The health of the U.S. manufacturing sector has been a major concern of Congress for more than three decades. Over the years, Congress has enacted a wide variety of tax preferences, direct subsidies, import restraints, and other federal programs intended to bolster the manufacturing sector, often with the goal of retaining or recapturing highly paid manufacturing jobs. Only a small proportion of U.S. workers is now employed in factories, as manufacturers have shifted low-value, labor-intensive production, such as apparel and shoe manufacturing, to other countries. Meanwhile, U.S. factories have stepped up production of goods that require high technological sophistication but relatively little direct labor. Despite highly publicized factory closures, the good-producing capacity of the U.S. economy remains near its all-time peak, as measured by the Federal Reserve Board. Recent data, however, challenge the belief that the manufacturing sector, taken as a whole, will continue to flourish. In particular, statistics showing that domestic value added represents a diminishing share of the value of U.S. factory output have been interpreted by many analysts as indicating that manufacturing is "hollowing out" as U.S. manufacturers undertake more high-value work abroad. Economic data have been slow to take note of this development, which raises the question of whether the United States will continue to generate highly skilled, high-wage jobs related to advanced manufacturing. This report discusses economic evidence related to the "hollowing out" thesis with respect to the manufacturing sector. It then considers the policy implications of the debate. The United States has a very large manufacturing sector. In 2011, manufacturers' shipments reached $5.4 trillion, more than one-third of the gross domestic product and 11% above the level of 2010. Although many factories closed or reduced production during the 2007-2009 recession, output has rebounded since the summer of 2009. In February 2013, the Federal Reserve Board's index of industrial production in manufacturing reached the highest seasonally adjusted level since June 2008, only 4% below the high recorded in December 2007. This cyclical recovery, however, has not stilled concerns about the sector's health. The number of U.S. manufacturing sites fell from 397,552 in 2001 to 335,553 as of September 2012, leaving many factories abandoned. Manufacturing employment, which peaked at 19.4 million in 1979, was 11.98 million in March 2013. Of those 12 million manufacturing workers, only 8.3 million, or 5.4% of the civilian labor force, are now engaged in factory production work. The remaining 3.7 million manufacturing workers are engaged in management, product development, marketing, and other nonproduction activities conducted within manufacturing establishments. These broad trends—generally expanding manufacturing output coupled with minimal job creation—are of long standing. In combination, they are taken as indicators of rapidly rising productivity. Labor productivity in U.S. manufacturing, defined as output per work hour, has increased 16% since 2005 and 45% since 2000 as manufacturers have shifted away from labor-intensive production. A rapid rise in productivity would be consistent with the belief that U.S. manufacturing is becoming more efficient and technologically sophisticated and therefore requires less labor; one analogy might be the farm sector, in which the labor force has shrunk to a small fraction of its size a century ago despite a vast increase in output. The estimates of rising manufacturing output and capacity and of rapidly improving labor productivity, however, rely critically on price adjustments that attempt to account for improvements in the quality of computers and certain other high-technology products. Such adjustments are required because, for example, simply measuring changes in the quantity or value of the computers produced each year would have little economic meaning given the very rapid increase in those computers' capabilities. Government statistical agencies address this problem by making highly technical adjustments when measuring certain prices. These adjustments can affect prominent economic indicators, such as gross domestic product and labor productivity. The industries for which data are adjusted in this way, such as semiconductor manufacturing, are among the most vigorous in U.S. manufacturing, leading to questions about whether reported improvements in manufacturing represent real changes or are merely the result of statistical adjustments. While some data thus indicate that U.S. manufacturing is resilient and recovering well from the 2007-2009 recession, two facts in particular support the argument that the manufacturing sector is more challenged than the government's output and productivity measures imply: Unlike previous expansions, the two most recent cyclical upturns in the U.S. economy have not brought more jobs in manufacturing. Factory output rose roughly 20% from the trough of the 2001 recession through 2007 without generating factory jobs. This pattern has repeated itself since June 2009; both total manufacturing employment and manufacturing production employment in March 2013 were only 2% higher than at in June 2009, the deepest point of the 2007-2009 recession, despite a 20.8% increase in factory output. By some measures, value added by U.S. manufacturing establishments appears to represent a declining share of the value of factory shipments. If this measurement is correct, although total factory output is rising, the measured contribution of U.S. workers to the value of the final products may not be keeping pace. Some commentators refer to this phenomenon as "hollowing out." Value added represents one measure of the health of manufacturing. Conceptually, value added equals the value of manufacturers' shipments less the value of purchased inputs. Employees' pay and benefits, depreciation of capital investment, business income taxes, and returns to business owners all are components of value added. In essence, value added is meant to capture the share of the value of final products that is being added "in house." Value added is typically assessed with two different metrics. One metric, the growth rate of "real" value added, provides information about the expansion of industrial output but is subject to the technology-related adjustment issues discussed above. The other metric, which avoids these adjustment issues, is the ratio of each year's manufacturing value added to that year's manufacturing shipments. For an individual firm, a decline in the ratio of value added to shipments may not be meaningful. To see why, consider a firm that produces a component, uses the component to make another product, and sells that product. If the firm were to split itself in half, so that one entity makes the component and sells it to a separate entity that makes the finished product, manufacturers' total shipments would increase but total value added would not change. The resulting decline in the ratio of value added to shipments would have no economic significance. The situation may be different, however, at the level of an industry or of the manufacturing sector as a whole. In these cases, a lower ratio of value added to shipments could reveal important changes. One might be diminished profitability. Another might be that manufacturers' costs for certain inputs, such as electricity or paperboard cartons, are rising faster than the prices manufacturers receive for their products. A third possibility could be that manufacturers are collectively making greater use of imported parts and components. From 1990 through 2005, U.S. manufacturing value added fluctuated in a narrow range, between 46.3% and 48.5% of the value of manufacturers' shipments, according to Census Bureau estimates. Since 2006, however, the ratio has remained below 44.8% (see Figure 1 ). The decline in the ratio, which began in 2003, predated the 2007-2009 recession. The ratio of value added to shipments as measured by the Census Bureau was 41.7% in 2011, well below the average of the past two decades. Data compiled by the Bureau of Economic Analysis (BEA), using different methods, show a generally similar trend, save for a spike in the manufacturing value-added ratio in 2009. According to BEA's estimates, the value-added ratio was 31.95% in 2011 and 32.5% in the first half of 2012, well below the 34.3% average since 1987. The interpretation of the trends in the two data series reported in Figure 1 is a matter of controversy among economists. A number of conceptual issues and statistical deficiencies complicate interpretation. Among the most important of these problems are the following. Accounting for purchased services. The Census Bureau includes manufacturers' outlays for telecommunications, advertising, transportation, and other services purchased from third parties in their value added, but BEA does not. This is the main reason the Census measurement of value added relative to sales is normally 9 to 12 percentage points higher than the BEA measurement. Census treats services purchased by manufacturers differently from materials purchased by manufacturers, which are excluded from its measurement of value added. Conceptually, there is no reason for this difference, but until recently the government lacked reliable data on purchased services, and a change in the Census methodology now would affect long-term comparability. Accounting for research and development. Government statistics include the costs of a manufacturer's research and development staff in value added in the same way as the costs of its production employees. Economists have long debated whether research and development should be treated instead as investment. BEA estimates that this accounting change would have raised the annual growth rate of value added in private industry slightly between 1995 and 2007, and that it would have caused value added in certain high-tech sectors, notably pharmaceutical, instrument, and aerospace manufacturing, to grow faster than official statistics indicate. BEA will begin publishing data treating corporate research and development spending as investment in 2013. Intellectual property exports. Many companies conduct research and development in the United States and use or license the resulting designs, patents, and brand names for manufacturing abroad. In principle, if this intellectual property is licensed to a foreign producer, whether or not owned by a U.S.-based company, it appears in U.S. trade data as a services export.