Fattening the "I" in CIGNX (GDP)

Every year, the Bureau of Economic Analysis (BEA) makes some revisions to the National Income and Product Accounts (NIPA) - these include changing the base year for chain-weighted indexes, adjusting benchmark years for input-output accounts, as well as different estimation and accounting methods for international accounts and other components of GDP. In what is truly a rare moment, however, the new revisions will increase US GDP by around 3 percent - roughly equivalent to the GDP of a country like Belgium.

Two-thirds of that increase will come from an idea that's been a long-time coming and long overdue - counting research and development as "fixed investment" in the national accounts. It's worthwhile to first understand what "fixed investment" really means.

Gross Domestic Product - GDP, as it's commonly known, is the sum of all economic activity in a particular country. Though it can be measured either as income or as expenditures, the latter approach is generally seen as more valid. Under the expenditure approach, there are 4 primary components of GDP (rough approximations of GDP contribution are given in parentheses).

(C) Consumption (70.8%): Everyday spending on goods and services by businesses and consumers.

(I) Investment (13%): This is generally thought of as spending on new equipment, construction of factories, or household spending on housing. (This category sees the biggest change in the new revisions).

(G) Government Spending (19.5%): Essentially, government spending on all final goods and services including salaries for public employees, but excluding transfer payments like social security and unemployment benefits.

(NX) Net Exports (-3.5%): Gross exports minus gross imports - the net amount that a country sells to the rest of the world (negative if a country is facing a trade deficit).

Under the new revisions, private investment and government investment will add an extra $300 billion to GDP - so what does this mean for the American economy?

First, at the macro level, private investment is historically almost perfectly inversely correlated with the unemployment rate: in other words, the more we invest in developing new goods and services, the lower the unemployment rate drops in the long term.


red line: unemployment; blue line: private investment share of GDP

Ultimately, GDP is really just an estimate for economic activity; the goods and services we provide deliver the actual value.  Still, with BEA's revisions to GDP, private investment (and government investment) will become more important in GDP calculations. This may help policymakers better understand the value of encouraging private investment and developing policies that maximize it (and in turn help reduce unemployment).

But there's much more to the BEA's change of heart than statistics. By virtue of counting domestic R&D as investment in the GDP accounts, R&D will now be given much more weight in terms of its value to the country's economic growth.

For industries that are very R&D intensive - like the pharmaceutical sector - this may be a much needed boon. As it has become ever more difficult and expensive to get a drug to market, the pharmaceutical industry (including academic researchers that rely on agencies like the NIH) will be better able to justify projects that require public investment; the benefits of expenditures on what may be relatively intangible (at least in the near future) will now become more clear.

Justifying blue sky research budgets in a climate of austerity is difficult; but it would seem that this new classification will help policymakers better  understand the "social value" of these investments. Other reforms such as making the research and experimentation credit permanent (as President Obama's FY14 budget does) should also become easier to justify with this new accounting scheme.

There may of course be pitfalls with BEA's new accounting. In a 2007 report, BEA economists noted that there are difficulties with counting R&D as private investment (for instance, separating R&D performance and investment [both financially and regionally] is non-trivial). This made it difficult for BEA to include R&D as investment for many years, but it would seem that they overcame the statistical quandaries. Interestingly, the same report made another important point: Order of magnitude estimates indicate that current dollar gross domestic product by state (GDPS) could be over eight percent higher in some states when R&D is treated as investment. These revisions could give a significant (if somewhat artificial) boost to states with well-established research hubs. Though areas like Massachusetts could have an unusually large bump due to biotech centers like Boston - at the same time, this could be a benefit by spurring state and local governments to offer more incentives to R&D-intensive businesses.   

More than any accounting changes, the most important takeaway from BEA's revisions is the realization that R&D has benefits beyond its simple costs (which were previously captured as consumption spending) -such as the$1 trillion social benefit of cholesterol lowering drugs.   In a world where economies are increasingly defined by their ability to develop new, high-tech goods and services, the BEA's revised estimates tell us where we stand today - and where the economy is going tomorrow. 

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