July 2007 Archives

Another oldie but goodie. I found this 2005 interview on start-ups and intangibles -- How Can Start Ups Grow? — HBS Working Knowledge:

Assistant professor Mukti Khaire believes that small companies can grow by developing intangible social resources such as legitimacy, status, and reputation. In an interesting twist, her research on this insight is that these intangible resources may be best acquired by following a road of conformity in how your company is organized and presented to the outside world. In start-ups in established industries, conventional business titles such as Marketing Director work better than novel ones like Chief Evangelist.

. . .

Q: Can you tell us about the concept of intangible social resources and how they contribute to a young firm's growth? How does a firm acquire non-tangible resources such as reputation and status?

A: Intangible resources are non-financial, non-material assets that a firm possesses by virtue of the social structure in which it is embedded. Although firms are economic entities, they are nevertheless affected by social variables such as legitimacy, status, and reputation because all economic transactions are embedded in a social supra-structure. Since most young firms are financially constrained, intangible assets that do not require outlays of financial resources are especially critical to new ventures.

An entity is considered to have legitimacy when its actions are considered proper, acceptable, or desirable under a widely accepted set of beliefs and norms. A new, unfamiliar activity or entity does not possess legitimacy because of its inherent novelty. A new firm, therefore, lacks legitimacy and may be looked upon with suspicion by stakeholders. In order to gain legitimacy, a new firm is required to look like existing organizations, which possess legitimacy because of their familiarity to observers. Hence, mimicry of existing organizations' structures and activities to a certain extent is essential if new ventures wish to gain legitimacy. A new venture with legitimacy acquired in this manner is more likely to succeed because it then can channel its resources and energy towards its core activity, rather than towards establishing its propriety. By doing so, it can improve performance and grow faster than an organization that does not conform to industry norms. As one founder I interviewed put it, "Customers are used to doing things in a certain way [with established organizations], and if a new agency is too far and out, it will not do well."

High-status organizations tend to be buffered from environmental shocks and more likely to survive adverse circumstances and perform better than low-status organizations. Organizational status is usually a function of size and good past performance. However, young firms possess neither large size nor a track record of good performance. Although the benefits of status are crucial to their performance, they are unable to avail of them. An alternate way of acquiring status is through high-status affiliations. When a young, unknown firm has affiliations with high-status entities, stakeholders tend to impute the status of the latter onto the former, thus granting higher status to the young firm. I found that young agencies with high-status clients performed better and grew faster than agencies without high-status clients (controlling for the revenues brought in by each client). Thus, status acquired through affiliations provided young firms with the buffering advantage that larger, well-established firms enjoyed due to their status, and enabled them to compete in the same arena as much larger firms.

Bottom line: Status and legitimacy are key organizational intangible assets. I wonder how you measure that?

Today's Wall Street Journal is running a story about how Critics See Some Good From Sarbanes-Oxley:

But even critics acknowledge the law has done some good. "There is without question greater accountability in the boardroom," says Thomas Lehner, an official of the Business Roundtable, a Washington group representing big-company CEOs. More boards resolve potential problems "before they fester and explode," concurs John Olson, a senior partner at Gibson, Dunn & Crutcher who advises directors at about a dozen concerns.

What the story didn't mention, however, is that SOX is forcing some companies to come to grips with their intangible assets. According to comments by Kimberly Klein Cauthorn at session “Intellectual Property and Intangible Assets: Growth of a New Asset Class” at the Milken Institute Global Conference 2007 (audio available), more companies are conducting audits of their intangibles as part of Sarbanes-Oxley compliance requirements.

To me, that is a big deal. If Sarbanes-Oxley ends up changing how the corporate culture deals with intangibles, it will be a major accomplishment just for that alone.

BusinessWeek has published its 2007 list of Best Global Brands. Toping the list of most valuable brands are Coke, Microsoft, IBM, GE, Nokia, Toyota, Intel, McDonalds, Disney and Mercedes-Benz. Google came in at number 20, Apple at 33 and Starbucks at 88. According to my calculation, the total value of the top 100 brands is over $1.5 trillion. The US brands are almost $745 billion.

The Business Week story highlights 5 comeback stories: Nintendo, Audi, HP, Burberry and Citibank. It also ranks the biggest gainers and losers:

A new study from the Center on Education Policy Choices, Changes, and Challenges: Curriculum and Instruction in the NCLB Era is providing a new spark to the debate over the No Child Left Behind law. The study finds improvement in math and science scores, but at a price. The finds are as follows:

Increased time for tested subjects since 2002. About 62% of districts reported that they have increased time for English language arts1 (ELA) and/or math in elementary schools since school year 2001-02 (the year NCLB was enacted), and more than 20% reported increasing time for these subjects in middle school since then. Among districts that reported increasing time for ELA and math, the average increase in minutes per week since 2001-02 was substantial, amounting to a 46% increase in ELA, a 37% increase in math, and a 42% increase across the two subjects combined.

Reduced time for other subjects. To accommodate this increased time in ELA and math, 44% of districts reported cutting time from one or more other subjects or activities (social studies, science, art and music, physical education, lunch and/or recess) at the elementary level. Again, the decreases reported by these districts were relatively large, adding up to a total of 141 minutes per week across all of these subjects, on average, or nearly 30 minutes per day. These decreases represent an average reduction of 31% in the total instructional time devoted to these subjects since 2001-02.

Increases and decreases more prevalent in districts with schools identified for improvement. Greater proportions of districts with at least one school identified for NCLB improvement than of districts without schools in improvement reported that they have increased time for ELA and/or math at the elementary and middle school levels since school year 2001-02. Districts with at least one school in improvement also reported in greater proportions than districts without schools in improvement that they have decreased time in social studies, science, and art and music.

Greater emphasis on tested content and skills. Since 2001-02, most districts have changed their ELA and math curricula to put greater emphasis on the content and skills covered on the state tests used for NCLB. In elementary level reading, 84% of districts reported that they have changed their curriculum “somewhat” or “to a great extent” to put greater emphasis on tested content; in middle school ELA, 79% reported making this change, and in high school ELA, 76%. Similarly, in math, 81% of districts reported that they have changed their curriculum at the elementary and middle school level to emphasize tested content and skills, and 78% reported having done so at the high school level.

These findings raised concerns as to whether students are getting a well-rounded education. The report recommend the following:

Stagger testing requirements to include tests in other academic subjects. Because our survey data indicate that what is tested is what is taught, students should be tested in math and English language arts in grades 3, 5, and 7 and once in high school, and in social studies and science in grades 4, 6, and 8 and once in high school. These tests should be used for accountability purposes. By staggering the subjects tested, the total amount of NCLB-mandated testing would stay the same, except in states that do not currently test social studies in high school.

Encourage states to give adequate emphasis to art and music. States should review their curriculum guidelines to ensure that they encourage adequate attention to and time for art and music, and should consider including measures of knowledge and skills in art and music among the multiple measures used for NCLB accountability.

Require states to arrange for an independent review, at least once every three years, of their standards and assessments to ensure that they are of high quality and rigor. Because districts in our survey report that they are changing their curriculum to put more emphasis on content and skills covered on the tests used for accountability, states should be sure these tests are “good” tests by commissioning reviews of their standards and assessments by independent organizations or agencies.

Provide federal funds for research to determine the best ways to incorporate the teaching of reading and math skills into social studies and science. By integrating reading and math instruction into other core academic subjects, students will be more ensured of a rich, well-rounded curriculum. Funds should also be provided through Title I and Title II of NCLB to train teachers in using these techniques.

I hope the recommendations will be carefully reviewed in the process of reauthorizing the No Child Left Behind law. Math and reading are foundation skills - however at some point it is necessary to build upon that foundation. Otherwise, you end up with a massive cellar and little living space above. In the I-Cubed Economy, it is important to be able to do your sums and follow written instructions. That is the starting point. But those are industrial era skills. Creativity in numerous areas is the driver of prosperity today. If our schools are not fostering that creativity, then we are preparing our children for 1910, not 2010.

The Intellectual Property Owners Association has posted a side-by-side of the House and Senate patent reform bills (as reported out of committee). With the House and Senate pushing for an August 6 summer recess, it is unlikely that the bills will come to the floor of either body until the fall.

The issue of taxes may be heating up in the Presidential race. Yesterday, Treasury Secretary Paulson teed up his proposals for corporate tax reform with a line up on mostly conservative luminaries, including Alan Greenspan (see Paulson Gets Support for Tax Overhaul - washingtonpost.com and my previous posting). The thrust of his ideas is a return to the 1986 deal of eliminating specific business tax incentives in return for a lower corporate tax rate.

On the other side, John Edwards unveiled his tax reform package that includes an increase in the capital gains tax rate (Edwards's Tax Plan Focuses On Low, Middle-Income Families - WSJ.com, Edwards Proposes Raising Capital Gains Tax - New York Times and John Edwards for President-Building One Economy With Tax Reform To Reward Work).

Without getting into the specifics of either camp's proposals, I would raise one very specific issue. If the I-Cubed Economy is fueled by development of intangible assets, how does your tax proposal foster or retard that development? Otherwise, you are just proposing a tax system for the past, not the future.

I recent ran across an OECD study (from last year) on Innovation and Knowledge-Intensive Service Activities:

From research and development to legal and marketing services, a wide range of knowledge-intensive service activities (KISAs) enables firms and public sector organisations to better innovate. KISAs are both sources and carriers of knowledge that influence and improve the performance of individual organisations, value chains and industry clusters across all sectors of the economy.

The study categorizes these services in four ways:

The case studies indicate that different types of KISA contribute in different ways to innovation (Table 0.1). Some KISA, such as R&D and strategic management, aid in firm renewal. Such renewal services are closely linked to innovation, but are relevant and accessible to a limited number of highly capable recipient organisations equipped with sufficient resources. Other, more routine services, such as accounting help maintain and improve existing systems and activities within organisations. Their significance for performance enhancement is highly important for most organisations. Compliance services, such as auditing and some legal services are not obviously linked with innovation, except to the extent that compliance with regulations related to health, safety, environment, etc., can stimulate innovation. Such KISA also offer an access route by which a wide range of organisations, among them the bulk of small businesses, can recognise the importance of KISA to their firm’s performance and begin to engage a broader set of KISA providers. Network services provide an important platform for knowledge exchange within formal and informal networks. They also represent a flexible resource base for the members of the network.

Table 0.1. Types of KISA and their role in innovation
Renewal services: Directly related to innovation, for instance R&D and strategic management consulting
Routine services: Contribute to improvement of maintenance and management of various subsystems within organisations, e.g. accounting
Compliance services: Help organisations to work within the legal framework and various other regulatory regimes, e.g. auditing and some legal services
Network services: Facilitate communication, knowledge exchange and flexible resource allocation,
e.g. informal personal networks and production related networks.

Among the policy recommendations were two I found particularly important:
1) innovation policy frameworks need to respond to the nontechnological aspects of KISA and their impact on innovation capability:

The traditional R&D-based approach to innovation is too narrow and that innovation policies need to recognise the various types of knowledge-intensive services activities that have different roles in the innovation processes. Policy needs to focus more on the interactive people-centred activities, less on the individual firm and more on developing the collective strength of the sector or network. Since typical KISA is mainly based on intangible assets, policies ought to secure sufficient supply of private and public financing for growth oriented KISA. Better understanding of the non-technological elements of innovation and the user contribution to innovation needs to be further developed.

2) a key challenge is improving access to KISA.

This challenge is highlighted by intangibility, complexity and difficulties in assessing the quality and suitability of the services offered prior to engaging with them. Financial assistance is only a partial solution. Awareness of KISA needs to be developed first and knowledge asymmetries between KISA suppliers and users need to be addressed, for instance, by certification of services and through publicly funded demonstration projects.

We often talk about the innovation ecosystem. It is clear that these knowledge-intensive service activities are an important part of that ecosystem - both for their own innovation activities and in how they facilitate innovation in other sectors.

The study also provides us with one more example of how the old boundaries of manufacturing and services are blurring in the I-Cubed Economy. And how we need to continue to change our mindset if we are to come up with appropriate policy responses.

A recent article in the McKinsey Quarterly proposes a new metric for measuring investments in intangibles: profit per employee:

* Today's approach to measuring financial performance is geared excessively to the capital-intensive operating styles of 20th-century industrial companies. It doesn’t sufficiently account for factors such as the contributions of talented employees that, more and more, are the basic source of wealth.
* Financial performance—observed through balance sheets, cash flow reports, and income statements—is and always will be the principal metric for evaluating a company and its managers. But greater attention should be paid to the role of intangible capital and the ways of accounting for it.
* The superior performance of some of the largest and most successful companies over the past decade demonstrates the value of intangible assets.
* Companies can redesign the internal financial performance approach and set goals for the return on intangibles by paying greater attention to profit per employee and the number of employees rather than putting all of the focus on returns on invested capital.

The article is based on a forthcoming book Mobilizing Minds: Creating Wealth from Talent in the 21st-Century Organization by Lowell L. Bryan and Claudia I. Joyce. The book focuses on the issue of organization design in the Intangible Economy. As the authors noted in a recent interview:

We believe the time has come for corporate leaders to view organizational design as a strategic imperative and high-return, low-risk opportunity for investment. The classic definition of “strategy” is a plan for actions to be taken with which to gain competitive advantage. Using this definition, we believe corporate leaders need to invest more energy than they have invested in the past in taking actions needed to create the strategic organizational capabilities that will enable their companies to thrive. We are convinced that in the digital age, if you want to create wealth, there is almost no better use of the CEO’s time and energy than making the organization work better. So if corporate strategy is about preparing the corporation to gain competitive advantage, designing a more effective organization is certainly central to this endeavour.

. . .

We believe that nearly all organizations are replete with opportunities to streamline and simplify the use of hierarchical authority to remove unproductive complexities – while simultaneously increasing that authority’s effectiveness.

The approach we advocate involves redesigning a company’s hierarchical order, thereby improving management’s ability to use hierarchical authority to power a company’s performance. The effort centres on defining a “backbone” or central management structure; and developing general line management or clear decision authority and accountability for operating performance. By a “backbone line structure” we mean a chain of command that puts authority to make tactical decisions close to the front lines. By “frontline manager”, we mean someone with the authority to set aspirations, define tasks and roles, assign people and hold them accountable, mobilize resources, and make decisions for frontline workers.

We have used military analogies to illustrate both aspects of the model. In terms of a backbone line structure, in the military, there is no ambiguity about who a soldier’s commanding officer is, we believe the corporations should move more toward this model, than the traditional multiple bosses matrix approach. We also believe that the frontline manager should have more authority and accountability to make decisions at the front line, as do front-line military officers.

Sounds like an interesting read. But I am especially interested with their notion of using profit per employee as the metric of choice. That is an important step toward getting out financial measures right in the I-Cubed Economy.

Speaking of tax breaks, here is an interesting story from today's New York Times Tax Break Used by Drug Makers Failed to Add Jobs:

Two years ago, when companies received a big tax break to bring home their offshore profits, the president and Congress justified it as a one-time tax amnesty that would create American jobs.

Drug makers were the biggest beneficiaries of the amnesty program, repatriating about $100 billion in foreign profits and paying only minimal taxes. But the companies did not create many jobs in return. Instead, since 2005 the American drug industry has laid off tens of thousands of workers in this country.

And now drug companies are once again using complex strategies, many of them demonstrably legal, to shelter billions of dollars in profits in international tax havens, according to their financial statements and independent tax experts.

In one popular accounting move, companies declare their foreign markets as far more profitable than their American businesses — even though drug prices are typically higher in the United States than anywhere else in the world.

Drug makers are not the only American multinationals using tax loopholes to declare large portions of their income beyond the reach of the Internal Revenue Service. The Brookings Institution estimates that multinational companies are using overseas tax shelters to lower their payments to the Treasury by about $50 billion a year.

Interestingly, this investment distorting tax incentive is only discussed in the Treasury Department's background paper on corporate taxation (see previous posting) in an Appendix on taxing international income.

The story goes on to talk about this relates to the issue of transfer of intellectual property offshore:

Tax experts like Michael J. McIntyre, a law professor at Wayne State University in Detroit, say the drug makers are taking advantage of antiquated rules that work better for manufactured products like steel and automobiles.

Under this system, when companies transfer products between divisions in different countries, they must account for the sales internally through “transfer pricing.” But they have significant discretion in how they set prices for these transactions.

That turns out to be especially so for high-margin products like drugs, which in pill form cost only a few cents each to make once they have been invented, but can be sold for several dollars apiece. The hefty profit margins result in part from patents that can protect the drugs from competition for years. And by transferring those valuable patents overseas, companies can declare that their profits should follow the patents overseas as well.

Under the rules of transfer pricing, if a company moves patents or other so-called intangibles from its United States division to a foreign subsidiary, the foreign unit is supposed to pay the American division a fair-market price. But outsiders have a difficult time determining if companies have properly assessed the value of patents, trademarks and other intangible properties.

To further complicate matters, some corporate subsidiaries in tax-haven countries, like Singapore and the Netherlands, now directly finance research in the United States. So they own the patents without ever having to “buy” them from their American parents, Mr. McIntyre said.

“They don’t even have to push it offshore,” Mr. McIntyre said. “It’s already offshore. And once it’s offshore, they strip the income from the onshore activity.”

In theory, companies are only deferring taxes on the profits they shelter overseas, not permanently avoiding tax. If they bring the money back to the United States to distribute to their shareholders, they still have to pay American taxes on it.

But those rules were temporarily suspended when President Bush signed legislation in 2004 to let companies return overseas profits at a rate of 5.25 percent, far below the official tax rate of 35 percent, if they moved the money back by 2006.

The story concludes with a suggestion:

Some experts now say the current system of taxing overseas profits should be scrapped. Even the companies that take advantage of loopholes might benefit if the system were changed, because they could save money on tax planning and have more certainty that the I.R.S. would accept their returns, said Michael C. Durst, a former I.R.S. official who is now special counsel to the law firm Steptoe & Johnson.

The simplest solution, Mr. Durst said, would be shifting to a system in which companies would assign a portion of profit to each country where they made a sale, relative to the size of the sale. Instead of trying to tax profits made overseas, the United States government would simply take its share of the profits on American sales. Such a system would be harder for the companies to game, Mr. Durst said.

But he and other tax experts say that any effort to close loopholes, to be politically viable, might have to be combined with a lowering of the corporate tax rate from its current 35 percent. And no one expects any legislation of that sort, at least not before the next election.

That is an interesting suggestion. The key will be looking at all the loopholes, not just a few tax incentives like the R&E tax credit.

In preparation for Thursday's short conference on tax policy and competitiveness (see earlier posting), the Treasury Department has released a background paper that makes the case for ending special tax breaks and reducing the corporate tax rate. According to a story in today's Washington Post (Reconsidering Corporate Tax Breaks), the paper is not meant to be the final word:

Treasury Secretary Henry M. Paulson Jr. said in an interview that the paper is not intended to state a position so much as to open a public discussion about how to streamline taxes and regulations to help U.S. companies compete.

However, the paper is rather forceful in its tone. As the paper states:

Other countries continue to reduce their corporate tax rates, leaving the United States still further behind.
. . .
Our current system for taxing businesses and multinational companies has developed in a patchwork fashion spanning decades, resulting in a web of tax rules that can harm the competitiveness of U.S. companies.
. . .
However, our tax system disrupts and distorts a vast array of business and investment decisions, leading to an inefficient level and allocation of capital through the economy.

There are other worrisome parts to the paper. For example, in the section on "Distortions caused by tax incentives" focuses almost exclusively on the research and experimentation tax credit and the domestic production provisions. What about all the other tax incentives?

I was especially interested in the section on tangible versus intangible assets:

Income from investment in intangible assets (e.g., R&D and advertising) generally receives more favorable tax treatment than does income from investment in tangible assets (e.g., plant and machinery). Investment in intangibles might be excessively encouraged by the tax system, relative to investment in tangible assets.

As discussed above, the cost of purchasing a tangible asset generally is written off (depreciated) over time to compensate for its decline in value due to wear and tear. In contrast, the cost of investment in intangible assets generally is deducted immediately (expensed). Expensing can give a substantial benefit to intangibles over tangible assets. For example, because of expensing, corporate intangibles face an effective tax rate that is close to zero, whereas corporate depreciable assets face an effective tax rate of around 30 percent.

While immediate expensing of intangibles may confer some tax advantage, I've seen no evidence to suggest the result is an over-investment in intangibles. In fact, the accounting side of the expensing on intangibles tends to push management toward treating intangibles as an operating expense to be minimized rather than a long term investment.

Likewise the section on physical versus human capital is interesting:

Investment in acquiring skills and abilities shares much in common with investment in more traditional physical assets. Investment in human capital can be thought of as an intermediate input that can be used to produce a final good. Much of the economic cost of acquiring abilities and skills is incurred in the form of earnings that are foregone during the period of training or schooling. Because these foregone earnings are not taxed (i.e., imputed and includable in income), this treatment, in effect, allows an immediate deduction for such investment. Similar to the discussion above on the tax treatment of investment in physical capital, in economic terms, the "deduction" for investment in human capital (i.e., the nontaxation of foregone earnings) equals the tax on the cash flow from the "expected" normal return on the investment, which eliminates the tax on this part of the return (in present value). To the extent that future earnings exceed the expected normal return - perhaps because of luck, innovation, or successful risk taking - the tax on these higher than expected normal returns will exceed the tax value of the initial deduction and would be taxed (in present value).

Investments in physical capital and human capital are treated very differently in our current tax system. Physical capital is typically depreciated over the life of an asset, while human capital is effectively expensed or deducted immediately because of the non-taxation of foregone earnings. This disparate treatment between physical and human capital discourages investment in physical capital relative to human capital. More uniform treatment would reduce this distortion. [Footnote: Of course, more uniform treatment could involve either expensing or applying economic depreciation to all investment (i.e., human and physical capital).]
The current income tax also offers a number of other incentives for investment in human capital. These include the tax exclusion of scholarships, fellowships, and the value of reduced tuition; education tax credits; deduction of student loan interest; tax advantaged education saving accounts; deductibility and exclusion of employer provided education expenses; deductibility of tuition; and allowing students beyond the normal age cut-off to qualify as eligible children when computing their parents' earned income tax credit and their parents' dependent deduction.

Again, I see no evidence that all these supposed tax incentives are resulting in an over-investment in human capital and an under-investment in physical capital. What I do see is a preemptive argument against the idea of a knowledge tax credit.

The paper also mounts a spirited defense of the practice of shifting intangible assets offshore:

Multinational corporations have developed a large number of valuable intangible assets such as patents and trademarks that allow them to earn supra-normal or infra-marginal returns on the tangible capital that is necessary to exploit the intangible. The decision on where to locate the production of a particular highly profitable good or service is usually a discrete one in which a certain amount of plant and equipment is required. The decision on how much to invest in any given country therefore is based not only on the effective tax rate on marginal investment, but also on the taxation of the infra-marginal returns.

A U.S. subsidiary abroad has to pay a royalty to the parent company for the use of the U.S. developed intangible. However, the evidence suggests that a substantial portion of the return to the intangible asset remains in the location where it is produced. Furthermore, under the current U.S. tax system, most foreign royalties are shielded from U.S. tax by excess foreign tax credits flowing from more highly taxed income. Multinational companies therefore have a strong incentive to locate the production of any new valuable products and services in low-tax countries. Lowering the corporate tax rate would make the United States a more attractive location.

Interesting, since they just stated that the US tax system benefits investment in intangibles over tangibles. So why is there then an incentive to shift production of intangibles offshore? And not a word about the issue of transfer-pricing, especially of intangibles -- which then IRS Commission Mark Everson labeled in Congressional testimony last year as "a high-risk compliance concern":

Taxpayers, especially in the high technology and pharmaceutical industries, are shifting profits offshore through a variety of arrangements that result in the transfer of valuable intangibles to related foreign entities for inadequate consideration.

What is also notable in the paper is what is missing. For example, missing from the paper is any discussion of any form of border-refundable tax that many other nations use to boost exports. Also missing is any discussion of payroll taxes.

I would like to think that the Thursday conference will be an open discussion of the issues. The background paper, however, is a set up to a preconceived solution: lower the tax rate. That may or may not be good tax policy. One would not know that from the one-sided advocacy brief that is being used for the background paper.

Today's FT has a poll showing that globalization is viewed a having a negative affect in all the rich countries -- two to one negative to positive in the US (with about 45% not sure). But over on Dani Rodrik's weblog: Globalization: we love it, we love it not..., he contrasts this with another recent poll that shows 60% of Americans think globalization is mainly good.

Sounds to me that the general public -- just like the experts -- are still grappling with what this thing called globalization really is.

Binary America: Split in Two by A Digital Divide - washingtonpost.com

Less than a mile and a half from the Citadel, the site of the Democratic presidential debate tonight, sits Cooper River Courts, a public housing project. Forget the Web. Never mind YouTube, the debate's co-sponsor. Here, owning a computer and getting on the Internet (through DSL or cable or Wi-Fi) is a luxury.

Enough said

Congress is finally looking to correct a major flaw in our trade adjustment assistance program, according to a story in today's Washington Post - Aid May Grow for Laid-Off Workers:

Under a Senate bill to be introduced today, computer programmers, call-center staffers and other service-sector workers who make up the vast majority of the nation's workforce would for the first time be eligible for a generous package of income, health and retraining benefits currently reserved for manufacturing workers who lose their jobs to international trade.

This is long overdue. The problem stems from the original belief that services, unlike goods, could not be traded over international boundaries. That belief by economist was never actually true but it didn't matter because so few services were actually traded. The situation has changed dramatically with more and more services now subject to international competition. (By the way, in the mid-1980, I worked on a report at the Congressional Office of Technology Assessment on International Competition in Services: Banking, Building, Software, Know-How....)

But my friend Howard Rosen, who heads up the Trade Adjustment Assistance Coalition, is quoted in the story as saying "This is not going to be a slam-dunk." If giving computer programmers who have been laid-off because of globalization the same benefits as auto workers laid-off because of trade is not a slam-dunk, then our entire trade policy is in serious trouble. If we can't provide even this band-aid, what can we do?

As I have said a number of times in this blog, we need a new trade policy (see here, here, here, here and here). How can we come up with a new workable trade policy if we can't take a simply step of acknowledging that services are, in fact, traded and therefore we need to treat service workers the same as manufacturing workers?

Keep an eye on this one - as it is likely to be a flashpoint in the trade policy debate.

The concept of "jurisdictional advantage" is one that Athena Alliance (and this blog) has followed for some time. Earlier this year, the Rotman School of Management at the University of Toronto announced the creation of a new research center on the topic:

"The Centre for Jurisdictional Advantage and Prosperity will enhance the province’s prosperity by taking an integrative approach to the study and creation of jurisdictional advantage. Currently, the study of how jurisdictions, including provinces, become magnets for companies to start-up, locate and grow, and for talent to study, live and work, has been fragmented across many diverse fields. This disconnected knowledge has been less helpful to policy-makers and businesses than is required,” says Rotman Dean Roger Martin. “The Centre will remedy this by attracting and bringing together the best group of scholars in the world to study jurisdictional advantage in order to create new and valuable insights that will benefit Ontario and the world at large.”

And last week, they announced that Richard Florida will be heading up this new Centre (Creative Class Thinker Joins Rotman School of Management).

Over the years, Athena Alliance has been fortunate to be associated with key members of the Rotman School. Dr. MaryAnn Feldman gave the original jurisdictional advantage paper at an Athena-Wilson Center symposium. and Dr. Florida presented his book, The Flight of the Creative Class, at another symposium. Dean Roger Martin spoke to an Athena sponsored Congressional briefing on innovation.

We wish Dr. Florida and the new Centre all the best in their work.

Here is an amusing copyright story to being your weekend -- Inmates Accused in Name Copyright Scheme - washingtonpost.com:

The four were indicted Tuesday on allegations that they copyrighted their names, then demanded millions of dollars from prison officials for using the names without authorization.

The indictment alleges that inmates Russell Dean Landers, Clayton Heath Albers, Carl Ervin Batts and Barry Dean Bischof sent demand notices for payment to the warden of the El Reno federal prison and filed liens against his property. They then hired someone to seize his vehicles, freeze his bank accounts and change the locks on his house.

Then, believing the warden's property had been seized, the inmates said they wouldn't return his property unless they were released from prison, according to the indictment.

But the person hired by the inmates turned out to be an undercover FBI agent, said U.S. Attorney John C. Richter.

Very creative. Maybe they can assert copyright ownership of the story when it gets made into a made-for-TV movie.

Following the House Judiciary Committee, the Senate Judiciary Committee has passed the patent reform legislation. The bills now go to their respective full chambers. On the House side, the bill is likely to remain pretty close to what the Committee reports. On the Senate side, however, the process is different. Senate rules are such that anyone can offer any amendment. So there are plenty of chances to change the bill. As the AP story (Senate Panel Approves Patent Reform Bill) notes:

The changes made by the two committees, so far, haven't satisfied many of the bill's opponents, which include pharmaceutical, biotech and manufacturing companies, as well as technology companies that rely on licensing patents, such as Qualcomm Inc.

So there is movement, but still a long way to go.

Next week, Treasury Secretary Paulson is hosting a conference on business taxes and competitiveness. In today's Wall Street Journal, he laid out the opening position in an op-ed piece Our Broken Corporate Tax Code. There is a thread to the Secretary's argument I very much agree with -- the complexity of the tax code:

Targeted provisions to encourage specific activity substantially narrow the tax base and thus, overall tax rates must be higher. And these provisions add complexity; some have estimated that businesses spend $40 billion annually on tax compliance costs -- $40 billion that could create jobs, provide greater employee benefits and generate economic growth. Even the opportunity for favorable tax treatment gives rise to corporate expenditures on lobbying, rather than on growth creation.

He also points out a specific concern of mine:

The current tax depreciation system does not treat investments uniformly; depreciation allowances vary without clear economic rationale. This can bias decision making and result in a direct misallocation of capital if firms make marginal investment choices based on taxation rather than innovation.

I have long argued that contrary to what some laissez faire analysts say, the US has an industrial policy: the tax code. And it is one of the worse types of industrial policies: non-transparent and not subject to any periodic review. Our treatment of intangibles is a case in point. I have not done a systematic study of depreciation rates -- but the mere fact that investment in intangibles such as product development and worker skills (training) are treated as an immediate expenses rather than depreciable investments has got to result in misallocation of capital.

However, there is an overriding theme to the Secretary's message: cut the corporate tax rate:

A study by Treasury economists estimated that a country with a tax rate one percentage point lower than another country's attracts 3% more capital. It's not surprising then, that average OECD corporate tax rates have trended steadily downward.

Now, I'm not a tax expert. But I am not convinced that problem is simply our tax rate, although I am willing to accept that the rate is worth looking at. There is a lively debate over the Scandinavian model with a combination of high personal income tax rates and low corporate rates. Nor is it just our corporate taxes. All of our regressive employment taxes, especially as they end up being applied to the self-employed, need careful examination.

Secretary Paulson is absolutely right: we need a new tax system for the I-Cubed Economy. However, the focus shouldn't be on tax rates but on the overall structure of the tax system -- including the recommendations of the President's Advisory Panel on Federal Tax Reform (commonly known as the Mack-Breaux Tax Reform Commission) (see my earlier posting).

Interesting story in the New York Times the other day about Costco -- How Costco Became the Anti-Wal-Mart. One theme of the piece was especially telling:

But not everyone is happy with Costco's business strategy. Some Wall Street analysts assert that Mr. Sinegal is overly generous not only to Costco's customers but to its workers as well.
Costco's average pay, for example, is $17 an hour, 42 percent higher than its fiercest rival, Sam's Club. And Costco's health plan makes those at many other retailers look Scroogish. One analyst, Bill Dreher of Deutsche Bank, complained last year that at Costco "it's better to be an employee or a customer than a shareholder."
. . .
"They could probably get more money for a lot of items they sell," said Ed Weller, a retailing analyst at ThinkEquity.
. . .
Emme Kozloff, an analyst at Sanford C. Bernstein & Company, faulted Mr. Sinegal as being too generous to employees, noting that when analysts complained that Costco's workers were paying just 4 percent toward their health costs, he raised that percentage only to 8 percent, when the retail average is 25 percent.
"He has been too benevolent," she said. "He's right that a happy employee is a productive long-term employee, but he could force employees to pick up a little more of the burden."

Sounds like the typical short-termism of Wall Street. On the other hand, it is not clear that the actual investors are paying any attention to what the bean-counter analysts are saying:

IF shareholders mind Mr. Sinegal's philosophy, it is not obvious: Costco's stock price has risen more than 10 percent in the last 12 months, while Wal-Mart's has slipped 5 percent. Costco shares sell for almost 23 times expected earnings; at Wal-Mart the multiple is about 19. Mr. Dreher said Costco's share price was so high because so many people love the company. "It's a cult stock," he said.

A "cult stock" or a good example of long-run value creation? (Of course, some analysts may think that long run value creation is some form of weird cult -- a secret society headed by Warren Buffet.)

When will Wall Street analysts learn that good employee and customer relations are the foundation of a good payoff for stockholders? Maybe because good employee and customer relations are intangible assets that they can't crank into their models. I would have thought that the Circuit City example would have pointed this out. Guess not.

Speaking of patent reform (see previous posting), I've run accord a new study that questions the efficacy of ever stricter intellectual property protection as a means of fostering innovation and creativity (recently reported in the New York Times: A Patent Is Worth Having, Right? Well, Maybe Not). In a forthcoming book, Innovation at Risk, James Bessen and Michael J. Meurer argue that the patent system fails to provide clear property right protection. The problems include:

1. Fuzzy or unpredictable boundaries. Surveying land is inexpensive, and the survey boundaries carry legal weight. While surveyors can plainly map the words in a deed to a physical boundary, it is much harder to map the words in a patent to technologies, as the E-Data patent illustrates. Not only are the words that lawyers use sometimes vague, but the rules for interpreting the words are also sometimes unpredictable. Although innovators can obtain expensive legal opinions about the boundaries of patents, these opinions are unreliable. There is no reliable way of determining patent boundaries short of litigation.
2. Public access to boundary information. The documents used to determine boundaries for both land and patents are eventually available to the public. However, it is possible for patent owners to hide the claim language that defines patent boundaries from public view for many years, a practice that is becoming increasingly frequent.
3. Possession and the scope of rights. Generally, tangible property rights are linked closely to possession, hence the classic phrase: possession is nine points of the law. Patent law also requires possession of an invention, but often this requirement is not rigorously enforced. Courts sometimes grant patent owners rights to technology that is new, different, and distant from anything they actually made or possessed. Not surprisingly, this practice makes patent boundaries especially unclear in fast-paced fields such as biotech and computer software. It certainly seems that E-Data was granted ownership of technology that was far removed from what Charles Freeny, Jr., actually invented.
4. The patent flood. Clearance costs are affected by the number of prospective rights that must be checked for possible infringement. Investments in land or structures rarely involve many parcels of land, and property law discourages fragmentation of land rights. In contrast, investments in new technology often need to be checked against many patents—even thousands in the case of e-commerce. Although the patent system has features that discourage patent proliferation, notably the requirement that an invention not be obvious, empirical evidence suggests these are not working well.

Thus, they caution against the straight line argument that economic growth relies on property rights and therefore stronger IPR is needed:

In summary, patents do not work “just like property.” While they do play some role in promoting innovation and economic growth, that role is limited and highly contingent compared to the role property rights normally play in promoting economic growth. The laws and institutions that implement property rights may be harder to get right for patents than for tangible property rights.

Their version of getting it right for patents requires improving patent notice:

We thus think it likely that effective reform will require structural changes, including, possibly, multiple appellate courts, specialized district courts and greater deference to factfinders. What other changes might improve patent notice? In Chapter 11 we consider many reforms, most of which have also been advanced by other people. These include:
• Make patent claims transparent. We recommend changes in the way patent claims are defined, published, recorded in the application process, and used for subsequent determinations so that innovators have clear, accessible, and predictable information on patent boundaries. This includes strong limits on patent “continuations,” a procedure used to keep patent claims hidden from the public for extended periods. We also consider a new role for the Patent Office where, for a fee, innovators can obtain opinion letters on whether their technology infringes a patent.
• Make claims clear and unambiguous by enforcing strong limits against vague or overly abstract claims. This includes a robust “indefiniteness” standard that invalidates patent claims that can be plausibly interpreted in multiple, fundamentally different ways. Also, we recommend reforms to limit overly abstract patents in software and other technologies. At the very least, patent law should prevent software patents from claiming technologies far beyond what was actually disclosed as the invention. If this proves inadequate, then we suggest subject matter tests to limit the range of software inventions that can be patented, tests similar to those used during the 1970s and 1980s.
• Make patent search feasible by reducing the flood of patents. This includes a strong requirement that patents should not be granted on obvious inventions, coupled with substantially higher renewal fees. Ideally, patent renewal fees should be set by a quasiindependent agency and should be based on empirical economic research. These reforms will help stem the patent flood by screening-out unwarranted patents and discouraging renewal of low value patents. Reducing the number of such patents should help notice by reducing the cost of clearance search.
• Besides improving notice, we also favor reforms to mitigate the harm caused by poor notice. These include an exemption from penalties when the infringing technology was independently invented and changes in patent remedies that might discourage opportunistic lawsuits.

But their conclusions are mixed with a good dose of skepticism:

In presenting this list of policy ideas, we admit that we really do not know what it will take to substantially improve patent notice. These policy reforms move us in the direction of an effective patent system, but we do not know whether they are sufficient to get us there.

All in all, an important and refreshing take on patent reform.

According to AP, the House Judiciary passed the patent reform legislation today, with some changes -- House Committee OKs Patent Bill: Financial News - Yahoo! Finance:

One of the biggest changes, proposed by Berman, alters the post-grant review process by eliminating a provision that allowed open-ended challenges to a patent's validity. The bill now largely limits such challenges to the first 12 months.

The committee also amended a controversial provision regarding how courts can calculate damages in patent suits. The original bill required courts to more closely tie damages to the actual value of the patented technology, rather than the value of larger goods that include the patented item as a component.

The committee amended the bill to allow judges to choose between those and other methods, depending on the facts of the case.

Another amendment by Rep. Rick Boucher, D-Va., would bar the increasing practice of patenting tax-planning strategies. Already, sixty such strategies have been patented, Boucher said, with 85 more pending.

Over at Dani Rodrik's blog there is this intriguing posting: Economic development strategy as a Toyota Production System:

Chuck Sabel has been telling me for some time that our Growth Diagnostic framework is nothing other than the application of TPS principles to the design of economic growth strategies for countries as a whole. Listening to Toyota trainers, the point really hit home this time around. Toyota training manuals make clear how TPS differs from conventional "Western" modes of organizing a manufacturing operation. The former is based on experimentation, gradual but continuous change, identification of bottlenecks, self-correction, group approaches, small investments at the outset but continuous attention and effort. This is to be contrasted to the Western mode, based on top-to-bottom direction, big leaps, large investments, and over-reliance on technology. Not a bad way to describe the difference between the Growth Diagnostics framework, on the one hand, and approaches such as the Washington Consensus or the Millennium Development Project, on the other.

Rodrik's (and his coauthors') Growth Diagnostic framework is an approach, not a set of specific answers:

The methodology that we propose for this can be conceptualized as a decision tree (see Figure 1, discussed below). We start by asking what keeps growth low. Is it inadequate returns to investment, inadequate private appropriability of the returns, or inadequate access to finance? If it is a case of low returns, is that due to insufficient investment in complementary factors of production (such as human capital or infrastructure)? Or is it due to poor access to imported technologies? If it is a case of poor appropriability, is it due to high taxation, poor property rights and contract enforcement, labor-capital conflicts, or learning and coordination externalities? If it is a case of poor finance, are the problems with domestic financial markets or external ones? And so on.

The paper’s conclusions are as follows:

Across-the-board reform packages have often failed to get countries growing again. The method for growth diagnostics we provide in this paper should help target reform on the most binding constraints that impede growth.

An important advantage of our framework is that it encompasses all major strategies of development and clarifies the circumstances under which each is likely to be effective. Strategies that focus on resource mobilization through foreign assistance and increased domestic national saving pay off when domestic returns are both high and privately appropriable. Strategies that focus on market liberalization and opening up work best when social returns are high and the most serious obstacle to their private appropriation is government imposed taxes and restrictions. Strategies that emphasize industrial policy are appropriate when private returns are depressed not by the government’s errors of commission (what it does), but its errors of omission (what it fails to do).

As our discussion of El Salvador, Brazil, and the Dominican Republic illustrates, each of these circumstances throws out different diagnostic signals. An approach to development that determines the action agenda on the basis of these signals is likely to be considerably more effective than a laundry-list approach with a long list of institutional and governance reforms that may or may not be well targeted on the most binding constraints to growth.

The framework is being applied to South Africa -- see the Accelerated and Shared Growth Initiative for South Africa (AsgiSA) website. I wonder what the analysis would show for the US.

One of the fascinating aspects of the I-Cubed Economy is that we are still trying to figure out what is and is not an intangible asset. Take for example, a lease. IASB (International Accounting Standards Board) is working on new rules for account for a lease : "the lessee’s contractual right to use the leased item meets the definition of an asset (right to use asset) and its contractual obligation to make payments to the lessor meets the definition of a liability." However, what type of asset? The Board specifically considered a number of methods, including treating it as an intangible asset (covered by IAS 38 Intangible Assets) or like the underlying property plant and equipment (covered by IAS 16 Property, Plant and Equipment). In the end, the Board chose the latter: treating leases as property, plant and equipment. So for account purposes, leases are not intangibles.

But ... (just to complicate matters), what if the "lease" i.e. the right to use an asset is really a license royalty, i.e. the right to use a patented technology or copyrighted material? In that case, is the lease like property even though the underlying asset is an intangible? Or is it an intangible?

The more we delve into this, the murkier it becomes.

Today's Wall Street Journal online has a report on Is the Negative Savings Rate A Negative for the Economy? which includes this graph:

The online debate is a lively exchange as to whether the negative savings rate will be a long term detriment to the economy. There is only one problem with this debate, as one of the participants pointed out: we may not be measuring the savings rate correctly. Savings is not measured directly, it is a residual of what is left over when we account for income and spending. It is subject to assumptions on what is spending and what is investment. And, in fact, BEA estimates that "if R&D were included in the GDP as investment instead of as an expense, business investment would be 11 percent, or $178 billion, higher; and the 2002 national savings rate would be 16 percent instead of 14 percent." (See my earlier posting on this.)

That is not to say that the overall direction of declining trend shown above isn't correct. Nor does it mean we should be concerned. It does mean that we don't know for sure. In the period of beginning in the mid 1980's -- when the trend line heads south -- the US economy what being transformed from an industrial to a knowledge economy. That change means our investment patterns have also changed. More and more of our investments are in knowledge and intangibles, rather than plant and equipment. But our account rules have not changed. Plant and equipment gets depreciated over time as an investment; knowledge creation gets expensed immediately. As a result, our savings rate is distorted (since investment gets counts as part of savings, not spending).

So, the question remains: How much of that decline in the savings rate is real and how much is an accounting issue? Before we starting reading too much into the numbers, let's figure out whether they are, in fact, correct.

Some time ago, I posted a few items about how I agreed with the idea that the music industry needed a new business model that stressed live performance over easily copied recordings (see this, this and this).

Now, the industry looks like it is going that way. According to a recent story in the Economist (The music industry | A change of tune), the record labels trying to moving into the larger business:

Seven years ago musicians derived two-thirds of their income, via record labels, from pre-recorded music, with the other one-third coming from concert tours, merchandise and endorsements, according to the Music Managers Forum, a trade group in London. But today those proportions have been reversed—cutting the labels off from the industry's biggest and fastest-growing sources of revenue. Concert-ticket sales in North America alone increased from $1.7 billion in 2000 to over $3.1 billion last year, according to Pollstar, a trade magazine.

Frustrated record companies have responded by trying to get their artists to spend more time promoting records and less time touring and endorsing products, says Jeanne Meyer of EMI, another big record label. “Sometimes you've got a tug of war going on,” she says. Yet the more labels spend on marketing pre-recorded music, the more they raise their artists' profiles and boost their other, more lucrative, sources of income. Pre-recorded music, no longer the main cash cow, increasingly serves merely as a marketing tool for T-shirts and concert tickets. The best seats for The Police's world tour this summer cost over $900; the group's entire catalogue on CD costs less than $100.

Record labels have come up with a remedy: the “360° contract”. Instead of settling for a cut of CD sales, they increasingly offer artists broader contracts that encompass live music, merchandise and endorsement deals. Such deals, also known as multiple-rights or all-rights contracts, are particularly important in regions with rampant CD piracy, such as Africa, Asia and Latin America. “The market has made it necessary—we've got to look for something else,” says Manuel Cuevas, an industry executive in Mexico City. His company, the Mexican subsidiary of a major label, decided earlier this year to adopt the 360° model. “It's a discussion you have with every new artist now,” says EMI's Ms Meyer.

Although record labels like the idea, artists are unsurprisingly less keen. Few established artists have accepted 360° deals, though the labels trumpet the exceptions, including Robbie Williams, the Pussycat Dolls and Korn. It is more profitable, the artists say, to stick with artist-management agencies, which have traditionally handled the job of cultivating careers beyond the realm of recordings.

Management agencies are also considered to have more respect for their artists' interests. Record labels, for example, have been criticised for obtaining rights to the names of artists and bands for use in internet addresses. Some clauses stipulate that name ownership applies even after contracts expire or artists die. This can prevent musicians from launching websites to promote tours, sell merchandise, and communicate with fans as they see fit. “Record companies don't exactly give many artists the warm, fuzzy feeling,” says Gary Bongiovanni, the editor of Pollstar.

Musicians with small fan bases and little business experience are much more receptive to the idea of 360° deals. There is no shortage of aspiring artists, and some will become big names. Juha Ruusunen, the founder of TWU, a small management agency for heavy-metal bands based in Jyväskylä, Finland, says European labels have begun to sign up new talent with 360° contracts. As record labels move more aggressively into the artist-management field, Mr Ruusunen worries that his agency might struggle to compete.

I'm not sure that the agencies need to worry that much. They just need to stay competitive with the labels in what they can offer. All this sounds like the old days where the record companies controlled everything an artist did. At least it worked that way in the movie industry in the heyday of the studios. That led to some of the biggest names breaking away and forming their own studio -- United Artists. Maybe the same thing will happen, and that will give the agencies the opening they need.

In the meantime, it is a good sign that the labels have caught on to the changing game. It is a lot better than their old strategy of trying to hold back the tide by suing every kid who downloaded a song.

Here is an interesting story -- Facing a Lawsuit, Corzine Swears Off E-Mail - New York Times

In response to a lawsuit filed by Republicans seeking public disclosure of e-mail messages he exchanged with the state union president who is also a former companion, Mr. Corzine said he had decided simply to stop using e-mail. He has insisted that his e-mail messages from a private campaign account to the union leader, Carla Katz of the Communications Workers of America Local 1034, are private, and therefore insulated by executive privilege.

To avoid any problems, he said, he has decided to rely on a mode of communication that was in vogue well before he was born in 1947. “We’ll go back to the 1920s, and have direct conversations with people,” Mr. Corzine said.

On the other hand, it might not change much in New Jersey government:

Interestingly, those who know Mr. Corzine well say he never exchanged a lot of e-mail messages in the first place.
Those intimidated by the gigabyte generation may take comfort in what friends and aides of Mr. Corzine, a former co-chairman of Goldman Sachs, say: that he is a bit of a technological klutz.

While this may sound silly, it raises fundamental questions of what is public and what is private. We have a situation where the technology is defining the situation rather than the common use. Email is treated as a permanent record (like a letter), rather than a temporary conversation (like a phone call) because it can be treat that way. The technology allows it. No matter that social custom has evolved in a direction that email is an informal conversation.

Now, the technology has evolved to a point where phone calls can be made into a permanent record as well. But, image the outcry if someone was taping all of our phone conversations. Oh. Um, well never mind . . .

The US trade deficit for May rose by $1.3 billion to $60 billion, according this morning's BEA trade data. The good news is that our intangibles surplus grew by over 2%, continuing its strong positive trajectory.

The increase in the overall deficit was due to a $4 billion rise in imports that overshadowed the $2.4 billion increase in exports. A large part of those imports were energy (oil, gas and petroleum products). But other areas increased significantly as well, such as telecommunications equipment and pharmaceutical preparations. While this matched Wall Street expectations, it was a turn around from last month. As the Washington Post reported, "The deficit with China rose to $20.02 billion, the biggest imbalance in four months. So far this year, the deficit with China is running 17.2 percent ahead of the pace set last year when the overall deficit soared to an all-time high of $233 billion." The deficit with Canada and the EU, however, declined. The overall deficit is still below last year's record setting pace.

Our surplus in intangibles grew by $227 million in May to $10.3 billion as exports grew faster than imports (in both royalty payments and business services). Both receipts (exports) and payments (imports) of royalties rose as did both imports and exports of business services.

The deficit in Advanced Technology Products eased somewhat, dropping to $3.1 billion from the April level of $4.7 billion. The main reasons for the improvement were increased aerospace and electronics exports. The last monthly surplus in Advanced Technology Products was in June 2002 and the last sustained series of monthly surpluses were in the first half of 2001.

As I reported last month, the statistics for services were revised going back to 2004. That revision showed a surplus roughly $1.5 billion greater than previously reported. It also indicated a much stronger positive trajectory over the past year or so, which has continued in May.

Note: we define trade in intangibles as the sum of "royalties and license fees" and "other private services". The BEA/Census Bureau definitions of those categories are as follows:

Royalties and License Fees - Transactions with foreign residents involving intangible assets and proprietary rights, such as the use of patents, techniques, processes, formulas, designs, know-how, trademarks, copyrights, franchises, and manufacturing rights. The term "royalties" generally refers to payments for the utilization of copyrights or trademarks, and the term "license fees" generally refers to payments for the use of patents or industrial processes.

Other Private Services - Transactions with affiliated foreigners, for which no identification by type is available, and of transactions with unaffiliated foreigners. (The term "affiliated" refers to a direct investment relationship, which exists when a U.S. person has ownership or control, directly or indirectly, of 10 percent or more of a foreign business enterprise's voting securities or the equivalent, or when a foreign person has a similar interest in a U.S. enterprise.) Transactions with unaffiliated foreigners consist of education services; financial services (includes commissions and other transactions fees associated with the purchase and sale of securities and noninterest income of banks, and excludes investment income); insurance services; telecommunications services (includes transmission services and value-added services); and business, professional, and technical services. Included in the last group are advertising services; computer and data processing services; database and other information services; research, development, and testing services; management, consulting, and public relations services; legal services; construction, engineering, architectural, and mining services; industrial engineering services; installation, maintenance, and repair of equipment; and other services, including medical services and film and tape rentals.

Two months ago, Allan Sloan wrote a column in the Washington Post about a new tax twist in corporate buyouts -- Yummy Tax Toppings Sweeten the Sale:

Of course, your refund is Uncle Sam returning an interest-free loan you graciously made him by overpaying during the year -- but it sure feels better to get a check than to write one. So imagine the joy at Great-West Lifeco, which has figured out how to get cash today for tax savings that it won't see for up to 15 years. It will do this by getting $550 million from the sale of securities backed by tax savings that it expects to get as the result of its $3.9 billion cash purchase of the Putnam Investments mutual-fund business.

Getting tax savings upfront? You gotta love it. Here's the deal: Great-West, of Winnipeg, Manitoba, is buying Putnam from Marsh & McLennan of New York.

Normally, this would be a plain-vanilla deal, with Great-West buying the stock of the M&M subsidiary that owns Putnam. This wouldn't give any U.S. tax breaks to Great-West, which has substantial U.S. profits. Instead, M&M and Great-West are adding yummy tax topping to the vanilla by making what tax techies call a 338(h)(10) election. This allows Great-West to treat the deal as if it had bought the assets of Putnam, the nation's 10th-largest fund company, rather than buying stock.

The difference? By buying assets for cash, Great-West -- perfectly legally and aboveboard -- gets to deduct what it paid for Putnam from its U.S. taxable income over the next 15 years by depreciating the assets it purchased. That would reduce Great-West's taxable income by about $260 million a year ( 1/15 th of the $3.9 billion purchase price). This deduction would save Great-West $88 million a year at the current corporate tax rate of 34 percent.

Great-West, which declined to discuss details, is doing a pioneering deal by selling securities tied to those savings. "These guys are breaking new ground," said Robert Willens, a tax expert at Lehman Brothers. "This is absolutely the first time anyone has done this."

I still have not been able to track down the details of the deal.

But now I've run into this intriguing statement that caught my eye in the Economist story on the proposed buy-out of Virgin Media -- Branson's bumpy landing:

Given Virgin Media's troubles, why would Carlyle want it? The firm offers a predictable cash flow that could be used to repay the loans needed to buy it; but there may be another reason too. Analysts at Merrill Lynch reckon Virgin Media has a “tax loss” of about £12 billion, which could be written off against profits, if Virgin made any. That could be useful for an acquirer looking to shelter earnings. Several private-equity groups besides Carlyle are also thinking hard about bidding for the media firm. Expect more twists in this suddenly unpredictable plot.

Could Carlyle, who is no stranger to the securitization process, be looking at the same deal? Carlyle was one of the buyers of Dunkin Donuts that securitized its franchise royalties (see earlier posting).

This could get very interesting -- especially as the asset backed securitization market starts going south because of the problems with sub-prime mortgages. (Just yesterday, S&P announced it is looking at its ratings for the residential mortgage backed securities. See also Ratings Cuts By S&P, Moody's Rattle Investors - WSJ.com)

One of the characteristics of the global I-Cubed Economy is the interconnection among industries and production processes. An example of this surfaced in a Wall Street Journal story this morning -- Fuel Rules Soak Soap Makers. As part of the push to reduce our dependence on imported oil, the soap industry is getting hit from two sides. First is the rise in corn prices as corn is diverted to make ethanol. Higher corn prices means higher beef prices and, more to the point, higher prices for beef tallow (animal fat). The second is the movement to use animal fat directly as an energy source (specifically as a diesel additive). The result is higher prices for tallow:

Already, rising tallow prices "are causing a radical change in the structure of our marketplace," says Dennis Griesing, a vice president of the Soap and Detergent Association. He says some major U.S. companies are importing more-expensive palm oil as a tallow substitute. But that makes those companies more vulnerable to competition from soap makers in Indonesia and Malaysia, which enjoy better access to palm oil and have cheaper labor.

Somehow, I think there might be a net gain to the US to import less oil and more palm oil and soap. But I would like to see the numbers.

According to a Treasury Department press release:

Secretary Henry M. Paulson, Jr. will hold a one-day conference on Thursday, July 26 in Washington, D.C. to examine ways in which our current business tax system affects economic growth and U.S. competitiveness in the global economy.

No other details are available at this time. But it looks like this is a follow on to an early June conference on New OECD International Tax Initiatives: Looking Ahead. However, that conference was more about the harmonization of specific tax details, such as transfer pricing, than about the impact of tax structures on competitiveness.

If the Secretary's conference is really going to look at tax policy as a factor in competitiveness, it will need to put ideas from both the left and the right on the table. From the left, it will need to address the concern over tax policies that are said to encourage the transfer of production and jobs overseas. From the right, it will need to look at concerns over double taxation of corporations and the capital gains tax rate. And while it is at it, it should look at the whole issue of moving to a Value Added Tax (VAT).

It should also bring to the table the recommendations of the President's Advisory Panel on Federal Tax Reform (commonly known as the Mack-Breaux Tax Reform Commission). While the Commission's recommendations have fallen on deaf ears and have been dismissed as impractical in some quarters, it should serve as at least part of the bases for continued discussion.

So, it is unclear in my mind what a one-day conference hosted by Secretary Paulson will accomplish. But if it does a good job of fairly raising all of the issues, it will be successful. If it becomes just another forum for spotlighting any number of specific hobbyhorses, then it will be just another meeting. Let's hope it can address the real tax issues facing the I-Cubed Economy

Looks like the hottest career path in the I-Cubed Economy right now is accounting --
Graduating With a CP-Yay - washingtonpost.com:

Accounting isn't typically considered to be the most thrilling course of study, but number-crunching students have become hot commodities on college campuses as firms try to keep up with the exploding demand for financial workers.

Increased scrutiny of public companies coupled with the impending retirement of thousands of baby boomers have driven accounting firms to snag the next generation of auditors, bookkeepers and tax experts as early as possible with promises of plump paychecks and tempting perks. Some firms are grooming potential interns as early as high school.

Now, if we could just get the number crunchers to understand intangible assets (he says tongue firmly in cheek).

I do have to wonder how many of these number crunchers are being drawn fro the ranks of potential engineers?

From today's Wall Street Journal - Microsoft Plans Canada Software Center:

Microsoft Corp. plans to open a software development center in Canada this fall to attract talent and avoid U.S. immigration issues.

The Vancouver, British Columbia location will be one of only a handful development centers outside the company's headquarters in Redmond, Wash., the software company said Thursday. It previously announced plans to build sites in Boston and Bellevue, Wash.

Microsoft said the Vancouver location will "allow the company to continue to recruit and retain highly skilled people affected by the immigration issues in the U.S."

So -- Canada picks up a jurisdictional advantage because of US immigration law (or lack thereof). Interesting.

In an earlier posting, I talked about how intangible assets are being used more and more as collateral for loans, including in one case to finance a leverage buy-out. So this item in today’s Washington Post about possible takeovers in the hotel industry (Stock Rush Belies Marriott Sale Odds) caught my eye.

Another reason Marriott is a less likely target, [Robert] LaFleur [an analyst with Susquehanna Financial Group] said, is because unlike Hilton, Marriott owns little real estate. The firm prefers to manage and franchise the hotels in its chain. At the end of last year, it owned only 13 of more than 2,800 hotels across its brands. That's important because private-equity groups like Blackstone can get more attractive financing rates when they can borrow against actual assets, letting them swallow companies cheaper and make more money quicker.

"The Marriott brand has a lot of value, but it is intangible value," LaFleur said.

It seems that tangible assets rich companies are more of a target than those with high intangible value. For now. My betting is that this will change as the financial community learns to monetize intangibles.

But as I said earlier, using intangibles as a form of financing is a difficult transaction - with a lot of back-up mechanisms needed. Lots of issues here - which will be explored in our forthcoming working paper on monetization of intangible assets.

Americans for the Art has published its latest survey - Arts & Economic Prosperity III: The Economic Impact of Nonprofit Arts and Culture Organizations and Their Audiences:

Nationally, the nonprofit arts and culture industry generates $166.2 billion in economic activity every year—$63.1 billion in spending by organizations and an additional $103.1 billion in event-related spending by their audiences. The study is the most comprehensive study of the nonprofit arts and culture industry ever conducted. It documents the economic impact of the nonprofit arts and culture industry in 156 communities and regions (116 cities and counties, 35 multicounty regions, and five states), and represents all 50 states and the District of Columbia.

The $166.2 billion in total economic activity has a significant national impact, generating the following:
• 5.7 million full-time equivalent jobs
• $104.2 billion in household income
• $7.9 billion in local government tax revenues
• $9.1 billion in state government tax revenues
• $12.6 billion in federal income tax revenues

Not covered in the report is the indirect effect of the arts -- as collaborators with other activities such as design and entertainment and as a source of creative training that benefits all sectors of the economy. The I-Cubed Economy is multifaceted -- and our policymakers need to remember the contributions from every sector, including the arts.

To read about the specific impact on three specific communities, see:
Arts return economic favor to supportive city- Ft. Collins, CO.:
Study shows economic power of the arts - Santa Cruz
Culture is economic development - Cedar Rapids

Thanks to our friends over at EDPro Weblog: Economic Development for Today's Professionals for pointing this out.

Speaking of reputation management, today's Washington Post has a story as well -- Calling In Pros to Refine Your Google Image:

Google's ubiquity as a research tool has given rise to a new industry: online identity management. The proliferation of blogs and Web sites can allow angry clients, jealous lovers or ruthless competitors to define a person's identity. Whether true or not, their words can have far-reaching effects.

Charging anything from a few dollars to thousands of dollars a month, companies such as International Reputation Management, Naymz and ReputationDefender don't promise to erase the bad stuff on the Web. But they do assure their clients of better results on an Internet search, pushing the positive items up on the first page and burying the others deep.

I find this fascinating, and a little disturbing in a number of ways. The first is in how easily rumor can become fact. Everyone knows that a major benefit of the Internet is the massive available of information. The dark side, however, is that not all of the information is accurate. As I mentioned earlier, information flows are much faster now - both accurate and inaccurate. Sorting out what is true or not is difficult.

That problem is compounded by the need to sorting out what is important or not. Here is my second issue. Who gets to determine what is important? These types of services are paid to make information seeker believe that the good stuff is always the most important. But sometimes the bad stuff is both important and true. I would like to think that if the bad stuff is both important and true, no amount of image management would help.

But, I’m not sure.

Business Week is running an interesting story on the intangible asset of reputation -- What Price Reputation?

Many savvy companies are starting to realize that a good name can be their most important asset—and actually boost the stock price

...

More and more are finding that the way in which the outside world expects a company to behave and perform can be its most important asset. Indeed, a company's reputation for being able to deliver growth, attract top talent, and avoid ethical mishaps can account for much of the 30%-to-70% gap between the book value of most companies and their market capitalizations. Reputation is a big reason Johnson & Johnson (JNJ ) trades at a much higher price-earnings ratio than Pfizer (PFE ), Procter & Gamble (PG ) than Unilever (UN ), and Exxon Mobil (XOM ) than Royal Dutch Shell (RDS ). And while the value of a reputation is vastly less tangible than property, revenue, or cash, more experts are arguing it is possible not only to quantify it but even to predict how image changes in specific areas will harm or hurt the share price.

This isn't just PR. In fact, as the story warns:

A company's message must be grounded in reality, and its reputation is built over years. And if there is a negative image based on a poor record of reliability, safety, or labor relations, "please don't hire a PR company to fix it," says strategy professor Phil Rosenzweig of Switzerland's International Institute for Management Development. "Correct the underlying problem first." The biggest driver of a company's reputation and stock performance is, after all, its financial results, notes Rosenzweig, author of The Halo Effect, a book that details how quickly reputations can turn.

Here are two examples of how it works:

in late 2005, UTC turned to a tiny consulting firm named Communications Consulting Worldwide, led by sociologist Pamela Cohen and former Ernst & Young strategist Jonathan Low, pioneers in the nascent study of how public perceptions affect a company's stock price. A CCW team spent months processing a bewildering amount of assorted data UTC had amassed over the years. It included studies tracking consumer perceptions of its brands, employee satisfaction, views of stock analysts and investors, corporate press releases, thousands of newspaper and magazine articles, and two years' worth of UTC financial information and daily stock movements. After feeding the data into an elaborate computer model, Cohen and Low concluded that 27% of UTC's stock market value was attributable to intangibles like its reputation.

The duo determined the way to drive up the stock was to make investors more aware of UTC's environmental responsibility, innovation, and employee training—points the company had not stressed publicly. To make sure investors got the message, UTC plastered the Sikorsky S-92 ads and others like it featuring an Otis elevator, a Pratt & Whitney jet engine, and a hybrid bus with UTC Power fuel cells, on four commuter train stations in Connecticut towns with high concentrations of financiers.

. . .

Southwest also leaves little to chance. The Dallas carrier already enjoys one of the industry's best reputations, and Wall Street rewards it accordingly. Its $11.4 billion market cap is bigger than the combined value of the two biggest airlines, American (AMR ) and United (UAUA ), a gap that differences in assets like planes and routes don't begin to explain. Still, when Linda Rutherford, Southwest's vice-president for public relations and community affairs, heard Low's pitch at a PR meeting two years ago, she decided to hire CCW to assess whether it was stressing the right points.

After crunching years' worth of data, Cohen and Low flew to Dallas last August with results that were eye-opening. CCW estimated public relations alone could move Southwest's stock up or down by 3.5%, equal to $400 million in market value today. The data also indicated Southwest was getting little return by stressing its budget fares—a familiar story. Instead, there was more upside potential for shares if Southwest stressed its extensive routes and schedules. "We had a bit of an 'Aha!" Rutherford recalls.

So Southwest has begun emphasizing long-haul flights and frequent service between many cities, points that seldom had gotten press. It also plans a third-quarter ad campaign based on CCW's advice. The effect so far: While airline stocks have fallen more than 15% overall in 2007, Southwest's shares are down only 5%, to about 14.80.

(In the interest of full disclosure, Jon Low is on the Board of my organization, Athena Alliance).

So -- it is not enough to have a good reputation, you have to let Wall Street know about it. This tracks our earlier findings that financial analysts and managers really don't understand companies' intangible assets (see Reporting Intangibles). If you don't measure it or at least track it, it doesn't get managed and only indirectly and informally valued.

And that is no way to run a railroad.