An Innovation Index Based on Knowledge Capital Investment: Definition and Results for the UK Market Sector Tony Clayton, Mariela Dal Borgo, Jonathan Haskel.

An Innovation Index Based on Knowledge Capital Investment:

Definition and Results for the UK

Market Sector Tony Clayton, Mariela Dal Borgo, Jonathan

[email protected]

www.ceriba.org.uk

Sheffield, 2008

Popular discussion: the transformation of the economy

• The new/knowledge economy– Technology changes

• Software, hardware, ICT

– Trade changes• Move to knowledge-intensive activities• Rise of the service sector

• Innovation as a key economic driver– DIUS “Innovation Nation” White Paper:

commission an “innovation index”

Where do we see Innov/New Economy in the macro statistics?

• The New Economy– GDP growth: stable– Labour prod growth/TFP growth: stable/slowdown – Investment shares: stable

• Innovation– Most think of R&D (input) or TFP (output)– Some innovation-type spending measured and

capitalised e.g. software– Most treated as an intermediate

• R&D• Apple

– Relegated to TFP– Limits what Economists can say about innovation

LPG and TFPG in the UK

0.65 0.48

1.00

1.55 2.001.35

0.810.43

0.28

0

1

2

3

4

1990-1995 1995-2000 2000-2004

TFP Capital deepening Human capital deepening

Note: LPG=Cap deep + human cap deep + TFPG

Our main claim

• Innovation and the New Economy – needs better measures of innovative investment– Incorporated into National Accounts

• Some new economy is about investment in tangible assets– Computer hardware– Telecoms equipment– Tangible investment: included in GDP

• But some about – investment in intangible “knowledge” assets– Broader than R&D

• Computerised information: software, databases• Creative property: scientific R&D, non-sci R&D (e.g. design)• Firm competencies: training, branding, organisational capital

Research programme

• Settle on list of intangible assets

• Measure investment in them

• Incorporate into National Accounts so consistent with GDP and explain growth

• Hopefully gives– Better GDP measure– Better account of drivers of GDP– Better account of innovation

The iPod• Current method

– Inputs: Count scientific R&D only. – Output/value added:

• No effect by assumption: all R&D used up in a year, no enduring asset created, so only an intermediate

• Intangibles approach– Inputs:

• Upstream: more than just R&D– Upstream spending also on design, software

• Downstream: need associated coinvestment– Marketing, organisational change

– Output/value added• Rises: spending is an enduring knowledge asset so its

investment

• Shows up as innovation spending on intangible assets

How does the iPod show up in (US) National Accounts?

• iPod: Designed in California, made in China• Apple

– nominal value added = • Sales – value of imports – (design+marketing+R&D)

– (Industry classification may be wholesaler) – Real value added: depends on deflators– Innovation effect of iPod: TFP growth if real value

added rises

• Alternative model– Apple builds knowledge capital asset by investing in

R&D but also design, marketing– Real GDP rises with more investment– Innnovation measured by more knowledge investment

and (maybe) increased TFPG

Growth and innovation accounting, outline

• 1. Data on invest in intang assets• 2. Deflate and build real intang asset stocks• 3. Recalculate GDP and factor shares to include intang• 4. Build Hall/Jorgenson capital services to add assets

together • 5. Build labour quality adjustment• 6. Calculate LPG, capital and labour deepening, TFPG• 7. Innovation

– accounting is spending on intang assets– Index is share-weighted knowledge capital growth plus TFPG

Questions we can answer

1. Is investment increasingly in know assets? 2. Is GDP or GDP growth understated?3. What has happened to investment?4. What has happened to the capital share?5. What has happened to Y/L growth?6. What are the contributions of labour, tangible

capital, knowledge/intangible capital and TFP to growth?

7. What does innovation look like1. What intangible assets are being spend on?2. What is the contribution to growth?

Other work

• Corrado, Hulten and Sichel (CHS) for the US• Findings interesting:

– Increasing importance of investment in intangible assets

– Y and I/Y understated– Capital share has been rising– Labour prod growth understated (although mid 90s

acceleration similar)– TFP growth has accelerated, but less TFP growth

than before• Giorgio Morrano, Haskel, Wallis for UK• Van Ark, Manole, Hao forEU countries

Results

• GHW paper, May 07– Followed CHS method– Growth a/c for whole market sector

• CDH paper, Sept 08– 6 market sector industries – Improved design data using OECD software

methodology

Summary of results• Innovation accounting

– 1997: Tang invest = £81bn, knwlg invest = £76bn– 2005: Tang invest = £96bn, knwlg invest = £117bn

• Of which R&D = 7%, software = 14%, training = 25%

• Innovation index– 2000-05 mkt sector lab prod. growth= 2.74 pppa,

• Contrib of knowledge capital= 1.24 pppa. • Contrib of mfring knowledge capital = 0.75pppa

Algebra of including intangibles

:

:

/ : ln ln ln ln

: ln

TAN

TAN

TAN TANV K

TANL K

Expenditure V C I

Income p V wL p K

Growth a c V s L s K TFP

Innovation II TFP

:

:

/ : ln ln ln ln ln

: ln ln

TAN INTAN

INTAN

INTAN TAN INTAN

INTAN TAN TAN INTAN INTANV K K

INTAN TAN INTAN INTANL K K

INTAN INTAN

K

Expenditure V C I I

Income p V wL p K p K

Growth a c V s L s K s K TFP

Innovation II s K TFP

Excluding intang:

Including intang:

Details of g a/c method

1. Collect nominal investment in intangibles time series

• What investment measures?• Availability of data over time e.g. training• Measures for market sector only: some interp needed

2. Deflate to get real investment series• Choice of deflator. Use mkt sector deflator• Software and hardware:

• Soft: purchased and own account (own a/c pro’y adjust)• Hardware

Method contd

3. Build real capital stock using perpetual invent method

• Starting point (1970=0)• Depreciation rates: use CHS rates. Experiment.• Adjustment for annual data (assumes investment

comes on stream in mid-point of year)• Assets:

– Tang: buildings, plant, vehicles, computers– Intang: see below, main are software, R&D, advertising,

training

Method contd

4. Re-calculate market sector GVA to include intangibles

• Adjusted Nominal GVA– Unadjusted nominal m.sector GVA + nominal investment

• Adjusted Real GVA growth – Weighted growth in real market sector GVA + weighted

growth in real investment

– Weights are shares of nominal market sector GVA and nominal investment in unadjusted market sector GVA

5. Adjust operating surplus of m.sector GVA– Adj op surpl =adjusted GVA – m.sector labour compensation

– Mixed income: allocated prorata (note BofEng, to wages)

Method contd

6. Build Hall/Jorgenson VICS measures• Rental rates and rate of return assume:

– equalised rates of return across all assets – rental rates times stock =– Tax adjustment

• Generate VICS for each asset as share of asset in payments in times real asset growth rate

• Generate economy-wide VICS summing VICS for each asset

Method,contd.

7. Build quality-adjusted labour index• BofE index adjusts hours for

– Education – Gender– Age

8. Do growth accounting

Types of intangible, detailsA. Computerized information• Computer software (bought in, own account)• Computer databases

B. Scientific and creative property• Science and Eng R&D spending, usually leading to a patent/licence• Mineral exploration (mostly R&D in oil and minerals)• Artistic originals (mostly R&D in creating artistic originals)• Other product development, design, research, usually not leading to a

patent/licence (I.e. non-scientific R&D spend)– product devel costs in fin svcs– architect and eng design– R&D in soc sci and humanities

C. Economic competencies• Brand equity (to develop reputation capital via branding or trademarks)• Firm-specific human capital• Organizational structure (organisational capital)

A. Computerized information

Method and data sources

Computerized information

Computer softwarePurchased: via surveys. Own account: labour force data on software professionals. Source: National Accounts

Computerized databases Included

B. Scientific and creative propertyInnovative property

Scientific R&DCurrent expenditure on R&D from BERD. R&D in computer industry subtracted

Mineral explorationMainly R&D in mining and spending on mineral exploration. National Accounts

Copyright and license costsSpending on creation of originals e.g. TV, movies, books. National Accounts

Other product development, design and research

New product development costs in the financial industry

20% of all intermediate purchase by Financial Services industry, ONS data. Intermediate purchases reduced by purchases of adv, software, consulting and design.

New architectural and engineering designs

Sales of architecture and design industry SIC 742, ABI data. Own account using labour costs data.

R&D in social science and humanitiesNo broad statistical information. Estimated as twice industry revenues of social science and humanities R&D industry

C. Economic competenciesBrand equity

Advertising expenditureTotal spending on advertising as reported by Advertising Association, less expenditure on classified ads

Market researchTwice revenues of the market and consumer research industry as reported in ABI.

Firm-specific human capital

NESS05, survey of employer provided training. Includes: A) Direct firm expenses (in-house trainers, outside trainers, tuition reimbursement, and outside training funds) B) Wage and salary costs of employee time in training.

Organizational structure

PurchasedData on revenues of managment consulting industry from Management Consulting Assocation.

Own accountNo broad statistical information. Estimated as 20% of value of executive time using ASHE data on wages in executive occupations, excluding software occupations.

Industries

TABLE 1 Assignment of SIC codes and NACE1 sections to our 6 industries

Proposed sector categories SIC code NACE1 sections

A Agriculture, hunting and forestry

B Fishing 1 Agriculture, Fishing and Mining 1 - 14

C Mining and quarrying

2 Manufacturing 15 - 37 D Total manufacturing

3 Electricity, Gas and Water Supply 40 - 41 E Electricity, gas and water supply

4 Construction 45 F Construction

G Wholesale and retail trade

H Hotels and restaurants 5 Wholesale and Retail Trade, Hotels and Restaurants, Transport and Communications

50 t- 64

I Transport and storage and communication

J Financial intermediation 6 Financial Intermediation and Business

Services 65 - 74 K Real estate, renting and business

activities

Tan and intang invest by ind

Total tangible and intangible investment by industry, 1997-2005 (£bn).

Agriculture, Fisihing & Mining Manufacturing

Electricity, Gas & Water Construction

Trade, Hotels & Rest., Transport & Comm.

Financial & Business Services Total Market Sector

Tangibles Intangibles Tangibles Intangibles Tangibles Intangibles Tangibles Intangibles Tangibles Intangibles Tangibles Intangibles Tangibles Intangibles

1997 7.2 2.5 19.8 26.1 5.3 1.1 1.9 3.2 30.8 17.6 16.1 25.1 81.0 75.6

2005 6.5 1.8 13.0 31.4 5.4 1.5 2.5 6.4 37.0 31.2 31.9 45.0 96.3 117.3

Intan investment by type (% total)

17.8

24.3

2.6

9.1

0.3

12.0

6.1

5.2

0.2

0.3

7.9

14.3

15.0

22.4

1.8

10.4

0.4

11.1

6.3

6.4

0.2

0.4

9.6

16.0

0.0 5.0 10.0 15.0 20.0 25.0 30.0

Organizational structure

Firm-specific human capital

Market research

Advertising

R&D in social sciences and humanities

Own-account architectural & engineering design

Purchased architectural & engineering design

Financial services innovation

Copyright licenses

Mineral exploration

Scientific R&D

Software

%

2000

2004

Intan investment by ind (% indVA)

0

2

4

6

8

10

12

14

16

18

20

1997 1998 1999 2000 2001 2002 2003 2004 2005

%

Agriculture, Fishing & Mining Manufacturing

Electricity, Gas & Water Construction

Trade, Hotels & Rest., Transp. & Comm. Financial & Business Services

Mkt sector intang invest, by asset type

0

5

10

15

20

25

30

1997 1998 1999 2000 2001 2002 2003 2004 2005

£bn

Software

R&D

Mining

Copyright

Finance

Design (purch.)

Design (own-

acc.)Non-scientific

R&DAdvertising

Market research

Training

Org. Structure

Decomposition of ALP

Excluding Software Including All Intangibles

Growth Rates

Aggregate Value-Added 2.81 2.80

Average labour productivity 2.74 2.74

Hours 0.08 0.07 Contributions

Average labour productivity 2.74 2.74

Capital Deepening 1.15 2.23

ICT Tangible Capital Deepening 0.52 0.47

Non-ICT Tangible Capital Deepening 0.63 0.58

Intangible Capital Deepening - 1.19

Labour Quality 0.52 0.45

Aggregate TFP 1.07 0.05

Innovation index Contribution of

Intangible Capital Deepening

Contribution of Aggregate TFP Total

All industries 1.19 0.05 1.24 1 Agriculture, Fishing and Mining 0.01 -0.19 -0.18 2 Manufacturing 0.54 0.18 0.72 3 Electricity, Gas and Water Supply 0.02 -0.02 0.00 4 Construction 0.08 -0.02 0.06 5 Trade, Hotels & Rest., T ransport & Comm. 0.29 0.18 0.47 6 Financial Intermediation and Business Services 0.25 -0.08 0.17 % of column totals 1 Agriculture, Fishing and Mining 1% -15%

2 Manufacturing 45% 58%

3 Electricity, Gas and Water Supply 2% 0%

4 Construction 7% 5%

5 Trade, Hotels & Rest., Transport & Comm. 24% 38%

6 Financial Intermediation and Business Services 21% 14%

6 Total 100% 100%

Future work: extended surveyIntangible investment type

Includes the following intangibles

Status

(1) Computer software √(2) Computer databases √(1) Scientific R&D √(2) Mineral exploration √(3) Copyright and license costs √(4) New product development costs in the financial industry

X

(5) New architectural and engineering designs

Part

(6) R&D in social science and humanities

√

(1) Brand Equity Part(2) Firm-specific human capital Part(3) Organisational structure X

Economic competencies

Computerised informationInnovative property

Initial feedback from summer pilot

• ‘Extended R&D’ survey– Firms understand technical/non-technical

innovation input– Important who we talk to, need more than one

contact– ‘Boundary of firm’ issues – with MNEs– Some industry differences in approach– Hard areas

• Own account organisational capital • Training – including ‘opportunity cost’

Extra slides

GHW Results for 2004Innov spend category

Measurement Amount 2004, £bn

% tot intan invest

Intangible goods

Software ONS surveys 22 18% Scientific and non-sci R&D

Sci R&D:ONS surveys. Non-sci R&D, guesstimate

18 15%

Patents, copyrights, mineral exploration

ONS 3 2%

Design Turnover of design ind 18 15% Intangible competencies

Product reputation

Adv and mkt research spending 19 8%

Human competencies

Employer-training 29 24%

Organisational competencies

Purchased: management consultancy. Own-account: 20% of value of management time

22 18%

Total 130.7 100%

Intangible investment by asset type, % of MGVA

0

3

6

9

12

15

1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

Brand Equity

Firm-specific resources

Scientific R&D

Nonscientific R&D

Computerisedinformation

UK

US

Invest share of MGVA

US

UK

8

10

12

14

16

18

20

22

24

26

28

1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

Including intangibles

Including software

Excluding software

LPG and TFPG

0.65 0.48

1.00

0.46 0.57 0.65

1.55 2.001.35

1.90

2.271.71

0.81 0.430.28

0.73

0.38

0.25

0

1

2

3

4

1990-1995 1995-2000 2000-2004 1990-1995 1995-2000 2000-2004

TFP Capital deepening Human capital deepening

Existing National Accounts Including all intangibles

Spares

Output concepts in the National Accounts

Firm A (Electricity provider) £

Firm B (Car producer) £

Elect 100 100Cars 200

Output 100 200Value added 100 100

Output with different treatment of intangibles

Firm A (Advertising

services provider) £

Firm B (Car producer) with advertising treated

as intermediate consumption £

Firm B (Car producer) with part of advertising treated as investment £

Advertising 100 100 50Cars 200 200

Output 200 200Value added 100 100 150

Treatment of intangibles in national accounts

Category Type of knowledge capital Treatment in accountsComputerized information •Computer software•Computer databasesScientific and creative property•R&D•Mineral exploration•Copyright and license costs•Other product developmentEconomic competencies•Brand equity•Firm-specific human capital•Organizational structure

Knowledge embedded in firm-specific human and structural

resources, including brand namesNo items recognised as assets of the

firm

Knowledge embedded in computer programs and computerized

databaseMajor component, computer software, mostly expensed

Knowledge acquired through scientific R&D and non-scientific inventive and creative activities

Most scientfic and non-scientific R&D is expensed

Should intangibles/knowledge assets be included in investment?

• Definition of investment: – Spending today to create an asset that

generates income in the future

• Examples:– R&D: creates scientific knowledge stock,

future returns– Software: creates computerised knowledge,

future returns– Training: creates knowledge in workforce,

future returns

Practical problems• Definitions: do intangibles generate an asset for the

firm?– Brands, yes– Workforce training, belongs to workers

• Measurement of intangible expenditure– Own account/purchased e.g. software– Valuation of intangibles e.g. brand names, organisational capital

• How much expenditure is investment? – Advertising: long term brand building versus short term publicity

• Redefining national accounts– Intangible investment is income to firms– So labour share of output changes

Our key argument to measure innovation

• Imagine an economy with no innovation• How could we get more output?

– Lay on another plane and another crew– Deepening physical capital and labour = duplication

• How would we get more output from innovation?– Faster boarding, turnaround: better software– Deepening knowledge capital = innovation

• Summary: innovation is – extra output over and above that from use of additional

physical capital and labour– Or, the extra output from use of new knowledge capital– Implications for measurement

• Measure growth in output (GDP), and in inputs: physical capital, knowledge capital, labour

• Innovation accounts are data on knowledge investment• Innovation index is contribution of knowledge investment to

output growth

What our measure is and is not• Output

– output of more goods and services. – Not number of inventions or ideas – GDP as currently measured does not fully capture this

• Inputs– knowledge capital

• Needs investment e.g. R&D• Comes for free e.g. imitating

– knowledge capital investment is more than just R&D• R&D, software, design, firm-funded training, organisational capital• Investment is not just purchases from the “creative inds” since in

house too. So covers hidden innovation

• Inputs to outputs– Needs assumptions on life lengths of knowledge stock, deflators

• Relation to other innovation definitions, see paper

Intangibles and innovation • Axioms

– Innovation is the implementation of something new

– It needs investment (unless pure spillover)

• Consistent framework: accounting for intangibles – Activity

• Innovation needs investment in knowledge• Knowledge investment is more than just

R&D, the creative industries, an intermediate input

• Knowledge investment produces knowledge or “intangible” assets

– Impact• Investment raises value added• Service flow from kn assets contributes to

growth