For physical capital, the major costs are the expenses of constructing the capital equipment and the interest during construction. In both cases, an individual presumably regards the investment as desirable if the extra returns, as he views them, exceed the extra costs, as he views them. If capital were as readily available for investment in human beings as for investment in physical assets, whether through the market or through direct investment by the individuals concerned or their parents or benefactors, the rate of return on capital would tend to be roughly equal in the two fields: if it were higher on non-human capital, parents would have an incentive to buy such capital for their children instead of investing a corresponding sum in vocational training, and conversely.
In fact, however, there is considerable empirical evidence that the rate of return on investment in training is very much higher than the rate of return on investment in physical capital. According to estimates that Simon Kuznets and I have made elsewhere, professionally trained workers in the United States would have had to earn during the s at most 70 percent more than other workers to cover the extra costs of their training, including interest at roughly the market rate on non-human capital.
In fact, they earned on the average between two and three times as much. Some part of this difference may well be attributable to greater natural ability on the part of those who entered the professions: it may be that they would have earned more than the average non-professional worker if they had not gone into the professions. Kuznets and I concluded, however, that such differences in ability could not explain anything like the whole of the extra return of the professional workers.
The postwar period has doubtless brought changes in the relative earnings in different occupations.
Relationship Between Education and Success
It seems extremely doubtful, however, that they have been sufficiently great to reverse this conclusion. It is not certain at what level this underinvestment sets in.
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It clearly applies to professions requiring a long period of training, such as medicine, law, dentistry, and the like and probably to all occupations requiring a college training. At one time, it almost certainly extended to many occupations requiring much less training but probably no longer does, although the opposite has sometimes been maintained. This underinvestment in human capital presumably reflects an imperfection in the capital market: investment in human beings cannot be financed on the same terms or with the same ease as investment in physical capital.
It is easy to see why there would be such a difference. If a fixed money loan is made to finance investment in physical capital, the lender can get some security for his loan in the form of a mortgage or residual claim to the physical asset itself, and he can count on realizing at least part of his investment in case of necessity by selling the physical asset. If he makes a comparable loan to increase the earning power of a human being, he clearly cannot get any comparable security; in a non-slave state, the individual embodying the investment cannot be bought and sold.
But even if he could, the security would not be comparable. The productivity of the physical capital does not — or at least generally does not — depend on the co-operativeness of the original borrower. The productivity of the human capital quite obviously does — which is, of course, why, all ethical considerations aside, slavery is economically inefficient. A loan to finance the training of an individual who has no security to offer other than his future earnings is therefore a much less attractive proposition than a loan to finance, say, the erection of a building: the security is less, and the cost of subsequent collection of interest and principal is very much greater.
A further complication is introduced by the inappropriateness of fixed money loans to finance investment in training. Such an investment necessarily involves much risk. The average expected return may be high, but there is wide variation about the average.
Student Success, in the Classroom
Death or physical incapacity is one obvious source of variation but is probably much less important than differences in ability, energy, and good fortune. The result is that if fixed money loans were made, and were secured only by expected future earnings, a considerable fraction would never be repaid. In order to make such loans attractive to lenders, the nominal interest rate charged on all loans would have to be sufficiently high to compensate for the capital losses on the defaulted loans.
The high nominal interest rate would both conflict with usury laws and make the loans unattractive to borrowers, especially to borrowers who have or expect to have other assets on which they cannot currently borrow but which they might have to realize or dispose of to pay the interest and principal of the loan. In this way, a lender would get back more than his initial investment from relatively successful individuals, which would compensate for the failure to recoup his original investment from the unsuccessful.
One reason why such contracts have not become common, despite their potential profitability to both lenders and borrowers, is presumably the high costs of administering them, given the freedom of individuals to move from one place to another, the need for getting accurate income statements, and the long period over which the contracts would run.
These costs would presumably be particularly high for investment on a small scale with a resultant wide geographical spread of the individuals financed in this way. Such costs may well be the primary reason why this type of investment has never developed under private auspices.
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But I have never been able to persuade myself that a major role has not also been played by the cumulative effect of such factors as the novelty of the idea, the reluctance to think of investment in human beings as strictly comparable to investment in physical assets, the resultant likelihood of irrational public condemnation of such contracts, even if voluntarily entered into, and legal and conventional limitation on the kind of investments that may be made by the financial intermediaries that would be best suited to engage in such investments, namely, life insurance companies.
The potential gains, particularly to early entrants, are so great that it would be worth incurring extremely heavy administrative costs. What form should government intervention take? One obvious form, and the only form that it has so far taken, is outright government subsidy of vocational or professional education financed out of general revenues. Yet this form seems clearly inappropriate. Investment should be carried to the point at which the extra return repays the investment and yields the market rate of interest on it. In a private market economy, the individual would get this return as his personal income, yet if the investment were subsidized, he would have borne none of the costs.
In consequence, if subsidies were given to all who wished to get the training, and could meet minimum quality standards, there would tend to be overinvestment in human beings, for individuals would have an incentive to get the training so long as it yielded any extra return over private costs, even if the return were insufficient to repay the capital invested, let alone yield any interest on it. To avoid such overinvestment, government would have to restrict the subsidies.
This seems an entirely arbitrary, if not perverse, redistribution of income.
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The desideratum is not to redistribute income but to make capital available for investment in human beings on terms comparable to those on which it is available for physical investment. Individuals should bear the costs of investment in themselves and receive the rewards, and they should not be prevented by market imperfections from making the investment when they are willing to bear the costs.
One way to do this is to have government engage in equity investment in human beings of the kind described above. A governmental body could offer to finance or help finance the training of any individual who could meet minimum quality standards by making available not more than a limited sum per year for not more than a specified number of years, provided it was spent on securing training at a recognized institution.
This payment could easily be combined with payment of income tax and so involve a minimum of additional administrative expense. In this way the individuals who received the training would in effect bear the whole cost. The amount invested could then be left to be determined by individual choice.
Provided this was the only way in which government financed vocational or professional training, and provided the calculated earnings reflected all relevant returns and costs, the free choice of individuals would tend to produce the optimum amount of investment. The second proviso is unfortunately not likely to be fully satisfied. In practice, therefore, investment under the plan would still be somewhat too small and would not be distributed in the optimum manner. To illustrate the point at issue, suppose that a particular skill acquired by education can be used in two different ways; for example, medical skill in research or in private practice.
Suppose that, if money earnings were the same, individuals would generally prefer research. The non-pecuniary advantages of research would then tend to be offset by higher money earnings in private practice. These higher earnings would be included in the sum to which the fraction x was applied whereas the monetary equivalent of the non-pecuniary advantages of research would not be.
In consequence, the earnings differential would have to be higher under the plan than if individuals could finance themselves, since it is the net monetary differential, not the gross, that individuals would balance against the non-pecuniary advantages of research in deciding how to use their skill. This result would be produced by a larger than optimum fraction of individuals going into research necessitating a higher value of x to make the scheme self-financing than if the value of the non-pecuniary advantages could be included in calculated earnings.
The inappropriate use of human capital financed under the plan would in this way lead to a less than optimum incentive to invest and so to a less than optimum amount of investment. Estimation of the values of x and y clearly offers considerable difficulties, especially in the early years of operation of the plan, and the danger would always be present that they would become political footballs.
Information on existing earnings in various occupations is relevant but would hardly permit anything more than a rough approximation to the values that would render the project self-financing. In addition, the values should in principle vary from individual to individual in accordance with any differences in expected earning capacity that can be predicted in advance — the problem is similar to that of varying life insurance premia among groups that have different life expectancy.
For such reasons as these it would be preferable if similar arrangements could be developed on a private basis by financial institutions in search of outlets for investing their funds, non-profit institutions such as private foundations, or individual universities and colleges. Insofar as administrative expense is the obstacle to the development of such arrangements on a private basis, the appropriate unit of government to make funds available is the Federal government in the United States rather than smaller units.
Any one State would have the same costs as an insurance company, say, in keeping track of the people whom it had financed. These would be minimized for the Federal government. Even so, they would not be completely eliminated. An individual who migrated to another country, for example, might still be legally or morally obligated to pay the agreed-on share of his earnings, yet it might be difficult and expensive to enforce the obligation.
Highly successful people might therefore have an incentive to migrate.
Education is The Key to Success – LIFE AS A HUMAN
A similar problem arises, of course, also under the income tax, and to a very much greater extent. This and other administrative problems of conducting the scheme on a Federal level, while doubtless troublesome in detail, do not seem serious. The really serious problem is the political one already mentioned: how to prevent the scheme from becoming a political football and in the process being converted from a self-financing project to a means of subsidizing vocational education.