Why does Capital Matter?

Capital is the engine of a growing economy. A recent study by Dale Jorgenson of Harvard University discovered that almost half of the growth of the American economy between 1948 and 1980 was directly attributable to the increase in U.S. capital formation (with most of the rest a result of increases and improvements in the labor force).

The term "capital" has more than one meaning. Most people think of capital as money--the rupees invested in the stock market or in a new business. But for the purpose of understanding the capital gains tax, it is wrong to think of capital as just financial assets. Capital is also physical investment--the plant, the factory, the forklifts, the computers, the fax machines, and the other nonlabor factors of production that make a business operate efficiently. A corner lemonade stand could not exist without capital--the lemons and the stand are the essential capital that make the enterprise operate.

Capital can also refer to technological improvements or even the spark of an idea that leads to the creation of a new business or product. Ten years ago when Bill Gates decided to form a computer software company and then brought MS-DOS to market, he was creating capital. An investor who had the foresight to take the risk of investing in Bill Gates's idea made fabulous amounts of money. That may seem like a huge windfall for the original financers of Microsoft, but without those investors' risking their money, a globally dominant American firm that employs 15,000 U.S. workers might not exist today. Of course, for every Microsoft whose stockholders make large profits, there are hundreds of risky investments that lose money for investors.

Opponents of a capital gains tax cut often maintain that the returns on capital accrue primarily to the owners of the capital and that those owners tend to be wealthier than the average worker or family. It is therefore argued that a capital gains tax cut would mostly benefit affluent citizens. But that ignores the critical link between the wage rate paid to working citizens and the amount of capital they have to work with.

What happens to the wage rate when each person works with more capital goods?

Because each worker has more capital to work with, his or her marginal product [or productivity rises. Therefore, the competitive real wage rises as workers become worth more to capitalists and meet with spirited bidding up of their market wage rates.

The relationship among productivity, wages, and capital is especially dramatic in agriculture.

The recap

There are three reasons capital should matter to the worker:

1. Capital represents the modern tools that work with on the job.

2. Capital formation makes the average worker more productive.

3. Improvements in worker productivity lead to higher real wages and improvements in working conditions.