AEG recommendations on COST OF CAPITAL SERVICES (Issue 15) Workshop on National Accounts December 2006, Cairo 1 UN STATISTICS DIVISION Economic Statistics Branch National Accounts Section

What is capital service? In production process, labour, capital and intermediate inputs are combined to produce output Employees/workers may be seen as repository of labour services Similarly, capital goods used in the process of production are seen as carriers of capital services that constitute the actual input. Capital service – input that flow to production from a capital asset used in the process of production. When the Capital good “delivers” services to its owner, no market transaction is recorded.

What is capital service? Measurement of these implicit transaction – whose quantities are the services drawn from the capital stock during a period – is one of the challenges of capital measurement for the productivity analysis. Conceptually, capital services reflect a quantity, or physical concept, not to be confused with the value or price concept of capital. Service flows of an office building are the protection against rain, the comfort and the storage services that the building provides to personnel during a period. Price of the capital service is measured as the user costs or rental prices of capital.

What is capital service? When a fixed asset such as a car is rented, rental paid is the payment for the capital service provided by the car. It is observable. Cost of using fixed assets is given by the rental payments by the user of a fixed asset to its owner. The rental should cover: Reduction in the value of the asset Interest cost on borrowed funds to purchase the asset Any other cost incurred by the owner CFC represents only part of the cost of using the asset, i.e. reduction in the value of the asset. The rental paid by the user of a rented non-financial asset to the owner covers both the costs incurred by the owner in providing the rental service and the capital services rendered by the asset to the user. If there were complete market for renting of capital goods, rental prices could be directly observed.

Rental price and capital service This is not the case for many capital goods that are owned for which rental prices have to be imputed. The implicit rent that capital good owners ‘pay’ themselves gives rise to the terminology user cost of the capital. For non-financial assets used by the owner, capital services appear implicitly as part of the gross operating surplus. Capital service= consumption of fixed capital + a return to capital (similar in value to the cost of interest on the remaining value of the asset)

What is capital service? When a fixed asset is for own-use, currently 1993 SNA does record the cost of the capital only as consumption of fixed capital (CFC). But theoretically, Capital service = CFC + return on capital Capital services may be generated by fixed assets, inventories, land and other non- produced assets. Value of capital stock is required for estimating the value of capital services.

Valuing Capital Stocks Two questions that may be posed about the value of the asset How much would it fetch if sold --Traditional NA valuation How much will it contribute to production over its useful life? -- Basic productivity question Two concepts of capital stock but these are not independent

Table 1: Deriving value of capital stock from knowledge of its contribution to production 13610Income Decline Value Discount rate 5% 100Year 1 Assumption: Asset prices and general price level are the same and move in line

Table 2: Deriving value of capital stock from knowledge of its decline in price 13610Income Price Decline Value Discount rate 5% 100Year 1

Table 1 vs Table 2 Exactly the same values Table 1 starts from assumption about the declining contribution to output, derives stock values (and depreciation) Table 2 starts with decline in the value of the stock, derives contribution to output (and depreciation) Both tables give value for balance sheets and for consumption of fixed capital In fact every pattern of decline in the contribution of an asset to production (usually called the age- efficiency profile) corresponds to one and only one pattern of decline in prices (usually called the age- price profile).

Interpreting the flows Year Value of asset (PV) CFC = Decline in value Income10631 The Table derive three time series: Contribution of asset over time to output – called Gross Operating Surplus Decline in value of asset - Consumption of fixed capital Income – Net operating surplus, Return to capital Rate of return: ratio of income flow to next year capital stock (that part not used in current year) Capital Services or GOS Return to capital or NOS

Capital services and gross operating surplus At this point, NA asks how can GOS be estimated in this way when it is derived as a balancing item in the generation of income account? Possible answers There is not a complete identity with GOS but to show capital services as an “of which” item relative to GOS The alternative to treating capital services as an element of gross operating surplus, is to equate GOS with capital services exactly and to do this by determining a rate of return which brings this about (endogenous rate).

Capital services Costs of capital services allow for measuring the contribution of each type of asset to value added and GOS, and makes it possible to study productivity. However, it cannot be introduced into the National Accounts in an isolated manner. They should be compiled in an integrated and consistent way with estimates of CFC and capital stock with an assumed rate of return.

AEG decisions Confirmed the importance of including the concept of capital services in the updated SNA. Strongly supported including the estimates of capital services in supplementary tables rather than in the core accounts of the SNA. Confirmed that capital services (comprising depreciation and return to capital) and capital stock measures should be compiled in an integrated and consistent manner.

AEG decisions Agreed that the basic concepts of the capital services approach be presented in the SNA and that the detailed recommendations would be elaborated in an updated version of the OECD manual on “Measuring Capital” Agreed that the concepts underlying the formulae presented in the paper (“Cost of capital services”, document number SNA/M1.05/04; Issue 15) are appropriate, subject to detailed checking.

AEG recommendations on Government and non-market producers– Cost of capital of own assets (Issue 16) 16 UN STATISTICS DIVISION Economic Statistics Branch National Accounts Section

1993 SNA treatment and critique Services from assets used in non-market production are reflected in output only as consumption of fixed capital. Implies no return to capital used in non-market production as against the one employed for market production. Zero net operating surplus for non-market producers as output estimated on cost basis; Output = IC+COE+CFC Implies inconsistency in capital services rendered by similar asset used in market and non-market production.

Govt. and non-market producers- cost of capital of own assets Asset, such as a building, a computer or a lorry can be used in exactly the same manner in either market or non-market production. Suppose the asset underlying table 1 is one such asset. If it is owned by a market producer and rented to government, say, then the rental charged must be sufficient to give the market producer an operating surplus, after all his costs have been met. Now suppose that either the same asset or another identical asset is purchased by government. The first proposition is that the value of the asset does not change depending on whether the owner is a market or non- market producer. If consumption of fixed capital is taken as the cost of using own capital, the return to capital (net operating surplus) is set to be zero.

Asset in Table 2 (with same CFC) - with zero rate of return Year Value Decline (CFC) Income00000 The asset has a value independent of the nature of the producer owning and using it, but for the non-market producer, the asset is less efficient than a market producer equivalent. Value of the asset remaining the same as in Table 2 Contribution to output decreased

Asset in Table 1 - with zero rate of return Year Value Decline (CFC) Income Clearly this is problematical also, since it now has a systematically higher value than the asset used in market production, with values of 300, 200, 120, 60 and 20 rather than the values of 280, 190, 116, 59 and 20 shown in Tables 1 and In addition the value of consumption of fixed capital from a series of 90, 74, 57, 39 and 20 has increased to 100, 80, 60, 40 and 20. Value of the asset has increased Contribution to output remaining the same CFC has increased

Own Assets used in non-market production Two alternatives can be summarised as follows: If the asset used by a non-market producer (NMP) is assumed to have the same value as an identical asset used by a market producer but the NMP has a zero discount rate, then the contribution to GOS for the NMP is lower than that for the market producer. There is no contribution to net operating surplus by the non-market producer.

Own Assets used in NM Production If the asset used by a NMP contributes the same amount to GOS as the asset used by a market producer but the former has a zero discount rate, then the value of the asset held by the NMP is higher throughout its life, the difference in value being absorbed by higher consumption of fixed capital. The size of the difference is equal to the return earned by the market producer.

Own Assets used in NM Production In the final analysis: The only way to allow two identical assets, one used by a market and one by a NMP to have the same value at all points in time and to contribute the same amount to gross domestic product is to allow the same rate of return on the asset used in non-market production as that used in market production.

Own assets used in NM Production What is the way forward? AEG decision Treat similar assets as providing similar services regardless of the nature of production. Therefore, include capital services as part of output of non-market producers. What assets? Fixed assets – (a compromise between what might be conceptually desirable and what is likely to be implementable) At what rate of return? - Expected real rate of return on govt. bonds (If necessary, it should be supplemented by other indicators of the cost of capital to government)

Government and non-market producers–cost of capital of own assets In country consultation opinions are divided Against Non-market equals non-profit, so why should the accounts include “profit” for government? Practical difficulties for implementation. Including a return to capital for assets used in non- market production means that GDP and NDP would increase and what then would happen to the resulting government operating surplus. What rate of return for estimating the opportunity cost of the capital ? It would add to the number of imputations, reducing users’ ability to interpret the national accounts estimates and making the national accounts more of an econometric modeling exercise

Government and non-market producers–cost of capital of own assets For Measure of non-market output calculated as the sum of costs, and capital services (user cost times volume of services) is a better measure of the costs incurred than is provided by the decline in asset value CFC) alone. Data requirements are similar for estimating consumption of fixed capital via a PIM. Government consumption expenditure would increase by the same amount. Expected real rate of return on Govt bond may be a good choice for the RR. Imputation is already a part of NA compilation anyway – owner occupied dwellings.

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