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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

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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-

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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

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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.

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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

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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.

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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.

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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.

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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,

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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

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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).

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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

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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

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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,

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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

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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).

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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) was1.5 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

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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

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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 rrC7(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

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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

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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.

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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).