Gross Capital Formation in current and constant prices, part 1: Gross Fixed Capital Formation 1

Gross Capital Formation in current and constant prices, part 1: Gross Fixed Capital Formation 1 Introduction This paper continues the series dedicated to extending the contents of the Handbook Essential SNA: Building the Basics 2. The aim of this paper is to provide some background to understand the compilation of two tables included in the Minimum Requirement Data Set (MRDS), the first data set that a country must have before it can claim to have implemented SNA: GDP by expenditure at current prices; GDP by expenditure at constant prices. To understand how these tables are compiled for gross capital formation and what data sources are required to do so, much of the paper is used to outline the expenditure approach to GDP compilation as applied to the case of gross capital formation. A previous paper in this series has examined the compilation of the two MRDS tables in general terms 3. In the current paper we will apply these general observations to the particular case of gross capital formation. Gross capital formation is measured by the total value of the gross fixed capital formation, changes in inventories and acquisitions less disposals of valuables (SNA 10.31). Since the paper will exceed the intended length of papers in the series, we will distribute its content over two parts, of which the current document on gross fixed capital formation is the first. In this paper we will also look at valuables. In the second part we will explore changes in inventories 4. Starting point: the Capital account In the presentation of the compilation of GDP by output approach and by expenditure approach in previous papers we have tried to elucidate the connections with the integrated economic accounts as presented in SNA 2008 5. The transactions used in the output approach output, intermediate consumption and value added belong to the Production account. The transactions for the expenditure approach explored so far household, government and NPISH final consumption expenditures belong to the Use of disposable income account. Both of these accounts are current accounts, in which the flow of value added to disposable income (out of which final consumption is paid) is followed for one accounting period. The last current account the use of disposable income account closes with savings as balancing item. Following the monetary perspective, this represents 1 This paper has been prepared with the technical assistance of DevStat Servicios de Consultoría Estadística in consortium with ICON Institute. 2 Henceforth called the Handbook ; references in this paper are to the second (2012) edition; it can be found at the following link: http://epp.eurostat.ec.europa.eu/portal/page/portal/product_details/publication?p_product_code=ks-ra- 12-001 3 Annual GDP by expenditure approach in current and constant prices: main issues 4 The other part is: Gross Capital Formation in current and constant prices, part 2: Changes in Inventories 5 The integrated economic accounts are presented in the following papers: Introduction to the SNA 2008 Accounts part 1, 2 and 3 1

surplus money in the economy that can be used for accumulating (building up) assets. Transactions in non-financial assets are recorded the capital account, the first accumulation account. The lefthand side of the capital account records the various types of investment in non-financial assets. The main use transaction is gross capital formation, which consists of the following three components, which are the main topics of this paper: Gross fixed capital formation; Changes in inventories; Acquisitions less disposals of valuables. To understand these transactions requires a good understanding of non-financial assets. Not all nonfinancial assets are involved. One of the other transactions on the left-hand side of the capital account is acquisitions less disposals of non-produced non-financial assets. This transaction also involves assets, in this case: Natural resources; e.g. land, mineral and energy reserves; Contracts, leases and licenses; Goodwill and marketing assets. Assets: an overview An asset, tangible or intangible, is a store of value that is capable of being owned or controlled. Assets can be financial and non-financial 6. Non-financial assets can be produced or non-produced. Produced assets included fixed assets, used in production repeatedly over an extended period of time, inventories and valuables. Non-produced assets include natural resources, licenses and marketing assets (including goodwill). Figure 1 presents these concepts graphically. We will explore them in some more detail below. Assets Nonfinancial assets Financial assets and liabilities Produced assets Nonproduced assets Fixed assets Inventories Valuables Tangible Intangible Tangible Intangible Figure 1 Classification of assets 6 Financial assets (and liabilities) are briefly discussed in the paper Introduction to the SNA 2008 Accounts, part 3: Accumulation Accounts 2

Produced assets are non-financial assets that have come into existence as outputs from production processes that fall within the production boundary of the SNA. Non-produced assets are non-financial assets that have come into existence in ways other than through processes of production. Fixed assets are produced assets that are used repeatedly or continuously in production processes for more than one year. They are divided into tangible fixed assets and intangible fixed assets. Examples of tangible fixed assets are dwellings, other buildings and structures, machinery and equipment, and cultivated assets. Examples of intangible fixed assets are mineral exploration, computer software and entertainment. We will explore these examples in more detail below. Inventories are produced assets that consist of goods and services, which came into existence in the current period or in an earlier period, and that are held for sale, use in production or other use at a later date. We will look at inventories in the second part of this paper. Valuables are produced goods of considerable value that are not used primarily for purposes of production or consumption but are held as stores of value over time. Examples are precious metals and stones, jewelry, works of art and antiques. Both fixed assets and inventories are assets that are held only by producers for purposes of production. Valuables may be held by any institutional unit and are primarily held as stores of value. Tangible non-produced assets are non-produced assets that occur in nature and over which ownership may be enforced and transferred. Examples are land, subsoil assets, non-cultivated biological resources and water resources. In SNA 2008 tangible non-produced assets are known as natural resources. Intangible non-produced assets are non-produced assets that are constructs of society. They appear as part of legal actions, such as the granting of a patent or the conveyance of some economic benefit to a third party. Examples are patented entities, leases and other transferable contracts and purchased goodwill. The term intangible fixed assets has been replaced with intellectual property products in SNA 2008. What is Gross Fixed Capital Formation? Gross fixed capital formation (GFCF) pertains to fixed assets and some non-produced assets. It is measured by the total value of a producer s acquisitions, less disposals, of fixed assets during the accounting period plus certain specified expenditure on services that adds to the value of nonproduced assets (SNA 10.32). GFCF can occur because: new or existing fixed assets are purchased; fixed assets are produced and retained for the producers own use (this includes own account production of fixed assets not yet completed or fully mature); new or existing fixed assets are acquired through barter; new or existing fixed assets are received as capital transfers in kind 7 ; new or existing fixed assets are acquired by the user under a financial lease; major improvements on fixed assets are carried out; natural assets yield repeat products because of natural growth. Negative values, i.e. disposals of fixed assets are recorded as negative acquisitions. These can occur because: 7 See for capital transfers the paper Introduction to the SNA 2008 Accounts, part 3: Accumulation Accounts 3

existing fixed assets are sold; existing fixed assets are surrendered in barter; existing fixed assets are surrendered as capital transfers in kind. An existing fixed asset is one whose value was included in the gross fixed capital formation of at least one producer unit at some earlier point in time either in the current period or in some previous accounting period. Following the breakdown of figure 1, Gross fixed capital formation is traditionally divided into three categories: Acquisitions less disposals of tangible fixed assets; Acquisitions less disposals of intangible fixed assets; Addition to the value of non-financial non-produced assets. Tangible fixed assets consist of dwellings, other buildings and structures, machinery and equipment and cultivated biological resources. As we have seen in a previous paper a number of changes related to non-financial assets have been made in SNA 2008 with respect to SNA 1993 8. The assets boundary has been extended weapons systems as another class of tangible fixed assets. Intangible fixed assets consist of mineral exploration and evaluation, computer software and databases, and entertainment, literary and artistic originals. Another class of intangible fixed assets is research and development. In SNA 2008 the activity of research and development is not treated as an ancillary activity anymore but the output of research and development is capitalized as intellectual property products except in cases where it is clear that the activity does not entail any economic benefit to its producer (in which case it is intermediate consumption). Mineral exploration and computer software and databases are other examples of intellectual property products. There are three distinct types of non-produced non-financial assets in the SNA: natural resources, contracts, leases and licenses, and goodwill and marketing assets. Transactions in these assets are not part of GFCF but of another capital accounts transaction acquisitions less disposals of nonproduced non-financial assets. There are two exceptions: major improvement to non-produced nonfinancial assets and cost of ownership transfer. Their inclusion into GFCF is consistent with the treatment of major improvements and cost of ownership transfer for produced assets. The most important major improvement included here is that of land. Costs of ownership transfer refers to the additional payments incurred during the acquisition or disposable of assets. They are listed in SNA 10.51. An example is the legal fee associated with the sale of a dwelling between one household and another. Accommodating these assets types in the GFCF framework results in the following (condensed) SNA 2008 classification for GFCF by type of asset: I. Dwellings II. Other buildings and structures (including land improvements) III. Machinery and equipment IV. Weapons systems 8 See the paper Main new SNA 2008 recommendations with impact on the level of GDP 4

V. Cultivated biological resources VI. Costs of ownership transfer on non-produced assets VII. Intellectual property products 1. Research and development 2. Mineral exploration and evaluation 3. Computer software and databases VIII. Entertainment, literary and artistic originals IX. Other intellectual property products Note that land improvements is part of other buildings and structures as a separate subcategory. In the following sections we will briefly explore the major categories of GFCF in tangible and intangible assets, after which we will present the full SNA 2008 classification for GFCF by type of asset. GFCF in tangible fixed assets Next to the new SNA 2008 category weapons systems 9 we distinguish four categories of tangible fixed assets: dwellings, other buildings and structures, machinery and equipment and cultivated biological resources. Dwellings Dwellings are buildings that are used entirely or primarily as residences, including any associated structures, such as garages, and all permanent fixtures customarily installed in residences. Included are also houseboats, mobile homes, caravans etc. used as principal residence. Examples of GFCF in dwellings: Dwelling purchased by a household; Dwelling self-built by a household; Dwelling purchased by a landlord for renting to households. Note that an increase in the value of a dwelling because house prices go up is not counted as part of GFCF but is treated as a holding gain and is part of the revaluation account 10. If a dwelling is sold to a person who lives in another country only the transfer costs are part of GFCF. Other buildings and structures Non-residential buildings consist of buildings other than dwellings. Examples are warehouses, industrial buildings, commercial buildings, buildings for public entertainment, hotels, restaurants, schools and hospitals. Other structures include structures other than buildings. Examples are roads, railways, bridges, tunnels, waterways, pipelines, power lines and constructions for sport and recreation. As noted earlier land improvement is also categorized here. Examples of GFCF in this category: Factory purchased by a manufacturing company; Barn purchased by a farmer to keep his animals in; 9 For more information see the paper Main new SNA 2008 recommendations with impact on the level of GDP 10 See part 2 of this paper for holding gains; for the revaluation account see the paper Introduction to the SNA 2008 Accounts, part 3: Accumulation Accounts 5

Barn constructed by farmer for the storage of his crops; Building a dam for the production of hydroelectricity; Construction of a new motorway by the government. Machinery and equipment Machinery and equipment consists of three subcategories: transport equipment, machinery for information, communication and telecommunications (ICT), and other machinery and equipment. Transport equipment consists of equipment for moving people and objects. Examples are motor vehicles, trailers, motorcycles, bicycles, ships, railway locomotives and aircraft. ICT equipment consists of devices using electronic controls and also the electronic components forming part of these devices. In practice this category consists mostly of computer hardware and telecommunications equipment. Other machinery and equipment consists of machinery and equipment not elsewhere classified. Examples are electrical machinery, radio, television, medical appliances, optical instruments, watches and clocks. Examples of GFCF for this category are: Car purchased by a taxi company directly; Car acquired by a taxi company using a loan from a bank; Installation of a new heating system to a dwelling; Ambulance bought by a government run hospital; Ambulance purchased by the army; Aircraft purchased by the national airline; Sale of a truck to an enterprise in another country (disposal of the asset). It should be noted that consumer durables are not treated as fixed assets. The services these durables produce are household services outside the production boundary of the SNA (SNA 10.34). So a car purchased by a household is not GFCF but household final consumption. Also, expenditures on small hand tools such as hammers, screwdrivers, wrenches etc. are not treated as GFCF but as intermediate consumption, provided that expenditures on such tools take place at a fairly steady rate and that their value is small compared with expenditures on more complex machinery and equipment (SNA 10.35). Major improvements to existing fixed assets such as building and machinery is also part of GFCF if it increases their productive capacity, extend their service lives, or both. The distinction between ordinary maintenance and repairs that constitute intermediate consumption and those that are treated as capital formation is not always clear cut, see SNA 10.45 10.47. Bearing this in mind we give some further examples of GFCF: Cost of installing a machine into a factory; 100 desks bought by an enterprise for use in their office; Replacing the roof on a dwelling; Some examples of intermediate consumption instead of GFCF: A desk bought by an enterprise for use by a member of staff (assumed to fall under small tools); Replacing a missing tile on the roof of a dwelling; Painting and decorating of a dwelling (final consumption if by households). 6

Cultivated biological resources Cultivated biological resources cover animal resources yielding repeat products and tree, crop and plant resources yielding repeat products whose natural growth and regeneration is under the direct control, responsibility and management of institutional units. Examples of animal resources are breeding stocks, dairy cattle, draft animals, sheep used for wool production and animals used for transportation, racing or entertainment. Animals raised for slaughter, including poultry, are not fixed assets but inventories. Examples of tree, crop and plant resources are trees (including vines and shrubs) cultivated for fruits and nuts, for sap and resin and for bark and leaf products. Some examples of GFCF: Sheep used in the production of wool; Bull (male cow) used for breeding; Chickens used to produce eggs; A vine tree used to produce grapes for wine. Chickens for slaughter and sheep used for meat are not part of GFCF but of inventories. GFCF in intangible fixed assets Next to the new SNA 2008 category Research and development 11 we distinguish the following categories of intangible fixed assets: mineral exploration and evaluation, computer software and databases, entertainment, literary and artistic originals and a residual category other intellectual property products. Mineral exploration and evaluation consists of the value of expenditures on exploration for petroleum and natural gas and for non-petroleum deposits. Mineral exploration is undertaken in order to discover new deposits of minerals or fuels that may be exploited commercially. Computer software and databases consists of computer programs, program descriptions and supporting materials for both systems and applications software. Examples are initial development and subsequent extensions of software. Entertainment, literary and artistic originals consist of the original films, sound recordings, manuscripts etc., on which drama performances, radio and television programming, musical performances, sporting events, literary and artistic output, etc., are recorded or embodied. Note that sold copies of the original are also treated as fixed assets when they are expected to be used in production for more than a year. Some examples of GFCF are: Original manuscript of a book; Painting owned by an enterprise exhibited on the wall of their boardroom; Cost of looking for a new oil field; Cost of the operating software supplied with the hardware; Purchase of computer software to run a company s payroll system; In-house production of computer software for the accounting department. Note that the acquisition or disposal of valuables such as paintings (and precious stones and metals, antiques and other art objects) e.g. by museums is recorded under changes in valuables, a separate category of gross capital formation. 11 For more information see the paper Main new SNA 2008 recommendations with impact on the level of GDP 7

GFCF by Asset type: Summary With the details of the previous two sections we can now give the full classification of GFCF by asset type: I. Dwellings II. Other buildings and structures 1. Non-residential buildings 2. Other structures 3. Land improvements III. Machinery and equipment 1. Transport equipment 2. ICT equipment 3. Other machinery and equipment IV. Weapons systems V. Cultivated biological resources 1. Animal resources yielding repeat products 2. Tree, crop and plant resources yielding repeat products VI. Costs of ownership transfer on non-produced assets VII. Intellectual property products 4. Research and development 5. Mineral exploration and evaluation 6. Computer software and databases i. Computer software ii. Databases VIII. Entertainment, literary and artistic originals IX. Other intellectual property products Measurement issues and GFCF in constant prices Like other categories of expenditure, GFCF can be measured from either the supply or demand side. Measurement from the supply side uses data on domestic output (in agriculture, manufacturing and construction) plus imports less exports of capital goods at the product level (final demand for capital goods does not exist) 12. Measurement from the demand side uses data (e.g. from an investment survey) from purchasers of capital goods on the purchases made. A disadvantage of this approach is that the product classification of GFCF from the demand (consumption) side generally has limited product detail. Constant price estimates of GFCF are usually prepared in a similar way as the current price estimates 13. Each category of GFCF separately needs to be expressed in constant prices. This is best 12 This is based on the fact that output + imports = GFCF + exports, which is derived for the special case of capital goods from equation (1) from the paper Annual GDP by expenditure approach in current and constant prices - Main issues: Output + Imports + Net taxes = IC + Final consumption + Gross capital formation + Exports; capital goods are not used as IC and final consumption is zero; also changes in inventories are zero so that gross capital formation = GFCF. Of course there are valuation issues that need to be solved (the net taxes term). For small countries, capital goods output and exports may be zero as well, making GFCF effectively equal to imports. 13 For background, see the papers: National Accounts in Constant Prices, part 1: Elementary Indexes and part 2: Aggregated Indexes. 8

done by deflation with an appropriate price index. Such price indexes may be difficult to compile. First there is the problem that some products included in GFCF can be unique, for example an oil rig or a specialized piece of plant and machinery so that no price indexes exist. This is especially the case for large equipment goods. The difficulties of deflating construction, computers and software have been noted already in previous papers 14. For price indices to be entirely appropriate they should measure changes in the purchasers' price of the particular products, including any non-deductible VAT included in the price. Price indices of this kind are often referred to as investment price indices. The direct use of PPIs is not entirely suitable because PPIs are measured at basic prices. The use of PPIs for the deflation of GFCF assumes that the changes in basic price and in purchasers' price are the same, i.e. taxes, transport, installation and other costs of ownership remain constant. Another important point is that some goods recorded as GFCF will have been imported. Consistent deflation of products within imports and GFCF needs to be ensured, taking into account differences in price, e.g. due to taxes and subsidies on imports. Concluding remarks This paper set out to provide some background on the methodology of compiling for gross capital formation the MRDS tables on expenditures in current and constant prices. In the current paper we explored gross fixed capital formation. In the next paper we will explore the other category of gross capital formation: changes in inventories. To find out more, Essential SNA: Building the Basics (2012 edition), Chapter 7 The 2008 SNA, European Commission, IMF, OECD, UN, World Bank, 2009, Chapter 15 Price and volume measures Handbook on price and volume measures Eurostat, Luxembourg 2001 14 Industry and Construction in National Accounts - Value added in current and constant prices; Services in National Accounts - Value added in constant prices 9