Concept Paper On Contribution of Research and Development to GDP

Introduction

There had been discussions at the National as well as at the International level regarding the issue whether Expenditures on Research and Development (R&D) is current consumption or intermediate consumption or could it be treated as Investment in the economy. The present structure of the Indian national accounts treats the R&D expenditures as intermediate consumption for the manufacturing or business enterprises and for the Government’s and non-profit institutions serving households such expenditures are treated as consumption expenditure. There had been discussions at the international forums since long on the treatment which R&D expenditures incurred by various institutions should get for working out macro aggregates of a national economy. Off late, UN System of National Accounts (SNA) in its latest version of the year 2008 has accepted the fact that the output of research and development should be capitalized as “intellectual property products” except in cases where it is clear that the activity does not entail any economic benefit to its producer (and hence owner) in which case it is treated as intermediate consumption.
If R&D is treated as investment rather than current expenditure, then this treatment of R&D expenditures is a step toward producing more comprehensive and accurate measures of gross domestic product (GDP), gross domestic capital formation/ investment (GDCF), and national savings. This treatment also allows for better identification of the variables that are important to a sources-of-growth analysis and, therefore, the determination of the contribution of R&D to economic growth.

UN SNA 93 and Present Status of R&D Expenditures in Indian National Accounts

The Indian national accounts is primarily based on UN SNA 68 and a few amended aspects of UN SNA 93. As per SNA 93, R&D expenditures are not recognized as Gross Fixed Capital Formation (GFCF) despite the fact that the Manual recognizes that they are inherently investment in nature. The 1993 SNA recognized that research and development is undertaken with the objective of improving efficiency or productivity, or deriving other future benefits. However, although these characteristics have the nature of investment activities, research and development was treated as part of intermediate consumption. It was recommended, though, that it should not be treated as an ancillary activity but that a separate establishment should be identified as secondary activity.
The SNA 93 recognizes patents as assets (called “patented entities”) but they are not produced and thus appear, as a miracle, in the other change in volume account, and not through GFCF. Overall, the SNA 93 recognizes those assets created by R&D which generate a monetary flow between units (copyrights on patents), but denies their connection with R&D production, and does not recognize at all R&D assets whose services are consumed by their owners. However, the SNA 93 was a progress compared to the SNA 68 in the fact that monetary flows associated with patents are recorded in SNA 93 as income from sales of a service, rather than property income. Clearly, the authors of the 1993 SNA thought that patents were produced assets but backed from going to the end of the rationale. Treatment of R&D expenditures in Indian National Accounts is part of intermediate consumption for the manufacturing sector or Non Departmental Commercial Undertakings of the Government or Private corporate Sector or incorporating enterprises of the Household sector. Thus, it does not form part of GDP and of GFCF. For the General Government or Departmental Commercial Undertakings spending on R&D, the treatment is to identify this as consumption expenditure, so it does not form part of GCF, but is taken as part of GDP. The same should be true for non-profit institutions serving households, but as such they are taken as part of Household sector at present and it is not at all clear what treatment R&D expenditures get for this sector.

UN System of National Accounts, 2008

In the 2008 SNA the activity of research and development is not treated as an ancillary activity. The output of research and development should be capitalized as “intellectual property products” except in cases where it is clear that the activity does not entail any economic benefit to its producer (and hence owner) in which case it is treated as intermediate consumption. With the inclusion of research and development in the asset boundary, the 1993 SNA asset category of patented entities as a form of non-produced assets disappears and is replaced by research and development under fixed assets.
In order to treat R&D in this way, several issues have to be addressed. These include deriving measures of research and development, price indices and service lives. Specific guidelines, together with handbooks on methodology and practice, will provide a useful way of working towards solutions that give the appropriate level of confidence in the resulting measures.
Treatment of research and development giving rise to produced assets has removed the 1993 SNA inconsistency System of National Accounts of treating the patented entities as non-produced assets but treating royalty payments as payments for services. Research and development is no longer treated as intermediate consumption but in most cases as fixed capital formation. Research and development is now treated as fixed capital formation in most cases.
Certain activities, although common, are not so common as to be considered ancillary. Many enterprises produce their own machinery and equipment, build their own structures and carry out their own research and development. These activities are not to be treated as ancillary, whether carried out centrally or not, as they are not found frequently and extensively in all kinds of enterprises, small as well as large.

Reasoning Behind Recommendations of SNA 2008 regarding R&D Expenditures as Investment or Intermediate Consumption and other relevant issues

Research and development is a creative work undertaken on a systematic basis to increase the stock of knowledge, and use this stock of knowledge for the purpose of discovering or developing new products, including improved versions or qualities of existing products, or discovering or developing new or more efficient processes of production. Research and development is not an ancillary activity, and a separate establishment should be distinguished for it when possible. The research and development undertaken by market producers on their own behalf should, in principle, be valued on the basis of the estimated basic prices that would be paid if the research were subcontracted commercially, but in practice is likely to have to be valued on the basis of the total production costs including the costs of fixed assets used in production. Research and development undertaken by specialized commercial research laboratories or institutes is valued by receipts from sales, contracts, commissions, fees, etc. in the usual way. Research and development undertaken by government units, universities, non-profit research institutes, etc. is non market production and is valued on the basis of the total costs incurred excluding a return to capital used. The activity of research and development is different from teaching and is to be classified separately. In principle, the two activities ought to be distinguished from each other when undertaken within a university or other institute of higher education, although there may be considerable practical difficulties when the same staff divide their time between both activities. There may also be interaction between teaching and research which makes it difficult to separate them, even conceptually, in some cases.
Research and [experimental] development consists of the value of expenditures on creative work undertaken on a systematic basis in order to increase the stock of knowledge, including knowledge of man, culture and society, and use of this stock of knowledge to devise new applications. This does not extend to including human capital as assets within the SNA. The value of research and development (R&D) should be determined in terms of the economic benefits it is expected to provide in the future. This includes the provision of public services in the case of R&D acquired by government. In principle, R&D that does not provide an economic benefit to its owner does not constitute a fixed asset and should be treated as intermediate consumption. Unless the market value of the R&D is observed directly, it may, by convention, be valued at the sum of costs, including the cost of unsuccessful R&D
With the inclusion of R&D expenditure as capital formation, patented entities no longer feature as assets in the SNA. The patent agreement is to be seen instead as the legal agreement concerning the terms on which access to the R&D is granted. The patent agreement is a form of license to use which is treated as giving rise to payments for services or the acquisition of an asset.
The fixed asset boundary of the SNA has been expanded to include the output of research and experimental development (R&D) that meets the general definition of an asset. It is evident that R&D captures part, but not all, of the innovation process. It may exclude many expenditures by the production and engineering departments of an enterprise. These same departments may also be responsible for identifying a potential new product and referring it to the R&D department to develop the science behind it. In addition, an enterprise may incur other expenditures before a new product goes to market. These include market research to determine the demand for a new product and marketing expenditures to promote it.
Goods or services used for own gross fixed capital formation can be produced by any kind of enterprise, whether corporate or unincorporated. They include, for example, the special machine tools produced for their own use by engineering enterprises, or dwellings, or extensions to dwellings, produced by households. A wide range of construction activities may be undertaken for the purpose of own gross fixed capital formation in rural areas in some countries, including communal construction activities undertaken by groups of households. In addition, intellectual property products such as R&D and software products may be produced on own account.
The 2008 SNA recommends that the output of research and development should be valued at market prices if purchased (outsourced) or at the sum of total production costs plus an appropriate mark-up representing the costs of fixed assets used in production if undertaken on own account.
Research and development expenditure carried out on contract is valued at the contract price. If carried out on own account, it is valued as cumulated costs. If it is carried out by a market producer, the costs include a return to capital. Both valuations need to be increased for changes in prices and reduced because of consumption of fixed capital over the life of the asset.
Research and experimental development (R&D) is another activity that is often undertaken on own account. However, given the heterogeneous nature of R&D, the choice for deflation lies between deriving pseudo output price indices and using input price indices.
The value of the processed goods may be greater than the costs of the components and the processing fee to the extent that the finished product incorporates part of the value of R&D treated as fixed capital formation of the economic owner.

Implementation of UN SNA 2008

SNA 2008 is for including all expenditures because simply all R&D qualifies as capital formation because consumption is foregone for the sake of future benefits. Regarding basic public research, even those which may be undertaken without any specific economic goal in mind, in fact are undertaken in the belief that there will be future benefits. Thus all most all the R&D expenditures will be capitalized in the SNA 2008.
By implementing the SNA 2008, it is expected to increase the level of the gross value added of the corporate/ commercial sector, by increasing the level of gross operating surplus. Indeed, the production will be higher; while there will be no additional intermediate consumption or labor costs or other costs. Expenditures on R&D of Government (public research, universities) and of non profit institutions will also be treated as own account production of R&D assets. This will correspond to a substitution of GFCF to part of the final consumption of these sectors. Production of these sectors will be increased through the inclusion of more depreciation (of R&D assets), thus also an increase of their gross value added.
In order to measure R&D in practice, one has to use expenditure data collected under the aegis of the “Frascati” manual. In the absence of direct price indices, to deflate R&D expenditures using input price indices. Work is needed to propose acceptable depreciation rates.
SNA 2008 has amply clear that most of the R&D expenditures should be included as part of GDP as well as of GFCF. R&D expenditures are being captured for the Indian Economy by Department of Science and Technology. There is a need to segregate the R&D expenditures incurred by at least the corporate/ industrial sector, whereas by the other sectors, the part expenditures may probably be taken as additional GDP and GFCF by those sectors as currently R&D expenditures are treated as an intermediate input for businesses and current consumption for nonprofit institutions and general government. Only new machinery & equipments are taken in GFCF. This needs to be thoroughly studied. Both GDP and GFCF are being underestimated on this count for manufacturing a well as for entire economy. Accounts need to be set right.
If R&D is treated as investment rather than current expenditure, then this treatment of R&D expenditures is a step toward producing more comprehensive and accurate measures of gross domestic product (GDP), gross domestic capital formation (GDCF), and national savings. This treatment also allows for better identification of the variables that are important to a sources-of-growth analysis and, therefore, the determination of the contribution of R&D to economic growth.
According to SNA 2008, research and development is to be treated as capital formation except in cases where it is clear that the activity does not entail any economic benefit for its owner in which case it is treated as intermediate consumption. Thus, the R&D expenditures have to be segregated into two components namely, Capital formation and the other as intermediate consumption. The intermediate consumption portion of it is not the final consumption and is input for generation of output. So it can’t be part of GDP, whereas the other component would be the part of GDP as it is expenditures on GDP. The recommendations made at the International level is yet to be implemented in case of India.

Objectives of a possible Project:
The project may provide:
1. To have a preliminary and exploratory examination of the role of R&D in the Indian economy.
2. To examine the R&D expenditure data and Indian National Accounts Statistics for their use in amending the National Accounts Estimates for various macro expenditure estimates.
3. To present a pilot R&D satellite account after modifying the National Accounting framework by capitalizing R&D. Capitalizing R&D requires modifying the National Accounts structure by including R&D expenditures and benefits within the National accounts.
4. To estimate the rate of depreciation of R&D capital, and the appropriate deflator for R&D expenditures.

Phase II Objectives of the Project:

Although to estimate R&D benefits are much more difficult to measure, yet estimating them is critical to establishing a link between R&D, technical change, and growth in GDP. As these measurement questions may not be fully resolved, this project accordingly is an important, albeit only a first, look at the effect of R&D on the economy. Rates of return to R&D are to be drawn from past analyses of rates of return, and estimates of the R&D investment and capital stock balance sheet may have to be seen in previously published Government data.
For this the following objectives can be feasible:
1. To explore the R&D benefits (returns to R&D capital) by using the existing data. Among the measurement topics discussed in this project are
• the magnitude of private and spillover returns to R&D,
• the R&D benefits that are already in the current measure of GDP,
• the lag with which R&D affects the economy.
2. If feasible, to analyze the impact of R&D on GDP, national saving, and other macroeconomic aggregates, and identifies the contribution of R&D to economic growth, using a sources-of-growth approach. Accomplishing both objectives entails modifying both the expenditure side and the income side of the accounts.