One idea threatens to bring an end to personal liberty combined with economic ruin. What is this single idea? Find out in The Great Utopian Delusion by Clarence Carson, Paul Cleveland, and L. Dwayne Barney. The new book, published by Boundary Stone, is now available and can be ordered at http://www.boundarystone.org/.
Hillary Clinton’s new proposal for changing the taxation of long-term capital gains prompted me to take a look back to see how capital gains have been taxed over the past 25 years. The tax treatment of long-term capital gains is illustrative of how the tax code grows, and shows why one should not expect tax simplification any time soon.
Back in 1990 the tax rates applied to long-term capital gains were the same as those applied to income derived from wages or dividends. Straightforward enough. And, in addition to its beautiful simplicity, there was no implication that one form of income is any better or worse than another. Income was taxed at the same rate, whether earned by backbreaking labor or because a stock went up in price.
During the period 1991 to 1997 long-term capital gains received a more favored tax treatment, with a tax rate of 15 percent or 28 percent applied depending upon the taxpayer’s total income. This basic approach has been utilized since, although the rates presently used are either 0 percent, 15 percent, or 20 percent (again, depending on income).
Clinton’s proposal last week was to add more tax rates, with the particular rate depending on the length of time the taxpayer holds the asset. Under the Clinton proposal those taxpayers in the highest personal income tax bracket will now face six long-term capital gains rates. For assets held less than two years the rate will be 39.6 percent, for two to three years the rate will be lower at 36 percent, and so forth, on down to a minimum of 20 percent. The low rate of 20 percent is suggested as appropriate for capital gains on those assets held longer than six years.
How Clinton determined the aforementioned rates for optimal social engineering purposes is somewhat unclear. Why 36 percent for assets held over two years, when 34.8 percent might be even better! And, are six rates enough? Perhaps a schedule with 10 or even 20 rates might accomplish the goal with far greater precision.
But arguing what might be the best tax rate schedule is not the purpose of this article. Deciding on the optimal number of long-term capital gains tax rates to most strategically direct investment in the U.S. economy is way too difficult of a problem for me. Thus I will leave those choices to the wise politicians capable of making such important determinations. My point is to illustrate how the tax code expands over time, and to contrast it with the elegant simplicity found in the law of tithing.
Of course, millions of Americans voluntarily pay a 10 percent tithe to their church. There is one and only one rate, and among the faithful there is little cheating. Further, there is no need for armies of lawyers and accountants. The applicable rule is simple: Pay 10 percent on your “increase.”
How come is tithing so straightforward and easily collected, and the tax code so complex and unwieldy? The obvious distinction is that one is voluntarily paid as a matter of personal choice, while the other is involuntarily extracted at the threat of imprisonment.
I am not going to suggest that the expanding and bewildering tax code could be “fixed” and work as smoothly as tithing by enacting a flat tax. Even with a flat tax folks will engage in all sorts of machinations to lower their taxable income. A flat tax might simplify one small piece of the tax code, but the issue of honestly determining and reporting income is the real snag. If people don’t want to pay taxes, there is no amount of IRS tax code that will close all the loopholes.
The conclusion I reach is that simplicity in taxation is only possible in a world where individuals pay taxes honestly and voluntarily. A similar idea can be extended to most forms of business regulation. Free enterprise will flourish if (and only if?) ethical and moral individuals voluntarily exchange one with another. When ethics and morality vanish governmental oversight moves in to fill the void. With regulation comes the threat of imprisonment, the use of force, cronyism, favoritism, and the heavy compliance cost of teams of bureaucrats monitoring mountains of paperwork.
So, can the tax code be simplified? More importantly, can free enterprise be saved? Perhaps, but the solutions may be found in the study of ethics and religion rather than in the social science of economics.
Visit the website shown below to see my article on the ongoing substitution of capital for labor in production.
This is the third in a series of blogs devoted to studying the NCAA’s propensity to layer on an ever increasing number of rules. Similar to the Code of Federal Regulations, the rules published in the NCAA Manual grow at a startling rate. In this blog we will examine some of the specific bylaws found in the NCAA Manual in an attempt to give the reader an understanding of the kinds of nonsense our university compliance officers are now grappling with. For a reader with a strong stomach, the entire manual can be found and downloaded from the NCAA’s web site.
Bylaw 13 of the NCAA Manual is concerned with recruiting. It spells out in excruciating detail what sort of activities are and are not permitted when it comes to contact between a member of an institution’s staff and a prospective student-athlete. For instance, bylaw 13.1.9 says “[a]n institutional staff member may attend the funeral or memorial services of a student-athlete, a prospective student-athlete, or a member of the student-athlete’s or a prospective student-athlete’s immediate family, at which prospective student-athletes also may be in attendance, provided no recruiting contact occurs.” Now, it is hard to imagine that there are many institutional representatives who would frequent funerals for recruiting purposes, but evidently the mere possibility of such is sufficient to justify a bylaw prohibiting it. Another example of the specificity found in the manual is bylaw 22.214.171.124, which details the types of printed materials that an institution can provide to prospective student-athletes. To cite an example, if an institution sends a prospective student-athlete a postcard it “may not exceed 4 ¼ by 6 inches.” (bylaw 126.96.36.199 (j)). And, it may contain “an athletics logo on one side….and may include only handwritten information….on the opposite side when provided to the recipients.” But schools should be careful when mailing out those 4 ¼ by 6 inch postcards, as bylaw 188.8.131.52.1 indicates that “[a]n institution is not permitted to use express mail delivery services and may only use first-class mail or a lesser rate of service.” The 432 page NCAA Manual is chock full of specific directives of dos and don’ts of this sort and, of course, more are added each year. Such is how things trend when rule-makers run amok; rules always beget more rules.
In June of 2011 representatives of Boise State University (including one of the authors of this blog) appeared before the NCAA Infractions Committee as a result of an NCAA investigation that began three years earlier. A portion of the NCAA investigation focused on the Boise State football program (an episode that a Sports Illustrated writer dubbed as “CouchGate.”.)1 At issue were impermissible benefits received by prospective student-athletes who participated in NCAA-allowed voluntary summer conditioning workouts held on campus prior to the start of fall semester. The athletes participating in the workouts had graduated from high school and most had signed the NCAA’s National Letter of Intent indicating their commitment to attend Boise State University. But, even though an incoming student has signed a letter of intent, according to NCAA bylaw 13.02.11 the incoming student remains a “prospective” student-athlete up until the individual either attends classes or participates in a “regular” squad practice. Regular squad practices are confined to a strictly defined fall football season, thus giving rise to the desirability for voluntary conditioning workouts during the summer. The summer conditioning program is allowable by NCAA regulation, but is not considered a “regular” squad practice. So the new players arriving on BSU’s campus were technically still deemed to be “football prospects.”
In the case of the newly-arriving football players enrolling at Boise State University, the NCAA referenced violations of bylaw 184.108.40.206. This rule specifically prohibits an institutional staff member or “representative of its athletics interests” from arranging for a prospective student-athlete to receive “Free or reduced cost housing.” It is likely that the original intent of the bylaw was to prevent an institution from providing a star recruit with luxurious accommodations in order to gain a recruiting advantage over rival schools. However, once a bylaw is in place it is difficult to know where the line will or should be drawn. As a result, eventually the rule is pushed to the point of absurdity. At Boise State University the housing violations occurred when some of the new incoming football players crashed on couches or in spare bedrooms that were available in the apartments of their older teammates. In most instances the incoming student-athletes did pay a portion of the rent during the time they spent in the apartment, while in some instances they did not.
The final NCAA ruling was that the sharing of apartments between the new and returning football players was improper regardless of how much rent was paid. Certainly, this seems like an odd ruling. At issue was the assistance provided by the coaches to the prospective student-athletes. The NCAA’s Public Infractions Report2 (2011, p. 10, 11) states that “It would have been permissible for a prospect to contact a student-athlete on his own initiative and [make] arrangements to stay with the student-athlete. The concern here is that the coaches’ arrangement of housing with student-athletes enabled prospective student-athletes to save time, effort, and perhaps money.” Heaven forbid.
1See Stewart Mandell’s May 4, 2011 article in Sports Illustrated. Available online at http://sportsillustrated.cnn.com/2011/writers/stewart_mandel/05/04/pac-12-mailbag/index.html
2 The entire Boise State University Public Infractions report is available online at http://news.boisestate.edu/update/files/2011/09/NCAA_Public_Report.pdf
Athletics departments are devoting ever more resources to insure that the NCAA’s rules are being enforced, but judging from the number of NCAA investigations and sanctions the institutions’ efforts are largely futile. Given the impossibility of monitoring everything, most institutions walk a tenuous path hoping to avoid investigation. Moreover, in a world where everyone is guilty, competitors can attempt to prompt NCAA investigations in order to gain a competitive advantage.
The Association has so many bylaws that the thought of an investigation strikes fear into administrators. Given that membership is entirely voluntary, how can this happen? What is it that induces universities to voluntarily participate in an arrangement that many find to be burdensome? The economic theory of rent seeking provides some insight into the matter.
The cash generated by intercollegiate athletics in general, and college football in particular, is enormous. An appearance in a Bowl Championship Series (BCS) game is highly coveted, since the payoff from these games result in millions of extra dollars of revenue for the universities involved. Likewise, an appearance in the NCAA’s final four in basketball generates huge sums of cash for the participating institutions.
Besides the direct cash payments to the universities, indirect benefits take the form of increased sales of season tickets, concessions, and merchandise with school logos. Given the large amount of money on the line, the competition between universities for the best student-athletes is intense.
In a recent column on academic pretense, Thomas Sowell pointed out the “hypocrisy” of academicians and school administrators who are vehemently opposed to paying student-athletes.(See the article titled “Academic Hypocrisy” at http://townhall.com/columnists/thomassowell/2012/02/21/academic_hypocrisy/page/full/).
Head football coaches at major colleges normally receive annual salaries well in excess of a million dollars. Assistant coaches are also handsomely rewarded, as are athletic directors. But student-athletes are not allowed to share in the windfall arising from their work on the field. For the guys on the field, even a booster-bought snow cone is prohibited. In commenting on the various recruiting and other NCAA violations being reported, Taylor Branch (2011, p. 1) observed that, “the real scandal is the very structure of college sports, wherein student-athletes generate billions of dollars for universities and private companies while earning nothing for themselves.”1
In his article, Branch (2011) provided an excellent review of the history and development of the NCAA. Branch’s scathing portrayal of the NCAA is largely focused on the institution as a rent-seeking cartel: “The NCAA makes money, and enables universities and corporations to make money, from the unpaid labor of young athletes.” (2011, p. 5). The argument is a familiar one from the theory of rent seeking. In a competitive market, productive inputs (student-athletes) would tend to be paid a wage equal to the value of their marginal product. Prices of inputs would be bid up, thereby reducing the economic rents accruing to universities and their athletic departments. To capture more of the economic rents, universities join in a cartel (the NCAA) to enforce a list of rules and thereby prevent an all-out bidding war for student-athletes.
As with any cartel, once the rules and guidelines are in place there is strong incentive for any particular cartel member to cheat on the agreement. In the case of the NCAA, the cheating takes place when individual schools or their boosters offer impermissible benefits in an attempt to recruit and keep a star athlete. An individual school can benefit economically by offering something to entice recruits to enroll in their institution and play for their team. For this to work, competing schools need to toe the line lest an all out bidding war occurs. Predictably, when a rival school is caught red-handed in some sort of NCAA violation, there is a high level of righteous indignation and scorn brought down on the offending institution. Any discovered violation on the part of a competitor is generally regarded as a purposeful attempt to cheat on the system and thereby gain an advantage, and offended institutions expect the guilty school to suffer the harshest of penalties for such violations. By way of contrast, a school’s own violations are almost always explained away as the result of an inadvertent slip up—the “sort of thing that could happen to anybody really.”
The NCAA actively works at defining and enforcing rules against any form of compensation or benefit directed at student-athletes. But what constitutes illegal compensation aimed at attracting and keeping a star athlete? In attempting to answer this question the NCAA has developed an incomprehensible rule book. The next blog in this series will provide some humor by looking at some of the specific NCAA bylaws that are particularly asinine.
 See “The Shame of College Sports” Atlantic Monthly, October 2011. Available online athttp://www.theatlantic.com/magazine/archive/2011/10/the-shame-of-college-sports/8643/2/
Throughout time empires, nations, communities, institutions, and associations have come and gone. Some last for long periods of time while others flourish for a brief period before withering away. There are perhaps many reasons for the success and failure of human organizations, but one stands out to us as being crucially relevant: Laws, rules, and regulations tend to multiply over time resulting in top heavy organizations that eventually become detested by those living in subjection to them. Over the next several weeks we will explore this process by looking at the NCAA as an illustration of this tendency.
The NCAA provides an interesting case study to analyze the growth of a bureaucracy. Membership in the Association is voluntary, and the Association’s members are responsible for proposing and voting on any new rules. A new bylaw becomes binding only after it has been approved by the membership through its established legislative process. However, even though member institutions are allowed to participate in the development of new bylaws, a large and ever-growing number of malcontents are finding the NCAA and its rules and regulations to be overly burdensome.
The NCAA routinely investigates universities for violations of its rules governing the member schools’ athletic programs. Within the past several years it has investigated several high-profile football programs to see whether an “extra benefit” was received by either a student-athlete or prospective student-athlete. An NCAA investigation can result in violations and subsequent penalties placed upon the guilty institution if it is determined that extra benefits were provided to athletes. In the past few years the NCAA has investigated Auburn University, The Ohio State University, Boise State University, and the University of Miami to name a few.
On page 1 of its burgeoning manual (2013-2014), the NCAA states that its purpose for existence is the maintenance of a “clear line of demarcation between intercollegiate athletics and professional sports.” On page 4, it asserts that “student-athletes should be protected from exploitation by professional and commercial enterprises.” In its attempt to “protect” student-athletes from receiving any extra benefits, the NCAA increasingly attempts to micro-manage the lives of all athletes falling under its rule. Like the federal tax code, as time has gone by rules have expanded to the point of absurdity. For example, a particularly laughable NCAA bylaw (#16.5.2 (h)) asserts that “[a]n institution may provide fruit, nuts and bagels to a student-athlete at any time.” Following the passing of this bylaw, the question of whether or not cream cheese can accompany the allowed bagel was hotly contested in athletics’ compliance circles.
Today’s blog is the first of a series that will examine NCAA regulation from an economics perspective. The next one will examine the NCAA’s amateurism principle through the lens of public choice theory and rent-seeking. It will be argued that despite the lofty language found in the NCAA Manual, a primary goal of its legislation is to establish a cartel arrangement to insure that economic rents accrue to the university, coaches, and athletics administrators, rather than to the student-athletes who are doing the heavy lifting on the field. We will then look at the ever-growing list of rules and regulations promulgated by the NCAA in its attempt to insure economic profits (i.e., extra benefits) are not accruing to student-athletes. To accomplish this objective the NCAA endeavors to monitor and control an ever greater part of a student-athlete’s life; a task that is ultimately impossible. Due to the inability of any institution or athlete to fully comply with all the NCAA’s rules and regulations, every institution has violations—some discovered but many more undiscovered—on what is most assuredly a daily basis. Thus, when everyone is guilty, the decision to investigate and penalize any particular institution can appear to be arbitrary and capricious. The parallels between this and our bigger “prohibited everything” economy are obvious.
The growth of the NCAA into a bulky, overbearing establishment that is insufferable to many of its own members is not a new or an isolated phenomenon. There is and always has been a disturbing deep-seated human tendency for groups to evolve from simple associations into large and oppressive establishments, a trend which will be explored in this series of blogs. We may be our own worst enemies.
Facebook stock had a good day today (1/30/2014), as it shot up $7.55 based on what was deemed to be a good quarterly earnings report. Suspicious that all the hype was airy-fairy, I decided to conduct some further investigation of my own. I began by looking at the two biggies—Twitter and Facebook. Yahoo Finance reported no P/E for Twitter as of 1/30/2014 as a consequence of the negative “E” in the denominator. Despite the negative earnings per share, Twitter’s market capitalization was reported as being over $34 billion. Turning to Facebook, it did have a small but positive “E,” and based on its trailing earnings per share the P/E stood at about 156 with a total market capitalization of around $150 billion.
Outlandishly high P/E multiples exist for the lesser known social media stocks as well. Zynga’s service allows a person to socialize by playing online games with friends. That doesn’t sound like a business model that would make a fortune, but I guess young people like it. (When I was in college fun was had by skiing on Friday and having a kegger afterwards. Now the college gang gets together virtually on Friday night for an evening of raucous online gaming.) Zynga’s market cap is $2.9 billion, with no reported P/E as a result of a negative “E”. LinkedIn has a market cap of about $25 billion, with a lofty P/E of 956.
Being one of those aging dinosaurs that rarely use any of the services the social media companies offer, I may not be in the best position to comment on whether such sky-high P/E multiples are reasonable. A short time ago I visited LinkedIn’s website in an attempt to better understand what LinkedIn does, and why it is so popular with folks. On the company’s website I read what the LinkedIn service helps you to do: “Connect. Find. Be found.” For those of us who don’t want to “connect, find, and be found” it is difficult to comprehend how a company that dishes out such punishment can be worth $25 billion.
In general, what little income the aforementioned social media companies generate is from advertising. An old marketing maxim says that “half of a company’s advertising budget is wasted—the problem is nobody knows which half.” Today Yahoo Finance conducted an online poll asking readers whether Facebook will continue to benefit from increased mobile ads in the future. As of the time when I checked the results, here is how the answers were stacking up: Of the respondents, 26 percent answered yes, Facebook will continue to benefit from mobile ads. The remaining 74 percent thought the mobile ads were either ineffective (31 percent), a passing fad (22 percent), or soon to be replaced with a different technology (21 percent). Obviously, the demise of the social media stocks will occur if advertisers come to the conclusion that they are throwing away a great deal of their shareholders wealth by marketing extensively through mobile ads.
Another canary in the coal mine for the social media stocks is the language the so-called analysts are now using to talk about the firms’ net income. Rather than focusing on “earnings per share,” the conversation now often centers on EBITDA per share, or even revenue per share. Now that’s going way up the income statement in order find a positive number. Flashback to 1999.
For years I have been expecting a surge in inflation. After all, how is it possible that the Fed can be creating so much new high-powered money without a jump in prices? Surely those who are familiar with the quantity theory of money share my puzzlement over the relatively stable Consumer Price Index (CPI).
In trying to understand the absence of rising prices I have thought a lot about fiat money and the process by which it enters into circulation. After a lot of searching and racking my brain I think I’ve found the inflation.
Low CPI inflation is in part a consequence of our broken banking system, as detailed in the January 22 blog. Because banks are reluctant to make loans, the rate of growth in high-powered money has greatly exceeded the growth rate in M-1.
But despite our broken banking system, M-1 is still growing pretty darn fast. For the six months ended December 31 M-1 has been growing at an annual rate of 10 percent, which compares to an annual CPI inflation rate of only about 1.5 percent. So, where is the money going? Where is the inflation?
Recall that the CPI measures inflation in the prices of consumer goods—capital goods are not included. If the price of an existing factory doubles, that doesn’t show up anywhere in the CPI. Nor do rising stock and bond prices. And that is where the inflation has occurred, as will be described below.
Perhaps it is useful to visualize an island economy where there are two goods, a consumption good (fish) and a capital good (fishing net). In the absence of fiat money there would arise some equilibrium price of a net in terms of fish—it might be 20 fish per net. If a net is expected to catch, say, 30 fish during its five-year economic life, an investor might reasonably be willing to give up 20 fish today in exchange for one. Of course, no rational investor would be willing to give up 32 fish now in exchange for a net that is only going to harvest 30 fish in the future—in that case the price of capital is simply too high.
Continuing with the illustration, let’s now suppose that fiat currency and a central bank emerge on the island. The central bank prints up money at a rate it deems to be appropriate. In order to get the new money into circulation the island’s central bank needs to buy something—it can buy fish and/or nets. Obviously, the terms of trade between fish and nets will be affected by the central bank’s decision as to which it buys. If the central bank is determined to rapidly print new money and introduce it into the economy entirely by purchasing nets, then initially the price of nets (capital goods) will soar relative to fish (consumption goods). Depending upon how feverishly the central bank is printing the money and buying up nets it becomes entirely possible that the fiat-currency price of a net will be 40 times the fiat currency price of a fish, even when the net is only capable of catching 30 fish over its economic life. The central bank in this example is not particularly worried about making a smart investment—its only goal is to get money out there, and fast!
Presently the Federal Reserve is introducing new money at a rate of $75 billion per month. The money enters the economy through open market operations where the Fed purchases government bonds and mortgage backed securities from hedge funds, mutual funds, investment banks and so forth. Obviously an initial impact may be to enrich the sellers of the securities the Fed is buying up. But more significantly for the economy as a whole the affect is to drive up bond prices well beyond what would otherwise make sense.
So that’s why bond prices are so high and interest rates are so low. However, the story doesn’t end there. The Fed’s intrusion into the market with a flood of fiat money has also impacted the stock market. Of course, the Fed doesn’t print up money to buy common stocks. So why have stock prices inflated? I believe this is easily understood when we consider who is selling all those bonds to the Fed.
Large financial institutions, hedge funds, and well-heeled investors who own bonds are rewarded when the Fed prints up new fiat money and buys some of their bonds for ballooned-up prices. But upon selling their bonds to the Fed the financial institution now finds itself invested in cash—an undesirable investment in a world where cash is being enthusiastically created by the central bank. Where do large investors then go in search for a better return? The answer is to stocks, and thus we see inflation appear in stock prices as well.
Have we reached the point where the price of capital goods exceeds the value of the future earnings the capital will be able to produce? (Is the fishing net now selling for 40 fish when it is only capable of catching 30 over its useful life?) Certainly the operation of the central bank the past several years has pushed us in that direction. To cite one piece of evidence, The Wall Street Journal reported a P/E ratio of 86 for the Russell 2000 as of January 17, 2014 (http://online.wsj.com/mdc/public/page/2_3021-peyield.html). So, this is where all the money is going, and where the inflation has first surfaced.
Ultimately markets converge towards rationality, and the relative prices of consumer goods and capital goods will make sense. This might happen with falling security prices or with rising prices for consumer goods. With all the new money sloshing around, I’m still expecting the latter.
This past summer the Bureau of Economic Analysis announced several changes to its approach for calculating GDP. (See Results of the 2013 Comprehensive Revision of the National Income and Product Accounts, published by the Bureau of Economic Analysis, July 31, 2013). The effect of the changes was to increase GDP by roughly 3 percent compared to what it would have been under the previous GDP accounting rules.
The observer of our government’s recent shenanigans will not be surprised that the accounting change has the impact of increasing reported GDP. The purpose here is to explain as clearly as possible the change using a simple numerical example. By understanding the modification one is able form a judgment as to whether the government’s objective is to truthfully and accurately report economic data, or whether the goal is to simply get a higher number that makes the economy appear healthier. (On a related note, see my March 15th blog titled “Numbers don’t lie, but liars use numbers.”)
To be as clear as possible, I’d like to begin with a review of what GDP is intended to measure. GDP is defined in textbooks as the “total value of all final goods and services produced in the economy during a year.” So, let’s begin there.
Consider an economy that consists of a single farm that produces only corn, and the farmer generates the following revenue stream by selling the corn (the final output) over a three-year period:
Year 1: $400
Year 2: $430
Year 3: $370
There are two ways to calculate GDP, referred to as the “expenditure” approach and the “income” approach. Properly calculated the two should result in the same GDP.
The expenditure approach involves tabulating the spending on final goods and services. As it used to be done, using the expenditure approach the GDP for our example is quite simply $400 for Year 1, $430 in Year 2, and $370 in Year 3. Easy enough.
The income approach to calculate GDP involves summing up wages, rent, interest and profits. It should give the same answer.
To illustrate the income approach, suppose our farmer paid an employee $100 wages in Year 1. The employee’s job was “research and development.” That is, the employee was paid $100 in Year 1 to sit around and “think” about how he might increase total output on the farm. And to keep the example simple, assume the farmer fired the researcher at the end of Year 1 so that no wages were paid in Year 2 or Year 3.
Let’s now calculate GDP for each year using the “income” approach as it used to be done prior to the BEA’s recent high jinx.
Using the income approach, for Year 1 the GDP is the sum of wages and profits, as calculated below:
Profit to the farmer in Year 1 = $300
Wages paid to the researcher in Year 1 (an expense to the farmer) = $100
Total GDP in Year 1 = $300 (profit) + $100 (wages) = $400.
Summing the farmer’s profit and wages to the worker gives the same $400 GDP figure as was obtained using the expenditure approach.
In Year 2 and Year 3 the farmer’s profits were $430 and $370 respectively, as there was no wage expense (recall, the “researcher” was fired at the end of Year 1). So GDP was $430 in Year 2 and $370 in Year 3.
So far so good. GDP is the same using either approach.
Now let’s talk about the recent accounting change and again calculate the GDP and using the expenditure and income approach.
First, consider the expenditure approach under the new rules. Now the $100 paid to the researcher is considered a “final output” and is added to the year’s GDP. That is, under the new rules GDP in Year 1 consists of the $400 of corn produced AND the $100 paid to the researcher. Using the expenditure approach, GDP for each year is now as follows:
Year 1: $400 (corn) + $100 (wages paid to the “researcher,” now dubbed to be output) = $500
Year 2: $430 (corn)
Year 3: $370 (corn)
Too bad the farmer didn’t pay the “thinker” to do more research in Year 2 and Year 3 so GDP would have been higher then as well! By “capitalizing” R&D spending it looks like GDP went up in Year 1, but no more output was really produced.
Lastly, let’s see how the GDP will be calculated using the “income” approach going forward. The researcher’s “thinking” has now been capitalized similar to the purchase of an asset such as tractor. Thus, like a tractor, it will be depreciated over time. When calculating GDP using the income approach the BEA adds back in depreciation on capital—that is the only way the expenditure and income approach will yield the same answer.
So, back to the example, suppose Year 1’s R&D spending is expensed using straight-line deprecation in Years 2 and 3.
Under the new GDP accounting gimmick, in Year 1 the farmer’s profit is $400, not $300. The reason is simple: The $100 wages paid to the “researcher” are not recognized as an expense in that year—it is now treated as the purchase of an asset! So in Year 1 the farmer’s profit is $400. Added to this are the wages earned by the researcher in the amount of $100, resulting in GDP of $500. Presto!
In Year 2 the farmer’s profit is only $380, as a result of the $50 expense incurred depreciating the capitalized R&D expenditures. But depreciation is added back on to wages, rent, interest and profit in order to calculate GDP using the income approach. So, here is Year 2’s GDP:
Year 2 GDP = $380 (profits) + $50 (deprecation) = $430.
And, for Year 3,
Year 3 GDP = $320 (profits) + $50 (depreciation) = $370.
Again, each year we obtain the same GDP whether we use the expenditure approach or the income approach. By either approach the accounting change makes the GDP higher in Year 1 by precisely the amount of the R&D spending.
My ultimate purpose here was not to provide a review of the expenditure and income approach to GDP accounting. But it was necessary to do so in order to provide clarity to the recent change that the government made to the GDP accounts. And the above example cuts to the heart of the matter.
By treating R&D expenditures as the purchase of capital—treating it like it was a tractor—allows for a higher reported GDP. In our numerical example, GDP went up in Year 1 by the amount of the R&D expense, with no change in Year 2 and Year 3. Of course, had our example also had R&D spending in those years, GDP would have been magically higher then as well.
Worse still, under the new GDP accounting, government spending on R&D will count as final output too!
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