Capital Formation 101

Originally published in inFOCUS Quarterly

Economic output is produced by combining various factors of production, including labor, land, capital and available technology. These factors of production must be increased or used more efficiently in order to achieve real economic growth.

First, for workers to provide their maximum contribution to the production of goods and services, they must use the most advanced equipment and tools available and have adequate education and training. These investments in both physical and human capital will boost labor productivity, thereby allowing for increased real wages and providing incentives for greater work effort. The resulting rise in economic activity will thus increase total income and total output.

Second, for capital equipment, structures, and the land upon which they are located to be efficient, funds must be constantly plowed back into new and innovative machinery and more efficient designs for buildings and land use. The capital that is efficient today may not be efficient tomorrow.

Third, for America to keep ahead of its foreign competitors, research and development must be encouraged to expand the frontiers of technological knowledge.

What Factors Interfere with Capital Formation?

Federal tax, spending, and regulatory policies may interfere with capital formation and diminish the prospects for economic growth to the extent that they create a different level and distribution of capital goods than would have otherwise existed. Such federal policies have interfered with the necessary expansion of capital formation in recent years.

According to Robert Gordon’s The Rise and Fall of American Growth: The U.S. Standard of Living Since the Civil War, rapid economic growth for the United States is a thing of the past and new technologies, such as the Internet, cannot be expected to boost both growth and productivity levels similar to advances between 1870 and 1970. Gordon argues that the some of the crucial inventions such as telephones, airplanes, television, synthetic fibers, plastics, and assembly lines and their application to ease our daily lives and increase our efficiency cannot be repeated.

Time will tell whether Prof. Gordon’s predictions are correct. However, if this is the case, federal policies to support and encourage lagging capital investment become much more important.

First, U.S. tax laws contain an inherent bias against saving, investment, and work effort. Our progressive tax rates reduce after-tax returns to work effort, thus decreasing the volume of work effort. At the same time, the relative “price” of leisure is reduced, further discouraging labor market participation. In a similar fashion, saving and investment are taxed more severely than consumption. A dollar of income earned and spent is taxed only once.

But a dollar of income saved is taxed when first earned, and, if invested, taxed over and over again as the returns to saving accrue. This taxation of capital gains, dividend, and interest income constitutes a tax bias against saving and investment and toward consumption. Economic theory suggests that taxing consumption is more conducive to economic growth than is taxing income.

In general, economists agree that taxes should be designed so that the relative prices of work effort and leisure, and of consumption and saving (and investment) are not disturbed after their imposition. The development of such “neutral” tax policies should be a major goal of tax reform. These “neutral” tax policies would not differentially alter the prices of the necessary ingredients of production: work effort, saving, and investment.

Second, the deficits generated by federal spending in excess of revenues represent claims against private resources and, as such, can preempt private sector activity. As a result, government financing of the deficit may “crowd-out” private sector needs in credit markets. For these reasons, federal finances have become a major concern of policymakers today. In 2000, budget outlays on a fiscal year basis were 17.6 percent of gross domestic product (GDP).

By 2017, federal government claims on total output had grown to 20.7 percent. According to the Congressional Budget Office’s 2017 Long-Term Budget Outlook, outlays will continue to grow, reaching 29.4 percent of GDP in 2047, increasing the U.S. budget deficit. These trends underscore the need for fiscal discipline to encourage real rate of growth in total output, lower capital costs, and encourage private sector capital formation.

Third, the rapid expansion of government regulation in recent years has resulted in high compliance costs to firms, with such costs being ultimately reflected in final prices to the public.

Regulation expert Murray Weidenbaum had noted that these costs also have had the effect of displacing productive investment and encouraging “defensive” research and development rather than innovative product research. For example, as firms devote greater portions of their resources to meeting federal regulatory requirements, new product development is delayed, increasing the final cost of bringing a new product to the market. If a firm is already operating efficiently, the increased costs caused by these government regulations may well result in either lower profit margins, which result in even fewer resources being devoted to product innovation, or higher prices to the public. Another concern with regulations is their impact on entrepreneurship. According to a body of economic literature, regulations may restrict entry, deter competition, and inhibit the disciplinary effect of competition on existing market players.

Of course, this is not to say that all regulation is bad. Over the years, the United States undertook major regulations to better protect human health and the environment. However, as President Ronald Reagan’s 1981 Executive Order stated, “Regulatory action shall not be undertaken unless the potential benefits to society for the regulation outweigh the potential costs to society.” With careful analysis of the costs and benefits of federal regulations, the number of regulations that drain capital from productive to nonproductive uses can be reduced, thereby encouraging more private capital formation.

Do We Have Adequate Levels of Capital Formation?

Recent statistics on U.S. economic health reflect a softening of vital indicators. Although America still produces the second largest share of world output after China, investment and productivity are sluggish and our international economic performance is lackluster. A closer look at the levels and trends of major economic aggregates and their components provide a better understanding of the reasons behind the recent slowdown in economic indicators.

The Recent Trends in Investment

In a classical formulation, the factors contributing to economic growth are labor, land, capital and technology. These factors are all interrelated in their contribution to real output.

Increases in investment will have positive effect on economic growth by increasing the quantity and quality of capital per employee. However, over the years both the investment and net stock of private capital have shown disappointing growth. While between 1947 and 1973, the net stock of fixed assets grew at an average rate of 3.8 percent, after 2007 (the period that started with the great recession), the average growth rate was only 1.5 percent.

This decline in net investment growth, combined with changes in labor structure and composition (such as the retirement of the baby boomers with lots of human capital and the lack of skilled labor, especially in the manufacturing sector), resulted in slower growth in labor productivity. Between 1947 and 1973, labor productivity grew at an average rate of 2.8 percent. After 2007, the average growth rate was only 1.3 percent.

Domestic capital formation not only declined over time, but also compared unfavorably relative to our top 10 trading partners. The United States lagged behind all countries except the United Kingdom in gross fixed capital formation as a percent of GDP for 2007-2015. This record reflects poorly on our ability to replace and expand the capital stock with new and innovative equipment, which is so important to improving the productivity of our work force.

Research and development expenditures, through their influence on technology, also contribute to increases in labor productivity. The relationship between R&D expenditures and productivity growth has been analyzed by many economists. According to a recent CBO analysis, the estimates are wide-ranging – from zero to substantial. However as stated in the paper:

Most of the estimates lie somewhere between the two extremes, and as a result, a consensus has formed around the view that R&D spending has a significantly positive effect on productivity growth, with a rate of return that is about the same size as (or perhaps slightly larger than) the rate of return on conventional investments.

Despite the importance of R&D, there is mounting evidence that the U.S. lead in technological advance has stagnated over the last decade. R&D as a percent of GDP has grown faster in many of our top trading partners (which include the top 10 economies in the world based on GDP). In 2000, the United States was ranked second among these countries in terms of R&D as a percent of GDP. By 2015, America had fallen to fourth, after Korea, Japan, and Germany.

Increases in capital investment and R&D are not the only factors needed to boost labor productivity. Investment in human capital through education and training results in an increase in the quality of the workforce, which in turn raises productivity. Educational progress affects productivity by increasing the number of engineers, scientists, and inventors who generate innovations, and entrepreneurs who make innovative investment decisions. But data shows that, especially in science, technology, engineering, and mathematics (STEM) fields, the United States is lacking.

According to National Math and Science Initiative (NMSI) data, only 44 percent of 2013 U.S. high school graduates were ready for college-level math and only 36 percent were ready for college-level science. Among the students who entered STEM fields between 2003 and 2009, a total of 48 percent of bachelor’s degree and 69 percent of associate’s degree students had left these fields by spring 2009. Half of these people switched to non-STEM fields and the rest left without earning a degree.

When we look at the impact of these numbers on U.S. R&D effectiveness, according to NMSI data, in 2009 U.S. scientists published nearly 29 percent of the research papers in the most influential journals, down from 40 percent in 1981.

Recent Trends in Saving

Recent figures comparing household saving rates as a percent of household disposable income among the U.S.’s top trading partners show that this country is in the middle of the pack, averaging 5.7 percent between 2007 and 2015. Our trading partners’ saving rates ranged from 1.2 percent (Japan) to 38 percent (China). Many experts think that U.S. personal saving rate is not nearly enough, especially to ensure a comfortable retirement for individuals. According to a recent report by the Center for American Progress, nearly one-third of working Americans do not have a pension or any savings. For many, Social Security income is still the source of sole support during retirement years.

However, questions about the financial health of the Social Security system and the continuing retirement of the baby boomers have increased the importance of the other income sources financed by personal savings. According to the 2016 Social Security Trustees Report, it is expected that Social Security will be able the pay full benefits until 2034. After 2034, the income generated by payroll taxes and other sources will only be sufficient to pay 79 percent of scheduled benefits. The shortfall in Social Security makes it even more important to find ways to encourage personal savings.

The Tax Burden on Capital

One way to increase rates of capital formation in the United States is to reduce the existing tax bias against saving and investment. Reducing the tax burden on income from capital services would lower the cost of capital relative to consumption, thus providing an incentive for individuals to save and invest rather than spend. Reducing the cost of capital in America would also boost capital formation by attracting inflows of foreign capital.

The current U.S. tax code can be described as a hybrid system that relies heavily on an income tax with some features that resemble a consumption tax. A pure consumption tax is defined as a system that taxes individuals on the goods and services they purchase and exempts all saving from tax.

The current U.S. tax code contains tax-preferred savings vehicles, such as IRA’s and 401k’s; these are features of the tax code that act like a consumption tax. Individuals can contribute pre-tax dollars to these accounts and the tax on the accumulation of savings is deferred until the funds are withdrawn.

In addition, the current tax system allows some investments to be expensed (deducted from taxable income in the first year). There is also accelerated depreciation, which reduces the tax burden on some investment. Even though these “consumption tax-like features” reduce the distortionary impact of the current tax system, they are selective and limited in scope. Most economists believe that switching to a system whereby the tax base depends primarily on consumption rather than income could increase saving, investment, real output, and long-run economic growth. In addition, the current tax treatment of dividends and capital gains both at individual and corporate level retains a substantial bias toward consumption. The outdated corporate tax system in the United States provides another burden for capital formation.

Conclusion: An Agenda for Economic Growth

In America today, capital investment is falling behind relative to our competitors and personal saving rates are far from sufficient.

There are signs that the direction of public policy is changing. Tax, spending and regulatory policies are now being carefully examined in light of their effects on capital formation. There is increased talk of moving towards a consumption income tax system to ease the tax bias against saving and investment. Among the constructive areas of future tax reform are proposals to reduce the corporate income tax rate and bring the business tax system into the 21st century. Tax and additional incentives for personal savings, especially in the retirement arena, are being considered to provide a more secure future for U.S. retirees. Budget reform should continue to aim at controlling the projected acceleration in the ratio of federal spending to GDP.

Future actions will be needed to reduce the federal budget deficit.

Finally, regulatory policy, so vital to any capital formation initiative, should maintain its emphasis on ameliorating the costly and burdensome restraints on productive saving and investment.

Pinar Çebi Wilber, Ph.D., is Chief Economist with the American Council for Capital Formation and an Adjunct Assistant Professor with Georgetown University.

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Dr. Pinar Cebi Wilber

Pınar Cebi Wilber’s research interests are diversified and include energy policy, tax policy, international trade and finance, and general government policy. Recently, Pınar has researched issues related to climate change legislation including the impact of such legislation on the U.S. economy. She has also done extensive research on the effect of government policies on retirement saving as well as the use of annuities in retirement.