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OCR for page 583
Capital Formation In the
United States and Japar1
RALPH LANDAU and GEORGE N. HATSOPOULOS
lt is important to sharpen our understanding of how economics
and technology come together to affect the competitiveness of capital
formation processes anti the financing of innovation awl technolog-
ical contnbanon to economic growth. In this critical area can be
found one of the major reasons why the Japanese growth rate in
GNP is outstripping that of the United States. This is Mrdly the rime
for business awl politics as usual. The United States has many ~n-
herent advantages if its economic policies can be harnessed in a
benign wary for innovation arm invesonent, leading to a higher sus-
tained growth rate. Americans are good at this, too, as their history
proves.
Several chapters in Ads volume* stress that the industrialized countries
now do business in Duly global markets. The United States, which dominated
these world markets after World War it, has seen its market share eroded
in product after product as over countnes recovered from the war, invested
in new and modern facilities, and employed the latest technology. The coun-
tries of the Common Market and those of the Pacific Rim, led by Japan,
now compete vigorously and often very successfully inside the United States
and in world markets generally. Thus, maintaining and increasing its com-
petinveness is the foremost contemporary challenge to Me United States as
it seeks to raise the standard of living of its population, reduce unemployment,
alleviate social concerns, and provide for the necessary defense.
Many factors contribute to a nation's competitiveness, but in the long run,
productivity of the human being is the fundamental detenninant of interna-
tional competitiveness. Productivity is the Society wit which an economy
utilizes the economic resources avaulable to it. Win a given quantity of
resources, productivity increase means obtaining greater and better~quality
*See, for example, chapters by John A. Young, N. Bruce Hannay, Stephen D. Bechtel, Jr.,
Ruben F. Mettler, Daniel I. Okimoto, Robert Malpas, and Albert Bowers.
583
OCR for page 584
584
RALPH LANDAU and GEORGE N. HATSOPOULOS
output per hour worked or per unit of capital input (factor productivity is the
designation for this broad definition). A country not only seeks to provide
greater total output of goods and services from its available resources for its
population, but also tries to do so with greater economy and skill by raising
productivity, getting more "bang for the buck." The greater the rate of
growth in efficiency or productivity, the greater will be the rate of increase
of the economy's output, and hence the greater will be the economy's growth
rate, even if the resources available are constant. With more labor and capital
resources, the economy will grow even faster. Thus, the basic determinants
of the growth rate of the economy as a whole are growth in productivity plus
the growth in capital and labor inputs ˘the resourcesJ. Of course, if a society
chooses to work less or invest less, but consumes more, it will grow less
In addition, its productivity will also be adversely affected, as described
below.
As Vemon W. Ruttan (in this volume) describes it, the process of
increasing productivity in agriculture (where land is also an important
resource) means an increase in output per man-hour. As a result, the
percentage of the population engaged in agriculture has dropped over the
years from a majority to barely over 3 percent. The increased labor thus
made available, plus the new additions to the work force, was absorbed
into a growing manufacturing sector and subsequently into a diversified
services sector.
The rate of productivity increase in the United States over the period since
the Civil War has been a little under 2 percent per year. So great is the power
of compounding that this enabled the United States to develop from a largely
rural economy into the world's greatest industrial power and increase the
real per capita income at about 2 percent per year while absorbing a huge
increase in population. In the process, this nation overtook the United King-
dom, the greatest power of 1850, which is now not even one of the richer
members of the Common Market. But since World War it, over countries,
especially Japan, have had greater rates of economic growth and productivity
(as Dale W. Jorgenson details in this volume) and are catching up rapidly
with the United States. At present, Japan is already the second greatest
~ndustnal power in We world, and if its relatively higher rate of grown vis-
a-vis the United States were to continue for not much more than another
generation, it would overtake the United States in total gross national product.
As Jorgenson also indicates, We United States has suffered an alarming
decline in its own p[~ucOvi~ Cow since We late 1960s. It seems clew,
therefore, Mat the challenge to the United States in meeting the vigorous
global competition it now encounters is to raise its rate of investment in
Oman and physical capital and to raise its rate of productivity growth, i.e.,
to improve the efficiency of its economic engine systematically and pur-
posefully. Economic grown at an increased rate of efficiency is Me prereq-
OCR for page 585
CAPITAL FORMATION IN THE UNITED STATES AND JAPAN
585
uisite for a rising standard of living and for the more humane society Hat
can result from such increasing wealth.
Classical economics identified land, labor, and capital as the basic re-
sources available to the economy to provide for economic growth. Of these
resources, capital is the most complex and least understood factor of pros
auction. In another chapter in this volume, Nathan Rosenberg explains He
origin of the fairly recent discovery by economists of a fourth component—
namely, the "residual," which has been attributed to technological change
and which now appears to be the fundamental determinant of productivity
grown. The rate of grown in productivity is at least as important as capital
input is to economic growth in historical perspective, as Jorgenson details.
Daniel I. Okimoto (in this volume) provides a table of technology's contr~-
bution to lapan's economic growth since 1955; inmost periods technology
accounted for over 50 percent of the economic grown rate. The conclusions
for the United States are similar in principle.
Michael I. Boskin (in this volume) further examines the key role of tech-
nological progress in economic grown and, more significantly for filture
policy, its role in increasing the economic growth rate (i.e., raising the rate
of productivity growth). He states Hat the ordy way to raise the long-run
grown rate permanently is to increase the rate of technical change (e.g. by
R&D expenditures) or to increase the rate of improvement in the quality of
He labor force by education and training (human capital). He makes a furler
point that experience ("leaniing by doing"), if positively fed back on the
rate of technical change through embodiment In higher investment rates,
could permanently increase the long-run rate of grown in productivity. Con-
sidering the histoncal evidence, this seems plausible (see, for example, Figure 2
in James Brian Qu~nn's chapter in this volume). Such an increase would be
In addition to He more straightforward effect of investment in "old" tech-
nology. The latter temporarily increases He productivity grown of the econ-
omy by increasing the capital:labor ratio (e.g., by providing economies of
scale, by reducing transportation costs, by supplying more tools per worker,
or by similar means), and yields a temporarily higher grown rate and a
permanently higher level of income.
In other words, real per capita income grows at the rate of technical change,
and labor quality improvement at a given capital:labor ratio. If, somehow,
more investment in "old" technology alone takes place, there is a spurt in
the shorts n grown rate until the same long-term grown rate at He new
ratio of capital to labor is achieved; this long-term rate must still reflect the
underlying rate of technical change and change in human capital quality.
Every technologist knows that the latest technology is frequently embodied
in new investment and is a spur to it. Hence, Boskin emphasizes that "~e
rate at which new technology really does augment the productivity of labor
and machinery will depend on He rate at which new capital is generated,
i.e., our investment rate." Paul A. David (in this volume) makes the same
OCR for page 586
586
RALPH LANDAU and GEORGE N. HATSOPOULOS
point. Thus, technological change and the capital investment embodying it,
employed by properly trained people, are seen as the keys to productivity
growth and rising standards of living in the face of increasing international
competitiveness.
As noted above, the countries in the Common Market (e g., Germany,
France, the United Kingdom) or on the Pacific Rim (e.g., Korea, Taiwan,
Singapore, Hong Kong) are not unimportant competitors either to the United
States or to Japan. In many areas they already excel. And mainland China,
with its cheap and abundant labor, looms on the honzon. This is not the
time for complacency. Nevertheless, the principal international competitor
of the IJnited States is Japan, and the principal disparity between the United
States and Japan is in the rate of capital formation. This chapter, therefore,
deals more specifically with capital formation in the United States and in
Japan.
Macroeconomic and `' second-tier" policies (as Boskin terms tax, regu-
latory, spending priority, and trade policies) have a profound effect on both
capital formation and its cost. They also affect currency exchange rates,
which are highly significant for competitiveness and trade. Table 1 shows
the recent change in American manufacturers' competitiveness as a result of
productivity changes, labor wage rates (another important determinant of
compenhveness), and currency adjustments. The left-hand section of the
table shows the effect of man-hour productivity and wage rates on labor costs
in several major countries between 1980 and 1984. It also shows a correction
for the relative inflation rates, which Hereby indicates how much the pur-
chasing power of the work force has changed. Despite the lower Japanese
inflation, the yen: collar ratio has hardly changed (as it should). The Japanese
work force, therefore, has achieved greater purchasing power in real terms
while retaining its export competitiveness. The yen should have strengthened,
but it did not. The right-hand section of Table 1 shows the currency effect
for the same countries in the same period. The column at He far right
combines the three effects.
While the United States has made significant gains in productivity, it has
fallen sharply behind Japan which signals a challenge to management.
Management's role is to invest in labor-saving and technologically advanced
equipment to the degree, as explained below, that it finds He economic
climate favorable. likewise, management and labor have a role to play in
wage-rate restraint. The column in Table 1 entitled "Unit Labor Costs,"
which combines data in local currencies win rates of inflation relative to
that of the United States, shows that the United States still lags West Germany
and Japan somewhat. However, when these data are corrected for currency
values, He picture changes drastically, and the hard dollar, which neither
management nor labor can control, becomes the overriding factor in relative
competitiveness.
OCR for page 587
CAPITAL FORMATION IN THE UNITED SIATES AND JAPAN
587
Relative to trends in other countries, the United States has lagged signif-
icantly in competitiveness in unit labor costs; the principal European powers
are the leaders. However, in view of the overall balance-of-payments figures,
the fundamental problem for American competitiveness is still Japan, against
which the United States seems not to be able to compete either inside Japan,
inside the United States, or in third-country markets in a whole range of
products, because the yen:dollar relation changes little even as the dollar
weakens against European currencies. There are few compensating areas in
which the United States is unequivocally strong, as in agriculture. Compa-
rable data are not available for the Pacific Rim countries, although Korea is
in the Japanese class in productivity and investment and has lower wage
rates.
Competitiveness not only involves productivity growth, which is strongly
related to the pace of technological change and investment rates, but also
requires labor wage rates and overhead costs Hat are competitive. As shown
above, the United States is a high-wage country, and Japan, which has
actually been increasing its wage rates faster than He United States over the
postwar era, is no longer low cost relative to its Asian competitors. This is
Rue even in recent years when adjustment is made for relative inflation.
Most raw material and energy costs have started to equalize among countries,
although there are still local advantages. R&D is intensive in all the industrial
countries that compete with the United States, particularly civilian R&D.
However, because of He rapid diffusion of technology in the age of tele-
communications and personal mobility, any advantage gained by any fin
or country will be short-lived unless embodied in physical capital. Capital
is involved in the R&D phase as well as in development, design, plant-
improvement modifications, automation, and so on, without any new inven-
tions necessarily being required per se mainly the incorporation of He
"learning by doing" process described by Boskin. Stephen S. Roach (in this
volume) also elucidates how capital-intensive the internationally competitive
service industries have become, where little invention occurs and only
small part of the economy's total R&D is performed.
The innovation process in its complete fonn consists of two stages: in-
vention and implementation. The former is usually a function of R&D and
experience; the latter is primarily a function of capital investment (which
includes the development and design stages) and is die much riskier part of
He innovation process. Thus, in examining capital fo~ation and costs in
the United States and Japan, this chapter focuses on capital fonnation in the
business sector, which, however, consists of a very wide diversity of com-
panies in venous stages of development. Most of the chapter deals with the
manufacturing sector, since this sector is the primary component of inter-
national trade flows (very few domestic service companies, except Dose in
banking, insurance, and the like, contribute much to imports). Also, as
OCR for page 588
588
RALPH LANDAU and GEORGE N. HA7.SOPOULOS
TABLE 1 Companson of Unit Labor Cost: United States
Versus Key Industrial Countnes
Unit Labor Cost Effects
Indices (1977 - 100)
In Home Currencies
Corrected Unit
for Relative Labor
Inflation Costs
% Change % Change 1984 as %
1980 1984 1980-1984 198~1984 of 1980
France 118.0
Productivity 112.4 135.2 20.3
Wage rates 148.1 247.5 67.1
Unit labor costs 131.7 183.1 39.0
Germany 117.7
Productivity 108.4 122.3 12.8 23.2
Wage rates 125.0 152.1 21.7 32.9
Unit labor costs 115.3 124.3 7.8 17.7
Italy 117.0
Productivity 116.9 134.4 15.0 - 19.1
Wage rates 160.2 306.0 91.0 34.5
Unit labor costs 137.0 227.7 66.2 17.0
United Kingdom 111.0
Productivity 99.9 123.0 23.1 17.4
Wage rates 162.8 233.4 43.4 36.7
Unit labor costs 163.0 189.8 16.4 11.0
Japan 109.6
Productivity 128.6 167.4 30.2 54.1
Wage rates 121.2 146.0 20.5 42.6
Unit labor CoStS 94.2 87.2 - 7.4 9.6
United States 112.3
Productivity 101.7 115.6 13.7 13.7
Wage rates 132.7 169.4 27.7 27.7
Unit labor costs 130.5 146.5 12.3 12.3
SOURQ: See note 1 in this chapter.
OCR for page 589
CAPITAL FORMATION IN THE UNITED SIATES AND JAPAN
589
Combined
Currency Effects Effects
Unit Labor
Cost
Corrected Unit Cost at Actual
for Relative Based on Exchange
Actual Exchange Rates Inflation Currency Rates
% Change % Change
1980 1984 1980-1984 198~1984
% Change 1984 as %
1980-1984 of 1980
France 0.237 0.114 - 51.9 -43.3 56.7 66.9
Germany 0.550 0.351 - 36.2 - 41.6 58.4 68.8
Itchy
0.00117 0.00060 -48.7 -27.1 72.9 85.2
United Kingdom 2.326 1.336 - 42.6 - 39.8 60.2 66.9
Japan 0.0044 0.0042 -4.5 - 19.4 80.6 88.4
United States 1.000 1.000 0.0 0.0 100.0 112.3
NOTE: Based on exchange-rate movements through Fall 1985, the unit-labor~ost differentials be-
tween the United States and other countries shown In the last column would still be significant
although somewhat smaller.
OCR for page 590
590
RALPH LANDAU and GEORGE N. HATSOPOULOS
H. W. Coover (in this volume) shows, the manufacturing sector performs
the bunk of the R&D undertaken by U.S. companies, hence investment in
knowledge and technology.
THE MANUFACTURING SECTOR
The vital role of manufacturing in the U.S. economy can be seen from
Me fact that manufacturing accounts for the following:
· About 20 percent of total employment (in Japan it runs close to 25
percent);
· About 23 percent of total output;
· 50 percent of goods output for the economy as a whole; and
· About 60 percent of exports and 75 percent of imports.
Moreover, the goods-producing sector has a milch greater rate of produc-
tivity increase than other sectors of the economy. Total factor productivity
in the goods-producing sector, for example, increased 175 percent between
1960 and 1984, whereas the rate in the service-producing sector was only
about 135 percent.
The average rate of productivity growth over the postwar period in man-
ufacturing has been 2.8 percent; in services, 2 percent; and in the overall
economy, about 2.5 percent. On constant 1972 dollars, the GNP:worker ratio
in manufacturing is about $20,000, and in all services about $11,000 (some
services, such as banking, are more efficient than the average). Because of
the recent cyclical recovery, manufacturing productivity increased by 4.5
percent, and services by about 3 percent, over the last 2~/: years. Thus, the
manufacturing sector is a vital part of the productivity growth of the entire
economy and is the most robust.2
The Japanese have done much better in their manufactunug sector than
has the United States, due to factors beyond the favorable dollar:yen ratio
and the government restrictions placed by the Japanese on imports or man-
ufacture in Japan by foreigners. They have been investing in their manufac-
turing sector at rates that are between 2 and 2/ times the U.S. rate of
investment in capital per worker (Figure 1~.3 It would seem clear, therefore,
that the stock of capital is growing more rapidly in Japan than in the United
States. Between 1970 and 1981 the rate of growth in constant-dollar gross
capital per worker in manufacturing in Japan was 7.1 percent per year, more
than twice the 3.5 percent annual rate of gain in Me United States. No data
are available for gross capital after 1981 for Japan, and none for net capital
on a replacement basis. The only data available are for net capital on a
historical basis. It is estimated that the net Legible capital per worker among
principal manufacturers, on a historical basis, is $4S,000 for Japan in 1982,
and $32,000 in Me United States.
OCR for page 591
CAPITAL FORMATION IN ME UNWED MATES ED Jig
9
8
7
6
-
— 5
Q
c
CO
0 4
2
591
-
1
-
Janan
United States _,'
~ 1
-
-
70 71 72 73 74 75 76 77 78 79 80 81 82
FIGURE 1 Manufacturing fixed investment per year per employee (thousands of 1975
dollars).
SOURCE: Hatsopoulos and Brooks (note 3 in Is chapter).
As noted above, it is well supported in the literature that productivity is
closely linked to capital:labor ratios. The higher rate of grown of capital
per worker in Japan, therefore, has resulted in a higher rate of productivity
grown in Japan as compared to the United States (Figure 21.4 Whatever the
reasons for changes in Me rate of productivity grown, as discussed for Me
United States in Jorgenson's chapter, Japan's advantage in capital investment
must be a major factor in its ability to do better than the United States. It
becomes important, therefore, to learn more about Me quantity and cost of
capital in the two countries.
CAPITAL AVAILABILITY
A striking difference between Me United States and Japan is the sheer
availability of capital. This is due in part to the much higher savings rate in
Japan. IN the United States, personal savings have averaged about 5 to ~
percent of disposable income over a long period of time, whereas 3apan's
personal savings rate is in Me 17 to 18 percent range (having been above 22
percent before 1975~- almost Tree times as great. In the United States,
OCR for page 592
592
175
1 SiO
125
50
-
-
United States
Japan _
.~
-
RALPH LANDAU and GEORGE N. HATSOPOULOS
1
1 1 1 1
-
/
/
o
1 1 1 1 1 i 1 1 1
60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83
FIGS 2 Smut Per how ~ ~~a~g (1977 = 1~).
SOURCE: Hatsopoulos and Brooks (see note 3 in this chapter).
Overall gross fixed-capital formation, as a percentage of GNP, is in the range
of 15 percent, whereas in Japan it is over 30 percent, or nearly twice as
much. While savings in the corporate and household sectors vary from one
country to the other, the overall effect is clearly that the greater Japanese
savings rate contributes to the greater availability of capital for private in-
vesunent (both governments run roughly comparable deficits as a percentage
of GNP).
What causes this greater Japanese savings rate is not easy to determine,
even for Japanese economists. There seem to be at least two fim~lamental
factors (before the war the Japanese did not have as high a savings rate, so
cultural factors are not likely to be the cause):
1. A conscious government policy to increase savings by means of fa-
vorable tax policies, control over financial markets, and investment options
available to We private saver; and
2. Limitations on social security provisions combined with early retire-
ment (at 55) for employees of large corporations.
John Shaven of Stanford University and Toshiaki Tachibanaki of the Kyoto
Institute of Economic Research have made an extensive survey of the talc
policies in Japan.5 Among many favorable features should be listed the
OCR for page 593
CAPITAL FORMATION IN THE UNWED MATES ED Jay
593
absence of a capital-gains tax and the existence of a tax-free savings plan
that permits an individual to save up to $56,000 in nontaxable form (con-
siderably higher than the average monetary assets per capita). When all We
members of a household are included and the widespread evidence of evasion
is taken into account, it is clear that households can save large sums tax free.
Dividends are taxed at a lower rate than is salary income (the opposite was
Sue in We United States until 1981 when the Economic Recovery Tax Act
was adopted, which made the tax on Me two forms of income the same,
although some states still maintain a differential in favor of earnings as against
investment income from interest and dividends). On Me other hand, mortgage
interest and He like are not deductible from income in Japan, unlike in the
United States. Thus, the Japanese tax system, Shoven and Tachibanaki say,
"is responsible for lowering He overall effective tax on income from cap-
ital." Hence, they continue, "the Japanese example . . . does seem to imply
Hat tax policy can be valuable in promoting a transition to a more capital
intensive economy." (Masahiko Aoki, in this volume, deals win the eco-
nomic policies of Japan and its enduring high savings rate in some detail.)
The fundamental difference between the two economies that arises from
this sheer abundance of capital in Japan is Hat the United States currently
imports perhaps $100 billion of capital annually to finance its investments
and government deficits, while Japan exports more Han $40 billion of capital
annually, including, of course, exports to He United States. This performance
demonstrates how economic policy is of critical importance In competitive-
ness. It also demonstrates Hat He financing of innovation is crucial to eco-
norn~c grown it is He area in which economics and technology truly intersect.
TYPES OF.COMPANIES AND FINANCING REQUIREMENT
Not every manufactunug company is of the same size or maturity or has
He same financing needs. In the United States, Tree types of companies are
generally recognized: (1) start-up or fledgling, (2) rapidly growing, and
(3) mature.
The financial needs and financing methods are different for each type of
company. William J. Perry and James D. Marver (each in this volume)
describe the usual techniques employed by start-up and, therefore, very risky
companies. For these companies, private capital and venture capital funds
provide the necessary finances. Borrowing is generally too risky for both
borrower and lender, so die investments are usually in He form of equity
purchases. Currently, most young companues, after the infusion of venture
capital has run its course, cannot generate enough internal cash flow to fuel
He necessary or desired grown. In He event that Hey remain independent,
this means they must go to the equities markets, which leads to an initial
public offering (IPO) and subsequent equity issues (as Marver describes).
OCR for page 596
596
RALPlI l~DAU and GEORGE N. HATSOPOULOS
anese managers recognize the greater political instability in the world today,
and always manage foreign operations from Japan so that local and national
aspirations do not interfere with the overall Japanese strategy (many American
films are still limited by geographic priorities).
These and other features make the provision of risk premiums in investment
decisions much less significant in Japan than in the United States. While
there is employment constraint to some degree as a result of the "lifetime"
system of employment in large fiens, capital constraints are much less severe
and the employment limitations are overcome by retraining, subcontracting,
"hiving off' of subsidiaries and joint ventures, and incessant expansion and
grow.
This recitation of Japan's capital advantages is indeed a sobering one. The
one area in which the United States has a substantial advantage is in the
entrepreneurial start-up world and the venture capital and IPO systems that
sustain it. This kind of risk taking suits the American culture very well, and
derives from its pioneering history. Entrepreneurs start their businesses com-
pletely confident of ultimate success, indifferent to the short-term financial
picture but determined to make and keep a fortune (based on favorable tax
rates) and prepared to work infinitely long hours. They are not true gamblers,
since they calculate that the odds are all in their favor is the entrepreneur
not smarter, quicker, harder working, and possessed of superior knowledge
than the big companies (as Gordon E. Moore,~in this volume, suggests)?
Entrepreneurs strike the best deals they can win venture capitalists (usually
giving up 40 to 60 percent of their company), but they do not figure that the
money costs them anything, since they cannot get it any other way.7 However,
why does the venture capitalist finance the entrepreneur when the risks of
success must be seen objectively as very great?
The secret lies in the portfolio method employed by experienced venture
capitalists, much like the product-diversificat~on strategy of a large company.
Perhaps only a few of the dozens of companies in any portfolio will hit big
and most will be failures, but those few successful ones provide (at low
capital-gains tax rates) a fine rate of return for He overall venture capital
pool, He rewards thus justifying all He risks taken. The venture capitalists
can realize these high returns because they sell their interest in He successful
business after a few years Trough an IPO or to a large company. The large
company, on the other hand, in undertaking a project of similar character,
must evaluate the potential rate of return over He life of He investment. The
venture capitalist earns a substantial multiplier on his investment because the
second rolled of investors (sometimes the third round), anticipating a large
future earnings steam after the initial risks have been borne, is now willing
to invest in the new business.
The pool of venture capital has risen sharply and is now abundant, led by
OCR for page 597
CAPITAL FORMATION Ill THE UNTIED STATES AND JAPAN
597
the 1978 and 1981 reductions in the capital-gains tax and the subsequent
flow of pension funds into this area. The general surge in the equities markets
resulting from these tax actions and the lower inflation rate brought about
by monetary policy have sustained the IPO and equities markets.
In this entrepreneurial venture capital area, the United States by far leads
the world. It is a tremendous advantage in innovation and technological
change. Likewise, as Reed and Moreno describe, the large American banks
have a major role in the financing of large American and foreign enterprises.
The inte~`ediate, growing firms have the greatest problems in financing
themselves and in competing with the Japanese, for the reasons cited In this
section.
THE COST OF CAPITAL
The abundance of capital or lack of it has been described above for the
United States and Japan in terms of the different types of organizations and
stages in their evolution. Equally important in assessing the competitive
situation is the cost of that capital. This is a much more complex subject,
and the material in this section is based largely on the work of George
Hatsopoulos, as exemplified in his paper with Brooks (see note 3 in this
chapter).
Cost of Funds (Cost of Capital)
The AAA corporate bond yield is a measure of He cost of low-risk, long-
tenn debt at fixed interest rate. In recent times, because of the steep yield
curves, U.S. corporations have switched to a greater proportion of short-
tenn debt at lower rates; this is the result of the Federal Reserve Boats
easing of the monetary policy. However, the recent decline in long-term
bond yields is leading corporate treasurers to a renewed interest in such fixed-
yield instruments. Hence, even the cost of debt in the United States is now
more difficult to track than it used to be.
Debt cost is deductible from gross income by corporations. Moreover, it
is He nominal interest cost that is deductible, not the real cost (as the Treasury
I tax proposal of November 1984 would have provided). Hence, in times of
inflation He tax structure favors debt. As an example, consider interest at
12 percent and corporate tax at 50 percept with expected inflation of 5 percent.
The net nominal cost to He corporation of the interest is 12 x 0.5 = 6%.
Subtracting the expected inflation yields a net real interest cost of just 1
percent. In the recent past, that cost has been strongly negative because the
rate of inflation was higher. If the short-term interest rate is 9 percent, then
the real interest cost becomes negative again with 5 percent inflation, as the
lender and the government subsidize He borrower. Since corporations have
OCR for page 598
598
RALPH LANDAU and GEORGE N. HATSOPOULOS
incurred different debt obligations over past years, the average cost of debt
requires a historical analysis for each company. However, in computing the
marginal cost of debt for a new investment, the calculation will be based on
the proposed method of financing.
The cost of equity is a considerably more elusive number. It is not, how-
ever, to be equated with the reciprocal of the price:eamings ratio (P/E), i.e.,
the E/P ratio as found on the stock markets. The underlying worm of a
corporate share is the discounted present value of the stream of cash flows
into the future that is anticipated by He owner. Dividends, capital distn-
butions, and so forth have historically served as proxies for investors' ex-
pectations about the future cash flows of the firm. An an efficient stock market,
the quoted stock prices will reflect such an underlying value. Each stockholder
has his or her own calculation of what such a future cash flow might be and
what the appropriate discount rate should be. The net effect of the perceptions
of all stockholders results in the market value of the stock. If the stock is
unlisted, or private, management would use comparisons with listed stocks
of similar companies or would apply discount rates prevailing in the economic
climate of the day. Often, management's perceptions of future dividends
differ from those of the public, in which case the P/E ratio of the stock
market may be low although dividend expectations of management may be
high.
Conditions in the stock markets change with general economic conditions,
interest rates, supply and demand of equities, and many other factors. Thus,
a rise in the market, or in a particular equity, will raise a company's P/E
ratio and hence lower the cost of its equity. These changes in market values
may occur almost independently of the expected dividends; what changes is
He appropriate discount rate. In addition, management's expectations of
future dividends may change rather abruptly if new technology becomes
available to competitors, or simply new market entrants appear. If this is not
realized by the market for some time, the cost of equity of the company is
temporarily reduced. Also, He stock market valuation is based on the overall
effective tax rate of the corporation, not the marshal rate for a new invest-
ment. Hence, past performance and He tax laws affect He marginal cost of
equity in an investment. These are examples of He complexity of calculating
the cost of equity. Nevertheless, it Is possible to study groups of companies
in Japan and He United States and to derive reasonable estimates of their
cost of equity.
Dividends, of course, are not deductible by American corporations; Hey
are in effect partly deductible in Japan since profits paid out as dividends
are taxed at a lower rate than retained earnings. In any case, He corporation
in each country must earn pretax dollars of sufficient amount to pay He taxes
and the dividend: this represents He pretax cost of equity. It will be appre-
ciably higher Can the pretax cost of debt (with prevailing corporate tax rates,
OCR for page 599
CAPITAL FORMATION IN THE UNITED STATES AND JAPAN
599
more than twice for new investments) because it includes, in addition to
taxes, a substantial risk premium inherent in equities that are subordinate to
debt as to distribution of earnings and security of the assets. On an after-tax
basis, therefore, equity is much more expensive in real cost than debt because
of the deduchbility of the nominal interest cost (shown above). Despite this,
well-managed mature organizations use debt within prudent limits only, be-
cause of Me risk of insolvency or business reverses. In the United States this
generally runs about 1;2. The Japanese, however, because of their unique
financial and corporate structure, as described above, have traditionally used
much higher leverage; although it is somewhat less so today than ir1 the past,
the debt to equity ratio is more like 2:1.
These relationships also help explain why leveraged buyouts, restmctunng,
takeovers, and acquisitions in the United States often feature a substantial
valuation for a company's equity in excess of market. This is not necessarily
because Me markets are inefficient but because these maneuvers substitute
cheaper debt for more expensive equity. It is the tax system that makes
corporate takeover specialists like Boone Pickens and Carl Icahn viable,
because debt is tax deductible. Of course, the company's risk becomes much
greater, too.
Real interest rates in Japan have also been lower than in the United States
because of controls on financial markets. Tax rates on corporations in Japan
are slightly higher than in the United States, but the effect of this difference
is not as great as that of the leveraging and of interest rates.
When a corporation's costs of debt and equity are calculated, the overall
cost of funds is obtained by weighting them in the actual pattern. It is, of
course. most meaningful if corrected for projected (not current) inflation, to
~ , , _ ~ ~ .
arrive at real costs after taxes.
The nominal after-tax cost of funds is used as a basis in calculating "hur-
dle" rates by corporations planning a new investment. They would typically
add a risk premium, which could be just as much. The resultant sum, which
may then be twice the nominal after-tax cost of funds, is the "hurdle" rate,
below which a project would not be justified. Then the cash flow after taxes
for the new project to Me end of its expected useful life is computed, and
discounted back to the present using the "hurdle" rate as the discount rate.
If the net present value so obtained is equal to or greater Man the original
total investment, the project is likely to be approved.
Tables 2 and 3 show calculations of Me cost of funds for Me United States
and Japan, respectively, in the three years 1975, 1981, and 1984. Notable
conclusions from these data and the facts underlying them are highlighted
below:
· Japanese real costs have been and are much below American costs.
· Dunng the period 1975 to 1981, when Japan was engaged in a massive
OCR for page 600
600
RALPH LANDAU and GEORGE N. HATSOPOULOS
TABf F 2 U.s. Cost of Funds: 1975, 1981, 1984 (percent)
1975 1981 1984
_ . .
Marginal tax rate (annual) 52.0 50.3 50.3
Expected inflation 6.5 9.0 4.7
Interest-beanng debt
Coupon rate (nominal pretax cost) 8.5 13.3 12.0
Real coupon rate 2.0 4.3 7.3
Nominal cost after taxes 4.1 6.6 5.9
Real cost after taxes - 2.4 - 2.4 1.2
Equity
Nominal cost before taxes 33.7 38.8 25.4
Nominal cost after taxes 15.0 17.6 11.9
Real cost after taxes 8.5 8.6 7.1
Fundsa
Nominal cost after taxes 11.0 13.1 9.1
Real cost after taxes 4.5 4.1 4.3
NOTE: All rates are instantaneous, except as noted.
aMix of funds: Interest-bearing debt 14.1%
L~terest-f,ree debt 16.7%
Equity 69.3%
SOURCE: Calculated from methodology of Hatsopoulos and Brooks (note 3 in this chapter).
TABLE 3 Japanese Cost of Funds: 1975, 1981, 1984 (percent)
1975 1981 1984
Marginal tax rate (annual) 52.6 54.7 54.7
Expected inflation 10.1 5.4 3.7
Interest-bearing debt
Coupon rate (nominal pretax cost) 9.2 8.0 7.6
Real coupon rate —0.9 2.6 3.9
Nominal cost after taxes 4.3 3.6 3.4
Real cost after taxes - 5.7 - 1.8 - 0.2
Equity
Nominal cost before taxes 36.6 24.9 20.4
Nommal cost after taxes 16.0 10.7 8.8
Real cost after taxes 5.9 5.3 5.2
Fundsa
Nominal cost after taxes 7.0 4.9 4.2
Real cost after taxes - 3.0 - 0.4 0.6
NONE: All rates are instantaneous, except as noted.
aMix of funds: Interest-bearing debt 32.9%
Interest-free debt 31.9%
Equity 35.1%
SOURCE: Calculated from methodology of Hatsopoulos and Brooks (note 3 in this chapter).
OCR for page 601
CAPITAL FORMATION IN THE UNITED STATES AND JAPAN
601
investment program, the actual real cost of funds was negative. Control of
interest rates by the government and high leveraging, together with a high
corporate statutory rate, produced this remarkable result. Only recently has
the real cost of funds become slightly positive.
~ Equity costs are lower in Japan, partly because of favorable taxation of
income from equities. Not only does a corporation pay less tax on distributed
dividends, the shareholder gets a lower tax rate than on earned income, plus
valuable exemptions. In addition, corporations are allowed to accumulate
substantial tax-free reserves. The Japanese tax structure, as Shoven and
Tachibanaki show (see above), makes equity investments very attractive,
particularly in view of the fact that the Japanese have no capital gains ~c.
They calculate that, from the individual Japanese shareholder's perspective,
the effective marginal tax rate in 1980 for all classes of industry and assets
(on a weighted basis) was—1.5 percent versus 37.2 percent in the United
States. Even if somewhat different indices of inflation are used, this effective
rate lies only in the 7 to 17 percent range. In essence, the marginal investor
is slightly subsidized rather than taxed, under the former assumption, or there
is nearly an effective expenditure tax in the latter case at the corporate level.
The high leveraging of Japanese companies, the special depreciation rules,
and the low rate of taxation of interest and dividends at the personal level
yield this stapling result.
· Under the Japanese system, the low cost of funds is available at Me
margin only if the company is expanding. If a successful company does not
increase its total capital, i.e., for expansion, We debt:equity ratio starts to
shrink, because the corporation pays off debt (~is is cheaper overall than
paying dividends beyond those required by Me stock market yields, because
of Me double taxation). As it does so, its reduced leveraging raises its average
cost of funds. This is what is now occumng win some successful Japanese
companies, such as Toyota, which is faced win export quotas and hence
has become cash rich for want of expansion. They, therefore, pay more taxes
and help offset the lost tax revenues from rapidly growing companies, which
borrow heavily for expansion and obtain all Me benefits therefrom at Me
expense of Me tax collector. The successful basic industries keep the cost
of capital low for Me expanding high-tech companies.
This tax-financial system works differently for companies in the United
States, where lower leveraging, lower corporate taxes, and higher equity
costs favor companies that are not expanding rapidly. Only incentives such
as accelerated depreciation and investment tax credits tend to offset this fact.
Lowering the corporate statutory rate further would reduce the cost of equity
somewhat for all corporations and reward capital investment already made,
but it would also decrease the double taxation of corporate income and
therefore tend to reduce expansion in favor of paying out dividends to inves-
tors who will be clamoring for them as Weir marginal rate goes down (a
OCR for page 602
602
RALPH LANDAU and GEORGE N. HATSOPOULOS
feature of the Treasury tax proposals of May 1985). It is the interplay of a
high statutory corporate tax rate (higher for retained profits Han for dividends
paid out), lower dividend taxation, no capital-gains tax, high leveraging, and
a financial-social system that spreads corporate risk that makes the Japanese
climate so unique for growth.
· The lower cost of funds in Japan means that Japanese companies can
sell products at cost, while their American competitors are losing money.
Over a long enough period of time, a determined well-financed Japanese
company cart drive its competitors out of business. This seems currently to
be happening in memory chips. Thus, this study of the cost of capital dem-
onstrates an enormous Japanese advantage. The hard dollar adds insult to
injury, and so an American company is crippled when it tries to retaliate in
Japan or in other overseas markets.
Cost of Capital Services
Raising money leads to the cost described above. However, the real overall
cost of capital depends on how it is used, and here there are different ad-
justments for inflation, taxation, depreciation, and investment allowances.
Thus, for equipment and similar fixed assets, the cost of capital is the cost
of funds, plus the cost of depreciation, less the tax benefits from venous
investment allowances, and less the benefit from inflation (the replacement
cost of He assets is appreciating because of inflation).
Land is not depreciated, but appreciates with inflation, and so on. The
overall real cost of capital is higher Han the real cost of raising He money
(cost of funds) because depreciation raises the cost of fixed assets, and the
cost of receivables is high because there is no offset for inflation or tax.
All these factors are taken into account when the cost of capital services
is computed. This concept was first introduced by Hall and Jorgenson,8 and
developed turner by Hatsopoulos and Brooks (note 3) to include inflation,
to reflect the timing of tax payments and tax credits, and to include intangible
assets, such as the technology resulting from an investment in R&D. Hat-
sopoulos and Brooks set form He details of He calculations for He two
countnes. A simple way of expressing it is to see it as equivalent to the fee
for which a leasing company would lease a piece of equipment (or a whole
plant), over the life of He item involved, including no profit in the fee (i.e.,
at the scrapping of the unit there is nothing leR, but the full cost has been
remeved after provision for all the elements described above, including all
applicable taxes). This figure, ~en, is He minimum pretax earning on a new
investment that a company could afford to make, assuming no risk involved
Table 4 is a summary of the calculation for the United States in 1984. It
uses He cost of funds shown in Table 2 for that year. These costs of capital
services include all the costs associated with the use of an asset: the real cost
OCR for page 603
CAPITAL FORMATION IN THE UNWED MATES ED Jay
TABLE 4 Summary Cost of Capital Calculations for the United States in
1984 (percent)
603
. . .
Concept
10-year R&D
Equipment Structures Ventures
p After-tax cost of funds 0.091 0.091 0.091
~ Expected inflation 0.047 0.047 0.047
ITC Investment tax credit 0.10 0 0.125a
T Marginal corporate tax rate 0.503 0.503 0.503
,B Portion of the ITC that reduces the
basis of equipment for tax
depreciation 0.5 0 0
Z Present value of depreciation
allowance (under ACRS) 0.83 0.63 1.0
~ Rate of economic decay 0.123 0.066 0.05
d Utilization delay (years) O O 10.0
C Gross cost of capital 0.169 0.151 0.106
NONE: A simplified version of the cost of capital equation is shown below. It ignores the tuning
of taxes and assumes that magnitudes of the key parameters are relatively small:
~t4 (1 —rrC—7(1 — OZ) (p ~ ~—A)
~ — ~
aInvestment tax credit of 0.125 on R&D assumes that only direct costs that constitute one-half of
R&D expenditures are allowed under the 25 percent R&D tax credit.
Of debt and equity, costs associated with taxes and credits, and Me cost
associated with We economic depreciation of Me asset. The same calculations
can be made for land and inventones, and when weighted appropriately yield
He gross cost of capital services for a company, an industry, or a whole
sector, as desired. Hatsopoulos and Brooks's methodology (note 3) shows
Hat for He years given in Tables 2 and 3 He comparative weighted results
are:
Gross Real Cost of Capital Services
(cents per year per dollar of capital)
U.S. Japan
1975 15.5 3.0
1981 13.6 6.8
1984 13.0 8.2
This again illustrates how He Japanese policymakers kept capital costs low
In order to spur He investments they deemed necessary to compete in world
markets. They did this despite He sharp increase in inflation in the later
1970s, by controlling interest costs.
Table 4 also gives a calculation for the cost of capital of an R&D project
that lasts 10 years before it can be commercialized; although it can be ex-
pensed in He year incurred under tax law, it is still a capital investment and
OCR for page 604
604
RALPH LANDAU and GEORGE N. HATSOPOULOS
has a cost. In the case shown, that cost is 10.6 percent. As mentioned above,
since company balance sheets do not reflect intangible investments in tech-
nology, such investments may even be larger than tangible investments, as
for example, at IBM.
These basic differences between Japan and the United States are what have
permitted the Japanese to invest approximately 2~/2 times as much in fixed
assets per worker as their U.S. competitors, and they lie behind the manu-
facturing productivity increase in Japan of 6.S percent per year between 1973
and 1983, compared with the 1.8 percent in the United States disclosed by
Jorgenson (in this volume). The Japanese thus can compete very effectively
in world markets for manufactured goods; the United States is fast losing its
competitive position, as the chapters by Young and Hannay demonstrate. It
is true that the United States has created many jobs in the service sectors,
especially in smaller companies, but except perhaps for a few large financial
institutions, the productivity and the competitiveness of the service sectors
are far below those of the manufacturing sector.
A furler conclusion from the data given above is that the cost of capital
differential in Japan's favor would permit a Japanese company to invest in
longer-term R&D projects, or to invest much more Han its American coun-
terpart. Then, when the fruits of that R&D are to be implemented by physical
investment as a completed innovation, the Japanese again enjoy an advantage.
This double advantage in the more technologically based manufacturing in-
dustries of the future bodes ill for the United States and suggests imminent
moves for protectionism and its consequences, such as inflation and loss of
markets elsewhere (e.g., in agriculture).
One of the important questions raised by these studies is how the costs of
capital compare with actual returns. Retums on investments, of course, are
not necessarily the "hurdle" rates; Hey can be higher or lower, depending
on the competitive situation, the economic climate, the state of the technol-
ogy, and other factors. Management seeks the highest return that conditions
permit, not just to retrieve the cost of capital. However, good data on actual
returns are difficult to obtain, as they must be based on cash flows after tax
and not on reported profits. Furthermore, accounting practices do not permit
ready calculation of the cash flows of many corporations. It would appear
that in recent years many U.S. corporations had a cost of capital above their
returns and the stock market reflected this fact, which explains why market
prices may be and often are below book value.9 This may be due to incom-
petent management, powerful competition, excessive regulations, obsolete
technology, poor labor contracts, or a whole host of possible problems. As
mentioned above, this is what attracts leveraged buyouts and acquisitions at
seemingly much higher Han such market pnces. The rise in the market in
the last several years suggests that increased corporate cash flow aided by
the tax advantages of the 1981 act (Accelerated Cost Recovery System and
OCR for page 605
CAPITAL FORMA T70N IN THE UNITED MATES ED Jew
605
Investment Tax Credit) and reduced inflation is bringing earnings on new
investments into an acceptable range. However, the Japanese are still well
ahead, as indicated.
There have been a few other studies of the subject of this chapter, e.g.,
by the Chase Manhattan Bank,~° the Department of Commerce, and Richard
R. Ellsworth. While methodologies differ, the general conclusions do not.
SOME RECOMMENDATIONS ON CAPITAL FORMATION
AND COMPETITIVENESS
This is not the place for an extended discussion of tax and over policies
required to put American companies into a more competitive position. Both
authors of this chapter have written separately on these matters.~3 But a
consideration of the studies described herein suggests several very basic
conclusions:
1. Interest rates need to be reduced. In view of the low American savings
rate in the private sector, dissaving by the government (through its deficit)
should be reduced. Permanent reductions will come only by cutting expen-
ditllres. This is because the level of spending, to a first approximation,
ultimately determines Be level of taxation, whether current or future. If
inflation is employed by government monetary policy to conceal this effect,
it merely substitutes a hidden tax for an overt one. A reduction in the deficit
would permit monetary policy to ease and become less volatile.
2. Stability of government policies is essential if America is to remain
competitive. Japan has had a long period of relative stability; the United
States has had widely varying monetary policies and three major tax bills in
four years. To enact another major tax bill incorporating many controversial
provisions would be an experiment with unforeseeable results affecting the
entire U.S. economy. It is far better to make changes slowly and incremen-
~ly-
3. The savings rate in the United States is not likely to increase signif~-
cantly until Be tax system moves toward a consumption tax and away from
an income tax. This can be accomplished incrementally, for example, by
easing the constraints on Individual Retirement Accounts, by allowing ex-
pensin=, for all capital investments (tangible or intangible) in Be year in
which Hey are incurred, and by permitting He issuance of qualified new
preferred issues deductible to He issuing corporation Hat are limited to
expansion. While an income tax system remains, He incentives for new
investment like the Accelerated Cost Recovery System and He Investment
Tax Credit are important. Elimination or reduction of capital-gains taxes on
financial assets, especially on rollovers into over investments, would yield
greater market liquidity and risk taking, and would help compensate for the
double taxation of corporate investment.
OCR for page 606
606
RALPH LANDAU and GEORGE N. HATSOPOULOS
This chapter, then, is an attempt to sharpen understanding of how eco-
nomics and technology come together in studying Me competitiveness of
capital formation processes, the financing of ~nnovahon, and the technolog-
ical contnbution to economic grown in the United States and Japan. In this
conical area can be found one of We major reasons why Me Japanese growth
rate in GNP is outstripping Mat of the United States. This is hardly Me tune
for business and politics as usual. The United States has many inherent
advantages if its economic policies can be harnessed in a benign way for
innovation and investment, leading to a higher sustained grown rate. Amer-
icans are good at Ads, too, as their history proves.
NOTES
1. Table 1 is based on data supplied by Charles B. Reeder of the Du Pont Economics Division,
updated with recent information from the Department of Labor and modified to include the
effects of inflation. (See also Reeder's chapter in this volume.)
2. Stephen S. Roach, Manufactunng, Cyclical Vulnerability and Grown Recession, Morgan Stan-
ley & Co., June 12, 1985.
3. From G. N. Hatsopoulos and S. H. Brooks, The gap in the cost of capital: Causes, effects and
remedies, in Technology and Economic Policy, R. Landau and D. W. Jorgenson, eds. (Cam-
bndge, Mass.: Ballinger, forthcoming).
4. Ibid.
5. John B. Shoven and Toshiaki Tachibanaki, The Taxation of lacome from Capital in Japan,
paper presented at Stanford Center for Economic Policy Research Conference on Government
Policy Towards Industry in the United States and Japan, May 1985.
6. James L. Hodder, Investment and Financial Decision Making in Japanese Firms: A Comparison
with U.S. Practices, paper presented at a Stanford University-Northeast Asia Forum Conference,
Honolulu, January 1985.
7. In strict financial terms it does have a cost. This cost would be measured by the value of the
intangible capital the entrepreneur brings to the enterpnse. Unfortunately, accounting practices
of companies everywhere make no provision for showing intangible capital assets in balance
sheets and profit and loss statements, so that using only financial-asset reporting frequently
understates a firms true strengths.
8. R. E. Hall and D. W. Jorgenson, Tax policy and investment behavior, American Economic
Review 57(June 1967):391~14.
9. Bank Credit Analyst, May 1985:23ff; C. G. Callard and D. C. Kleimnan, Financial Analysts
Journal, May-June 1985:51.
10. U.S. and Japanese Semiconductor Industries: A Financial Comparison. Report prepared by the
Chase Manhattan Bank N.A. for the Semiconductor Industry Association, June 9, 1980.
1 1. U.S. Department of Commerce, Intema~onal Trade Administration, A Historical Comparison
of the Cost of Financial Capital in France, He Federal Republic of Germany, Japan, and the
United States, April 1983.
12. Richard }it. Ellswor~, Capital markets and competitive decline, Harvard Business Review,
September-October 198S:171.
13. See Technology and Economic Policy (note 3 above).
Representative terms from entire chapter:
real cost
