International Value-Added Linkages in Development Accounting

Development accounting evaluates how much of the variation in per-worker incomes across countries can be attributed to quantifiable factor endowments, and how much is due to unobserved TFP differences. We use a standard trade model to generalise the development accounting framework to a setting in which countries are open to trade, and consume both domestic and foreign value added. In addition to differences in factor endowments and TFPs, the generalised framework highlights differences in relative factor costs as source of real-income variation across countries. In turn, countries' relative factor costs are determined by their trade linkages, and the international distribution of factor endowments and expenditures. We use information on value-added trade from international input-output tables for 40 major economies in the period 1995-2011 to back out their relative factor costs in a model-consistent manner. Incorporating this information into the development accounting equation reduces the variation in unobserved TFPs required to explain the distribution of per-worker incomes among our sample countries by more than one half. Our findings suggest that the large international TFP differences found in traditional development-accounting exercises are in part due to their implicit assumption that countries are closed.