Unmeasured Investment and the Puzzling U.S. Boom in the 1990s

For the 1990s, the basic neoclassical growth model predicts a depressed economy, when in fact the U.S. economy boomed.We extend the base model by introducing intangible investment and non-neutral technology change with respect to producing intangible investment goods and find that the 1990s are not puzzling in light of this new theory.There is micro and macro evidence motivating our extension, and the theory's predictions are in conformity with U.S. national accounts and capital gains.We compare accounting measures with corresponding measures for our model economy and find that standard accounting measures greatly understate the 1990s boom.* An earlier version of this paper circulated under the title "Expensed and Sweat Equity."The authors thank the National Science Foundation for financial support and seminar participants and referees for comments on earlier drafts of the paper.The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.in business cycle research.2 However, doing so would have violated two criteria that we require to successfully resolve the puzzling 1990s boom-or any other puzzle, for that matter.The first is the input justification criterion.By this, we mean that we require our exogenous inputs to be consistent with micro and macro empirical evidence.A large rise in preferences for leisure, on the other hand, cannot be justified by any observations on tax rates, tax credits, or welfare benefits.The second of our two criteria for successfully resolving of the puzzling 1990s boom is the prediction criterion.At a minimum, to satisfy this criterion, a theory's predictions must not be counterfactual.A stronger requirement-one that is satisfied by our theoryis to make correct predictions for data that were not used to set parameters and exogenous inputs.Thus, we do not follow the widely used practice in the business cycle literature of including the same number of exogenous inputs as observed time series, which is done to ensure a perfect fit between data and theory.Here, there are two sequences of TFP parameters that are free in the analysis and many time series that must be in conformity with the theory.We find that the equilibrium paths of our extended theory are in close conformity with time series of both NIPA products and incomes and, most importantly, with the increase in capital gains that occurred in the second half of the 1990s.This increase was large, with the average real gains going from 6 percent of GDP in the period 1953 -1994 to 12 percent of GDP in the period 1995 -2003. .Data on factor incomes and capital gains are not used to identify the TFP parameters.In contrast, a theory based on a large shift in preferences for leisure during the 1990s does not account for the observed changes in factor incomes and capital gains.3 After demonstrating that the model's predictions are in conformity with U.S. time series, we use the model to compare current accounting measures for investment and labor productivity with corresponding measures that include expensed and sweat investment.2 See, for example, Hall (1997), Chang and Schorfheide (2003), Galí (2005), Comin and Gertler (2006), Galí, Gertler, andLópez-Salido (2007), Kahn and Rich (2007), Smets and Wouters (2007), and Ireland and Schuh (2008), who point out that these shocks proxy for variations in tax rates and other labor market distortions, which are especially important in accounting for changes in hours.In McGrattan and Prescott (2009), we show that labor tax rates do account for much of the cyclical variation in hours prior to the 1990s but not in the 1990s.3 See McGrattan and Prescott (2009) for details.