How capital and income are mutually dependent
Growing societal awareness of environmental damage raises challenges for conventional measures of economic progress. Are measures of capital, in the broadest sense, and income, mutually dependent? In this article, we stand back and consider how the growth in capital (investment) is measured.
Investment is an elixir. It broadens the capital base of an economy. A larger and growing capital stock in turn enables economic growth. As a result, nations that save today to invest for tomorrow enjoy rising living standards over time. This truism holds for all countries – no matter what economic model they choose to pursue.
Different types of capital
What do we mean by investment? Investment includes any spending that adds to a country’s capital stock. To be additive to capital stock, investment spending needs to exceed the wear and tear, obsolescence and destruction of existing capital.
As societies have developed, capital has broadened to include not just physical capital (factories, machinery, roads, infrastructure and technical know-how), but also human capital (education, training), social capital (rule of law, democratic institutions) and natural capital (forests, water, resources). Spending to maintain and grow these assets adds to the wealth of a nation. In turn, a wealthy nation is one that has accumulated a large stock of physical, social, financial and natural capital.
How does it get distributed?
World Bank’s World Wealth Report of 2018 contrasts the distribution of human and natural capital across different income groups. Over the centuries, investment in physical and human capital has lifted the standard of living in high income countries. In contrast, lower income countries have a greater proportion of their wealth in natural capital. They have yet to invest and accumulate physical and human capital. It should be noted though that natural capital per person in high income countries is three times that in low income countries. It has not been necessary to liquidate natural capital to get rich.
Accounting for resource depletion
Of all the capitals, natural capital is most unique. While an abundance of natural capital may not necessarily correlate with high living standards, its depletion can become a serious impediment to growth. The World Bank has tried to estimate the impact of natural capital depletion on growth with a new measure known as Adjusted Net National Income (ANNI). ANNI adjusts a country’s income level for the wear and tear of its physical capital (depreciation) and depletion of natural capital (reduction in subsoil assets and net forest depletion). Very simply, ANNI is a more accurate measure of income that is available either for consumption today or for investment today to fund consumption tomorrow. While ANNI might not be a comprehensive measure of all the resource depletion taking place (it does not capture water depletion, air quality depletion etc.), it is a powerful illustration of the impact that natural capital depletion can have on income over time.
In chart 1, the red line plots the world’s national income without accounting for resource depletion, and the blue line plots ANNI or world national income adjusted for resource depletion. There is a large and growing disparity between the two measures of income. This illustrates the negative impact of natural capital depletion on income growth over time. Growth funded by resource depletion comes carries a long term cost.
A fairer view of investment?
An alternative method to estimate the net investment is by measuring net savings. The benefit of starting with savings is that it allows us to capture the flows into the broader categories of capital such as physical, human and natural capital. The World Bank’s estimate of net national savings is Gross Savings plus expenditure in education minus depreciation of physical capital, depletion of natural capital and pollution damage costs. Chart 2 illustrates the large disparity between gross and net savings, particularly in fast growing emerging markets like China and India. While both countries boast exceptionally high savings rate, if we make adjustment for negative impacts on natural capital, their savings rates are considerably lower. In other words, current growth is being funded by resource depletion. This carries a longer term cost in terms of growth and income sustainability.
Wealth and growth are mutually dependent. Investing to grow the capital base secures future income this is true for all forms of capital. Only with a clearer picture of both can we have a full understanding of the long term outlook.