Treating intangibles as an investment in GDP – and next steps

The advanced estimate of GDP for the 2nd quarter of 2013 is out — and it surprise everyone by showing a 1.7% growth rate. Economist had expected the growth rate to be less that 1% (as was noted yesterday in the New York Times and the Wall Street Journal). Revisions to previous data also showed the economy was stronger that we thought.
The big news, from our perspective however, is the changes to the way GDP is calculated. There are a number of technical fixes (e.g. how pensions are accounted for) also being applied. But the most important is the treatment of spending on two intangibles: R&D and “creative works” — which will be treated as an investment rather than an immediate expense (see earlier posting). This means that for purposes of calculating the size of the economy, this spending will be depreciated over a number of years just like spending on plant and equipment. As BEA explains:

Expenditures by business, government, and nonprofit institutions serving households (NPISH)for research and development (R&D) are recognized as fixed investment. The new treatment improves BEA’s measures of fixed investment and allows users to better measure the effects of innovation and intangible assets on the economy.
Similarly, expenditures by private enterprises for the creation of entertainment, literary, and artistic originals are recognized as fixed investment, further expanding BEA’s measures of intangible assets.

(For more background, see the BEA article “Toward Better Measurement of Innovation and Intangibles
Peter Coy sums up the change in his BusinessWeek article “The Rise of the Intangible Economy”:

Steering a $16 trillion economy with the aid of historical GDP data is like driving a car while looking in the rearview mirror. But if that’s what policymakers must do–and it is–they need to make sure that the view to the rear is as clear as possible. That’s the purpose of recognizing R&D and artistic originals as investments, and bringing the national accounts more closely in line with the way the economy works and businesspeople think. Is it perfect? No. But better to be imprecisely correct than precisely incorrect.

With companies now spending more on intangibles than tangibles and with intangible assets making up most of the value of companies, it only make sense that we start treating intangibles as the investment they are. As Federal Reserve Board Chairman Ben Bernanke noted at a May 2011 Athena Alliance event, “We will be more likely to promote innovative activity if we are able to measure it more effectively and document its role in economic growth.”
Much of the press attention has been on the creative works part of the equation (see “Seinfeld Bests Kardashians as U.S. Recalculates GDP” on Bloomberg and “Getting creative with the GDP” in the New York Times). But the more important part is the treatment of R&D as an investment. This has two important aspects. One is that more data on R&D will be included, specifically as BEA notes, “a new category of investment, ‘intellectual property products,’ consists of research and development; entertainment, literary, and artistic originals; and software.” (This category grew by 3.8% in the last quarter.) The other is the change in mindset. BEA has actually been calculating GDP treating R&D as an investment for some time in a so-called “satellite” account. Now this recognition of R&D as an investment has gone mainstream.
Next steps
Recognition that R&D is an investment is mainstream in macro-economic, that is. There is, however, another data driven profession that still refused to count R&D as an investment: accounting. And those U.S. accounting rules may be creating a barrier to and distorting company R&D activities.
Under U.S. Generally Accepted Accounting Practices (GAAP), company research and development expenditures are considered expenses. They are treated as day to day operating costs, similar to workers’ wages or the electricity bill. As such, when it comes time to calculate the company’s profit, these expenses are subtracted directly from the bottom line. The higher the spending on R&D, the lower the profit.
However, if you allow for R&D spending to be treated as an investment (as now with GDP), then costs are apportioned over a number of years. Known as capitalization as it treats the spending as a form of capital improvement rather than an immediate cost. As a result, the immediate expense is lower and profits are recorded as higher.
To complicate matters, internal R&D spending is treated differently than R&D acquired from outside. If a company spends $1 million to develop a new technology, that is counted as an immediate expense. If a company spends $1 million to buy another company to acquire that technology, it is counted as an investment and must be capitalized. From an accounting point of view, this process may make sense because an internal expense is different from an acquisition. However, from an operating perspective, this difference between R&D expensing and R&D capitalization can be profound.
There are two possible problems: a decrease in R&D spending (a “lock up” effect) and a distortion of R&D spending toward acquisition versus internal R&D (the “balance” issue). The lock-up effect occurs when a company is hesitant to spend funds on R&D for fear of lowering reported profit — and thereby having a negative impact on shareholder value. The case of the stock market’s reaction to the divergent paths of Pfizer and Merck is a illustration of how increased R&D can be viewed by investors as a negative. This effect may be more pronounced for the small to medium sized (mid-capitalized) companies where stock analysts may not have the time to dig far beyond the profit and loss statements.
The balance issue affects where R&D takes place and who is making the research decisions. If acquired R&D is treated more favorable from a shareholder’s perceptive, there may be incentives created for existing companies to acquire technology from outside the company rather than development the technology in-house. Because of that incentive, the decision (consciously or unconsciously) regarding to what research is undertaken may not be made on the nature of the research but rather by who does it. For example, a company may decide not to pursue a certain line of research because it would have to be done in-house. Instead the company may wait to see what is developed externally and then seek to acquire that technology.
The balance issue may also impact the financial situation of startup companies. Startups are not well capitalized and are not in the position to acquire R&D from others. While startups may have access to R&D from universities and other public-private platforms funded by R&D activities flowing from the government or corporations, it is typical that a new, small business is creating their own R&D internally. As a result of the accounting rules, the smaller company which is reliant on internal R&D may be disadvantaged in the capital markets because of an appearance of lower profitability.
All of this has serious implications for the interaction between startups and existing companies — and the dynamics of the innovation process. Ideally, research decisions should not be biased one way or the other; the rules should be balanced or neutral between internal and external R&D. If a bias is to exist, there should be a solid public policy reason for that externally imposed bias. There may be good policy reasons to encourage the start-up/acquisition model of R&D over the in-house R&D model. But the possible existing bias toward acquisition due to the account rules exists because of historical circumstances, not a deliberate policy choice.
It is time to look more carefully at this issue to see whether the way in which account rules treat R&D (and intangibles in general) have become an impediment to innovation. And we need to ask a fundamental question: if we can treat research as an investment in our national accounts, why can’t we do the same in our company accounts?

G-20 plan calls for growth and investment

As noted briefly in yesterday’s posting, one of the big press take-ways from the G-20 meeting last weekend was a switch in orientation from austerity to growth. According to the G20 Labour and Employment and Finance Ministers’ Communiqué, “all the G20 economies are facing challenges in terms of productivity, jobs, skills, training, working conditions, and living standards.”
The Communiqué goes on to describe general policies for confronting those challenges. For example, it states:

We commit to reinforce our efforts to target investments in the employment programs, life-long learning and labour activation programs that increase youth employment, address the problems of long-term unemployed/underemployed workers, and help increase the labour force participation of the groups that face specific labour market barriers. The measures should be combined with appropriate macroeconomic and labour policies to ensure decent work, and broad-based increases in productivity. We commit to implement policies that foster innovation, enhance the skill supply, improve labour market mobility, and reduce informality.

It also addresses social protection, however.

We have a strong commitment to achieving higher productivity and improving living standards through appropriate macroeconomic and labour market policies. Investments in human capital and adequate social protection are central to our agenda. We recognize the importance of establishing nationally determined social protection floors, and of modernizing the social protection systems to raise their coverage, effectiveness, efficiency, adequacy, and sustainability. Our social protection policies should incentivise work for those who are able, supporting them to find and stay in employment.

Later on it addresses SMEs: “Given the high relevance of long-term investment for growth and employment, we support measures to provide better access to financing sources, including for small and medium-sized enterprises, tailored to national circumstances.”
The same themes are echoed in the G20 Finance Ministers and Central Bank Governors Communiqué. While both Communiqués also talk about structural reform, the G-20 is clearly calling for an investment-led growth strategy. Let see if the U.S. can implement such a strategy as well.

Will G20 support of OECD report on tax modernization (that highlights intangibles) spur action?

Last Friday and Saturday, two sets of top finance officials and labor policy officials from the G-20 countries meet in Moscow in preparation for the big September summit. The meetings covered a number of topics, with the top news item being a call for growth over austerity (see WSJ and Bloomberg News). But also, as expected, leaders from the G-20 countries adopted the OECD Action Plan on Base Erosion and Profit Shifting (BEPS) dealing with corporate taxation. According to the G20 Finance Ministers and Central Bank Governors Communiqué:

Ensuring that all taxpayers pay their fair share of taxes is a high priority in the context of fiscal sustainability, promoting growth, and the needs of developing countries to build capacity for financing development. Tax avoidance, harmful practices and aggressive tax planning have to be tackled. The spread of the digital economy also poses challenges for international taxation. We fully endorse the ambitious and comprehensive Action Plan submitted at the request of the G-20 by the OECD aimed at addressing base erosion and profit shifting (BEPS) with a mechanism to enrich the Plan as appropriate. We welcome the establishment of the OECD/G20 BEPS project and encourage all interested countries to participate. We look forward to regular reporting on the development of proposals and recommendations to tackle the 15 issues identified in the Action Plan and commit to take the necessary individual and collective action with the paradigm of sovereignty taken into consideration. We acknowledge that effective taxation of mobile income is one of the key challenges. Profits should be taxed where functions driving the profits are performed and where value is created. In order to minimize BEPS, we call on member countries to examine how our own domestic laws contribute to BEPS and to ensure that international and our own tax rules do not allow or encourage multinational enterprises to reduce overall taxes paid by artificially shifting profits to low-tax jurisdictions.

In addition to the general issue of shifting worldwide income to low tax jurisdiction, the OECD Action Plan key in on specific issues of the Intangible Economy:

The digital economy is characterised by an unparalleled reliance on intangible assets, the massive use of data (notably personal data), the widespread adoption of multi-sided business models capturing value from externalities generated by free products, and the difficulty of determining the jurisdiction in which value creation occurs. This raises fundamental questions as to how enterprises in the digital economy add value and make their profits, and how the digital economy relates to the concepts of source and residence or the characterisation of income for tax purposes. At the same time, the fact that new ways of doing business may result in a relocation of core business functions and, consequently, a different distribution of taxing rights which may lead to low taxation is not per se an indicator of defects in the existing system. It is important to examine closely how enterprises of the digital economy add value and make their profits in order to determine whether and to what extent it may be necessary to adapt the current rules in order to take into account the specific features of that industry and to prevent BEPS.

The report goes on to describe the problem:

In 1998,the OECD issued a report (OECD, 1998) on harmful tax practices in part based on the recognition that a “race to the bottom” would ultimately drive applicable tax rates on certain mobile sources of income to zero for all countries, whether or not this was the tax policy a country wished to pursue. Agreeing to a set of common rules may in fact help countries to make their sovereign tax policy choices. The underlying policy concerns expressed in the 1998 Report as regards the “race to the bottom” on the mobile income tax base are as relevant today as they were 15 years ago. However, the “race to the bottom” nowadays often takes less the form of traditional ringfencing and more the form of across the board corporate tax rate reductions on particular types of income (such as income from financial activities or from the provision of intangibles).

In other words, the creation of “patent boxes” can lead to a “race to the bottom.” However, the focus of the action item in this area is the differential tax treatment of financial activities — not on the patent box.
One of the action items in the report does specifically addresses transfer pricing of intangibles:

Action 8 – Intangibles
Develop rules to prevent BEPS by moving intangibles among group members. This will involve: (i) adopting a broad and clearly delineated definition of intangibles; (ii) ensuring that profits associated with the transfer and use of intangibles are appropriately allocated in accordance with (rather than divorced from) value creation; (iii) developing transfer pricing rules or special measures for transfers of hard-to-value intangibles; and (iv) updating the guidance on cost contribution arrangements.

According to Bloomberg, Treasury Secretary Lew endorsed the Action Plan. And Senator Carl Levin, who has been investigating the tax avoidance issue for some time, praised the report. But to date, I have seen no reaction from the Congressional tax writing committees.
As I have note many time before, transfer pricing for intangibles is a long standing problem. Both the Obama Administration and Congressman Dave Camp, the Chairman of the House Committee on Ways & Means have included proposals to address the issue in their respective tax packages (see earlier postings). The OECD has an ongoing project on transfer pricing of intangibles. And over a year ago, the anti-tax haven group known as the Task Force on Financial Integrity called for stricter accounting rules on transfer pricing, among other reforms (see the Economist “Avoiding tax: Havens above”).
Tightening up the transfer pricing rules will help. But there will always be people trying to find ways around the rules. It may be that a carrot and stick approach is called for. In our Intangible Asset Monetization report, I suggested that we should explore lowering the tax rate on intangible asset royalties, in conjunction with stricter regulations on international transfer-pricing mechanisms and cost-sharing arrangements and on passive investment companies:

Providing a more direct tax incentive to the licensing of intangibles by lowering the rate on intangible asset royalties, such as to the capital gains rate, is a more controversial proposal. This lower rate could be crafted to apply only to royalties for new licenses for a limited time, such as a sliding scale for three years. In crafting such an incentive, safeguards would need to be established to prevent the incentive from being used for simply transferring existing licenses to SPEs and to ensure that the incentive went to new licensing activities only.
In conjunction with such a tax incentive, the problem of tax havens should be addressed. Transfer pricing mechanisms and cost sharing arrangements need to prevent those transfers that, as the IRS describes, are “for inadequate consideration.” The issue (some would say the abuse) of “passive investment companies” should also be handled.
The notion of tax havens and loopholes is often a matter of perspective. One person’s loophole is another person’s incentive. However, there is a growing concern that the tax code has become overly complex and that rates could be lowered in conjunction with the elimination of certain specific provisions. Any such tax reform, including the possibility of closing loopholes currently applied to intangibles and lowering the tax rate on royalties, should be looked at very carefully in the context of the impact on the creation and utilization of intangible assets.

As I’ve noted before, the idea of a lower tax rate on patent royalties — the “patent box” — has gained acceptance in a number of countries. The rate and what constitutes “qualifying income” vary from country to country. For example, some countries allow a lower rare for income from copyrights as well as patents.
My recommendation is a version known as the Dutch “innovation box.” The Dutch innovation box is an expanded version of their earlier patent box to include credit for the outcome of research activities that have not yet resulted in a patent (referred to as a “technology intangible asset”). The tricky part is determining the amount of what income qualifies as income from a technology intangible asset. The Dutch use transfer pricing mechanisms negotiated with the tax authority. In their more limited patent box, Luxembourg uses a royalty approach assuming the income that the taxpayer would have earned if it had licensed the right to use the patent to a third party. The UK is using a “qualifying residual profit” formula for its new patent box. By the way, the UK took a year of consultations to come up with its method. And the methodology is so complicated that the UK is making their system optional – i.e. a company can elect to apply for the lower rate but are not required to go through the calculation if they don’t feel it is worth the effort.
But I would also tie the lower tax rate to domestic production. This could be done through a domestic production bonus provision where an even lower tax rate is applied to companies where over 50% of the royalty income comes from products manufactured in the US. The rate could even be on a sliding scale depending on the amount of domestic production.
The reason for such a provision goes back to the underlying goal. The public policy goal here is to promote more innovation and the utilization of that innovation (via production using that innovation) in the United States. This creates jobs and economic growth. A secondary goal is to capture the revenues from the income generated by that innovation and production activity. Tax policy should be crafted to provide an incentive to undertake innovation and production in the United States while creating a disincentive to move that activity elsewhere.
Maybe the G-20 support for the OECD Action Plan will help make sure the issue is addressed in the upcoming tax reform debate here in the United States.

Dani Rodrik on sources of growth

I recently came across Dani Rodrik’s piece on The Past, Present, and Future of Economic Growth. As the introduction notes:

The paper emphasizes two key dynamics behind growth. The first is the development of fundamental capabilities in the form of human capital and institutions. Long-term growth ultimately depends on the accumulation of these capabilities–everything from education and health to improved regulatory frameworks and better governance (Acemoglu and Robinson 2012; Allen and others2013; Behrman and Kohler 2013). But fundamental capabilities are multidimensional, have high set-up costs, and exhibit complementarities. Therefore, investments in them tend to yield paltry growth payoffs until a sufficiently broad range of capabilities has already been accumulated–that is, until relatively late in the development process. Growth based on the accumulation of fundamental capabilities is a slow, drawn-out affair.
The second is structural transformation–the birth and expansion of new (higher-productivity) industries and the transfer of labor from traditional or lower-productivity activities to modern ones. With the exception of natural-resource bonanzas, extraordinarily high growth rates are almost always the result of rapid structural transformation, industrialization in particular. Growth miracles are enabled by the fact that industrialization can take place in the presence of a low level of fundamental capabilities: poor economies can experience structural transformation even when skills are low and institutions weak. This process helps explains the rapid take-off of East Asian countries in the postwar period, from Taiwan in the late 1950s to China in the late 1970s.
The policies needed to accumulate fundamental capabilities and those required to foster structural change naturally overlap, but they are distinct. The first types of policies entail a much broader range of investments in skills, education, administrative capacity, and governance; the second can take the form of narrower, targeted remedies. Without some semblance of macroeconomic stability and property rights protection, new industries cannot emerge. But a country does not need to attain Sweden’s level of institutional quality in order to be able to compete with Swedish producers on world markets in many manufactures. Furthermore, as I discuss below, fostering new industries often requires second-best, unconventional policies that are in tension with fundamentals. When successful, heterodox policies work precisely because they compensate for weakness in those fundamentals.

In other words, you need to work on both the fundamentals and the transformation of the economic structure. Both require attention to intangible assets. The fundamentals consist of a nation’s intangible assets, such as the institutional framework and the level of human capital. Structural transformation once meant switch from human and animal energy to mechanical energy. It now means switching from physical capital to knowledge capital.
But even the earlier industrial revolution was driven by intangible assets. As Rodrik points out:

Parts of the world that proved receptive to the forces of the Industrial Revolution shared two advantages. First, they had a large enough stock of relatively educated and skilled workers to fill up and run the new factories. Second, they had sufficiently good institutions–well-functioning legal systems, stable politics, and restraints on expropriations by the state–to generate incentives for private investment and market expansion. With these preconditions, much of continental Europe was ready to absorb the new production techniques developed and applied in Britain. Elsewhere, industrialization depended on “importing” skills and institutions.
. . .
International trade induced industrial countries to keep investing in skills, technology, and other drivers of economic growth. It also encouraged families to have fewer children and to educate them more, in light of the high returns to skills that modern manufacturing industries brought. These effects were reversed in the developing countries of the periphery. Specialization in primary commodities did not encourage skill accumulation, and it delayed the reduction in fertility and population growth: birth rates remained high in the developing world well into the 20th century, unlike in the industrialized countries, which experienced sharp declines in fertility toward the end of the 19th century. In the words of economists Oded Galor and Andrew Mountford (2008), commodity-exporting countries gave up productivity in exchange for population. Developing countries are still trying to break free of the long-term consequences of this division of labor. That escape is possible was shown by the experience of the first non-Western country to industrialize before 1914: Japan.

He goes on to stress the importance of the transformation:

Poor economies are not shrunk versions of rich economies; they are structurally different. This key insight of old-fashioned development economics is often forgotten when modern growth theory is applied to developing economies. Developing countries are characterized by large structural gaps in productivity between traditional and new economic activities. Hence the essence of development is structural change, which entails moving workers from traditional, low-productivity activities to modern, high-productivity activities that are quite different in terms of location, organization, and technological characteristics. Rapidly growing countries are better at removing the bottlenecks that impede this transformation.

I would add a very important point here: transformation is an ongoing process. Yesterday’s “new economic activities” are tomorrow’s “traditional, low productivity activities”. The bar is constantly begin raised and the process of creative destruction continues.
The paper has more to say, especially about the historic and current role of manufacturing as a driver of growth and the role of government intervention (including both government and market failures). He is more sanguine about deindustrialization than I am. Although he notes that while the a shift to tradable services has worked for Hong Kong, the process has not worked well in the US or UK.
I will end with his final prognosis:

In the long run, convergence with wealthy economies requires the accumulation of human capital and the acquisition of high-quality institutions. But the quickest way to become rich is to deploy policies that help build modern industries that employ an increasing share of the economy’s labor resources. Policies of this type overlap with policies needed to build up fundamental capabilities, but they are not one and the same, and they often diverge significantly. An excessive focus on “fundamentals” may slow growth if it distracts policy makers from resorting to the (often unconventional) policies of structural transformation required to get modern industries off the ground. Similarly, excessive focus on industrialization may set the economy up for an eventual downfall if the requisite skills and institutions are not built up over time.

It all comes down to fostering your intangible assets.

June's employment data

The June employment numbers are out with 195,000 net new jobs and the unemployment rate at 7.6%. This is somewhat better than expected. Economist surveyed by Bloomberg and the Wall Street Journal expected a growth of 160,000 to 165,000 jobs with the unemployment rate dropping slightly to 7.5%.
The trend in involuntary underemployed (part-time for economic reasons) — which represents a waste of human capital — as more interesting. Part-time work stayed basically the same. But slack work grew substantially. This is a worrisome trend as it indicated a slowing of demand.
The number of involuntary underemployed spiked at the onset of the Great Recession and has stayed at a historically high rate with only a slight downward trend (as the chart below shows).
Involuntary underemployed June 2013.png

May trade in intangibles

Today’s trade data from BEA continues to point to a mixed economy, at least as of a couple of months ago. The deficit grew by $4.9 billion to $45.0 billion in May. Falling back into a bad habit, exports were down while imports were up. And although the deficit in petroleum goods increased, the deficit in non-petroleum goods grew by a larger amount. So it looks like a re-run of the old story of US demand (imports) feeding a slower world economy.
And the same song repeats for our pure intangibles trade surplus. Exports of business services rose slightly more than imports and royalty receipts (exports) rose slightly more than royalty payments (imports). As a result, the intangibles surplus grew slightly by $144 million in May to $15.7 billion
The deficit in Advanced Technology goods also had a very slight improvement after last month’s huge surge. The May deficit was down to $7.1 billion in May from almost $7.9 billion in April. 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.
Advanced Technology goods also represent trade in intangibles. These goods are competitive because their value is based on knowledge and other intangibles. While not a perfect measure, Advanced Technology goods serve as a good approximation of our trade in embedded intangibles. Adding the pure and embedded intangibles reveals an overall surplus of $8.5 billion
Intangibles trade-May13.png
Intangibles and goods-May13.png
Oil good intangibles-May13.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.