Modelling the Lisbon Strategy: Analysing Structural Reforms in the EU using QUEST III

Werner Röger, Jan in ‘t Veld, Janos Varga

European CommissionDG ECFIN

June 2008

1966 1971 1976 1981 1986 1991 1996 2001 200650

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Capital Intensity

TFPLabour Productivity per Hour

Labour Productivity per Hour Levels Accounting (EU15 relative to US) (US = 100)

Europe’s productivity performance

The EU’s Innovation Gap:

EU US JP

INNOVATION DRIVERS

1.1 S&E graduates 12.9 10.6 13.7

1.2 Tertiary education 23.0 39.0 40.0

1.3 Broadband penetration rate 14.8 18.0 18.9

KNOWLEDGE CREATION

2.1 Public Sector R&D expenditures 0.65 0.69 0.74

2.2 Business Sector R&D expenditures 1.17 1.87 2.40

2.3 Share of medium-high / high-tech R&D 85.2 89.9 86.7

INNOVATION & ENTREPRENEURSHIP

3.4 Early-stage venture capital 0.022 0.035 --

3.5 ICT expenditures 6.4 6.7 7.6

APPLICATIONS

4.2 High-tech exports 16.7 26.1 20.0

4.5Employment in medium-high / high-tech manufacturing

6.63 3.84 7.30

INTELLECTUAL PROPERTY

5.1 EPO patents 128.0 167.6 219.1

5.2 USPTO patents 49.2 273.7 274.4

5.3 Triad patents 19.6 33.9 87.0

Possible explanations

1. Product market competition2. Skill composition of the labour force3. Financial market imperfections4. R&D subsidies

Methodology:

Semi endogenous growth model (Jones)

calibrated for the EU (27) and the US

1. Model

Main characteristics:• Three sectors: final goods, intermediates, research• Monopolistically competitive final and intermediate goods sector • Three types of labour (low, medium and high skilled)• Only high skilled workers can move between production and

R&D• Technical progress is modelled as increasing variety of

intermediates

Sources of market failure:

• Monopoly pricing in the final goods sector.• Monopoly pricing in the intermediate goods sector (but

free entry).• Administrative entry costs.• Limited access to loans. • Intertemporal knowledge spillovers.• International knowledge spillover.• (Imperfect competition in the labour market).

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Ai : Rental rate required by the investor i : Risk free rate of return

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1. High financing costs ( Arp is large)

2. High administrative entry barriers ( XFC is high)

3. High price( AP ) for intangible capital (inefficient research sector) 4. Low profits (high costs for tangible inputs in the production of intermediate

products)

Table 2: EU - US Parameter Comparison EU US Source R&D sector LA 0.010 0.017 EUROSTAT/OECD R&D intensity (%) 1.860 2.670 EUROSTAT/OECD 0.779 0.900 calibration (constrained by equations) 0.344 0.771 Botazzi-Peri (2007)/Coe-Helpman (1995) 0.552 0.109 Botazzi-Peri (2007)/Coe-Helpman (1995) (R&D efficiency) 0.190 0.261 calibration (constrained by equations) Intermediate sector markup 0.11 0.12 ECFIN fixed entry costs 0.38 0.02 Djankov et. al. (2002) Final goods sector Final good mark up 0.242 0.205 ECFIN Skill distribution sL 0.350 0.121 EUROSTAT/OECD sM 0.588 0.803 EUROSTAT/OECD sH 0.062 0.076 EUROSTAT/OECD Employment rates LL 0.572 0.600 EUROSTAT/OECD LM 0.744 0.774 EUROSTAT/OECD LH 0.837 0.871 EUROSTAT/OECD (elasticity of. substitution) 1.400 1.400 Katz and Murphy (2002) L 0.689 0.760 EUROSTAT/OECD Skill premium % (high vs. medium)

27.25 72.00 EUROSTAT/OECD

Skill premium % (medium vs. low)

56.38 53.84 EUROSTAT/OECD

Efficiency levels ef*

L 1.000 1.000 calibration (constrained by equations) ef*

M 4.782 4.517 calibration (constrained by equations) ef*

H 11.114 30.141 calibration (constrained by equations) Financial market Risk premium (intangibles) 5.2 2.6 Calibration (constrained by equations) Taxes and subsidies B-Index 0.96 0.89 OECD/Warda (2006) Labour taxes 0.386 0.306 ECFIN Labour market Labour adjustment cost (% of total add. wage costs)

18 10 ECFIN, QUEST III

Labour supply elasticity (1/ ) 1/2.9 1/.8 ECFIN, QUEST III

Reform Scenarios How to increase knowledge investment? 4.1 Raising R&D through tax credits 4.2 Reducing mark-ups in the service sector 4.3 Reducing entry barriers 4.4 Increasing the share of high skilled workers

4.1 Raising R&D through tax credits

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EU: 0.96 US: 0.89

US provides slightly more subsidies to R&D compared to the EU Table 4.1 0.1% of GDP tax-credit to the intermediate sector

Years EU

1 2 3 4 5 10 20 50 100

GDP -0.01 -0.04 -0.06 -0.06 -0.05 -0.01 0.07 0.22 0.30 TFP 0.00 -0.02 -0.02 -0.01 0.00 0.05 0.13 0.24 0.27 "Ideas/Patents" 0.05 0.22 0.43 0.67 0.90 1.96 3.50 5.45 6.04 Capital 0.00 0.00 -0.01 -0.02 -0.02 -0.04 -0.04 0.09 0.20 Capital intensity 0.01 0.02 0.05 0.07 0.10 0.22 0.38 0.59 0.66 Employment 0.03 0.03 0.03 0.03 0.02 0.01 0.00 -0.01 -0.01 -low 0.01 0.02 0.03 0.03 0.03 0.02 0.00 -0.02 -0.02 -medium 0.01 0.01 0.02 0.02 0.02 0.01 0.00 -0.01 -0.01 -high -0.37 -0.89 -1.21 -1.36 -1.42 -1.37 -1.20 -0.98 -0.91 -R&D 2.58 4.84 5.76 6.13 6.24 5.93 5.17 4.19 3.91 Consumption 0.02 0.02 0.01 0.00 -0.01 0.00 0.06 0.19 0.24 Investment -0.01 -0.03 -0.04 -0.05 -0.06 -0.06 -0.02 0.11 0.20 Wages 0.04 0.09 0.11 0.11 0.12 0.15 0.21 0.34 0.40 -low -0.01 -0.02 -0.02 -0.02 -0.02 0.03 0.11 0.26 0.33 -medium -0.01 -0.01 -0.01 -0.01 -0.01 0.03 0.11 0.25 0.32 -high 0.36 0.80 1.00 1.06 1.07 1.03 0.97 0.95 0.97 R&D intensity (% of GDP) 0.10 0.12 0.13 0.14 0.14 0.13 0.11 0.09 0.08

4.2 Reducing mark-ups in the service sector

Mark up estimates suggest that competition in services is stronger in the US than in the EU

Service Sector mark up

US: 20% EU-15: 24%

Table 4.2 A 1 pp level reduction of the final goods market mark up

Years after the shock EU

1 2 3 4 5 10 20 50 100

GDP 0.12 0.33 0.38 0.39 0.40 0.51 0.69 0.91 0.97 TFP 0.07 0.18 0.20 0.19 0.19 0.18 0.16 0.16 0.15 "Ideas/Patents" 0.01 0.05 0.09 0.12 0.14 0.22 0.31 0.41 0.45 Capital 0.02 0.09 0.18 0.27 0.36 0.72 1.20 1.76 1.93 Capital intensity 0.00 0.01 0.01 0.01 0.02 0.02 0.03 0.05 0.05 Employment 0.08 0.20 0.20 0.16 0.13 0.11 0.13 0.14 0.14 -low 0.10 0.25 0.28 0.25 0.22 0.18 0.22 0.24 0.23 -medium 0.07 0.18 0.17 0.13 0.10 0.09 0.11 0.12 0.11 -high -0.02 -0.01 -0.07 -0.10 -0.10 -0.04 -0.01 0.00 0.01 -R&D 0.66 1.01 0.92 0.76 0.64 0.44 0.35 0.31 0.30 Consumption -0.13 -0.08 0.00 0.04 0.07 0.16 0.22 0.30 0.33 Investment 0.30 0.60 0.76 0.84 0.90 1.12 1.43 1.82 1.94 Wages 0.53 1.03 1.28 1.40 1.47 1.59 1.75 1.95 2.01 -low 0.48 0.93 1.17 1.31 1.39 1.53 1.69 1.88 1.94 -medium 0.52 1.02 1.28 1.41 1.47 1.60 1.77 1.97 2.03 -high 0.64 1.25 1.51 1.59 1.61 1.69 1.85 2.05 2.11 R&D intensity (% of GDP) 0.04 0.04 0.04 0.04 0.03 0.03 0.03 0.03 0.03

4.3 Reducing entry barriers

4.3.1 Financing constraints for intangible investment (venture capital):

Share of venture capital financing (in GDP)

US: 0.19% EU: 0.12%

Risk premium (in tangibles) US: 2.6 EU: 5.2

Table 4.3.b Reduction of intangible capital costs of 50bp

Years EU

1 2 3 4 5 10 20 50 100

GDP -0.01 -0.05 -0.06 -0.06 -0.06 -0.01 0.08 0.24 0.33 TFP -0.01 -0.02 -0.02 -0.01 0.00 0.05 0.14 0.26 0.29 "Ideas/Patents" 0.06 0.24 0.47 0.71 0.96 2.11 3.78 5.96 6.65 Capital 0.00 0.00 -0.01 -0.01 -0.02 -0.04 -0.04 0.09 0.22 Capital intensity 0.01 0.03 0.05 0.08 0.11 0.23 0.41 0.65 0.72 Employment 0.03 0.03 0.03 0.03 0.03 0.02 0.00 -0.01 -0.01 -low 0.01 0.02 0.03 0.04 0.04 0.02 0.00 -0.02 -0.02 -medium 0.01 0.01 0.02 0.02 0.02 0.01 0.00 -0.01 -0.01 -high -0.40 -0.95 -1.30 -1.46 -1.53 -1.48 -1.30 -1.08 -1.01 -R&D 2.77 5.18 6.18 6.58 6.71 6.40 5.62 4.62 4.32 Consumption 0.00 -0.01 -0.01 -0.02 -0.01 0.01 0.08 0.21 0.27 Investment -0.01 -0.02 -0.04 -0.05 -0.05 -0.05 -0.02 0.12 0.22 Wages 0.04 0.09 0.11 0.12 0.13 0.16 0.23 0.37 0.44 -low -0.01 -0.02 -0.03 -0.03 -0.02 0.03 0.12 0.28 0.36 -medium -0.01 -0.01 -0.02 -0.01 -0.01 0.04 0.12 0.27 0.35 -high 0.39 0.86 1.07 1.14 1.15 1.11 1.06 1.05 1.07 R&D intensity (% of GDP) 0.10 0.13 0.14 0.15 0.15 0.14 0.12 0.10 0.09

4.3 Reducing entry barriers

4.3.2 Reducing administrative entry barriers

Costs of setting up a standard firm (annual GDP per capita)

US: 2% EU: 38% Table 4.4 10% reduction in int. firms entry barriers

Years EU

1 2 3 4 5 10 20 50 100

GDP 0.00 -0.01 -0.01 -0.01 -0.01 0.00 0.02 0.06 0.08 TFP 0.00 0.00 0.00 0.00 0.00 0.01 0.04 0.07 0.07 "Ideas/Patents" 0.01 0.06 0.12 0.18 0.24 0.53 0.94 1.47 1.64 Capital 0.00 0.00 0.00 0.00 0.00 -0.01 -0.01 0.02 0.06 Capital intensity 0.00 0.01 0.01 0.02 0.03 0.06 0.10 0.16 0.18 Employment 0.01 0.01 0.01 0.01 0.01 0.00 0.00 0.00 0.00 -low 0.00 0.01 0.01 0.01 0.01 0.01 0.00 0.00 0.00 -medium 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 -high -0.10 -0.24 -0.32 -0.37 -0.38 -0.37 -0.32 -0.27 -0.25 -R&D 0.69 1.30 1.55 1.64 1.67 1.59 1.40 1.15 1.07 Consumption 0.00 -0.01 -0.01 -0.01 0.00 0.00 0.02 0.05 0.07 Investment 0.00 0.00 -0.01 -0.01 -0.01 -0.01 0.00 0.03 0.06 Wages 0.01 0.02 0.03 0.03 0.03 0.04 0.06 0.09 0.11 -low 0.00 -0.01 -0.01 -0.01 -0.01 0.01 0.03 0.07 0.09 -medium 0.00 0.00 0.00 0.00 0.00 0.01 0.03 0.07 0.09 -high 0.10 0.21 0.27 0.28 0.28 0.28 0.26 0.26 0.27 R&D intensity (% of GDP) 0.03 0.03 0.04 0.04 0.04 0.03 0.03 0.02 0.02

4.4 Increasing the share of high skilled workers

Share of high skilled (scientists and engineers) in the labour force

US: 7.6 EU: 6.2 Table 4.5 Increasing the share of high skilled workers by .3% over 10 years

Years EU

1 2 3 4 5 10 20 50 100

GDP 0.02 0.03 0.05 0.06 0.09 0.19 0.27 0.29 0.30 TFP 0.01 0.02 0.04 0.05 0.07 0.15 0.19 0.19 0.19 "Ideas/Patents" 0.02 0.05 0.10 0.17 0.26 0.85 1.30 1.28 1.28 Capital 0.00 0.00 0.01 0.02 0.02 0.09 0.21 0.28 0.31 Capital intensity 0.00 0.01 0.02 0.04 0.06 0.20 0.30 0.30 0.30 Employment 0.01 0.01 0.02 0.02 0.03 0.05 0.05 0.05 0.05 -low -0.02 -0.03 -0.05 -0.07 -0.09 -0.18 -0.21 -0.21 -0.21 -medium -0.02 -0.04 -0.06 -0.08 -0.11 -0.20 -0.21 -0.22 -0.22 -high 0.37 0.68 1.03 1.42 1.83 3.35 3.71 3.70 3.70 -R&D 0.19 0.38 0.59 0.82 1.06 1.80 1.54 1.57 1.58 Consumption 0.02 0.03 0.05 0.07 0.09 0.17 0.25 0.29 0.30 Investment 0.02 0.05 0.08 0.11 0.14 0.28 0.30 0.30 0.31 Wages 0.00 0.00 0.01 0.02 0.03 0.10 0.16 0.19 0.20 -low 0.03 0.05 0.07 0.10 0.13 0.27 0.35 0.38 0.39 -medium 0.03 0.06 0.08 0.11 0.14 0.28 0.36 0.38 0.39 -high -0.39 -0.62 -0.87 -1.14 -1.41 -2.23 -2.37 -2.34 -2.33 R&D intensity (% of GDP) 0.00 0.00 0.00 -0.01 -0.01 -0.01 -0.02 -0.02 -0.02

Summary:

Could these reforms close the productivity gap with the US?

By how much?

How long would it take?

% Increase of GDP after

10 Years100 Years

R&D tax credits 0.0% 0.3%

Service Competition 1.5-2% 3-4%

Venture capital 0.0% 1.5%

Admin Burden 0.0% 1.0%

High skilled share 1.0% 1.5%

_____________________________________________

Sum 2.5-3% 7.3-8.3%