Behind the Numbers: US capital stock part II

Businesses are investing more in knowledge generation, but can private investment make up for less government investment?

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View the Behind the Numbers collection, a monthly series from Deloitte’s economists.

As noted in last month’s “Behind the Numbers,” business investment in structures has remained within a relatively narrow band over the last 35 years, even as the two other components of investment—equipment and intellectual property (IP)—were growing faster than the economy overall. This month’s post focuses on the faster-growing of those two components, IP, a category that includes investment in software, research and development (R&D), and “entertainment, literary, and artistic originals.” IP investment plays a critical role in generating the innovation that fuels economic growth—a huge topic that we will save for another day. For now, the focus is on amount of the investment in IP. Business investment in IP occurs primarily at the developmental stage, while the federal government is the primary source of investment in basic research and development.1 But a possibly problematic disconnect has developed: even as private IP investment continues to rise, government investment has been falling. Since investment in the development stage builds on basic research, the question becomes, will slower government investment eventually erode the capacity of businesses to innovate?

Private IP investment

The composition of US capital investment has changed dramatically in recent decades. With the real level of investment in nonresidential structures approximately the same as it was in 1980, its share of the total investment has fallen from 33 percent in 1980 to 23 percent in 2014. Even though equipment investment was growing over the period, its share also declined (53 percent to 46 percent), as much faster growth in IP investment drove up its proportion of business investment from 13 percent to 31 percent.

Within IP, software replaced R&D as the largest category of IP investment in 2003 (see figure 1). However, the faster growth in R&D seen in recent quarters might soon reverse the order. In 2014, investment in R&D rose by 6.9 percent as compared to increases of 3.6 percent in software investment and 2.1 percent in the artistic category. In the first quarter of 2015, real R&D investment rose by an additional 12.4 percent (annualized). With some other GDP components, such as personal consumption and exports, showing weakness, this trend is a welcome vote of confidence in the US economy by the business sector.

BTN_June15_Figure1

Just over two-thirds of private sector R&D is conducted by manufacturing, with the largest investments being accounted for by pharmaceuticals (22.4 percent of total private sector R&D), semiconductors and other electronic components (11.5 percent), other computer and other electronic products (11.7 percent), motor vehicles (6.3 percent), chemicals (4.1 percent), and aerospace products (2.8 percent). The other funders of private sector R&D are services (16.0 percent) and nonprofit institutions serving households (7.4 percent).2

Categories of software include custom, own account, and prepackaged—each accounting for roughly a third of software investment (although prepackaged is slightly smaller).3

The entertainment, literary, and artistic originals are primarily movies, long-lived television programs, music and books, with movies and television accounting for over 75 percent of the investment in this category.

Government IP Investment

In 2013, the most recent data available, government investment in IP totaled $188.4 billion, of which the federal government accounted for 83 percent of the total. The comparable investment in the private sector was $647.1 billion. With the artistic category removed, since the government does not produce many movies or television shows (long-lived or otherwise)4, private investment in IP is still three times as large as government investment. In real terms, IP investment by the federal government fell by 4.4 percent and state and local investment rose by 3.0 percent in 2013 as compared to the 4.3 percent increase in private investment.

Government investment at the federal level is heavily weighted toward R&D investment (84 percent of total IP investment valued at $156.2 billion), while state and local government investment is more equally weighted between R&D and software (57 percent and 43 percent, respectively of $32.2 billion). The decline in real investment by the federal government was in R&D. Investment in software remained flat.

A look at the growth patterns of real investment in R&D of the federal government and the private sector in Figure 2 shows very disparate patterns. Private investment in R&D follows a cyclical pattern, with investment contracting during the recessions and increasing during expansions. As mentioned earlier, growth in 2014 was particularly strong—it was the fastest rate of increase since 1995. In contrast, annual increases to real federal investment in R&D have been declining since 2003, with investment actually contracting in the last three years. In 2013, the level of real federal investment in R&D was back to where it was in 2005.

BTN_June15_Figure2

What are our competitors doing?

While direct international comparison are difficult because countries are only now moving to include capitalized R&D in their GDP statistics—the United States first did so only in 2013,5 looking at measures of R&D spending, the United States remains a world leader. In absolute dollar amounts, the US spends the most on R&D, although double digit spending increases by China is closing the gap: in 2010, China’s spending on R&D was equal to 52 percent of US spending. In just two years, China’s R&D spending was equal to 66 percent of US spending. Relative to GDP, US spending ranks high among the OECD countries, although countries including Israel, Korea, Japan, and the Nordics spend proportionally more.6

However even with stellar overall statistics, this is not the time for complacency given the pace of technological change. While budget deficits remain a concern, the United States should continue to make investments that will provide the building blocks for innovation going forward. Our economic future depends on it.