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Social Security, Saving, and Capital Formation

Much controversy has developed recently over capital formation and the claim that the social security system has reduced savings and as a result the potential for economic growth in this country. Concerned that there was much misunderstanding with respect to the subject, the Commissioner of Social Security asked the Office of Research and Statistics to make a presentation to top-level staff to clarify the concept, stimulate intelligent discussion, and place the issues in proper perspective.

This article is based on the presentation made at the Executive Staff Meeting on April 18, 1975. To facilitate understanding of the issues, the article begins with a discussion of the general nature of capital formation and its relationship to saving and economic growth. The balance of the article focuses on three questions: What is the impact of social security on saving? If social security reduces saving, is this necessarily bad? If it is desirable to increase saving and economic growth, what alternative policies can be considered?

by SELIG D. LESNOY and JOHN C. HAMBOR*

growth? These basic concepts are discussed in the first section of the article.

CAPITAL FORMATION, SAVING, AND
ECONOMIC GROWTH

Capital formation plays a dual role in the economy. In the short run, capital formation is an important and volatile component of aggregate demand. In the long run, capital formation adds to productive capacity and contributes to economic growth. The focus here will be on the role of capital formation in increasing the productive capacity of the economy.

the OASDI system has affected the capital formation of the country and will continue to affect it in ways that are not clearly understood at this time....

-Advisory Council on Social Security, 1975.

IN RECENT MONTHS, editorials and scholarly articles have appeared criticizing the social security system for reducing saving and capital formation. This article presents a review of the relationship of social security to saving and capital formation. The main concern is with the impact of the social security program on saving and capital formation. Does social security reduce saving! If it does, is that bad? If it is bad, what should be done? These questions are addressed in the second part of the article.

The issues can be discussed more easily if the general nature of capital formation and its relationship to saving and economic growth are first understood. What is capital formation? How does it take place? What is its relationship to economic

• Division of Economic and Long-Range Studies, Office of Research and Statistics.

What do we mean by capital and capital formation?

Every society has limited productive resources -land, minerals, machines, buildings, workers of various skills-to satisfy its wants. These resources may be used to satisfy current wants by producing food, clothing, concerts, ball games, and similar goods and services. Alternatively, resources may be used to produce machinery, factories or houses; to find mineral deposits; to build roads and dams; to educate and train workers; and to investigate scientific problems and develop new technologies uses that do not satisfy current wants but do expand future consumption possibilities.

In its broadest sense, capital formation is the use of resources to expand the productive capacity of the economy, including both physical capitalbuildings, machines, roads, inventories and intangible capital. The latter includes both human capital-individuals with their embodied knowledge and skills-and society's accumulated stock of knowledge.

There is a more limited view of capital formation that is reflected in most empirical studies

of capital formation. This narrower view excludes investment in human beings and, with the exception of dwellings, household durables. Those conceptual frameworks that consider the output of government as consumption also exclude public capital-government buildings, dams, roads, etc. Under the narrower concept, capital consists of produced goods that are used as inputs in the productive process-factories, machinery, inventories, and dwellings. Net capital formation is the net addition to the capital stock after allowing for the using up of existing capital goods. For some purposes it is useful to refer to gross capital formation, which is the addition to capital stock before allowing for capital consumption.1

In 1974, net capital formation was $89.4 billion, or 7.0 percent of net national product. Gross capital formation was $208.9 billion, 15.0 percent of gross national product. Because 1974 was a recession year, these proportions are somewhat below historical averages.

Real investment must be distinguished from financial investment.

In economic analysis, "capital formation" and "investment" are used synonomously and the terms are used here interchangeably. This point is stressed because in everyday language, "investment" frequently refers to the accumulation of financial assets such as stocks and bonds or existing real assets-such as real estate or paintings.

For the economy as a whole, the accumulation of financial assets does not represent an increase in real wealth. Every increase in financial assets held by one household or business is exactly offset by a reduction in financial assets held by, or increase in liabilities of, another economic unit. Similarly, the purchase of existing-that is, previously produced-real assets represents transfer of ownership, not a net addition to the economy's stock of real capital. In the use of the term here, investment refers only to real capital formationthe current use of resources to produce new capital goods.

'Although net capital formation is often the preferred concept, empirical studies generally use gross capital formation. Estimates of gross capital formation are more accurate than those of net capital formation because it is very difficult to obtain reliable estimates of capital depreciation.

Capital formation requires that society choose between present and future consumption

At any point in time, the capital stock available to a society consists of its accumulated inheritance from past economic activity. To add to or simply maintain-this capital stock, society must use part of its potential output for capital formation rather than present consumption.

Capital formation requires that society choose between present and future consumption. That is, if labor and other resources are fully employed, and if we want to increase future output by producing capital goods, then we must forgo present consumption. Further, the more output we want in the future, the more resources we must devote to capital formation and the less to present consumption. The real cost of adding to the stock of capital to produce goods tomorrow is the sacrifice of consumption today.

It is important to note that if there are unemployed productive resources, society does not have to give up current consumption to obtain more capital formation. That is, the unemployed labor, machinery, and other resources can be used to increase production of both consumer goods and capital goods.

Every society must somehow choose between present and future consumption. In an economy such as ours, private capital formation-factories, machinery, houses, etc.-is essentially the result of individual decisions to save and invest, which are coordinated by a complex system of market institutions. Government policies taxes, subsidies, regulations-have an important effect on these private decisions to save and invest.

The problem of choice can be illustrated graphically.

If an economy is to increase its future consumption by devoting part of its productive resources to capital formation, consumption must be reduced in the present. This problem of choice may be illustrated by the use of a "production possibility curve" (chart 1).

Suppose that an economy may use its resources for either consumption or capital formation. If all resources are used to produce consumer goods, we may have OA of consumption. If all resources are devoted to investment, we may have OE of capital formation. The curve ABCDE traces out

SOCIAL SECURITY

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all possible combinations of consumption and capital formation that the economy could produce on a normally sustained basis by using all land, labor, and capital equipment. Its curvature reflects the increasing opportunity cost of the alternative output and reflects the fact that resources are not perfectly substitutable in the production of consumer goods and capital goods. The graph shows clearly that increased capital formation is obtained only at the sacrifice of present consumption. It should be noted that, if resources are unemployed, and we are at a point such as X, we can increase both consumption and capital formation.

The problem of choice over time is brought out more clearly in chart 2, in which ABCDE again represents the production possibilities of period 1. If A is chosen, with all resources devoted to consumption, capital wears out and is not replaced. With less capital, the production possibilities for period 2 are only FG. Suppose that, if B is chosen, net capital formation is zero we simply replace capital used up. Then the production possibilities for period 2 are identical with those of period 1. Choices C and D represent positive capital formation. If Cis chosen, HJ is possible in period 2; with D, it is KL. Clearly, the more potential consumption

BULLETIN, JULY 1975

O

F

A

H K

Consumption

wanted in period 2, the more consumption must be given up in period 1.

How does capital formation take place?

Capital formation requires resources-labor, machinery, materials-to produce capital goods. How do the producers of capital goods obtain these resources?

Saving releases resources-investment absorbs

resources.

If individuals used all of their incomes for consumption, all productive resources would be involved in the production of consumer goods. However, individuals save part of their incomes. They save for a multitude of reasons-to provide for retirement, to leave an estate, to provide for emergencies, or simply to accumulate wealth. When individuals in the aggregate refrain from consuming, the resources that would be used to produce consumer goods are released. The resources released from consumer goods industries can then be shifted to the capital goods industries to produce factories, machines, etc.

Capital markets coordinate the saving-investment process.

In some cases, the units that save are identical with those that invest. Independent businessmen save in order to finance investment. Corporations finance the purchase of capital goods by retaining earnings. In large measure, however, saving and investing are done by different units. That is, saving is done primarily by individuals and families; capital formation is carried on largely by business firms.

The transfer of saving from individuals to business firms is coordinated by the capital market-a

t-a complex system of financial intermediaries dealing in a multitude of financial instruments. Individual savers may purchase new or old securities, accumulate cash, pay debts, etc. In the aggregate, saving is used to purchase new securities issued by business firms. The business firms that issue these new securities use the proceeds from their sale to purchase newly produced capital goods.

What is the relationship between capital formation and economic growth?

Capital-using production is indirect. To produce automobiles, we need steel. To produce steel, we need blast furnaces and iron ore. To produce iron ore, we need mining equipment, etc. We must also educate and train workers so that they are capable of handling complex tasks, whether it is assembling an engine part, planning production schedules, engineering a new part, or designing a new plant.

Roundabout processes need not be productive, as many a Rube Goldberg cartoon has shown. The empirical evidence provides strong support, however, that such processes are highly productive.

Growth of output is related to growth of capital.

If the American experience is examined in historical perspective, rising output is seen to be associated with a rising stock of capital. A study by Simon Kuznets of Harvard University shows that from 1869 to 1955, total capital (measured in 1929 dollars) increased from $36 billion to $649 billion, an increase of 40 percent per decade.

'Simon Kuznets, Capital in the American Economy, National Bureau of Economic Research, Oxford University Press, 1961.

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Growth cannot be accounted for simply by the quantitative increase in labor and capital.

Economists have attempted to divide sources of growth into its components. Almost all these studies find that after accounting for growth in labor force and capital, there is an unexplained "residual." This residual reflects increased output per unit of input and is largely attributed to technical progress.

According to Edward Denison of the Brookings Institution, the sources of growth of total U.S. output for 1929-69 are summarized in table 1. It is striking that the increase in capital input contributes only 15 percent of observed growth. The major sources are advances in knowledge (27 percent) and increases in education (12 percent).

Table 2 provides a similar breakdown for output per employed person. Again, the contri

Edward F. Denison, Accounting for United States Economic Growth, 1929-1969, The Brookings Institution, 1974. See also The Sources of Economic Growth in the U.S. and the Alternatives Before Us, Committee for Economic Development, 1962, and Why Growth Rates Differ, The Brookings Institution, 1967, by the same author.

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Output is measured by national income. Potential output adjusts actual output for demand-related factors

Source: E. F. Denison, Accounting for US Economic Growth, 1989-1969, The Brookings Institution, 1974, table 9-7, page 136, and table 9-8, page 137.

bution of capital input is less important than the increase in output per unit of input.

The interpretation of these results is not unambiguous. Some economists argue that technological change must be "embodied" in real capital goods. Human capital theorists also argue that technological change is embodied, but in human

capital. Despite these controversies, it is clear that we must consider the growth of skills and knowledge as well as the accumulation of physical capital in explaining the growth of output.

The relationship between saving ratios and growth rates is tenuous.

The discussion thus far may lead to the inference that the rate at which an economy grows depends upon its saving ratio-the proportior. of current income that the economy is able to save and invest. A recent editorial in the Wall Street Journal for example, suggests a strong relationship between productivity growth and the ratio of investment to total output.

Panel A, chart 3, shows this relationship for seven major countries for the period 1950-62.

Wall Street Journal, February 20, 1975.

Data for all countries except Canada and Japan are from Edward F. Denison, Why Growth Rates Differ, The Brookings Institution, 1967. Data for Canada and Japan are from Long Term Economic Growth, 1860-1970, Bureau of Economic Analysis, 1973.

CHART 3. Growth of rea: output per worker and percent of gross national product invested

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Source: E. F. Denison, Why Growth Rates Differ, and Bureau of Economic Analysis, Long Term Economic Growth, 1860-1970.

BULLETIN, JULY 1975

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