Ken Houghton | September 5, 2011 6:24 pm



The standard model of Economic Development is Romer’s (1989, JPE 1990) adaptation* of Solow’s (1956, 1957) Model. Basically,

became

Y = AKα(HL)(1-α)

where the H stands for “human capital,” which multiplies the ability of labor. (Think high-skills labor—construction work, plumbing, teaching—where the worker continually “learns by doing” [op cit., Arrow, 1962]. The additional “human capital” multiples the effect of the labor.

One central question is how much of α is attributable to capital and how much is attributable to labor. Standard Macroeconomics and Economic Development courses teach varying values for α, ranging from around 25% to about 1/3 (33.3%): that is, the mixture is between 3 and 4 parts of Labor to every one part of Capital.

How does the compensation go? Well, not quite that way:

The banded area is the estimate of actual allocations of capital and labor. The bars show the compensation to labor (and, therefore, the area above that to 100% are the portion of GDP that is being allocated to capital).

Economic theory tells us that if something is receiving excessive rents—as capital is clearly doing in the United States—there is suboptimal growth occurring across the economy. The standard method of adjusting for that is to reduce the excessive rents through either the introduction of competition (preferred if possible) or through taxation and redistribution. Following are the tax rates on Capital v. Labor:

Labor Tax Bracket Capital Gains, Short Term Capital Gains, Long Term 10% 10% 0% 15% 15% 0% 25% 25% 15% 28% 28% 15% 33% 33% 15% 35% 35% 15%

Note also that labor is not necessarily allowed to exclude its “depreciation” above the value of the “standard deduction” ($8,500 for an individual, $11,600 for a married couple). This is clearly a skewed incentive, with preferable tax treatment given to the overvalued resource (capital) at the expense of the undervalued one (labor).

Happy Labor Day!

*NBER subscribers can access paper w3173. Others can just type “Human Capital and Growth: Theory and Evidence” and probably find an ungated copy somewhere. The uncurious are referred to Wikipedia.