Capital Accumulation: The Missing Variable in Economic Policy Debates

[This post appeared originally in a slightly shorter form in American Thinker magazine on Feb. 3, 2016.]

Americans are rightly concerned about their current and future economic well-being. For several years, middle class household incomes have seen little overall growth, and tepid growth in hourly wages has meant that the purchasing power of incomes for some families has actually declined.   A consequence is that too many Americans live largely paycheck to paycheck.  Although on the macro level, there has been some deleveraging of debt on the part of households since the 2008 financial crisis, debt remains a significant problem for many.  It is not therefore surprising that polls show that Americans are deeply worried about their ability to sustain their standard of living, let alone pass on a better standard of living to their children.

In this political season, exposure to debates on economic policy for most Americans centers around what the presidential candidates in both parties have said about the economy and about what their economic plans will be, if elected.  In this regard, all of the Republican candidates have proposed tax plans of one form or another that either reduce marginal tax rates on businesses and individuals or, in the case of former Arkansas Governor Mike Huckabee, would replace the income tax all together with a national consumption tax.  Differences among those advocating reform to the income tax are largely in matters of degree, focusing on how much rates can be reduced, what deductions and tax credits should be retained, and how flat tax rates should be.  The common thread is that these reforms are necessary to incentivize work by allowing people to keep and spend more of what they earn, which will generate economic activity and job creation.

As for the Democrats, both Vermont Senator Bernie Sanders and former Secretary of State Hillary Clinton also want to adjust taxes.  Both say that income inequality is a serious national problem that the federal government needs to address through the tax system.  Specifically, taxes should be raised on higher income earners in order to pay for additional government services that will principally benefit the middle class.  Details, of course, differ between the two candidates respecting the extent of the additional services and the degree to which tax rates should rise, but the overall aim of their respective programs rests on a common belief that tax rates are too low on many higher income Americans.

The presidential candidates’ proposed tax reforms, having now entered the public discourse, regrettably focus almost exclusively on short term considerations.  Not surprisingly, presidential candidates seek to appeal to what they perceive as the current desires of voters.  What this has meant is that consideration of a crucial variable is missing from the public discussion, namely the impact of tax policies on capital accumulation.

Capital accumulation is essential to long-run growth and rising standards of living.  As most every student learns in the first week of an introductory economics course, a nation’s production possibilities – that is, its total potential output — at any given point in time is determined by its endowment of natural resources (including labor), current technology, and its capital stock.  At full employment of all of these factors, there is a near infinite range of alternative mixes of final goods and services that can be produced.[1]  Each of these mixes of goods and services, however, resides at a frontier.  With all resources fully employed, no more goods and services can be produced in the aggregate.  A boundary has been reached.  Thus, at full employment, the only way by which the output of any single good or service can be increased is to take resources away from the production of other goods and services.  That is to say, the cost of consuming more of one good or service is less consumption of other goods or services.[2]

At first glance, the concept of production possibilities seems to suggest that standards of living are fixed in place or, possibly worse, must decline over time because of depreciation of the capital stock.  In fact, experience tells us that this result need not be the case.  New natural resources can be discovered, the labor force can increase through immigration and natural population growth, technology can advance, and the capital stock can expand.[3]  It is the last of these on which tax policy can have the most significant impact.

To see why, consider that plant and equipment wear out over time.  Some plant and equipment may also simply become obsolete with the introduction of new technology.  If the capital stock is not replaced as it depreciates, production possibilities must necessarily decline to the extent not compensated by increases in the stock of other productive factors.  In the modern economic world, however, sufficient amounts of such compensation are highly unlikely.  Therefore, just to maintain current production possibilities, it is essential that some of a nation’s productive factors be devoted on an ongoing basis to replacing the capital stock that is wearing out.  What this means is that some amount of the production of final goods and services for current consumption must be sacrificed in order that resources can be diverted to producing capital goods.  In other words, a nation must consume less in the present and save more in order to sustain its capacity to produce.

Carrying this fundamental principle one step further, it becomes clear that, to grow (i.e, to expand its production possibilities over time), a nation not only must replace its depreciating capital stock, but it must accumulate capital at an even greater rate.  Of course, to do so means that still more sacrifice of current consumption is required.  Hence, society must save even more in the present.

Taxes on savings and investment discourage both and thus slow long run growth.  So, for example, taxes on business income, capital gains, and income from dividends and savings accounts reduces the returns on capital, makes capital less desirable to accumulate, and thus slows expansion of a nation’s production possibilities boundary.  Hence, such taxes rob future generations of goods and services that otherwise would have been forthcoming.  When taxes on saving and investment are claimed by the political class to be necessary to pay for additional government services, it is simply a claim that current needs are of higher priority than future needs.  More bluntly, it is a claim that future generations be damned.

In this regard, of the proposed tax reforms offered by the candidates, Senator Sanders’ and Mrs. Clinton’s rob the future the most.  Their proposals specifically aim to feed current gluttony for government services at the expense of capital accumulation.  Although considerably better in that they reduce marginal rates across the board, the Republicans’ tax proposals nonetheless would continue to tax income from saving and investment.  With the possible exception of former Governor Huckabee’s national consumption tax (flawed in other respects), none can be genuinely called pro-growth.  None fully replaces the anti-growth tax system that has hindered the U.S. economy for way too long.

At bottom, little or no economic growth can occur without capital accumulation.  Taxes that discourage saving and investment slow capital accumulation and thus adversely affect long run growth potential.  Surely during this political season, at least one member of the political class can muster the courage to explain the importance of capital accumulation and make clear that every new government service promised today robs the future.  I am not holding my breath, however.


[1] In a free market economy, the mix of final goods and services actually produced is determined by consumers expressing their wants and desires with their spending votes in the marketplace.  Relative prices adjust to reflect such consumer preferences, signaling producers as to which goods and services will be most profitable to produce.  Although this is an important economic principle, it is not essential to the point at hand.

[2] This is a stark illustration of the principle of opportunity costs and tradeoffs in a world of scarcity.

[3] International trade can also increase production possibilities by permitting nations and economies to specialize in producing those goods and services for which their respective endowments are best suited.  This principle is tangential to my main point, however; so I will not explore it further in this post, but readers may want to see my earlier post discussing the benefits of trade linked here.