Theodore W. Schultz, Investment in Human Capital (American Economic Review, 1961)

I’m using this article as an introductory reading for my tax policy seminar.   My seminar will focus on the taxation of human capital.

Why focus the seminar on the concept of human capital investment?  Understanding the impact of human capital investment is perhaps the most important question of all in law and economics, as it has the power to explain why some societies thrive and others fail.  It’s well understood (now) that having a lot of natural resources or financial capital isn’t enough to guarantee success in the long run.  Conversely, many countries succeed without great resources or financial capital to begin with.  Schultz argues, persuasively, that investment in human capital has more explanatory power.

It’s tempting, perhaps, to point to cultural explanations to explain variations in GDP or other measures of economic output.  But I don’t think culture gets you very far analytically.  It’s too broad and undefined.  Schultz’s framework of investment in human capital provides a way to study these questions in more detail and with more precision.  Becker’s book, Human Capital, contains a great deal of theoretical and empirical research advancing the ball on these questions, but for introductory purposes it’s useful to focus on Schultz’s pioneering work.

Schultz’s thesis is that investment in human capital accounts for most of the rise in the real earnings per worker observed in the US (and many other countries) in the middle of the 20th century.  Schultz points to a variety of facts to support his claim, including differences in earning power based on education, on-the-job training, and selective migration.  As the US economy strengthened after WWII, income in the US rose faster than the standard economic inputs of land, man-hours and physical capital.  Perhaps part of the increase could be explained by better physical inputs — technological advances in materials, say — but the more likely explanation is an improvement in the quality of the labor input.  Schultz’s point is that this isn’t a “windfall,” but the product of investment in human capital.

Schultz breaks investments in human capital into 5 categories:

• health care
• on-the-job training
• formal education
• (agricultural) extension programs
• migration

One of the challenges is that each of these expenditures is a blend of investment and consumption.  If you go to the doctor to get a flu shot, it’s an investment in human capital (protecting your earning power) but also consumption (it’ll keep you from feeling lousy).  Similarly, going to graduate school to study French philosophy could be characterized as an investment (if it’s likely to lead to a job) or consumption (if it’s a substitute for going to see artsy movies).  As we will see, this distinction between investment and consumption is critical for tax purposes, as well as for many economic measures.

Schultz ends his essay with a series of points about how social and economic policy should be revised to account for the importance of investment in human capital, and his very first charge is against the tax law.  Schultz claims that “our tax laws everywhere discriminate against human capital” because, while investment in human capital depreciates (as an economic matter) like any other investment in a capital asset, the tax laws do not recognize this fact.

Now, Schultz is partly right and partly wrong.  Many educational investments, like some scholarships, expenditures from 529 plans, and forgone earnings while in graduate school, are excluded from the tax base.  This is important:  If you can pay for your education using pre-tax dollars, that’s roughly equivalent to paying with after-tax dollars, capitalizing the expense, and depreciating the educational “asset” over the expected useful life.  On the other hand, Schultz is right that if you use after-tax dollars to invest in your education, health care, and so on, you do not receive a basis in that investment which would allow you to depreciate that investment to offset a portion of your future income.

In the coming weeks, my seminar class will be exploring the critical foundational questions of how to define the tax base and how to tax labor efforts and investments in human capital, as well as some specific applications.  Schultz’s framework begs more questions than it answers.

But what’s so remarkable about the framework is just how accepted it has become.  There’s no longer much resistance to the metaphor of human capital– the idea that each of us makes investments in ourselves, as if we’re putting a new solar roof on a house.