Knowledge and Innovation Oriented Economy wide Model for Egypt

Transcription

1 Knowledge and Innovation Oriented Economy wide Model for Egypt Economic Rationale, Structure and Development scenarios Motaz Khorshid Former Minister of Higher Education And Scientific Research Professor, Cairo University Egypt Tel: Mail: International Conference on Economic Modeling (EcoMod2018) Venice,Italy July 4-6,

2 Overview: The issue-oriented knowledge-innovation multi-sector medium-long term computable general equilibrium simulation model for Egypt is developed under the auspices of the United Nations economic and social commission for west Asia (ESCWA). It is based on the social accounting matrix (SAM) principles of the United Nations system of national accounts (UNSNA) as its accounting framework (Khorshid 2008 and Pyatt 1985), and the computable general equilibrium tradition for constructing economy wide models (Dervis 1982, Robinson 1989,Taylor 1990, Shoven 1990). The model is particularly formulated to analyze the transformation process of the Egyptian economy and society towards the Knowledge era via enhanced research and development (R&D) policies, effective national innovation system (NIS) and supported high value-added knowledge intensive industries and services. To meet this long-term objective, the model structures and level of disaggregation reflected the following specific features: 1. The disaggregation level is designed to capture on one hand, the specific features needed to analyze the structural transformation towards the knowledge intensive high value-added scenarios and keep on the other hand other particular characteristics reflecting the current status and context of the Egyptian Economy. 2. The activity-commodity breakdown in the SAM as well as the model includes most of the activities representing the Knowledge Economy, highly generated value added and efficient research and innovation performance as far as the national accounting data permit. 3. Since knowledge intensive and research, development and innovation (RDI) activities require highly skilled labor services, the labor compensation account is broken down into three skill categories: low, medium and high. 4. To capture the increase in knowledge stock over time, a separate activity/commodity is allocated to Research and Development (R&D) in the Model. 5. The services sector is disaggregated to include information and communication, finance and insurance and real estate and business services which are generally considered as candidates for being knowledgeintensive ones. 2

3 6. The model divides investment goods by sectors of origin and destination. This investment matrix permits to test alternative investment allocation policies targeting the Knowledge era. Furthermore, total investment spending is broken down into gross fixed capital formation in the private and public sectors, as well as the breakdown of its sources into investments of domestic origin and foreign direct investments (FDI). 7. To reflect the recently approved Egypt s fiscal reform program and permit analyzing its repercussions on the future performance of Egypt s economy, detailed tax and subsidy accounts are included in both the SAM and Model. 8. In order to reflect the duality among private and public enterprises along with their role in the reform program and the transformation process, activities are divided into private and public enterprises with each having its own value added and labor and capital services. As most economy wide models, the SAM has a separate account for general government services. 9. The urban- rural dimensions and dualities are captured in the household income and expenditure accounts. Review of Previous Work: Despite the generally massif efforts of most developed and developing countries to move towards a Knowledge-intensive economy and high value added industries based on enhanced research, development and innovation (IDR) national system, generation of creative output and investment in intangible assets, and although there is a general consensus among economists and policymakers that Research and Development (R&D) activities play a decisive role in fostering productivity growth and raising the efficiency of factors of production, the literature reports limited modeling efforts to handle these critical issues. The exceptions to this case are the models constructed under the auspices of the OECD, UNESCO and the European Commission (EC). The relation between RDI and the productivity growth has been first formalized by Griliches (1973) and Terleckyj (1974) and has widely been accepted since. Yet, markets are likely to under provide R&D because of the wedge between private returns of the innovators and social returns for the overall economy (Griliches, 1995; Jones and Williams, 1998; Klette et al., 2000; Bye et al., 2011). To address this potential market failure, a wide array of policy interventions has been 3

4 designed by governments to stimulate innovation and realign public and private interests. In fact, the impact assessment of such policies requires the development of adequate modeling frameworks in order to capture the specific characteristics of research and innovation. The most significant work are the four models currently used by the European Commission to this end: QUEST, RHOMOLO, GEM-E3 and NEMESIS. Before turning to the specific characteristics of the four macroeconomic or economy wide models, it would be useful as well as important to illustrate the overarching issues that any general equilibrium model dealing with RDI has to face. One of the key issues modelers are faced with, when dealing with RDI, is the issue of how to deal with spillovers, which are a typical feature of R&D. As noted by Leahy and Neary (2007), any innovative activity has an information component that is almost completely non-appropriable and costless to acquire, an idea dating back to Marshall (1920), Nelson (1959) and Arrow (1962). The introduction of this idea in general equilibrium models, though, is more recent, splitting research activities into an appropriable and non-appropriable knowledge, as for example in Goulder and Schneider (1999) in the context of climate studies, or Diao et al. (1999) based on a theory of endogenous growth. However, in order for society to enjoy the non-appropriable component of RDI, some specific economic agents have still to incur investment costs which need to be associated with a positive return to be compatible with individual incentives. To this end, every country has devised mechanisms such as patents to allow agents to privately appropriate parts of the output of their R&D efforts to provide incentives for innovation. As for the modeling of this appropriable part of knowledge, almost all general equilibrium models include a knowledge-creation sector where firms buy and sell ideas, patents, blueprints or any other output of ingenuity produced similarly to any other commodity in the economy. As for the modeling of the nonappropriable part, and its relevance, there is much less agreement among economists (see, for example, Bernstein, 1998). While the existence of spillovers is seldom contested (early empirical overviews can be found in Coe and Helpman, 1995; Park, 1995; Adams, 1997), its general equilibrium modeling requires making bold choices on their sources and functioning. For example, spillovers may be associated with trade, as in Coe and Helpman (1995), Lee (1995) or Ghosh (2007). They can be linked to a global level of knowledge and a firm- 4

5 specific absorptive capacity (as in Cohen and Levinthal, 1989, who define it the ratio of usable to actual rival R&D), which can be developed by firms' investments (Hammerschmidt, 2006) or depend on macroeconomic variables such as the adoption rates of new technologies as in Comin and Hobijn (2010) or Parente and Prescott (1994). Other models relate spillovers to geographic distance, based on papers such as Audretsch and Feldman (1996), showing that spillovers tend to be extremely localized and may even fail to spread across borders, as Branstetter (2001) notices showing that spillovers seem to be more important intra- than internationally. An empirical complication in modelling R&D is the heterogeneity of activities that can be classified as such. For example, Varga, Pontikakis and Chorafakis (2014) distinguish between market-oriented and science-driven research, finding that agglomeration appears to be more important in fostering the former and interregional scientific networking in strengthening the latter. There are also different kinds of agents that can undertake R&D, as it can be modeled as a private-sector profit- maximising activity or public pursuit aimed at fostering productivity (Nadiria and Mamuneas, 1994; Guellec and De La Potterie, 2001; Bor, Chuang, Lai and Yang, 2010). For example, in Kristkova (2013), the public R&D sector is not involved in the production of capital varieties, but it does produce general knowledge that enters the production processes of both public and private R&D as a specific production factor. Of course, modeling public intervention in R&D as a free productive input (or equivalently, as a productivity shock) raises questions on the determination of optimal policies, as the role of the policymakers would not be limited to subsidize an activity which may be under provided by the market because of positive spillovers across firms, but it would allow governments to directly affect the production frontier of the economy, which calls for caution in the determination of the parameters capturing this effect in the economy. Modeling Features of RDI based Models: The literature records four conceptually different modeling traditions in RDIbased modeling: macro-econometric models, Computable General Equilibrium (CGE) models, Spatial Computable General Equilibrium (SCGE) models, and Dynamic Stochastic General Equilibrium (DSGE) models. The main characteristic of macro-econometric models is their reliance on long-run time-series data and solid 5

6 empirical base. Their structural equations are estimated econometrically. Following a neo-keynesian theoretical approach, the economies are characterized by a demand-driven structure with the possibility of under-utilization of productive capacity, which implies the relaxation of some equilibrium constraints. Computable General Equilibrium (CGE) models rely instead on Arrow-Debreu framework where markets are always in equilibrium balancing supply and demand through the system of prices. Policies that alter the equilibrium are considered shocks that induce new equilibria in the interaction between consumers and producers in the different markets. Household preferences and production functions are usually described by constant elasticity of substitution (CES), Leontief (IO), Cobb Douglas (CD) functions or Linear expenditure System (LES). Spatial Computable General Equilibrium (SCGE) models are similar to CGE models in their structure but, in addition to CGE models, they explicitly model regional economies and spatial linkage connecting them, such as trade of goods and services, factor mobility, income flows and knowledge spillovers. In addition, SCGE models account for spatial frictions between the regions, such as transportation costs, which typically is not the case in the other three types of macroeconomic models. Finally, Dynamic Stochastic General Equilibrium (DSGE) models follow the rigorous market equilibrium concept of CGE models, but derive agents' decision rules explicitly from inter-temporal optimization under technological, institutional and budgetary constraints, which is the main difference with respect to the other two types of model. The internalization of inter-temporal considerations from economic agents makes DSGE particularly valuable instruments for R&D policy analysis because they can capture phenomena such as anticipation effects from future shocks and consumption smoothing behavior. An overview about the key features of the first three CGE-based Economy-wide models is provided in the table below. As can be seen, QUEST is the only Dynamic Stochastic General Equilibrium (DSGE) model among the four; RHOMOLO is a Spatial Computable General Equilibrium model (SCGE); GEM-E3 is a Computable General Equilibrium models (CGE); and NEMESIS is a macro-econometric model. 6

7 General characteristics of QUEST, RHOMOLO, GEM-E3: QUEST RHOMOLO. GEM-E3. 1 Model type. DSGE. SCGE. CGE. 2 Multi-country EU-28+RoW EU-27+RoW EU+RoW5 3 No of sectors Inter temporal fully dynamic recursively. recursively 5 Estimation. Stochastically. Structurally. Structurally All four macro-models are multi-country (multi-region) models, and capture international (inter- regional) linkages between economies of Member States. All EU-28 Member States are included in QUEST (as 28 countries), GEM-E3 (as 1 country group), RHOMOLO (as 267 NUTS2 regions) and NEMESIS (as 28 countries). The QUEST model does not differentiate between industrial sectors. RHOMOLO disaggregates economies into 6 sectors, GEM-E3 into 38 sectors and NEMESIS into 30 industrial sectors. Whereas QUEST, RHOMOLO and NEMESIS model industrial sectors as monopolistically competitive, in GEM-E3 they are modeled as perfectly competitive. Only QUEST is a fully dynamic model with intertemporal optimization of economic agents. The other three are recursively dynamic models. As usually in macroeconomic models, all key parameters are estimated econometrically, whereas the rest are calibrated in the model. In addition, QUEST can be also estimated stochastically. Overall Structure of Egypt s Economy Wide Model The overall structure of the knowledge and innovation oriented dynamic computable general equilibrium (CGE) simulation model is schematically represented in Figure (1). The modeling system is composed of three specific models. The first model is the within-period static CGE model used to generate the equilibrium solution per year. Based on the computable general equilibrium tradition, the within period static model includes three main modules; (i) the consistency accounting relations reflected in the SAM structure, (ii) the independent behavioral rules of economic agents such as producers, consumers, importers and exporters, and (iii) the model closure rules or market clearing mechanisms such as the macroeconomic investment saving balance, the 7

8 commodity markets equilibrium, government income and expenditure clearing rule. To ensure the dynamic path of the CGE modeling system, the second model provides the dynamic adjustment relations such as physical capital adjustment relation, breakdown of Labor Supply by skill category, investment allocation between domestic and foreign direct investment (FDI) flows and wage rates dynamic adjustment relations (Khorshid 2016,2010,2009aand 2009b). Given its special purpose and specific orientation, the third dynamically adjustment model derives the mathematical relations pertaining to the knowledge economy transformation process based on R&D, innovation, creative outputs and investment in intangible assets policy instruments. These relations represent the main contribution to traditional CGE modeling process. In principle, knowledge stock, software development, creative outputs and other intangible assets need to have their capital stock updating mechanisms. Here, we used similar approach used to update physical capital based on base year capital stock, consumption of fixed capital, investment spending in these intangible assets and expected return on their capital. The process of identifying knowledge stock and intangible assets from the industrial classification system of the United Nations (UNISIC) is explained bellow. Furthermore, in this third model, the impacts of dynamic changes in knowledge and other intangible assets on total factor productivity as well as labor and capital efficiencies by sector is mathematically formulated based on the concept of elasticity of spill-over effects. Finally, mathematical specifications of labor movement across skill categories due to efficiency enhancement are developed in this third model. 8

9 Figure (1) Overall Structure and Components of CGE Simulation Model 9

10 Breakdown of the SAM and Model Accounts Figure (2) summarizes the disaggregation levels of the SAM and the model which delineate the following analytical points: 1. Primary activities in the SAM include two sectors, agriculture and fishing and mining and querying (mainly composed of oil extraction and natural gas). 2. Manufacturing industries are broken down in the SAM into petroleum products and other manufacturing. While petroleum products sector is capital intensive sector and is not necessarily part of the knowledge economy and innovation efforts, some of the other manufacturing sectors will be part of the Knowledge economy transformation process. 3. In order to adjust knowledge stock over years, a separate sector for basic and applied research and experimental development and (R&D) is included in the SAM as well as the Model. 4. Since innovation is increasingly expanding in the majority of the services sectors, a breakdown is ensured to include financial and insurance sector, real estate and business sector and information and communication activity. 5. To capture the impact of education and health sectors as an enabling environment to innovation, they are included in one sector along with creative and intellectual services. 6. Other model classification is done to include the recently approved fiscal reform package of the IMF. Disaggregated tax and subsidy accounts are considered to explicitly implement the new tax policy and the subsidy elimination process. 7. Some accounts are disaggregated to reflect the particular features and duality prevailing in the Egyptian economy such as private versus public activities, Duality among urban and rural households. 8. As an important policy-oriented tool, gross fixed capital formation is divided by sectors of origin and destination, by private and public enterprises and by sources of finance (Foreign direct investments (FDI) and gross fixed capital formation of domestic origin). An explicit matrix by sectors of origin and destination are developed to serve the purpose of investment allocation policies. 10

11 Figure (2) Disaggregation Levels of Egypt s SAM and Model Levels Of The Model Disaggregation Account Type Level1 Level2 Level3 Level4 Production Private Activities Activities 1. Agriculture & Fishing. 2. Oil extraction & other mining. 3. Petroleum Products. 4.Manufacturing. 5. Electricity, Gas and Water 6. Building & Construction. 7. Transport & Internal Trade. 8. Finance & Insurance services. 9. Real estate & Business Services. 10. Information& Communication 11. Research, Development & Innovation. 12. Public Admin. & Social Insurance. 13. Health, Education & other Social Services. Public Activities 13 Sectors Commodities Composite 13 sectors Domestic 13 Sectors Imported 13 Sectors Exported 13 Sectors Factors of production Labor Compensation Private Sector High skill Labor 11

12 Public Sector Government Sector Capital Services Private 13 Sectors Public 13 Sectors Institution Households Urban Area (Current Accounts) Rural Area Companies Private Public General Government Institutions Capital Accounts Taxes & Subsidies Accounts Rest of World Saving/ Investment Investment by Destination Taxes Accounts Subsidies Accounts 12 Sector of Origin 12 sectors of Destination Direct& Personal Taxes Tax on Production Value Added Tax Indirect Commodity tax Import taxes Food Supply Petroleum Products Electricity Other Subsidies Medium Skill Labor Low Skill Labor 3 Skill Levels 3 Skill Levels 12

13 Economic Rationale and Structure: This section gives an overview of the basic characteristics, economic rationale and structural features of the economy wide simulation model. As we have explained previously, the modelling system is broadly divides into a static within-period model, a dynamic inter-period model and a Knowledge and innovation dynamic model. The Knowledge-innovation oriented economy wide simulation model represents an economy with thirteen production activities (Agriculture, extraction, petroleum products, manufacturing industries, electricity and water, building and construction, transport and trade, information and communication, finance and insurance, real estate and business services, research and development, education and health and public administration), five domestic institutions (urban and rural households, private and public corporations, and general government) and the outside world. Domestic institutions have both current and capital accounts. Factors of production include labor and capital services. Labor factors (or compensation of employees) are broken down by economic activity (private, public and government labor) and skill category (high, medium and low skilled labor). Capital services include both public and private accounts. The markets of goods and services in the model are composed of domestic, imported, exported and composite commodities (merging domestic with imported goods), with each of them divided into thirteen commodity types. Gross capital formation is composed of private (households and private companies) and public (government and public enterprises) investments as well as foreign direct investments (FDI). The model makes the distinction between investments by sectors of origin and destination using a square matrix. Government account disaggregates net tax income into direct and indirect taxes and subsidies. Direct taxes include personal and corporate tax programs. Indirect taxes are broken down into import duties, the newly adopted value added taxes and other commodity indirect taxes. Commodity subsidies are divided into food supplies, petroleum products, electricity and other subsidies. Finally, the rest of the world account includes net transfers from abroad in the form of worker s remittances, investment income, foreign direct investments, current transfers to domestic institutions as well as imports and exports of goods and services. 13

14 Production Activity and Commodity System: In the within period model, each producer (represented by an activity) is assumed to maximise profits, defined as the difference between revenue earned and the cost of factors and intermediate inputs, subject to a production technology constraint. The structure of which is shown in Figure (3). It is classified as a multilevel nested production function. At the top level, the technology is specified by a CES function of the quantities of value-added and intermediate inputs. This choice is preferable if empirical evidence suggests that available techniques permit the aggregate mix between value-added and intermediate inputs to vary, if not a Leontief fixed quantity share production function is used. Value added is itself a two level CES function of primary factors whereas the aggregate intermediate input is a Leontief function of disaggregated intermediate inputs. The sector specific value added uses a CES function to allocate income between compensation of employees (Income of labor services) and gross operating surplus (return on capital services). Given the important role of human capital formation, a CES disaggregation function linking skill categories of labourers involved in the production process is used. The model assumes that a factor is unemployed and the real wage is fixed. This assumption may, for example, be appropriate in settings where there is considerable unemployment for a given labor category. Each activity is free to hire any desired quantity at its fixed, activity-specific wage (which, implicitly, is indexed to the model numéraire). This formulation permits also to have estimates for the unemployment rates if the quantity of supplied labor is provided. On the supply side, aggregated domestic output is allocated between exports and domestic sales on the assumption that suppliers maximise sales revenue for any given aggregate output level, subject to imperfect transformability between exports and domestic sales, expressed by a Constant-Elasticity-of-Transformation (CET) function. In the international markets, export demands are infinitely elastic at given world prices. The price received by domestic suppliers for exports is expressed in domestic currency and adjusted for the transactions cost (to the border) and export taxes (if any). The supply price for domestic sales is equal to 14

15 Gross Output Gross Value Added Intermediate Inputs Public Value Added Private Value Added Public Sector Capital Services Public Sector labor Compensation Private Sector Labor Compensation Private Sector labor Capital Services Labor compensation by skill category Low skill Labor Medium skill Labor High skill Labor Figure (3) Multi Level Nested Production Function 15

16 the price paid by domestic demanders minus the transactions cost of domestic marketing (from the supplier to the demander) per unit of domestic sales. If the commodity is not exported, total output is passed to the domestic market. Institutions: Households (disaggregated into urban and rural areas) receive income from factors of production (directly or indirectly, via the enterprises), and transfers from other institutions. Transfers from the rest of the world to households are fixed in foreign currency (All transfers between the rest of the world and domestic institutions and factors are fixed in foreign currency.). Households use their income to pay direct taxes, save, consume, and make transfers to other institutions. Direct taxes, transfers to other domestic institutions and savings are defined as fixed shares of household income. Income that remains is spent on consumption. Household consumption covers marketed commodities, purchased at market prices. Household consumption is allocated across different commodities according to a Linear Expenditure System (LES) demand functions. Instead of being paid directly to the households, factor incomes may be paid to one or more enterprises. Private and Public enterprises may also receive transfers from other institutions. Enterprise revenues are allocated to direct taxes, savings, and transfers to other institutions. Apart from this, the payments to and from enterprises are modelled in the same way as the payments to and from households. The government collects taxes and receives transfers from other institutions. In all taxes are at fixed ad valorem rates. The government uses this income to purchase commodities for its consumption and for transfers to other institutions., government consumption is fixed in real terms whereas government transfers to domestic institutions (urban and rural households and public and private enterprises) fixed in nominal terms. Government savings (the difference between government income and current spending) is computed as a flexible residual. The rest of the world is the only remaining institution. As noted, transfer payments from the rest of the world and domestic institutions and factors are all fixed in foreign currency. Commodity trade with the rest of the world and foreign savings (or the current account deficit) will be discussed in the closure rule sector. 16

17 Model Closure Rules The set of closure rules or market clearing mechanisms of the model include domestic, imported and exported commodity markets, factor markets, government and other institutions saving closure, foreign exchange balance and investment saving macro closure rule. These rules are explained below. 1. Input and output of the thirteen activities are modeled using multi-level production function, the first level divides output into gross value added and intermediate inputs. The second level decompose gross output into private and public value added. The third level breaks down both private and public values added into labor compensation and capital services. Finally, the last level divides labor income according to the skill level (low, medium and high skilled). Commodity markets produced by the thirteen activities apply a flexible price clearing mechanism. All production functions are equipped with total factor productivity parameters and labor and capital efficiency parameters. 2. Government income is composed of profits transferred from public enterprises which is treated as a fixed value share of their income, transfers from domestic and foreign institutions based on income distribution shares and direct taxes (personal and companies taxes) and indirect tax revenues (value added tax, other indirect commodity taxes, import taxes) which use a fixed tax rate. This tax Rate is fixed in the within period sub model but can be changed in the inter period dynamic adjustment sub-model. On the expenditure side, Government final consumption spending (including government wage bill and purchases of goods and services) is fixed in real terms (or in constant prices). Government current transfers to domestic and foreign institutions are fixed in nominal terms (or in current prices), spending on subsidies is done using a fixed subsidy rate. Given government income and current spending, general government savings clears government account (they are computed as a residual). 3. Investment saving macroeconomic closure rule differs between private and public institutions. Savings of Public sector capital account, including general government and public enterprises, are computed using fixed saving rate of disposable income for public companies and as a residual for general government. After excluding public- private capital transfers and public investment spending (which is exogenous in the within period model), public borrowing from the outside world (or public current account deficit) clears 17

18 public sector capital account. Savings of private sector, composed of households and private corporations are computed as a fixed value share of their disposable income, private- public capital transfers are treated as exogenous variables, private sector borrowing from ( or lending to) the outside world is exogenous in the within period sub model, and private investment spending ( gross fixed capital formation plus change in stock) clears the private sector capital market ( it is an endogenous variable determined by the equilibrium solution of the within period model). An alternative formulation of the private saving investment balance is to be handled in a similar manner to the public investment saving balance. The choice between the two alternatives will be determined during the validation exercise and the reliability of the obtained economy wide projections. 4. Labor compensations are broken down by skill level (low, medium and high skilled labor). Demand for labor by skill level is determined from a multi-level nested production function given the rule of profit maximization subjected to technology constraint (the production function). Given exogenous average wage rate per skill category, the quantity of labor by production activity and skill category is computed as a demand driven quantity. Furthermore, given the fixed supply of labor (which is computed from population growth rate and labor force activity or participation rate in the inter-period part of the model), unemployment rate is determined. Note that the production functions in the model are equipped with a labor efficiency factor by skill category. This labor efficiency factor can be simulated as an exogenous variable or embodied in an inter-period dynamic relation that can be affected by knowledge, R&D, innovation and other intangible assets, which is the case in our model. Government labor demand by skill category is determined within its final consumption spending as a fixed quantity share. 5. The foreign exchange market is treated as follows. Supply of exports is the outcome of profit maximization rule subject to a constant elasticity of transformation (CET). The outcome of the profit maximization problem determines also domestic sales. On the other hand, demand of the outside world for Egypt s exports is determined as a function of base year exports, the ratio of world prices in domestic currency to the producer s supply price of exports as well as the sector specific trade elasticity. The interactions between forces of supply and demand for exports determine their equilibrium quantities. Imports of goods and services are computed using the composite commodity approach (or Armington elasticity). According to this approach, 18

19 demand for composite commodity ( composed of both domestic and imported goods and services) is estimated from intermediate demand (estimated as a fixed quantity share of gross output based on Leontief production function), government final consumption demand ( which is fixed in quantity term), urban and rural household final consumption using a linear expenditure system (LES), public and private investment spending (derived from the savinginvestment balance explained in point 2). The demand for composite commodity is then broken down into domestic sales and imports based on cost a minimization rule subject to a constant elasticity of substitution or a CES function. Note that the equilibrium domestic sales are determined jointly by the confrontation of the CET function transforming output to exports and domestic sales, and the CES functions distributing composite demand between domestic sales and imports. The Inter-Period Dynamic Relations The inter-period model is composed of the relations needed to ensure the dynamic path of the economy under alternative development policies. The first set of equations adjusts the physical capital stock as a function of previous year capital stock, investment spending and the consumption of fixed capital. Similar equations are developed to update knowledge stock, software and information technology and other intangible assets. These updating relations are explained in a separate section latter on. A second important set of relations concerns those directed to estimate the spillover effects of changes in knowledge, software and other intangible assets on total factor productivity and efficiency of labor and capital inputs based on the sector specific elasticity of spillover effect. Another set of equations is directed to labor mobility between different labor skill category (low, medium and high skill). The inter-period relations include also the population and labor force projections, the breakdown of investment into gross capital formation of domestic origin and foreign direct investment flows and wage rate adjustment mechanism. Scenario Development and Policy Formulation Process: The issue-oriented economy wide simulation model for Egypt is particularly constructed and typically designed to capture the medium-long term transformation process towards Knowledge economy based on appropriate policies for research and development, innovation, creativity and other 19

20 productivity enhancement measures. This orientation has its start up in the selection of the disaggregation levels of the SAM and the model as well as their specific structure. In order to generate alternative future development paths for Egypt - based on the economy wide simulation model a comprehensive set of policy measures and development choices need to be defined. These measures can be grouped under six specific categories; (i) category of measures pertaining to Egypt s external balance in the within period sub-model, (ii) measures explaining government policies and directives to implement the recently approved fiscal reform program with the IMF as well as its strategy to move to a Knowledge economy supported by RDI and other efficiency raising mechanisms, (iii) policies related to the domestic pricing system, expected world export and import price indices and the adopted foreign exchange policy, (iv) investment quantity and its allocation patterns as well as the expected flow of foreign direct investments ( FDI) during the projection period, (v) measures adjusting Egypt s dynamic path via the model in light of population, labor force, physical capital, knowledge stock and other intangible assets updating mechanisms and (vi) the set of within period and inter period parameters and technical coefficients. The fist category includes policy variables and/or external conditions reflecting current transfers to the Egyptian economy in foreign currency such as return on Egypt s investments abroad, worker s remittances and other current transfers to domestic institutions (government, households and corporation). The second category determines government current spending and capital transfers including; government final consumption expenditure in real terms broken down into public wage bill and purchases of goods and services, government current transfers to domestic and foreign institutions in nominal terms, in addition to the allocation of government final consumption spending to different commodity groups. Tax and subsidy rates are also part of government strategy towards reducing price distortions in the domestic markets and increasing its revenues through the application of new value added tax system and improved tax collection process. In fact, these measures are fully defined in the fiscal reform agreement between IMF and the Egyptian authority. To properly deal with this recently adopted agreement, Egypt s tax system in the model is broken down into direct taxes on households and corporations, value added taxes, import taxes and other commodity indirect taxes. Subsidies account makes the distinction between the rate applied to petroleum products, electricity, food supplies and other subsidies. The third category of inputs to the model is concerned with the pricing 20

21 policy at large. These include fixed wage rates by skill category, exchange rate policy and expected movement in the world price of exports and imports. Since gross fixed capital formation is considered as one of the important tools that can be applied to achieve growth and productivity, the fourth category of policy measures is related to investment quantity and allocation patterns. Both the magnitude and distribution pattern of public and private investment are exogenously handled in the model. Furthermore, gross fixed capital formation is composed in the model of investment of domestic origin and foreign direct investments (FDI). The fifth category is concerned with parameters and variables ensuring the dynamic path of the economy. It includes Base year population and labor force along with the parameters used to project their future values such as the natural growth rate of population size, the breakdown of this population among urban and rural areas based on expected internal migration, participation rate or gross activity rate of labor force. Base year capital stocks in the private and public sectors along with the prevailing depreciation rates (or consumption of fixed capital) and the return on fixed capital are also needed to dynamically adjust physical capital stock over time. On the Knowledge and RDI fronts, the ratio of return on knowledge stock to the base year knowledge stock need to be estimated, guesstimated or determined from similar studies, with particular reference to the efforts done in the European Commission and by the OECD. Depreciation of Knowledge is another concept to be identified and measured. In most previous studies knowledge depreciation is neglected or not considered in the knowledge capital stock updating mechanism. In the model we assume that the Creation of knowledge and it s updating over time needs investment in research, development and innovation (RDI) in addition to a percent of gross fixed capital formation in education sector. Similar parameters and base year input indicators are needed for the adjustment of software industry, information technology and other intangible assets such as cultural and creative services, trademarks and industrial designs, printing and publishing and on-line creative products. Note here that the determination of the sub-sectors to be used in the updating of software and other intangible assets requires further disaggregation levels compared to the basic thirteen sectors of the model. This will be explained in a forthcoming section. 21

22 Finally, the sixth and last inputs needed to run the model are the behavioral parameters of the within period model such as the elasticity of substitution between domestic and imported goods and services, shares of value added and intermediate inputs in the production function by economic activity, labor compensation and capital income as well as labor income by skill category. The model uses also an elasticity of transformation parameters for allocating gross output between domestic sales and exports. Finally estimates of trade elasticity with the outside world by sector based on relative prices of domestic and world prices. With respect to the inter period dynamic relations used to estimate the impact of knowledge and RDI transformation policy measures on total factor productivity and factors efficiency in the sectoral production functions of the economy. Here, we need to have estimates for the elasticity of spillover effects of knowledge creation and RDI enhancement policies on total factor productivity, labor efficiency by skill category and the efficiency of using capital stock. knowledge Stock and intangible assets updating Mechanisms: Sectors contributing to the creation and dissemination of knowledge, Development of technological and non-technological innovation as well as creative output and intangible assets are generally specific part or of thirteen sectors of the model or that may be composed of a combination of them. Knowledge stock for example is dynamically adjusted by investment in research and development (R&D) as a major contributor to its increase, in addition to part of the outcome of the education process (which contributes to creation of knowledgeable human capital). Intangible assets producing creative out appears in specific portion of sectors such as business services, programming and broadcasting, publishing activities, software industry, etc. Based on the above rationale, Knowledge stock and R&D and other knowledge economy related activities can be partially captured from more detailed activity breakdown that can to a great extend captured from a dipping or mining process into the Industrial classification (ISIC) to estimate its Percentage share in the sector GDP. It should be noted however, that this process based on the logic and understanding of what we mean by industries satisfying the Knowledge economy along with high value added, knowledge workers and knowledge intensive activities with considerable spending on R&D as well as innovation 22

23 We have according made a detailed investigated of each activity in the model in order to identify this knowledge, R&D and innovation related activities based on the above rationale. The main outcome of this exercise is represented by the sub activities of ISIC related to computer programming and consultation, information services, programming and broadcasting, motion pictures and TV, broadcasting, publishing activities, advertising and market research, creative services, as well as parts of the financial, real estate business, transport, and other creative and intangible services. Based on the above conceptual design, the sectors of the model are disaggregated to estimate the relative weights of these knowledge-innovative activities in GDP as a proxy to update the software and other intangible capital stocks, as shown below. Information and communication. Percent of GDP Software and IT creative activities: 8.2% Computer programming and Consultation. 6.8% Information Service Activities. 1.4% Creative outputs and intangible assets: 7.7% Motion picture, Video and TV 1.0% Programming and broadcasting. 4.0% Publishing activities. 2.7% Real estate and Business services: Percent of GDP Advertising and market research 3.58% Business services % Education, Health and Cultural Services. Education % Creative Arts and Entertainment % Libraries, Archives, Museums and Other cultural activities % 23

24 Financial Sector: Health % Financial Services Insurance & Ancillary activities. 9.35% Transport, Trade and Storage: Wholesale and Retail Trade. 59.1% Others. 40.9% The obtained relative weights are used to estimate the percentage share of knowledge-innovation related activities in the composition of each sector GDP as well as their percent in the Investment spending allocated to each economic sector defined in the model. The R&D activity is however taken as a whole in updating the knowledge stock. The estimation of the Spillover Effects on sector specific total factor productivity and factors efficiency parameters is done based on the changes in knowledge stock, Software and other IT assets and other intangible assets coupled with elasticity of each sector to these changes (Spillover parameters by activity or sector). The mathematical implementation of this process is explained in the forthcoming sections of the report. It constitutes an integral part of the inter period dynamically adjusted sub model. Formulation of the tested development scenarios: Based on the above rationale, two future development scenarios are formulated using the economy wide simulation model, the first scenario assumes the continuation of the currently adopted policy measures including foreign exchange rate floating measures, encouraging exports and rationalizing imports. A continuation of public and private investment quantities and allocation patterns are also considered. Government revenue and spending policies follow the same pattern with special references to the adopted fiscal reform program concluded with the IMF. This scenario assumes also that Egypt will pursue its policy towards encouraging foreign direct investments as well as private initiative. In particular, the new value added tax program as well as subsidy elimination measures of fuel and electricity subsidies are part of this scenario. 24

25 The second scenario assumes that Egypt decided to apply advanced measures towards the transformation to the knowledge economy. This would include the development of knowledge intensive high value-added technology-based manufacturing and services activities based on increased current and capital spending on research and development, innovation, creative outputs and intangible assets. Given its long-term nature, the policy instruments for applying this knowledge-oriented scenario include; public, private and FDI investment quantities and allocation patterns as well as public spending measures to encourage the transformation process. The adopted policies will concentrate on the reallocation process of public and private capital and current spending towards knowledge and innovation related industries and sectors rather than increasing the aggregate quantity of gross fixed capital formation. RDI, Information and communication and real estate and business, financial and cultural services will certainly benefit from this reallocation process, while keeping reasonable investment growth rates for other sectors of the economy. Higher expenditure on enabling environment such as education and health is however considered. This would reflect also both government and nongovernment spending directed to training human capital formation. To implement this second scenario, the mechanisms of updating knowledge and intangible assets are activated in order to compute the spillover effects on total factor productivity and efficiency of inputs in the sectoral production functions using sector specific elasticity of spillover. Experimental Results: Tables from (1) to (3) summarize the results of applying the two development scenarios to determine the future performance of the Egyptian economy. Table (1) estimates GDP indicators corresponding to the two development scenarios. This table includes sources and uses of GDP as well as Per Capita GDP in real term or constant prices. Table (2) shows sector specific value added in real terms with special reference to the activities leading the knowledge economy transformation process. These two tables compare the two tested scenarios beginning from the 25

26 Economic Indicators Table ( 1 ) GDP Summary Table (Real Terms) Base year Year (2019/20) Reference Path Development Scenarios Knowledge /Innovation 2024/ / / /30 Value (1) (%) 2) Value (1) (%) 2) Value (1) (%) 2) Value (1) A. Sources of DP Private Sector Public Sector GDP at Factor Cost B. Uses of GDP Final Consumption Investment Exports Imports GDP at Market Price (%) 2) Per Capita Real GDP (3) (1) In Billion Egyptian Pounds (EGP) (2) Annual Growth rate (%) (3) Egyptian Pounds 26

27 Tale (2) Impact of Development Scenarios on Sector Specific GDP (Real Terms) Economic Indicators Base year (2019/20) Reference Path Development Scenarios Knowledge /Innovation 2024/ / / /30 Value (1) (%) 2) Value (1) (%) 2) Value (1) (%) 2) Value (1) (%) 2) Agriculture, live stock & fishing Manufacturing Transportation Information & Communication Finance & Insurance Real estate & Business Services Education, Health and Social Services (1) In Billion Egyptian Pounds (EGP) (2) Annual Growth rate (%) 27

28 Table ( 3 ) the current Account of the balance of payments (current Prices) Economic Indicators (1) Base year (2019/20) Development Scenarios Reference Path Knowledge /Innovation 2024/ / / /30 Total Exports Total Imports Trade Balance (goods and Services) Net Factor income Net current transfer (180.8) (404.0) (781.2) (376.7) (658.8)

29 Current account Deficit (1) In Billion Egyptian Pounds (EGP) Figure (3) Impact of Development Scenarios on Per Capita GDP (Real Terms) 29