The Limits of the Knowledge-Based Capital Framework

Knowledge-based capital (KBC) investment refers to business spending on knowledge-related assets such as R&D, managerial competence, and advertising that incurs future returns for firms. However, many forms of KBC, or intangible capital as it is also known, have to date been absent from national economic accounting, and many advocate their inclusion as an important step toward a better understanding of our changing economy. Unfortunately, the KBC framework as currently conceived suffers from a number of fundamental problems: in particular, it wrongly assumes that that firms are rational investors, glossing over differences in returns to different types of capital, and it oversimplifies the aggregation of capital from the firm level to the national level. These issues need to be overcome before the KBC framework should be applied to economic theory and policy.

The KBC framework as currently promoted by its advocates suffers from two key challenges. First, by incorporating the neoclassical assumption that firms invest rationally in all capital with a positive net return, the framework effectively assumes that all classes of capital spending have the same return for firms and thus the same effect on economy-wide productivity. This assumption obscures more than it reveals. The inclusion of all forms of knowledge capital risks leading policymakers to give short shrift to certain kinds of physical capital, particularly ICT capital, that research has shown plays an outsized role in driving productivity and innovation. At the same time, the KBC framework overvalues whole classes of intangible investments that have little or no impact on growth, such as architectural designs, or that can actually destroy economic value, as we have seen in the case of investments in new financial products.

Second, the KBC framework assumes that the sum of benefits to firms from investments can be aggregated to national levels. There are a number of reasons why this may not be the case, particularly for intangible capital investments in things like advertising and brand development, in large part because much of the benefits are zero-sum in nature with one firm’s benefit coming at the expense of another.

In order to incorporate intangibles into national accounts in a more useful and accurate manner, the following changes should be made to the framework:

It should focus on the types of capital that do the most to drive productivity instead of making an artificial tangible/intangible distinction. Emphasizing KBC sends a misleading message to policymakers: that intangible capital is inherently good and tangible capital is in the “buggy whip” category. The right message, instead, is that investments must be understood first and foremost by the contribution they make to economy-wide productivity and innovation. This should be true regardless of their tangibility.

In addition, more careful attention should be paid to the problems inherent in aggregating firm-level expenditures into national accounts, as intangibles present a particularly tricky problem due to the peculiarities of market structures. A more careful distinction needs to be made between positive- and zero-sum investments at the national level, and develop more robust estimates of the actual net value created. The value of advertising spending is particularly difficult to pin down objectively. As firms compete for a fixed supply of attention using theoretically costless information, the link between individual and aggregate benefit is elusive. As a concept KBC may be somewhat better linked to international competitiveness than to simple productivity comparisons.

Finally, additional adjustments to methodology should be made, including: finding more accurate ways of valuing human capital, reconciling important differences in international economic systems that can lead to distorted and misleading international comparisons, and including the value of prosumer capital.