Fiscal Policies Aimed at Spurring Capital Formation: A Framework for Analysis

By Chirinko, Robert S.; Morris, Charles | Economic Review - Federal Reserve Bank of Kansas City, First Quarter 1994 | Go to article overview
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Fiscal Policies Aimed at Spurring Capital Formation: A Framework for Analysis

Chirinko, Robert S., Morris, Charles, Economic Review - Federal Reserve Bank of Kansas City

In recent years, policymakers have proposed various fiscal policies to spur long-run economic growth through increased capital formation. The Bush Administration, for example, proposed lowering the capital gains tax rate. The Clinton Administration, among other measures in its economic package, proposed reinstituting the investment tax credit. These proposals stem from heightened concerns that the U.S. economy has been growing by less than its long-run potential, and from the judgment that this subpar growth is due in part to deficient capital formation.

This article presents a framework for examining fiscal policies aimed at spurring capital formation and highlights the conditions for their success. The first section shows why capital formation is an important determinant of economic growth. The second section shows how the optimal amount of capital formation, and therefore economic growth, is determined. The third section shows how economic distortions can cause capital formation to fall short of the socially optimal amount. The final section discusses several fiscal policies that have been proposed to raise capital formation.


Capital formation refers to the increase in the capital stock that results from investment spending.(1) Capital formation also includes improvements in the quality of capital. For example, the development of faster personal computers also represents capital formation.

Capital formation increases per capita output by making workers more productive. For example, the substitution of typewriters for penmanship enhanced the productivity of office workers. The substitution of word processors for typewriters, in turn, has further raised office worker productivity. Because capital formation increases output per worker, the greater the amount of capital formation, the greater will be the growth rate of per capita output.

The standard theory of economic growth pioneered by Robert Solow suggests policies that raise capital formation cannot permanently raise the growth rate of per capita output. The key assumption in the standard model is diminishing marginal returns to capital formation. Diminishing marginal returns means each successive unit of capital adds less and less to a worker's total output. For example, giving an office worker a word processor will greatly improve performance, but giving the same worker a second word processor will have little additional effect on performance. Due to diminishing returns, as firms acquire more and more capital, the return to capital declines until it just equals the cost of capital. As a result, capital formation will eventually stop, and there will be no growth of per capita output in the long run. In other words, policies aimed at raising capital formation can raise growth in the short run but not in the long run.(2)

In contrast to the standard theory, empirical evidence suggests there is a positive long-run relationship between capital formation and per capita growth (Chart 1). (Chart 1 omitted) Chart 1 is a scatterplot of capital formation and economic growth. Capital formation is measured by domestic real gross investment's share of real GDP. Economic growth is measured by the percentage change in per capita real GDP. The scatterplot includes 52 countries for which data are available from 1950 to 1988. In order to measure long-run growth and investment, the data point for a particular country represents the average of annual observations over the whole sample.(3) Because countries with low income levels tend to grow faster than countries with high income levels, the data were purged of the effect of the initial level of income.(4)

Chart 1 shows that countries that invest more tend to have higher long-run rates of economic growth.(5) The average relationship is summarized on the chart by a regression of growth on investment. The regression line has a positive slope, which is statistically significant and economically important.

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