S. person has ownership or control, directly or indirectly, of 10 percent or more of a foreign business enterprise’s voting securities or the equivalent, or when a foreign person has a similar interest in a U.S. enterprise.) Transactions with unaffiliated foreigners consist of education services; financial services (includes commissions and other transactions fees associated with the purchase and sale of securities and noninterest income of banks, and excludes investment income); insurance services; telecommunications services (includes transmission services and value-added services); and business, professional, and technical services. Included in the last group are advertising services; computer and data processing services; database and other information services; research, development, and testing services; management, consulting, and public relations services; legal services; construction, engineering, architectural, and mining services; industrial engineering services; installation, maintenance, and repair of equipment; and other services, including medical services and film and tape rentals.