Are the Irish 26.3% better off?

observer-ireland
OECD Observer on Ireland’s economy

OECD Statistics Directorate

On 12 July 2016, the Irish Central Statistics Office published data showing that real GDP grew by 26.3% in 2015. This huge leap led many commentators to question the figures and wonder whether GDP adequately reflects economic activity. To answer this, one first has to be clear about what GDP is – what is being captured when one tries to measure Gross Domestic Product.

The international standard, the 2008 System of National Accounts (SNA), says: “Production is an activity, carried out under the responsibility, control and management of an institutional unit, that uses inputs of labour, capital, and goods and services to produce outputs of goods and services”. GDP corresponds to the value added, i.e. the balance of total output and the intermediate use of goods and services related to this production. It consists of the remuneration for the input of labour, in the form of compensation of employees, and the remuneration for the input of tangible and intangible capital, in the form of operating surplus.

Up until the last few decades, intangible capital was largely used where it was produced. However, globalisation, in particular the growing importance of global value chains, combined with the increasing importance of “intangible assets” used in production, has changed the production landscape, as multinational enterprises (MNEs), in particular, have sought to maximise profits and minimise costs, including through minimisation of their global tax burden, by (re)allocating their economic activities across the world. These relocations include transfers of economic ownership of Intellectual Property Products (IPPs), with associated risks as well as benefits from their use. The latter is in the form of income from the production of goods and services, including receipts from licenses and patents, accruing to the host economy.

The above issue to a large extent explains the case for the recent increase in Ireland’s GDP, albeit with the added complication that the intellectual property is used in contract manufacturing type of arrangements. Under these arrangements, Irish enterprises (among which Irish affiliates of foreign MNEs) involve contract manufacturers, including those domiciled outside Ireland, to produce final products using the blueprints from the IPPs. The subsequent distribution and sale of these products, organised by the Irish enterprises, results in value added being created in the Irish economy, which also includes income generated by the IPPs.

The use of intangible assets in production can generate significant value added, and so the recording of value added through their use reflects one dimension of economic reality. But in some cases the question is whether that economic reality (value added) is recorded in the correct place, in Ireland or elsewhere.  To determine this, the SNA looks to economic ownership as opposed to legal ownership. The economic owner of an asset is the entity that assumes the risks and gains the rewards of ownership, and it would be wrong to assume that legal and economic ownership necessarily align. In the Irish case, it is clear that the legal ownership has been transferred to Ireland, but it is important to stress that it does not immediately follow that economic ownership has also been transferred. However, decision making and control, two important criteria used in assessing economic ownership, do appear to have been relocated to Ireland as well, justifying the inclusion of the associated value added leveraged from the use of the underlying intellectual property in Ireland.

That is not to say that this is an entirely satisfactory outcome for everybody. The increasing use of intellectual property in production challenges the arguably “archaic” views of production that sees growth through a prism of physical factors of production, such as tangible capital and labour. Some have argued that adjustments should be made to better reflect an alternative view of economic reality. However, it is simply impossible to adjust for the relocation of IPPs, and to create a complete set of alternative prices for the transfer prices charged by the multinationals for their internal cross-border deliveries alike. Statisticians would, for example, have to impute prices, in a consistent way at a global level, using questionable assumptions, such as allocating an equal proportion of profits to nationally available compensation of employees. They would also need to adjust the business accounting data for the relocation of IPPs. Legal arrangements would also not allow for the international exchange of individual data, needed to make these adjustments in an internationally consistent way. But perhaps more importantly, the fact is that the relocation of IPPs does actually represent an economic reality, even if that may not be the preferred perspective for all types of economic analysis.

What further complicates the understanding of the Irish case is that often GDP is interpreted as an indicator of the purchasing power or the material well-being of a country. In this respect, it is important to state that GDP is primarily a gross measure of economic activities on the economic territory of a country, and the income generated through those activities. High levels of GDP thus do not necessarily mean high levels of income flowing to the residents. This is because some of the income generated by production may be repatriated to non-residents, for example in the case of income generated by affiliates of multinational enterprises. Another part may be needed to compensate for the additional depreciation costs. In the case of Ireland, Net National Income (NNI), which equals GDP plus net receipts of compensation of employees and property income (interest, dividends, reinvested earning of foreign direct investment, etc.) from the rest the world minus depreciation, shows a considerably lower growth rate. Whereas in 2015 GDP in current prices increased by 32.4 %, nominal growth of NNI amounted to “only” 6.4 %.

Going one step further, one could also look at household disposable income, a key measure of average material well-being of people. In 2015, Irish households’ disposable income grew by 4.6 % when adjusted for price changes. And while Irish GDP per capita is well above the OECD average, by 24 percentage points in 2014, Irish household disposable income per capita is 22 percentage points below the OECD average.

When looking at the economic performance of a country, it is therefore important not to focus solely on GDP. The system of national accounts is a complete and consistent framework for the description of an economy. From this system, a variety of indicators can be derived, depending on what exactly one wants to monitor or analyse. If one wants to look at the material well-being or the purchasing power of a country’s resident population, it is much better to use data on, for example, household disposable income or household final consumption (see the OECD Dashboard of Household Statistics). An even broader perspective on the well-being of a society, which goes well beyond income developments, and also takes into account other aspects affecting well-being such as health, education, security, housing, etc., is provided in the OECD Better Life Initiative.

The Irish figures help to illustrate the limits of GDP and in particular the care needed in its interpretation, particularly in the domain of material well-being. It also highlights the importance of focussing on additional aggregates including those defined within the system of national accounts, and not exclusively on GDP.

Useful links

To read the full story, go to: www.oecd.org/std/na/Irish-GDP-up-in-2015-OECD.pdf

Calculate this country’s GDP OECD Insights article on the System of National Accounts

New standards for compiling national accounts: what’s the impact on GDP and other macro-economic indicators? Peter van de Ven, OECD Statistics Brief, February 2015

Calculate this country’s GDP

national accountsLast week, the media reported on the questions Oxford University asked candidates as part of their entrance interview. The questions aren’t designed to test knowledge of facts, but to give students a chance to show how they think about solving problems, whether they can see links between one subject taught at school and another, and so on. One of the questions in history was “How much of the past can you count?”. The idea, as interviewer Stephen Tuck told the Daily Mail, is to provoke a discussion about “all sorts of issues relating to historical evidence. For which periods and places and aspects of the past is data readily available?”. It’s a question you could ask in economics too: how much of a country can you count? And one that the newly updated Understanding National Accounts from the OECD answers.

Governments have always wanted to have data on who and what they govern – a population census is part of the Christmas story for instance – and, as we mentioned in this post, the origins of the modern system of counting a country can be traced back to the 17th century and William Petty’s Political Arithmetick. Petty developed and applied his techniques in England’s first colony, surveying land in Ireland that was to be given to Oliver Cromwell’s troops. His statistical methods were rudimentary, often involving estimation based on exports, deaths and the number 30: a 30% increase in exports means the population increased by 30%; multiply the number of deaths by 30 to find out the size of the population. His components of national accounts though contain much that is still familiar – land, real estate and other personal property, ships…

How though do you count all this? Samuel Beckett, one of the Anglo-Irish descendants of Cromwell’s invaders, tackles this problem in Malone Dies, when the eponymous hero decides, on his deathbed, to make a list of everything he possesses. He’s overwhelmed by the complexity of the task and can’t figure out what to include and how. (Is a pair of shoes one or two items? And what about the laces?). In fact he doesn’t get much further than the pencil and notebook he was going to use to make his inventory and gives up.

OECD statisticians are made of sterner stuff, and know exactly what they’re including and why. Petty would recognise our colleagues’ claim to provide “information on the economic interactions taking place between different sectors of the economy (households, corporations, government, non-profit institutions and the rest of the world) to allow for macroeconomic analysis and evidence-based decision making”.

Given the military origins of his Arithmetick, he’d also be pleased to see the main change in the new system of calculations introduced in 2008: “…expenditure on research and development and weapons systems (warships, submarines, military aircraft, tanks, etc.) are now included in gross fixed capital formation, i.e. investment. This is recognition that expenditure on these items provides long-lasting services to businesses, non-profit institutions, and the governments who use them. This increases the level of GDP across time, but the impact on GDP growth rates will generally be minor.”

Understanding National Accounts was first published in 2006 to give experts and non-experts a practical summary of how to calculate the accounts, but also an understanding of the principles and data sources behind them. Most countries have now adopted the 2008 methodology, but the new edition reflects three other developments too.

First, the financial crisis highlighted the need to better explain how strong movements in economic activity are actually reflected in national accounts. Second, national accounts can be a source for tracking households’ material well-being in line with the emphasis on “better lives”, beyond the traditional objective of economic growth and GDP, exemplified by the OECD Better Lives Initiative,. Finally, the data on trade in value added now being compiled in parallel to core national accounts shed a new light on the interconnectedness of economies.

Obviously somebody reading about national accounts already has some interest in economics, but one of the strengths of the book is that it takes nothing for granted, and explains every technical term clearly and simply, even familiar ones like “the bizarre title “Gross Domestic Product”, or GDP”. Likewise, to explain the difference between GDP and gross national income (GNI), it uses a simple example: “The earnings of workers living in Germany but working in neighbouring parts of Switzerland or Luxembourg have to be added to the German GDP to obtain its GNI. Conversely, the earnings of the seasonal or regular workers living in France or Poland and working across the border in Germany have to be deducted from the German GDP to obtain the German GNI.”

Once you’ve read the main text, you can test your knowledge using a series of exercises (the answers are provided). It’s true that “Calculate the GDP of this economy” is for the bold and the brave, but maybe all national accountants recognise themselves in Petty’s birth horoscope: “Jupiter in Cancer makes him fat at heart”, even if they’d prefer to avoid a second opinion that “vomits would be excellent good for him”.

Useful links

OECD Statistics Directorate

OECD data portal

Is GDP a satisfactory measure of growth? François Lequiller, co-author of Understanding National Accounts talks to the OECD Observer