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Relative Prices and Relative Prosperity

By CHANG-TAI HSIEH AND PETER J. KLENOW*

The positive correlation between real investment rates and real income levels acrosscountries is driven largely by differences in the price of investment relative tooutput. The high relative price of investment in poor countries is due to the low priceof consumption goods in those countries. Investment prices are no higher in poorcountries. Thus, the low real investment rates in poor countries are not driven byhigh tax or tariff rates on investment. Poor countries, instead, appear to be plaguedby low efficiency in producing investment goods and in producing consumer goodsto trade for them. (JEL E22, E23, O16, O47)

One of the strongest relationships establishedin the empirical growth literature is the positivecorrelation between the investment rate in phys-ical capital and the level of output per worker.As illustrated by Figure 1, a well-known styl-ized fact is that the real investment rate ofwealthy countries such as Norway and theUnited States is roughly two to three timeshigher than that of poor countries such as Maliand Kenya. This positive correlation also holdswhen considering the growth rate, rather thanthe level, of output per worker.1 Based on thisevidence, empirical work accounting for whysome countries are rich and others are poor hasassigned an important role to differences inphysical capital intensity.2

Two broad sets of explanations have been

proposed for the low real investment rates inpoor countries. The first set of explanationsoperates through savings rates (combined withlimited international capital mobility). Primeexamples are theories in which poor countrieshave low savings because of institutions andpolicies that result in high effective tax rates oncapital income (e.g., financial repression).3

Other authors have argued that poor countriesare stuck in low-savings traps because of sub-sistence consumption needs.4 Regardless of theunderlying mechanism, the notion that poorcountries have low savings was central to theway development economists in the 1950s and1960s thought about the problem of develop-ment, and was an important intellectual founda-tion for the lending work of institutions like theWorld Bank.

A second set of explanations focuses on forcesdirectly affecting investment. A number of re-cent papers argue that poor countries have pol-icies that drive up the cost of capital. Accordingto this view, poor countries have low real in-vestment rates because they tax capital goods,have barriers to capital goods imports, or grantmonopoly rights to domestic capital goods pro-

* Hsieh: Department of Economics, University of Cali-fornia, Berkeley, 549 Evans Hall, Berkeley, CA 94720and National Bureau of Economic Research (e-mail:[email protected]); Klenow: Stanford University, 579Serra Mall, Stanford, CA 94305, and NBER (e-mail:[email protected]). We are indebted to Romans Pancs forsuperlative research assistance. We are also grateful toFrancesco Caselli, Angus Deaton, J. Bradford DeLong, BillEasterly, Gene Grossman, Chad Jones, Sam Kortum, DavidRomer, Mark Spiegel, Silvana Tenreyro, and three referees forhelpful comments. For financial support, Hsieh thanks theAlfred P. Sloan Foundation and Klenow the Stanford Institutefor Economic Policy Research.

1 Ross Levine and David Renelt (1992) single out theinvestment rate as the lone robust correlate with growth inincome per person. Xavier Sala-i-Martin (1997) finds theinvestment rate to be significantly correlated with growth in99.97 percent of the 32,509 cross-country regressions he ranwith investment alongside other regressors.

2 See N. Gregory Mankiw, David Romer, and David N.Weil (1992), Klenow and Andres Rodrıguez-Clare (1997),and Robert E. Hall and Charles I. Jones (1999).

3 See Ronald I. McKinnon (1973). Poor countries havealso been hypothesized to have low savings rates because ofhigh dependency ratios (Matthew Higgins and Jeffrey G.Williamson 1997), high discount rates (Christopher D. Car-roll, Byung-Kun Rhee, and Chang-Yong Rhee 1994), andhigh explicit tax rates on capital income (William Easterlyand Sergio Rebelo 1993).

4 The earliest papers were by Richard R. Nelson (1956)and Robert M. Solow (1956). More recent papers includeMark Gersovitz (1983), Kiminori Matsuyama (1992), andDan Ben-David (1998).

562

ducers. Advocates typically point to the fact thatthe relative price of capital is two to three timeshigher in a poor country than in a rich country.5

Investment distortions have also played a promi-nent role in historical accounts of countries thathave experienced dramatic reversals of fortune.6

In this paper, we present a series of facts toshed light on the underlying causes of differ-ences in real investment rates across rich andpoor countries. The first fact involves the rate ofinvestment at international prices versus at do-mestic prices. When evaluated at domesticprices, richer countries have only modestlyhigher investment rates than poorer countriesdo.7 Figure 2 illustrates this for 114 countries in

1996. Whereas the correlation between the pur-chasing power parity (PPP) investment rate andPPP income is 0.50, that between the domestic-price investment rate and PPP income is only0.05. At domestic prices, poor countries do notinvest much less than rich countries do. Thisevidence suggests that explanations involvingdiscount rates, subsistence consumption, low-savings traps, and the taxation of capital incomecan account for only a small part of the differ-ence in capital intensity between rich and poorcountries. Instead, the domestic relative price ofinvestment—which accounts for the differencebetween investment rates at domestic prices ver-sus at international prices—is much higher in poorcountries.

The second stylized fact is that the high rel-ative price of investment in poor countries isdriven entirely by the denominator rather thanthe numerator. We find that investment goodstend to be no more expensive in poor countriesthan in rich countries, whereas consumptionprices tend to be lower in poor countries. Thiscontradicts the hypothesis that investmentgoods are taxed more heavily in poorer coun-tries, or are subject to high tariffs or transpor-tation costs that make them expensive for poorcountries.

To be sure, none of these facts is new. Thepositive correlation between investment rates(measured in PPP prices) and income and thenegative correlation between the relative priceof capital and income are two of the most

5 See Jones (1994), Jong-Wha Lee (1995), V. V. Chari,Patrick J. Kehoe, and Ellen R. McGrattan (1996), McGrat-tan and James A. Schmitz (1999), William Collins andWilliamson (2001), Jonathan Eaton and Samuel Kortum(2001), and Diego Restuccia and Carlos Urrutia (2001).

6 See Carlos Diaz-Alejandro (1970) and Alan M. Taylor(1998a, 1998b) for the role of investment distortions inArgentina.

7 We focus on data from 1980, 1985, and 1996 becausethe Penn World Tables (PWT) has benchmark price data fora large number of countries in these years. The data fromnonbenchmark years still provide useful information, how-ever. In particular, the income elasticity of investment rateswas generally higher in the 1960s than in recent decades.And, although Stephen L. Parente and Edward C. Prescott(2000, 39) find savings rates to be modestly correlated withincome, they are more highly correlated with income thanare domestic-price investment rates: 0.43 versus 0.05 in1996, 0.55 versus 0.17 in 1985, and 0.53 versus 0.23 in1980. Interestingly, the correlation of savings rates withincome has remained unchanged since the 1960s. Sincedomestic-price investment rates have become much lesscorrelated with income in recent decades, capital flows fromrich countries to poor countries must have increased sincethe 1960s. Clearly, understanding why the investment rateswere more highly correlated with income in the past and

understanding the distinction between savings and invest-ment rates at domestic prices are important topics for futureresearch.

FIGURE 1. INVESTMENT RATES AT INTERNATIONAL PRICES FIGURE 2. INVESTMENT RATES AT DOMESTIC PRICES

563VOL. 97 NO. 3 HSIEH AND KLENOW: RELATIVE PRICES AND RELATIVE PROSPERITY

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widely cited stylized facts in the growth litera-ture, starting with Robert J. Barro (1991). Sim-ilarly, the low price of consumption goods inpoor countries is a well-established fact, knownas the “Balassa-Samuelson effect.”8 The lasttwo facts—that investment rates measured indomestic prices are no lower in poor countriesand prices of capital goods are no more expen-sive in poor countries—may not be as wellknown.9 It is useful, however, to think about theinvestment rate measured in domestic prices asthe product of the investment rate measured inPPP prices and the relative price of capital, andthe price of capital as the product of the relativeprice of capital and the price of consumption. Itshould therefore not be surprising that the prod-uct of a variable positively correlated with in-come (investment rate in PPP prices or price ofconsumption) and a variable negatively corre-lated with income (the relative price of capital)is only weakly correlated with country income.

While these facts are all individually known,our contribution is to provide a unified expla-nation for them. Taken together, the facts sug-gest that savings and investment distortions canaccount for only a small part of the differencesin physical capital intensity across countries.Instead, the facts point to important differencesin sectoral productivity across countries. Poorcountries appear to have low investment rates inPPP terms primarily because they have eitherlow productivity in producing investment goodsor low productivity in producing tradables toexchange for investment goods. This interpre-tation does not require investment goods to beentirely tradable, but does require that the shareof nontraded services be larger in consumptiongoods than in investment goods. To the extentinvestment goods are easier to trade than areconsumption goods, however, this is a corollaryto the Balassa-Samuelson hypothesis that poorcountries have low productivity in tradables rel-ative to nontradables.

Eaton and Kortum (2001) provide an alterna-tive interpretation for the high relative price ofcapital and low price of consumption in poor

countries. In their framework, both consump-tion and investment goods are tradable, buttransportation costs prevent prices from equal-izing across countries. In addition, they assumethat poor countries are completely specializedin producing consumption goods (and importinvestment goods from rich countries), whilerich countries produce both consumption andinvestment goods (and import consumptiongoods from poor countries). Price differencesacross countries are determined by trade barri-ers and by a country’s specialization in produc-tion. Consumption goods are therefore moreexpensive in rich countries simply because richcountries face barriers in importing consump-tion goods from poor countries. Similarly, therelative price of capital is higher in poor coun-tries simply because poor countries face barriersin importing capital goods from rich countries,and because consumption goods are cheaper inpoor countries. Eaton and Kortum’s model thuscaptures the fact that consumption prices arecheaper in poor countries, but is inconsistentwith the fact that the absolute price of capitaldoes not appear to be any higher in poorcountries.

Trade frictions play no role in our story.Instead, we argue that the high relative price ofcapital in poor countries is entirely due to poorcountries’ low productivity in producing invest-ment goods and in producing tradable goods inexchange for investment goods (relative to theirproductivity in the nontradable service sector).This interpretation is consistent with the twokey facts about the cross-country pattern inprices—that consumption good prices are lowerin poor countries and that investment goodsprices are no higher in poor countries.

Our results thus imply that the correlation ofphysical capital investment rates and incomearises from a deeper productivity puzzle. Thechallenge is to explain not only low overallproductivity in poor countries, but also low pro-ductivity in investment goods (or in providingconsumption goods to trade for investmentgoods) relative to consumption goods.

The rest of this paper proceeds as follows. InSection I we present models in which a coun-try’s investment rate and income level are en-dogenous to its tax rate on capital income, itstax rate on producing and importing investmentgoods, and its productivity in producing invest-ment and consumption goods. In Section II we

8 See Bela Balassa (1964) and Paul A. Samuelson(1964), and also Jagdish N. Bhagwati (1984). Robert Sum-mers and Alan Heston (1991) further document this phe-nomenon, using services as a proxy for nontradables. Andsee figure X in Barro (1991).

9 But see figure XI in Barro (1991).

564 THE AMERICAN ECONOMIC REVIEW JUNE 2007

compare the predictions of the model to PennWorld Trade (PWT) benchmark data on invest-ment prices, consumption prices, income levels,and investment rates. In Section III, we discussthe impact of possible measurement error in theinternational price data. In Section IV wesummarize.

I. Models with Endogenous Investment Ratesand Income Levels

We begin by considering a simple model withtwo sectors and two taxes: a nontraded con-sumption sector, a tradable investment sector, atax on retail sales of investment goods, and a taxon capital income. Aside from having separateconsumption and investment sectors, it is a con-ventional neoclassical growth model. We usethis simple model to illustrate how the two taxesand productivity levels affect a country’s priceof investment, price of consumption, PPP in-vestment rate, and PPP income per worker. Wethen consider a more complicated model thatintroduces a tradable consumption sector and anontradable investment sector. In this setup,countries with a comparative advantage in trad-able investment goods (presumably rich coun-tries) export capital goods in exchange forconsumption goods produced by countries witha comparative advantage in tradable consumergoods (presumably poor countries).

A. A Model with Tradable Investment andNontraded Consumption

We begin by laying out the simple two-sectormodel. The production technologies in the con-sumption and investment sectors in country j are

(1) Cj � ACj �KC

j ��LCj �1 � � and

(2) Ij � AIj�KI

j��LIj�1 � �.

The variables ACj and AI

j are exogenous produc-tivity indices that grow at the constant rate gAacross sectors and across countries. The param-eter � � (0, 1) is the elasticity of output withrespect to physical capital, and (1 � �) that withrespect to labor. For simplicity, we assumethese elasticities are the same across countriesand across sectors. We also assume that theaggregate endowment of labor is given by Lj �

LCj � LI

j and the aggregate capital stock is givenby Kj � KC

j � KIj.

We will assume that consumption goods can-not be traded internationally, whereas invest-ment goods are fully tradable. Empirically,some consumption is in fact tradable (e.g.,clothing and cars) and even tradable investmentgoods have a nontradable component (e.g.,some distribution and retail services). For expo-sitional simplicity, we will first model the polarcase of purely nontradable consumption andtradable investment. However, we will relaxthese assumptions in the next section by intro-ducing nontradable investment goods and trad-able consumption goods that can be exchangedfor (traded) investment goods.

We model the investment distortion as a tax� I

j levied on sales of investment goods at theretail level. Specifically, we assume that allproducers of investment goods sell their prod-ucts at a fixed wholesale price determined inworld markets. In turn, the wholesaler sells cap-ital goods to firms wishing to invest, at whichpoint the government in country j imposes asales tax at rate � I

j. We thus denote the pre-taxwholesale price of investment goods by P I

j/(1 �� I

j), where P Ij represents the after-tax price of

investment goods at the retail level.10

We assume that consumption and investmentgoods are produced by representative firms fac-ing competitive output and input markets. Thecurrent profits of firms producing consumptionand investment goods are, respectively:

(3) � Cj � PC

j Cj � wjLCj � RjKC

j ;

(4) � Ij �

PIj

1 � � Ij Ij � wjLI

j � RjKIj.

Here, PCj denotes the price of consumption

goods, wj denotes the wage, Rj represents therental price of capital, and Cj and I j are given byequations (1) and (2). Assuming that firms max-imize profits, one can show that

(5) Rj � �� PIj

1 � � Ij�AI

j�Kj

Lj�� 1

and

10 We assume the wholesaler does not provide any ser-vices. In the next section we relax this assumption.


(6)PC

j

PIj �

AIj

ACj �1 � �I

j�.

Equation (5) equates the rental price of capital Rto the marginal product of capital. Marginalproducts in the two sectors are equated to thecommon rental price. This implies a commoncapital-labor ratio in the two sectors equal to theeconomy-wide K/L. Expression (6) says the do-mestic price of consumption relative to invest-ment is inversely related to relative total factorproductivity (TFP) in the two sectors, and de-creasing in the tax rate on producing and im-porting investment goods. The relative pricedoes not depend on the wage or real interest ratebecause both sectors face the same factor pricesand use factors with the same intensity.

Finally, we model the savings distortion as atax �K on income from domestically locatedcapital. Specifically, we assume that eachworker supplies one unit of labor inelasticallyand chooses current consumption to maximize

�t � 0

�

�t�Cj�t��1 � �1/��

1 � �1/��

subject to the constraints

(7) Kj�t � 1� � �1 � �Kj�t� � Ij�t�,

PCj �t�Cj�t� � PI

j�t�Ij�t� � wj�t�

� �Rj�t� � � Kj �Rj�t� � PI

j�t��Kj�t� � Tj�t�,

and Rj�t� �r j�t� � � � K

j

1 � � Kj PI

j�t�.

� is the discount factor, � is the intertemporalelasticity of substitution, � K

j is the capital in-come tax, r j is the real interest rate, and Tj � I

jPIj/(1 � � I

j)Ij � � Kj (Rj � PI

j)Kj are govern-ment transfers (lump-sum rebates of tax revenue).

The discount rate (�), intertemporal elasticity(�), and depreciation rate () are the same in allcountries. Sectoral TFP grows at the constantrate gA across sectors and across countries.What we allow to vary across countries are thetax rate on capital income (�K), the tax rate onproducing and importing investment goods (�I),

TFP in the investment sector (AI), and TFP inthe consumption sector (AC). TFP ascends par-allel paths, but can differ across countries andacross sectors at a point in time.

Steady State.—Variation in �K, �I, AI, and ACgenerates cross-country variation in steady-statelevels of the investment rate at domestic pricesand in the domestic price of investment relativeto consumption. Because capital income istaxed based on where the capital is located,there is no incentive for international capitalflows. Real interest rates are the same in allcountries:

(8) r j � �1 � g�1/�/� � 1.

Here (1 � g) � (1 � gA)1/(1��). Expression (8)follows from the consumption Euler equation andthe steady-state assumption. As no capital flowsinternationally, saving and investment rates (atdomestic prices) are equal within countries, andcountries own their domestic capital stocks.

We now solve for the steady-state values ofthe model. We use the following definitions:

Domestic Price GDP � PCj Cj � PI

jI j;

PPP GDP � Yj � PCCj � PIIj;

Domestic Price Investment Rate

� idomj �

PIjI j

PCj C j � PI

jI j ;

PPP Investment Rate � i j �PII

j

PCCj � PIIj .

Here, PC and PI (no superscripts) denote thePPP price of consumption and investment. Al-though any common set of prices could be usedas the PPP price, in practice the PPP priceprovided by the PWT is effectively the priceprevailing in rich countries.11

11 The PWT uses a Gheary-Khamis procedure to calcu-late PPP prices. Specifically, the PPP price of a good, sayconsumption (the individual goods are finer than this),would be defined as Pc � ¥j (P C

j /Ej) � (Cj/Cw), where P Cj is

the domestic currency price of consumption in country j,Cw � ¥j Cj is world consumption, and Ej � (P C

j Cj �


To determine each country’s steady-statepath, we proceed as follows. We first solve forthe share of labor (and capital) devoted to in-vestment goods production:

(9) LIj/Lj

��g � ��1 � � K

j �

�1 � � Ij��1 � g�1/�/� � 1 � �1 � � K

j ��.

It is then straightforward to show that the steady-state investment rate at domestic prices is

(10) i domj �

�1 � � Ij�LI

j/Lj

1 � � IjLI

j/Lj .

According to (9) and (10), nominal investmentrates are affected by the two tax rates, but areunaffected by changes in sectoral TFP.

We can then express the real investment rateas a function of the nominal investment rate andthe relative price of capital:12

(11) ij � i domj �(1 � idom

j )PI

j/PI

PCj /PC

� idomj ��1

;

� i domj �(1 � idom

j )AC

j (1 � � Ij)

AIj �

PC

PI� idom

j ��1

.

The second line in (11) expresses the relativeprice of capital in terms of relative TFP (equa-tion (6)). Intuitively, equation (11) expressesthe real investment rate as the product of thenominal investment rate and the price of outputrelative to capital, where the latter is itself aninverse function of the price of capital relativeto consumption.

Given that all of the parameter values liebetween 0 and 1, (9), (10), and (11) imply thatthe investment rates at both domestic prices andat international prices are strictly decreasing inthe capital income tax. To see why intuitively,we combine (5) and (7) to arrive at

(12)r � � � K

j

1 � � Kj �1 � �I

j� � �AIj�Kj

Lj�� 1

.

A higher capital income tax rate raises the left-hand side and the rental price of capital, so theright-hand side and the marginal product ofcapital must be higher. For a given level of TFPin the investment sector, a higher marginalproduct of capital requires a lower capital-laborratio and therefore a lower nominal investmentrate. The tax rate on capital income does notaffect relative prices by (6), so the investmentrate is lower at domestic as well as internationalprices.

The negative effect of the investment tax on thePPP investment rate follows similar logic. Ahigher tax rate on investment raises the rentalprice of capital, necessitating a higher marginalproduct of capital and a lower PPP investmentrate. The negative effect on the investment rate atdomestic prices is less transparent. A higher in-vestment tax raises the relative price of investmentgoods in (6), a force for a higher investment rate atdomestic prices. But the adverse effect on thequantity of investment is larger, leaving thedomestic-price investment rate lower. From (9),(10), and � 1, the capital-labor ratio must fallproportionately more than the tax-induced in-crease in the price of investment. As the realcapital-labor ratio is proportional to a country’sreal investment rate (controlling for TFP), thereal investment rate must fall more than theprice of investment rises, yielding a lower in-vestment rate at domestic prices.13

Finally, the investment rate at domesticprices does not depend on sectoral TFP. TFPlevels do not affect the investment rate at do-mestic prices because the quantities and pricesof investment and consumption respond in pre-cisely offsetting ways. In contrast, while thePPP investment rate is invariant to equipropor-tionate changes in sectoral TFP, low TFP in theinvestment sector relative to TFP in the con-sumption sector does depress a country’s realinvestment rate. It makes investment expensive,just like high taxes on capital income or invest-ment do. Because PPP prices of investment andPI

jI j)/(PCCj � PIIj) is the PPP exchange rate of country j. In

addition, EUS is typically normalized to 1 so that the unitsare US dollars. Because the weights used to aggregatecountry prices are aggregate quantities, rich country pricesare weighted more than poor country prices.

12 We substitute the nominal and real investment rate def-initions into i j � idom

j � (i j/idomj ) to obtain the first line in (11).

13 For plausible parameter values, we find this negativeeffect (of the investment tax rate on the domestic price invest-ment rate) to be small. We illustrate this in Figure 3 below.


consumption do not vary across countries, thereis no offsetting relative price effect as operateson the investment rate at domestic prices. Forthe same reason, a higher investment tax ratelowers the PPP investment rate more than itlowers the domestic-price investment rate. Incontrast, a higher capital income tax rate doesnot affect the relative price of investment andtherefore has the same (negative) effect on in-vestment rates at domestic and internationalprices.

How can we determine whether the high rel-ative price of capital in poor countries is drivenby high investment distortions or by low pro-ductivity in investment goods relative to con-sumption? This is where the assumption thatcapital goods are tradable is crucial. Specifi-cally, because capital goods are assumed to betradable goods, a standard arbitrage conditionpins down the absolute after-tax price of capitalas a function of the pre-tax wholesale price ofcapital in world markets (which we assume eachcountry takes as beyond its control) and thecountry-specific tax on retail sales of invest-ment goods:14

(13) PIj � �1 � � I

j�.

We can then substitute (13) into (6) to obtain thefollowing expression for the price of consump-tion:

(14) PCj �

AIj

ACj .

In short, the assumption that capital goods aretraded implies that � I

j affects the relative priceof capital only through the price of capital, andthat country differences in relative productivityshow up entirely as differences in the price ofconsumption.

Along steady-state paths, PPP output perworker in country j is

(15)Yj

Lj � �Kj

Yj��/1 � �

�TFP j�1/1 � �,

where (Kj/Yj) � i j/(g � ). Expression (15) isready-made for development accounting. In thistwo-sector model, however, there is no cleandemarcation of parameters into those affectingcapital intensity versus those affecting aggre-gate TFP. Take the tax rate on investmentgoods: according to (9), a higher tax rate oninvestment goods lowers the share of labor de-voted to investment goods production, andhence the PPP investment rate (11) and PPPcapital intensity. Unless PC and PIAI happen tobe equal in the country, this higher tax rate alsoaffects aggregate TFP. It does so by reallocatinglabor away from producing investment goodstoward producing consumption goods. An eas-ier way to see this is to express economy-wideTFP as

(16) TFP j � PCACj �1 �

LIj

Lj� � PIAIjLI

j

Lj .

From this expression it is clear that reallocatinglabor away from investment goods productionlowers aggregate TFP if PC AC PI AI, andraises aggregate TFP if PC AC � PI AI. The useof PPP prices is crucial here. At domesticprices, the marginal product of labor is equatedacross sectors. At international prices this neednot be so.

One can similarly show that sector TFP af-fects both aggregate TFP and capital intensity.Consider a drop in AI, holding AC fixed. Thislowers aggregate TFP and the PPP investmentrate. The lower PPP investment rate meanslower PPP capital intensity. TFP in the invest-ment sector matters more than the share of labordevoted to investment would suggest, as it af-fects capital intensity throughout the economy.That is, the effect of TFP in the investmentsector is amplified through its effect on capitalaccumulation.15 As we shall see, poor countriesappear to have not only lower AC and AI thanrich countries do (as one would expect), butespecially lower AI. Their low sectoral TFPcontributes to their low aggregate TFP, andtheir low AI/AC ratios contribute to their lowcapital intensity in PPP terms.

In summary, although there are three poten-

14 We normalize the pre-tax wholesale price of invest-ment goods on world markets to one (i.e., it is our nu-meraire).

15 Schmitz (2001) emphasizes this effect in a model withinefficient government production of investment goods.


tial explanations—high investment distortions,high capital income taxes, and low productivityin tradables relative to nontradables—behindthe low real rates of investment in poor coun-tries, each force will result in different patternsin the data. A higher capital income tax willlower both the nominal and the real investmentrate by the same magnitude, but will have noeffect on prices. Higher investment distortionsand low TFP in investment relative to consump-tion will increase the relative price of capitaland thus lower the real investment rate, but willeither have no effect (in the case of relative TFPdifferences) or only a small effect on the nom-inal investment rate (in the case of investmentdistortions). Finally, although both investmentdistortions and differences in relative TFP willaffect the relative price of capital, investmentdistortions will affect only the absolute price ofcapital while relative TFP differences will affectonly the price of consumption.

B. A Model with Both Tradable andNontradable Consumption and Investment

Thus far we have made the polar assumptionthat capital goods are perfectly tradable and thatconsumption goods are not. We now relax thisassumption in three ways. First, we allow fortwo types of traded goods: consumption goodsand producer durables. With this change, coun-tries will now specialize in one of the twotradable sectors: countries with a comparativeadvantage in consumption goods will exportthese goods in exchange for imports of producerdurables (and vice versa). Second, we allow forthe fact that even tradable goods have a non-tradable component at the retail level. Third, weassume that in addition to tradable producerdurables, investment can also take the form ofnontradable structures.

Model Setup.—We assume that every coun-try produces two nontraded goods, services (Sj)and investment structures (IN

j ), and one of thetwo tradable goods, consumption goods (CT

j ) orproducer durables (IT

j ). The production func-tions of these sectors are

(17) CTj � ACT

j �KCTj ��LCT

j �1 � �;

(18) Sj � ASj �KS

j ��LSj �1 � �;

(19) ITj � AIT

j �KITj ��LIT

j �1 � �;

(20) INj � AN

j �KNj ��LN

j �1 � �.

We assume that countries are small enough sothey produce only one of the two tradable goods(and import the other). Specifically, country jwill export consumer goods and import pro-ducer durables if the world price of tradableconsumption (relative to tradable investment)PCT is greater than country j’s TFP in tradableinvestment relative to its TFP in tradable con-sumption:16

AITj

ACTj PCT .

These countries will use resources to producetradable consumption, which it exchanges inworld markets for tradable investment goods atthe terms of trade PCT prevailing in world mar-kets. Therefore, country j’s production of trad-able consumption goods CT

j has to be equal tothe sum of these goods consumed at homeCT,Home

j and the value of tradable investmentgoods used for domestic investment IT,Home

j ex-pressed in units of tradable consumption: CT

j �CT,Home

j � IT,Homej /PCT.

On the other hand, if country j’s productivityin tradable investment relative to tradable con-sumption is greater than PCT, then it will spe-cialize in producer durables and export thesegoods in exchange for imports of tradable con-sumer goods. In this case, country j’s produc-tion of tradable investment goods IT

j has to beequal to the sum of tradable investment goodsdestined for domestic investment IT,Home

j andthe value of tradable consumption goods pur-chased from abroad for domestic consumptionCT,Home

j expressed in units of tradable invest-ment: I T

j � I T,Homej � PCTC T,Home

j .We will denote the TFP of the tradable sector

in country j by ATj , defined as

(21) ATj � max�ACT

j PCT , AITj .

16 Again, we normalize the pre-tax wholesale price oftradable investment in world markets to one.


For countries with a comparative advantage intradable investment, AT

j is simply TFP in thetradable investment sector. For countries with acomparative advantage in tradable consump-tion, AT

j is the product of TFP in tradable con-sumption and the terms of trade it faces in worldmarkets. In turn, the world price of tradableconsumption is determined by the world supplyand demand of tradable consumption goods(relative to world supply and demand of trad-able investment goods). Therefore, for a countrythat exports consumption goods, AT

j will in-crease not only when the country’s productivityin producing tradable consumption increases,but also when general equilibrium requires ahigher world price of tradable consumptiongoods. For example, an increase in the worlddemand for tradable consumption goods canhave important effects on the relative price ofcapital in poor countries by improving the termsof trade they face.

We also assume that nontraded services haveto be used to make both consumer goods andtradable investment goods available at the retaillevel. Specifically, consumer goods and pro-ducer durables at the retail level (we use a tildeto denote a tradable good at the retail level) are“produced” by combining a traded intermediategood with nontraded retail services:

(22) CTj � �SCT

j ��C�CT,Homej �1 � �C;

(23) ITj � �SIT

j ��I�IT,Homej �1 � �I.

Here, SCT and SIT denote nontraded services inthe two sectors, and �C and �I the shares ofnontraded services in the two sectors. There-fore, the following adding-up constraint has tohold:

Sj � SITj � SCT

j � CNj .

Here, CN denotes services used as a final con-sumption good. The total endowment of labor isgiven by Lj � LIT

j � LNj � LCT

j � LSj and the

aggregate capital stock by Kj � KITj � KN

j �KCT

j � KSj . The aggregate capital stock Kj is

itself a Cobb-Douglas aggregate of tradablecapital (KTj) and structures (KNj):

(24) Kj � �KTj��j�KNj�1 � �j.

� Ij � (0, 1) is the elasticity of aggregate capital

with respect to producer durables and 1 � � Ij is

the elasticity with respect to structures (we al-low these elasticities to vary across countries).

Finally, to close the model, we assume thatrepresentative households maximize

�t � 0

�

�t��CT

j �t�� Cj

�CNj �t��1 � � C

j

�1 � 1/�

1 � 1/�

subject to the transition equations for the twotypes of capital (producer durables and struc-tures):

KTj�t � 1� � �1 � �KTj�t� � ITj �t�;

KNj�t � 1� � �1 � �KNj�t� � INj �t�;

and the standard lifetime budget constraint.We begin by solving for the key prices. First,

as before, the price of traded intermediate in-vestment good is pinned down by the invest-ment distortion

(25) PITj � 1 � � I

j.

Second, the price of the nontraded goods isderived from equating the marginal revenueproduct of the factors of production in all sec-tors:

(26) PSj �

ATj

ASj ;

(27) PNj �

ATj

ANj .

Third, we obtain the retail price of consumergoods and producer durables by substituting theprices in (25) and (26) into the dual cost functionsof the production functions in (22) and (23):

(28) PCTj � �AT

j

ASj � �C

PCT1 � �C��C

�C�1 � �C �1 � �C�;

(29) P ITj � �AT

j

ASj ��I

�1 � � Ij�1 � �I��I

�I�1��I�1 � �I�.


Steady State.—We now solve for the steadystate of the model. We proceed in the samemanner as we did for the two sector models.First, the key labor share is now either the shareof workers producing consumption goods forexport (for countries that export consumptiongoods and import investment goods) or the shareof workers producing tradable investment goodsfor domestic investment (for countries that spe-cialize in producing machinery and equipment):

(30)LT

j

Lj ��g � ��1 � � K

j �

(1 � � Ij)��1 � g)1/�/� � 1 � (1 � � K

j ��

�1 � �I ��Ij.

We then solve for the domestic-price invest-ment rate as a function of this share:

(31) i domj � �

LTj

Lj (1 � � Ij)

1 � � IjLT

j

Lj �

1

�1 � �I�� Ij .

From comparing (30) and (31) with the expres-sions defining the nominal investment rate in thetwo-sector model (equations (9) and (10)), it isclear that the only additional factor that potentiallydrives country differences in nominal investmentrates (and only when � I

j � 0) is the share ofproducer durables in aggregate investment.

The real investment rate is still given by theproduct of the nominal investment rate and aninverse function of the relative price of capital,with the only difference being that PC

j /PC andP I

j/PI now refer to the aggregate price indicesof consumption and investment:

(32) ij � i domj �(1 � idom

j )PI

j/PI

PCj /PC

� idomj ��1

where

PIj/PI

PCj /PC

�

� Cj PCT�1 � �C

PCT�1 � �C�AS

j

ATj �C��C

� �1 � � Cj �PS

ASj

ATj

� IjPIT�1 � �I

1 � �Ij�1 � �C�AS

j

ATj �I��I

� �1 � � Ij�PN

ANj

ATj

.

The second line in (32) expresses P Ij /PI as a

weighted average of the price of producerdurables and the price of structures, andPC

j /PC is expressed as a weighted average of theprice of tradable consumption and the price ofnontraded services.

As in the simple two-sector model, low pro-ductivity in traded goods relative to nontradedservices in a country that exports tradable in-vestment goods results in a low price of non-traded services (relative to the price of thetraded investment good) and a low real invest-ment rate. In this setup, however, some coun-tries specialize in tradable consumption goods,which they export in exchange for tradable in-vestment goods. For these countries, low pro-ductivity in producing tradable consumptiongoods has exactly the same effect on the price ofnontraded services (again, relative to the priceof the traded investment good). In all countries,as long as services are used more intensively inconsumption than in investment, cheap services(relative to producer durables) lower the aggre-gate price of consumption by more than theprice of investment, and thus lower the realinvestment rate (for a given nominal investmentrate).

The effect of low TFP in investment struc-tures relative to TFP in nontraded services onthe relative price of capital follows a similarlogic. From (26) and (27), low TFP in structuresrelative to nontraded services makes structuresexpensive relative to the price of consumer ser-vices. Since the aggregate price of investment isa weighted average of the price of producerdurables and investment structures, low AIN

j /ASj

will increase the aggregate price of capital rel-ative to the price of consumption and thus lowerthe real investment rate.

Finally, the shares of tradables in aggregateconsumption and aggregate investment will alsopotentially affect the relative price of capital. Adecline in the share of tradables in consumption� C

j will lower the aggregate price of consump-tion (and thus increase the aggregate relativeprice of capital) when PCT

j /PCT � PSj /PS. Simi-

larly, an increase in the share of tradables ininvestment � I

j will raise the absolute and rela-tive price of capital if the price index of pro-ducer durables is larger than the price index ofinvestment structures.

For completeness, steady-state PPP outputper worker can be expressed as a function of the


capital output ratio and aggregate TFP (equa-tion (15)), where aggregate TFP is now

(33) TFPj � ATj �

LTj

Lj ��1 � � I

j�

� Ij�1 � �I �

�� Ij

PIT

PITj � �1 � � I

j�PIN

PINj � � AT

j

�1 �L T

j

Lj �1 �1 � � I

j

1 � �I��I �

1 � � Ij

� Ij ��

�� Cj

PCT

PCTj � (1 � � C

j )PS

PSj � .

Here, LTj /Lj is given by (30), P IT

j by (29), P INj by

(27), P CTj by (28), and P S

j by (26). As before,aggregate TFP is a function of sectoral TFP andthe allocation of resources between domesticconsumption and investment. What is new isthat the allocation of resources between trad-ables and nontradables within the consumptionand investment sectors will also potentially af-fect aggregate TFP. In particular, a higher shareof services in consumption lowers aggregateTFP if PS

j /PS � P CTj /PCT, and raises aggregate

TFP if P Sj /PS P CT

j /PCT.Figures 3A and 3B illustrate the quantitative

predictions of the model.17 In the first two pan-els of Figure 3A, tax rates are shown to mate-rially discourage PPP investment and income.In Figure 3B, TFP in one sector relative to theothers is likewise shown to influence PPP in-vestment rates and PPP incomes. In all cases,the qualitative results of the simpler model inSection IA are shown to carry through to themodel in this section. A proportional increase in

TFP in all sectors has no effect on investmentrates. Rising TFP in tradables (or investmentmore broadly) relative to services drives up thePPP investment rate while leaving the domesticprice investment rate unchanged. In the nextsection we will use data on the endogenousvariables to infer the underlying causes ofhigher PPP investment rates in richer countries.

II. Cross-Country Facts about Investment Ratesand Income Levels

The United Nations International Compari-son Program (ICP) collects data on the prices ofbetween 500 and 1,500 individual goods andservices in selected countries and years. Thecountries for which the ICP has price data in agiven year are “benchmark” countries for thePWT. The PWT uses the benchmark price datato convert each country’s expenditures at do-mestic prices into expenditures at a common setof international prices. For nonbenchmarkcountry-years, prices and therefore PPP valuesare inferred from fitted values of price regres-sions run on benchmark data. Because pricedifferences across countries are at the crux ofour investigation, we concentrate on the bench-mark country-years for which actual price datawere collected. Benchmark data currently existfor 1970 (16 countries), 1975 (34 countries),1980 (61 countries), 1985 (64 countries), 1990(24 countries), and 1996 (115 countries). Wefocus on 1980, 1985, and 1996, the years withbroad cross sections of countries.18

We examine simple univariate regressions ofobservables on country log PPP income perworker. We do not consider other regressors be-cause we are interested simply in how the depen-dent variables co-vary with income. Our firstdependent variable is the log PPP fixed investmentrate (expressed in percentages). Fixed investment

17 For Figure 3 we set capital’s share � � 1⁄3 , thedepreciation rate � 0.07, the annual growth of income perworker g � 0.02, the intertemporal elasticity � � 1, and thediscount factor � � 0.97. We set the world prices oftradable consumption and tradable investment to one, anddid the same for the PPP prices of services and nontradableinvestment. Finally, we set the PPP prices of the retailversions of tradable consumption and investment consistentwith (28) and (29) and the other PPP prices (based on thestarting TFP values of one). We do not plot the effects of � C

j

or � Ij because they do not affect the PPP investment rate at

these parameter values. In our empirical Section III, weshow that � C

j does affect the PPP investment rate, but not toan economically significant degree.

18 We obtained the benchmark data from the PWT Website (http://pwt.econ.upenn.edu). See Summers and Heston(1991) and Heston, Summers, and Bettina Aten (2002) for afuller description of PPP methodology. We made two minorchanges to the 1996 benchmark sample. First, we excludedMongolia because its prices and quantities are zero for ma-chinery and equipment. Second, for Antigua and Barbuda, St.Kitts and Nevis, and St. Lucia, we imputed missing employ-ment as 0.5*(adult equivalents). For the other benchmarkcountries, 0.5 is the average ratio of employment to “adultequivalents” (which the PWT defines as population over 15plus one half of the population 15 and under).


excludes inventory investment and includes bothpublic and private investment. We exclude inven-tory investment because some inventories are forconsumer goods. The PWT does not contain sep-arate data on public and private investment rates.19

Table 1 provides results from regressing the logPPP fixed investment rate on log PPP income per

worker. An additional log point of income is as-sociated with about an additional 0.3 log pointPPP investment rate in the 1980 and 1996 crosssections and a 0.5 log point increase in thePPP investment rate in the 1985 cross section.Across the 114 benchmark countries in 1996,the mean of the log fixed investment rate is2.7 log points and PPP income per workervaries by 4.4 log points. The estimated co-movement of the PPP fixed investment ratewith PPP income is therefore significant rel-ative to the mean investment rate.

19 Lant Pritchett (2000) argues that public investmentshould be distinguished from private investment, wherepossible, because public investment is less likely to createeconomically viable capital.

FIGURE 3A


Table 1 also presents results for investment inproducer durables, which includes machinery,equipment, and vehicles, and investment instructures. Producer durables are arguably themost tradable components of fixed investment(in contrast to construction). Moreover, J.Bradford DeLong and Lawrence H. Summers(1991) presented evidence that the investmentrate in producer durables was most stronglyrelated to growth and development. Using thelog PPP investment rate in producer durables,the coefficients on country income remainhighly significant.

We next examine the log investment rate atdomestic prices. Table 1 documents that, in allthree years, coefficients on PPP income perworker fall by two-thirds or more when thefixed investment rates are evaluated at domesticprices rather than at international prices. Eatonand Kortum (2001) and Restuccia and Urrutia(2001) also note this low correlation betweendomestic-price investment rates and PPP in-comes across countries. In addition, this corre-lation between the fixed investment rate atdomestic prices and income appears to bedriven by the correlation between investment in

FIGURE 3B


structures and income rather than by investmentin producer durables. The point estimate of theelasticity of the log nominal investment rate inproducer durables with income is essentiallyzero in 1980 and 1996 and small and marginallysignificant in 1985.

The results in the right half of Table 1 con-trast sharply with those of Levine and Renelt(1992) and Sala-i-Martin (1997), who identifiedthe investment rate as an indomitable correlateof income. When evaluated at domestic prices,the fixed investment rate is rendered insignifi-cant for the broadest set of countries (the 1996sample). The most tradable portion of invest-ment (producer durables) is uncorrelated withPPP incomes in all years. Note that no condi-tioning variables are included in these regres-sions. The distinction between domestic pricesand international prices is evidently crucial tothe connection between investment rates andincome levels. We now investigate price differ-ences across the benchmark countries.

Many studies have noted the high relativeprice of investment in poor countries, and usedit to help explain differences in country in-comes. Examples include Jones (1994), Lee(1995), Chari, Kehoe, and McGrattan (1996),McGrattan and Schmitz (1999), Jovanovic andRob (1999), and Eaton and Kortum (2001). Acommon theme in these papers is that the priceof investment in poor countries is high relativeto the price of investment prevailing in richcountries. A simple way to test this hypothesisis to compare prices of investment goods in rich

and poor countries after appropriate conversioninto a common currency.

Table 2 presents regressions of log invest-ment prices on log PPP GDP per worker. Weobtained these prices by converting PWTbenchmark prices in national currency units intoUS dollar prices. We did this in two differentways: using official exchange rates from thePWT (whose source is the International Mon-etary Fund (IMF)), and using black marketexchange rates from the World CurrencyYearbook.20 Although the official exchange ratemay accurately reflect the market exchange ratein many country-years, black market premia arewell documented in others. Our logic for pre-senting results using official exchange rates aswell as black market exchange rates is as fol-lows. First, countries may allow preferentialaccess to the official exchange rate for trade (asopposed to purely capital account transactions).Second, countries may allow preferential accessto the official exchange rate for imports ofequipment (as opposed to consumer goods).Finally, and most important, to the extent thata good is imported at a devalued exchangerate relative to the official one, this shouldshow up as a high dollar price when domestic

20 For 1996 we use black market exchange rates col-lected by the IMF, since the World Currency Yearbookceased publication after 1995. We thank Carmen Reinhartand Kenneth Rogoff for providing these data. See Reinhartand Rogoff (2004) for documentation.

TABLE 1—PPP INVESTMENT RATES VS. INVESTMENT RATES AT DOMESTIC PRICES

(Independent variable � PPP GDP per worker)

Dependent variable

PPP investment rates Investment rates at domestic prices

1980 1985 1996 1980 1985 1996

Fixed investment 0.30 0.52 0.31 0.09 0.11 0.06(0.06) (0.05) (0.04) (0.04) (0.03) (0.04)

R2 � 0.37 R2 � 0.60 R2 � 0.32 R2 � 0.10 R2 � 0.15 R2 � 0.02Producer durables 0.28 0.58 0.43 0.04 0.10 0.04

(0.07) (0.06) (0.08) (0.05) (0.04) (0.06)R2 � 0.24 R2 � 0.60 R2 � 0.28 R2 � 0.02 R2 � 0.08 R2 � 0.01

Structures 0.34 0.49 0.36 0.13 0.13 0.26(0.07) (0.06) (0.09) (0.04) (0.04) (0.09)

R2 � 0.32 R2 � 0.51 R2 � 0.16 R2 � 0.14 R2 � 0.18 R2 � 0.13Number of benchmark

countries61 64 114 61 64 114

Notes: All variables are in logs. Each entry is a coefficient from a single regression. Robust standard errors are in parentheses.Bold coefficients are significant at the 5 percent level. Fixed investment includes producer durables and structures, andexcludes inventory investment. Producer durables include machinery, equipment, and vehicles.


prices are converted to dollars at the officialexchange rate. Using official exchange ratesis most favorable to the conventional viewthat investment goods are expensive in poorcountries.

As documented in Table 2, none of the pricesof fixed investment, producer durables, or thestructures is negatively related to PPP incomeper worker. This is true when prices are con-verted at official exchange rates as well as atblack market exchange rates. In several cases,investment goods, particularly investment struc-tures in 1996, actually appear more expensive inricher countries. Figure 4 illustrates the case of1996 prices of producer durables, convertedinto dollars at official exchange rates. As thefigure reveals, the price of producer durablesdoes vary across countries, especially outsidethe richest countries. But prices of producer

durables look no higher in poor countries over-all than in rich countries.

If the high relative price of investment in poorcountries does not stem from a high price ofinvestment, it must reflect a low price of con-sumption. Figure 5 shows consumption pricesacross countries in 1996. Table 3 provides elastic-ities with respect to country income. A doublingof income goes along with 20 to 50 percent higherconsumption prices. Table 3 also provides sepa-rate elasticities for “nontradable” and “tradable”consumption. Following Heston et al. (1995), ser-vices are nontradables (housing, medical care,purchased transportation, communications, recre-ation, education, and personal services) and goodsare tradables (food, beverages, tobacco, clothing,footwear, fuel, house furnishings, vehicles, andpersonal care items). The elasticities for nontrad-able consumption prices with respect to PPP in-

FIGURE 4. 1996 PRICE OF PRODUCER DURABLES FIGURE 5. 1996 PRICE OF CONSUMPTION

TABLE 2—THE PRICE OF INVESTMENT GOODS


Dependent variable

At official exchange rates At black market exchange rates

1980 1985 1996 1980 1985 1996

Fixed investment 0.024 �0.038 0.183 0.190 0.096 0.245(0.049) (0.048) (0.047) (0.053) (0.050) (0.043)

R2 � 0.00 R2 � 0.01 R2 � 0.13 R2 � 0.14 R2 � 0.03 R2 � 0.19Producer durables �0.006 �0.142 0.052 0.055 �0.085 0.113

(0.034) (0.035) (0.032) (0.039) (0.035) (0.030)R2 � 0.00 R2 � 0.14 R2 � 0.02 R2 � 0.03 R2 � 0.05 R2 � 0.08

Structures 0.016 �0.029 0.339 0.181 0.105 0.401(0.068) (0.061) (0.060) (0.067) (0.066) (0.055)


countries61 64 114 61 64 114

Notes: All variables are in logs. Each entry is a coefficient from a single regression. Robust standard errors are in parentheses.Bold coefficients are significant at the 5 percent level. The dependent variable is the log investment price expressed in dollars(converted from national currencies at official or black market exchange rates).




come per worker in Table 3 are around 40 to 70percent. Figure 6 plots nontradable consumptionprices in 1996, converted at official exchangerates. The elasticities for tradable consumptionprices are also shown in Table 3; these are alsopositive, but markedly lower, ranging from 14 to37 percent.21

In sum, real investment rates are lower inpoor countries largely because the relative priceof capital is high. In turn, the relative price ofcapital in poor countries is high because con-sumption goods are cheap, not because invest-ment goods are more expensive. Why mightconsumption goods be cheaper in poor coun-tries? From (32), there are two potential expla-nations. First, poor countries might have lowTFP in tradables (in producing tradable con-sumption goods or tradable investment goods)relative to nontradable services. Second, if theprice of nontradable services in poor countriesis higher than the price of consumption goods(relative to the ratio of PPP prices), a low shareof tradable goods in consumption would alsolower the aggregate price of consumption. Ta-ble 4 shows that the share of tradable goods inconsumption appears to be higher in poor coun-tries. As we will document shortly, the price ofnontradable services relative to the price of con-sumption goods is lower in poor countries.Therefore, the higher share of tradable consump-

tion in poor countries would have the effect ofraising the price of aggregate consumption.

If low consumption prices in poor countriesare not due to a lower share of goods in con-sumption, the only remaining explanation mustbe low productivity in tradables relative tonontradable services. Using equation (26), wecan estimate this key relative productivitydirectly from the price of consumption ser-vices. From the elasticity of the price of con-sumer services (converted at market exchangerates) to income presented in Table 3 (secondrow), we infer that a log point decline in incomeis associated with a 0.54 to 0.72 log point de-cline in the ratio of TFP in tradables to TFP innontradables.

An alternative approach is to use the fact thatthe retail price of traded consumption goodsis a function of the price of nontraded distri-bution and retail services. From (28), the ratio

21 Our measure of nontradable consumption includes onlyprivate services. We obtained very similar price elasticitieswhen we added government services to private services.

TABLE 3—THE PRICE OF CONSUMPTION


Dependent variable


1980 1985 1996 1980 1985 1996

All consumption 0.221 0.286 0.446 0.387 0.420 0.507(0.053) (0.049) (0.057) (0.048) (0.039) (0.056)

R2 � 0.25 R2 � 0.41 R2 � 0.43 R2 � 0.43 R2 � 0.46 R2 � 0.46Consumption services 0.377 0.415 0.660 0.542 0.549 0.721

(0.064) (0.050) (0.070) (0.062) (0.050) (0.073)R2 � 0.38 R2 � 0.51 R2 � 0.48 R2 � 0.49 R2 � 0.53 R2 � 0.52

Consumption goods 0.141 0.223 0.310 0.307 0.357 0.372(0.047) (0.049) (0.048) (0.045) (0.034) (0.044)


countries61 64 114 61 64 114

Notes: All variables are in logs. The dependent variable is a log consumption price expressed in dollars (converted fromnational currencies at official or black market exchange rates). Nontradables are services; tradables are goods.

FIGURE 6. 1996 PRICE OF NONTRADABLE CONSUMPTION



of TFP in tradables to nontradables is given by(1/�C)log PCT

j , where �C is the share of distri-bution costs in the retail price of consumergoods. Ariel T. Burstein, Joao C. Neves, andRebelo (2003) estimate this distribution share toaverage more than 40 percent in the G7 coun-tries and over 60 percent in Argentina. Burstein,Martin Eichenbaum, and Rebelo (2002) assessdistribution costs to be around 50 percent ofconsumer goods prices in South Korea andMexico. If we take 50 percent as our centralestimate of �C, the elasticities of the retail priceof consumption goods (converted at market ex-change rates) with income in Table 3 (third row)suggest that the ratio of TFP in tradables tonontradables declines by 0.62 to 0.74 percent-age points for a log point fall in income. Thus,when we use an independent source of data toimpute the ratio of TFP in tradables to nontrad-ables, we obtain estimates that are virtuallyidentical to those obtained directly from theprice of consumption services.

Turning to the price of investment goods,what might explain the fact that these priceslook no higher in poor countries? From (29), thefour factors varying across countries that affectthe price of investment are: (a) the ratio of TFPin tradables to nontradable services; (b) the ratioof TFP in tradables to investment structures; (c)the investment distortion; and (d) the nominalshare of producer durables in aggregate invest-ment. We assess each factor in turn.

First, as with the price of aggregate consump-tion, low TFP in tradables to nontradables inpoor countries, by lowering the price of retailand distribution services, would lower the retailprice of producer durables and, by extension,the price of aggregate investment. The impor-

tance of this effect on the retail price of pro-ducer durables depends on the share ofdistribution and retail services in the investmentgoods sector (equation (29)). Burstein, Neves,and Rebelo (2004) estimate that distributioncosts accounted for an average of 17 percent ofthe price of machinery and equipment, with 7percent as the low value (Spain) and 29 percentas the high value (Mexico). If we apply Bursteinet al.’s central estimate of nontraded share inproducer durables (�I � 16.7 percent) to ourestimates of the elasticity of the ratio of TFP intradables to nontradable services with income,say 0.6, this would suggest that the lower priceof services in poor countries would lower theretail price of producer durables by 10 percent(0.6 � 0.167) for every log point decline inincome. Note that in the data, the 1996 price ofproducer durables falls by 11.3 percent for ev-ery log point fall in income (Table 2), whichsuggests that low TFP in tradables to nontrad-ables in poor countries can explain most of theco-variation of the price of producer durableswith income.

With this estimate in hand, we can use theretail price of producer durables to estimate theimportance of investment barriers in poor coun-tries. Specifically, we rearrange equations (28)and (29) to get the following expression (up toa constant) for the investment barrier:

(34) log�1 � � Ij� � log P IT

j ��I

�Clog PCT

j .

Using this equation, Table 5 (row 1) presentsthe estimated elasticity of the investment distor-tion to output per worker. The dependent vari-

TABLE 4—THE SHARE OF TRADABLE CONSUMPTION AND INVESTMENT

(Independent variable � log PPP GDP per worker)

Dependent variable 1980 1985 1996

Share of goods in consumption(at domestic prices)

�7.27 �9.49 �13.64(0.99) (0.79) (0.69)

R2 � 0.55 R2 � 0.66 R2 � 0.75Share of producer durables in

investment (at domestic prices)�2.10 �0.70 �4.16(1.29) (1.10) (2.01)

R2 � 0.07 R2 � 0.00 R2 � 0.05Number of benchmark countries 61 64 114

Notes: The dependent variable is in percentage points. Each entry is a coefficient from a singleregression. Robust standard errors are in parentheses. Bold coefficients are significant at the5 percent level.


able, based on equation (34), is the log price ofproducer durables minus �I/�C times the logprice of traded consumption goods. We useBurstein et al. central estimates of the nontradedshare in the two sectors, namely �I � 16.7percent and �C � 50 percent. As can be seen,the elasticity of investment distortions to coun-try income is basically zero in four out of sixcases. In particular, when black market ex-change rates are used to convert local currencyprices to dollars, the estimates suggest that in-vestment distortions are no higher in poor coun-tries than in rich countries. The two cases thatyield statistically significant point estimates arewhen official exchange rates are used to convertlocal currency prices to dollars. As previouslymentioned, the use of official exchange rates toconvert to a dollar price is likely to overstate theprice of capital in a country with a large blackmarket premium.

An alternative would be simply to use theprice of consumer services as an estimate of theprice of distribution services in the investmentsector. The advantage of this procedure is thatwe would use an independent set of data (theprice of consumption services rather than theprice of consumer goods) to back out the im-puted investment distortion. These estimates areshown in row 2 in Table 5. Here, the dependentvariable is the log price of producer durablesminus �I times the log price of consumptionservices (we maintain our assumption of �I �16.7 percent). As shown, the estimated elastic-ity of investment distortions to income is stillbasically zero in four out of the six cases, andstatistically significant only when official ex-change rates are used to convert local currency

prices to dollars. These two pieces of evidencethus suggest that investment distortions are gen-erally no higher in poor countries than in richcountries.

The two remaining forces that also poten-tially affect the price of capital are the share ofproducer durables in aggregate investment andthe productivity in tradables relative to struc-tures. From (27), we can infer the ratio of TFPin tradables to structures from the price of struc-tures (shown in Table 2). As can be seen, theprice of structures appears to be generally lowerin poor countries, particularly when market ex-change rates are used to convert domestic cur-rency prices to US dollars. This negativecorrelation between income and relative TFP intradables to structures would have the effect oflowering the price of aggregate investment inpoor countries. Finally, as with the share ofgoods in aggregate consumption, the share oftradable investment goods in aggregate con-sumption appears to be negatively correlatedwith income (Table 4), although the point esti-mate is much smaller and statistically signifi-cant in only one year (1996).

In summary, low productivity in tradables(either in producing investment goods or inproducing consumption goods for export) rela-tive to nontradables appears to be the main forcebehind the low price of consumption in poorcountries. The effect of low relative TFP onconsumption prices is counteracted by thehigher share of tradables in consumption in poorcountries, but this effect is clearly smaller thanthe effect of low TFP in tradables relative tonontradables. Meanwhile, the two main forcesbehind the modestly lower price of aggregate

TABLE 5—IMPUTED INVESTMENT DISTORTIONS

(Dependent variable � log price of machinery and equipment �(�I/�C)log price of consumption;independent variable � log PPP GDP per worker)


1980 1985 1996 1980 1985 1996

Using the price of consumer goods �0.033 �0.133 �0.052 0.077 �0.043 �0.011(0.044) (0.031) (0.023) (0.055) (0.044) (0.024)

�I � 0.167 R2 � 0.01 R2 � 0.16 R2 � 0.03 R2 � 0.04 R2 � 0.01 R2 � 0.00�C � 0.5Using the price of consumer services �0.049 �0.127 �0.059 0.089 �0.016 �0.007

(0.041) (0.032) (0.027) (0.056) (0.043) (0.024)�I � 0.167 R2 � 0.03 R2 � 0.14 R2 � 0.03 R2 � 0.05 R2 � 0.00 R2 � 0.00�C � 1Number of benchmark countries 61 64 114 61 64 114


investment in poor countries are the lower priceof distribution services and the lower price ofstructures. There appears to be no evidence,however, that investment distortions are higherin poor countries than in rich countries. In thenext subsection, we quantify the contribution ofthese different factors in explaining the low realinvestment rates in poor countries.

A. Development Accounting

We now ask what tax rates and productivitylevels would enable the model to match thedata. For each country, we calculate the tax rateon capital income, �K, the tax rate investmentgoods, �I, and the level of TFP in each sector( AT for tradable consumption or investment,AS for services, and AN for structures) so thatthe model matches exactly the country’s priceof tradable investment goods, price of struc-tures, price of consumer services, investmentrate at domestic prices, and PPP income perworker. We do this for the benchmark coun-tries in each of the benchmark years (1980,1985, and 1996).

As we did for Figure 3, we set capital’s share,� � 1⁄3 , the depreciation rate, � 0.07, theannual growth of income per worker, g � 0.02,the intertemporal elasticity, � � 1, and thediscount factor, � � 0.97. We use data oninvestment prices and tradable consumptionprices to calculate the tax rate on investmentgoods as implied by (34). We set the worldprice equal to the US price of investment underthe assumption that the US tax rate on invest-ment goods is approximately zero. Using theprice of consumer services, we infer TFP in thetradable sector relative to the service sectorfrom (26). Similarly, we use the price of struc-tures to estimate TFP in the tradable sectorrelative to construction from (27). We back outthe tax rate on capital income from (30) and(31), using the domestic price investment rateand the inferred tax rate on investment goods inthe process. Finally, we solve for the level ofTFP in the tradable sector that, combined withthe relative TFPs, will match the data on PPPincome per worker.

The implications of this exercise for tax ratesand productivity levels in 1996 are as follows.The median investment tax rate is 23 percent,and the interquartile range (twenty-fifth toseventy-fifth percentiles) is 5 percent to 40 per-

cent. The United States, recall, was assumed tohave an investment tax rate of zero. The mediantax rate on capital income is 33 percent, with aninterquartile range of �1 percent (a slight sub-sidy) to 53 percent. Median TFP in tradablesproduction is 20 percent of the US level, withmiddle quarters 10 percent to 61 percent. Me-dian TFP in structures is 32 percent of the USlevel, with an interquartile range of 19 percentto 58 percent. Median TFP in services is in-ferred to be 73 percent of the US level, with aninterquartile range of 56 percent to 88 percent.Note that service TFP does not differ as much asinvestment TFP does. As we describe next, thissuggests that differences in relative TFP explainsome of the differences in PPP investment rates,capital intensity, and income.

Table 6 decomposes the elasticity of PPPinvestment rates with respect to PPP incomes.The top row presents the actual elasticity, andthe rows beneath the sources of this elasticity.We vary the underlying determinants of countryPPP investment rates one by one. We set all thevariables to their US levels, save for the vari-able in the row. We have no row for � I

j, theshare of tradable investment in total investment,because it has no effect on the PPP investmentrate at the PPP prices considered.22 Accordingto the second row of Table 6, variation in � C

j ,the share of tradables in total consumption,pushes PPP investment rates down in richercountries. But this force is an order of magni-tude smaller than the overall elasticity to beexplained. The third row of Table 6 shows thatricher countries tend to have higher PPP invest-ment rates in part because of their lower taxrates on capital income. But capital income taxrates explain around a quarter or less of theoverall elasticity. The next row indicates thatthe implied barriers to buying investment goodsplay an even smaller role. As reported in thepenultimate row, the dominant contributioncomes from variation in relative sector TFPs.Excluding residual co-variance terms, higherTFP in tradables and structures in richer coun-tries explains two-thirds or more of the overallPPP investment rate elasticity.23

Table 7 presents elasticities of productivity

22 Empirically, the share of producer durables in invest-ment appears to be little correlated with income (Table 4).

23 We used official exchange rates in Table 6. TFP playsan even bigger role with black market exchange rates.


with respect to PPP output per worker in 1980,1985, and 1996. The first three rows show thatricher countries have higher productivity in pro-ducing tradables (whether investment goods orconsumer goods), structures, and services—hardly surprising. More striking is that richercountries appear particularly proficient at mak-ing goods and structures compared to services.The elasticities of TFP for making goods andstructures are more than double the elasticitiesfor services TFP. In our model, these TFP pat-terns trigger a lower price of investment relativeto consumption in richer economies servicesbeing more important to final consumption thanto final investment goods. Because investmentis tradable, its price before distribution is pinneddown in the world market (conditional on thetariff). Rich countries’ productivity advantagein investment and, more generally, in producingtradables shows up as a higher price of consump-tion services in rich countries. This is what weestimated in Table 3. Viewed through the lens ofthe model, poor countries have low PPP invest-ment rates mostly because they have especiallylow productivity in their tradable sectors.

The remaining two rows of Table 7 presentdevelopment accounting. We use (33) to calcu-late the level of aggregate TFP implied by sec-toral TFP, and we use (32) to find the PPPinvestment rates implied by sectoral TFP. Weset all variables other than TFP (i.e., tax rates

and spending shares) to their US levels to iso-late the effects of TFP differences. We regressthe predicted contributions to PPP incomes onactual PPP incomes (all variables in logs), andpresent the results in the last two rows of Table7. Sectoral TFP appears to explain 60 percent ormore of observed differences in income through

TABLE 6—DECOMPOSING PPP INVESTMENT RATES


Dependent variable 1980 1985 1996

Actual PPP investment rate 0.298 0.520 0.311(0.051) (0.054) (0.043)

PPP investment rate with only . . .. . . �C varying �0.033 �0.038 �0.050

(0.004) (0.003) (0.003). . . (1 � �K) varying 0.079 0.097 0.048

(0.033) (0.032) (0.032). . . (1 � �I) varying 0.025 0.079 0.019

(0.013) (0.016) (0.011). . . AT/AS and AT/AN varying 0.252 0.283 0.276

(0.033) (0.030) (0.035)residual �0.025 0.099 0.018

Number of benchmark countries 61 64 114

Notes: All variables are in logs. Each entry is a coefficient from a single regression. Standarderrors are in parentheses. Bold coefficients are significant at the 5 percent level. Investmentrefers to fixed investment. See equations (31) and (32) for how each variable listed affects thePPP investment rate. We set variables to their US values except for in the term listed. Inconstructing this table, we used prices converted into dollars at official exchange rates.

TABLE 7—PRODUCTIVITY LEVELS AND INCOME

DIFFERENCES

(Entries are elasticities with respect to PPP Y/L)

1980 1985 1996

AT 0.739 0.714 0.962(0.049) (0.047) (0.047)

AN 0.723 0.743 0.622(0.039) (0.040) (0.048)

AS 0.363 0.299 0.303(0.030) (0.025) (0.029)

TFP as a result of Avariation

0.700 0.606 0.624(0.031) (0.031) (0.034)

K/Y as a result of Avariation

0.126 0.141 0.138(0.016) (0.015) (0.017)

Number of countries 61 64 114

Notes: All variables are in logs. Each entry is a coefficientfrom a single regression. Standard errors are in parentheses.Bold coefficients are significant at the 5 percent level. Forthe last two rows we calculated TFP and K/Y using countryTFP in each sector but setting all other variables (spendingshares on durables, tax rates) to US levels. In constructingthis table, we used prices converted into dollars at officialexchange rates.


its impact on aggregate TFP. More to the heartof our investigation, relative sectoral TFP ap-pears to explain another 13 percent of observedincome differences through its impact on phys-ical capital intensity. Consistent with our Table6 results suggesting relative TFP explains mostof the PPP investment rate elasticity, relativeTFP appears to explain the bulk of the contri-bution of capital-output ratios to incomes.24, 25

To recap, poor countries do not exhibit par-ticularly low investment rates at domesticprices. Nor do they exhibit high investmentgoods prices. Instead, they exhibit low con-sumption prices. When consumption is valuedat PPP prices, the investment rates in poor coun-tries are lower than in rich countries. Poor coun-tries do not appear to suffer from low-savingstraps brought on by high discount rates or sub-sistence consumption needs. If they did, wewould expect to see much lower domestic-priceinvestment rates in poor countries. Nor do theyappear to heavily tax the returns to capital. Ifthey did, we would, again, expect to see lowdomestic price investment rates in poor coun-tries. Finally, poor countries do not appear toimpose high taxes and tariffs on producing andimporting investment goods. If they did, wewould expect to see high investment goodsprices in poor countries, as PWT prices aresupposed to include all taxes, tariffs, and trans-portation costs. Poor countries do not appear tolack investment effort, but rather efficiency inproducing tradable goods in exchange for in-vestment goods.

III. Measurement Error

We have assumed that the ICP price dataare well measured. In this section, we briefly

consider how our inferences would change ifthe data were mismeasured in particular ways.First, we note that classical measurement er-ror across countries would generate the oppo-site patterns as those in the data. Countrieswith overstated prices would tend to haveunderstated incomes. Because consumption isabout three times investment, countries withoverstated prices of consumption relative toinvestment, in particular, would tend to haveunderstated incomes. And countries withoverstated PPP investment rates would tendto have understated PPP incomes. Some formof nonclassical measurement error would seemnecessary to explain our findings.

The Food and Agricultural Organization ofthe United Nations (FAO) provides an inde-pendent source of data on food prices in manycountries, which we can compare to the foodprices in the PWT benchmark data.26 In 1994,the year with FAO data for the most coun-tries, the prices of all 190 crops rise withcountry income. For 48 of the 49 crops withdata for at least 50 countries, the elasticity isstatistically significant (the exception beingwheat). Pooling all 190 crops and allowingfor crop dummies, we estimate an elasticitywith respect to country income per worker of0.37 (standard error 0.01). This does notmerely reflect agricultural price supports inOrganisation for Economic Co-operation andDevelopment (OECD) countries; the elasticityis 0.32 (0.01) across countries outside theOECD. The elasticities would be even higherusing black market exchange rates. FAO dataon food prices clearly support the conclusion wereach from the PWT data: food prices are de-cidedly higher in richer countries.27

One could argue that crops are relativelyhomogeneous, whereas other goods and ser-

24 Using (15), the contributions of aggregate TFP and thecapital-output ratio to PPP income differences are 85 per-cent and 15 percent in 1980, 75 percent and 25 percent in1985, and 84 percent and 16 percent in 1996. Our analysisomits human capital, so these figures are in line with Kle-now and Rodrıguez-Clare (1997) and Hall and Jones (1999),who estimate that TFP and human capital together explain75 to 85 percent of income differences, with physical capitalresponsible for the remaining 15 to 25 percent.

25 The TFP and capital contributions in Table 7 do notsum to 100 percent because we set tax rates and spendingshares to US levels. The higher share of services in richcountry consumption, in particular, yields bigger TFP dif-ferences.

26 The data can be downloaded from http://apps.fao.org/page/collections?subset�agriculture. The FAO data pro-vide prices in local currency. We convert to dollar pricesusing IMF official exchange rates.

27 Food may be more expensive in rich countries becauseour price data are retail prices. As discussed in Section III,the income elasticity of food prices is about half the incomeelasticity of services, which is consistent with the fact thatthe share of nontraded services in food at the retail level isroughly 50 percent. At the wholesale level, food pricesshould presumably be no higher in rich countries.


vices can differ substantially in quality acrosscountries. This raises the issue: how closelydoes the ICP come to pricing comparablequality items in different benchmark coun-tries? This is the stated goal of the ICP, sothere is some hope that comparable qualityitems are priced even if the average quality ofitems sold is higher in richer countries.

The ICP’s goal notwithstanding, it may in-advertently price higher-quality items inricher countries. Properly adjusted for qualitydifferences, the price of investment goodsmight fall (and the price of consumption nolonger rise) with country income. Trade bar-riers to importing equipment could be higherin poor countries than ICP prices suggest.Eaton and Kortum (2001) take this view. Ifthey are right, then ICP data understate dif-ferences in PPP income per worker acrosscountries. According to Table 3, an unmea-sured quality elasticity of 0.25 or more wouldbe needed to keep quality-adjusted consump-tion prices from rising with PPP income. Withan elasticity of unmeasured quality of 0.25with respect to measured PPP income, truepurchasing power would vary by a factor of40 rather than 32 across the richest and poor-est economies.

Might unmeasured quality differences belarger for consumption (e.g., education andhealth care) than for investment? If so, thenmeasurement error would contribute both tothe high measured price of consumption andto the high measured PPP investment rates inrich countries. Adding in unmeasured con-sumption in rich countries would lower theirPPP investment rates. The correlation be-tween PPP investment rates and PPP incomeswould partially reflect measurement error ratherthan reality. This would undercut our interpre-tation of the data, but would also undercut taxand tariff explanations. It would mean differ-ences in PPP income are larger and differencesin PPP capital intensity smaller than the PWTdata suggest. If true, we have even morevariation in income and TFP to explain andunderstand.

IV. Conclusion

The higher investment rate in rich countriesthan in poor countries is arguably the most

consistent finding in the empirical growth anddevelopment literature. We find that richercountries have a significantly higher investmentrate in PPP terms, but not in domestic priceterms. This pinpoints the low price of invest-ment relative to consumption in rich countriesas the main force behind their high PPP invest-ment rates. We find no lower investment pricesbut notably higher consumption prices in richeconomies.

Many of these facts are individually wellknown. The contribution of this paper is toconsider all these facts and to channel them intoan explanation of why poor countries have lowreal investment rates. These facts suggest thatlow PPP investment rates in poor countries arenot due to low savings rates or high tax rates oncapital or investment. Instead, the facts point tolow TFP in producing investment goods andtradable goods relative to nontraded consump-tion services. Consumption is cheap in poorcountries, making investment expensive, andlowering PPP investment rates.

We offer two main caveats to our results.First, investment distortions could be moreimportant than they appear from investmentprice data if they are masked by differences inlocal distribution costs. We estimate a modesteffect of incorporating such distribution costs,but more direct evidence on distortions wouldbe helpful. Second, our evidence and inter-pretations hinge on the quality of the ICPprice data. It is likely that such data do notadequately control for differences in the qual-ity of investment (e.g., equipment) and con-sumption (e.g., education and health) acrosscountries.

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