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Entrepreneurs should pay attention to recent changes in the way the U.S. calculates Gross Domestic Product (GDP). The revision, which shifts research and development (R&D) from an operating expense to a fixed investment, could stimulate greater R&D spending and promote much-needed technological innovation.
Calculating the GDP has become more complex as the U.S. shifts from a manufacturing economy to a knowledge economy more dependent on the often-abstract products of innovation. The Bureau of Economic Analysis’ (BEA) definition of GDP — “the market value of final goods and services produced by labor and property within the United States during a given period” — can be problematic for entrepreneurship. This is particularly true for enterprises focused on translating emerging scientific discoveries into new products and businesses.
Entrepreneurs often start companies with technologies that are years away from producing a final finished good or service. Research in industries as diverse as biopharmaceuticals, aerospace, agriculture, and even semiconductors suggests that the lag between scientific discovery and final products is often as much as 20 or 30 years. All the while, companies are making multi-billion dollar investments in R&D and production capacity.
In the classical formulation of GDP, R&D is an expense that has no direct or temporal impact on the GDP. R&D contributes to GDP growth only when it leads to finished products, or as an “intermediate input” whose value is then subtracted from that of the finished product. BEA’s revised calculation considers R&D as a fixed investment that contributes directly to the GDP in a new category of “intellectual property products.”
BEA says these changes will “better measure the effects of innovation and intangible assets on the economy.” To an entrepreneur, these changes simply make sense.
The greatest single expense of science-driven, entrepreneurial enterprise is R&D, and the greatest asset of such companies is the intellectual property — or scientific capital — that results from this investment. The revised categorization of R&D recognizes the scientific capital as a positive contribution to the GDP at the time the work is performed.
The principle that R&D represents a fixed investment versus an operating expense creates a powerful argument for investment in innovation. Accounting for R&D as an operating expense compromises earnings and profits, and negatively impacts a company’s near-term valuation as well as its access to capital and its cost. This is exactly the opposite effect that R&D has on long-term value creation, where R&D spending may be expected to provide a significantly greater return on investment than ordinary capital.
Accounting for R&D investments as a fixed investment removes an artificial drag on corporate earnings and profits, and enhances the economic incentives for investing in innovation. Similarly, recognizing government spending on R&D as fixed investment establishes a direct and temporal metric of the impact of such spending on economic growth, and reinforces the rationale for government investments in innovation.
Revisions in the way the GDP is calculated will not immediately lead to the approval of new drugs, improve cancer outcomes or produce cleaner energy. But the principle that R&D represents a fixed investment introduces a more temporal and appropriate measure of the value created by R&D. Similar principles are already being introduced into accounting standards, which could have a positive impact on corporate and government investments in R&D investment and technology-driven innovation.
A knowledge economy is critically dependent on innovation to provide new products and services, jobs and economic growth. These changes will help ensure that our economy is robust and competitive in the future.
Fred Ledley is a professor in the Department of Natural and Applied Sciences at Bentley University and director of Bentley’s Center for Integration of Science and Industry. Listen to a podcast featuring Ledley’s ideas on GDP revisions on Bloomberg Radio on Hays Advantage.
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Bentley University is named one of the country’s best institutions for undergraduate education in the just-published 2016 edition of The Princeton Review Annual college guide, “The Best 380 Colleges,” (Random House/Princeton Review).