Social Security, Saving, and Capital Formation by SELIG D. LESNOY and JOHN C. HAMBOR* growth? These basic concepts are discussed in the Much controversy has developed recently over first section of the article. ’ capital formation and the claim that the eocial security system has reduced savings and a3 a reeult the potential for economic growth in this country. Concerned that there was much misunderstanding with respect to the subject, the Comm483ioner of Social Security asked the Ofice of Reeearch and CAPITAL FORMATION, SAVING, AND Statietics to make a presentation to top-level stag ECONOMIC GROWTH to clarify the Concept, 8timUlate intelligent discus- eion, and place the issues in proper perspective. Capital formation plays a dual role in the This article is based on the presentation made at the Executive Staff Meeting on April 18, 1975. economy. In the short run, capital formation is To facilitate understanding of the issuea, the an important and volatile component of aggregate artmle begin8 with a discussion of the general demand. In the long run, capital formation adds nature of capital formation and it3 relationship to eavang and economic growth. The balance of the to productive capacity and contributes to economic artzcle focusee on three questions: What (8 the growth. The focus here will be on the role of impact of social security on saving? If 8ocial 8ecu- capital formation in increasing the productive rity reduce8 satiing, is this necessarily bad? If it (8 desirable to increase saving and economic growth, capacity of the economy. w-hat alternative policies can be coneidered? What do we mean by capital and capital . the OASDI system has affected the capital formation of the country and will continue to formation? affect it in ways that are not clearly understood at this time . Every society has limited productive resources -land, minerals, machines, buildings, workers of -Advisory Council on Social Security, 1976. various skills-to satisfy its wants. These re- sources may be used to satisfy current wants by producing food, clothing, concerts, ball games, IN RECENT MONTHS, editorials and scholarly and similar goods and services. Alternatively, articles have appeared criticizing the social secu- resources may be used to produce machinery, fac- rity system for reducing saving and capital tories or houses; to find mineral deposits; to build formation. This article presents a review of the roads and dams; to educate and train workers; relationship of social security to saving and capi- and to investigate scientific problems and develop tal formation. The main concern is with the lm- new technologies- uses that do not satisfy current pact of the social security program on saving wants but do expand future consumption possi- and capital formation. Does social security reduce bilities. saving? If it does, is that bad? If it is bad, what In its broadest sense, capital formation is the should be done? These questions are addressed in use of resources to expand the productive capacity the second part of the article. of the economy, including both physical capital- The issues can be discussed more easily if the buildings, machines, roads, inventories-and in- general nature of capital formation and its rela- tangible capital. The latter includes both human tionship to saving and economic growth are first capital-individuals with their embodied knowl- understood. What is capital formation? How does edge and skills-and society’s accumulated stock it take place? What is its relationship to economic of knowledge. * Division of Economic and Long-Range Studies, OBlce There is a more limited view of capital for- of Research and Statistics. mation that is reflected in most empirical studies BULLETIN, JULY 1975 a of capital formation. This narrower view excludes Capital formation requires that society choose investment in human beings and, with the excep- between present and future consumption tion of dwellings, household durables. Those con- ceptual frameworks that consider the output of At any point in time, the capital stock avail- government as consumption also exclude public able to a society consists of its accumulated inher- capital-government buildings, dams, roads, etc. itance from past economic activity. To add to- Under the narrower concept, capital consists or simply maintain-this capital stock, society of produced goods that are used as inputs in the must use part of its potential output for capital productive process-factories, machinery, inven- formation rather than present consumption. tories, and dwellings. Net capital formation is Capital formation requires that society choose the net addition to the capital stock after allow- between present and future consumption. That is, ing for the using up of existing capital goods. if labor and other resources are fully employed, For some purposes it is useful to refer to gross and if we want to increase future output by pro- capital formation, which is the addition to capital ducing capital goods, then we must forgo present stock before allowing for capital consumption.l consumption. Further, the more output we want In 1974, net capital formation was $89.4 billion, in the future, the more resources we must devote or 7.0 percent of net national product. Gross to capital formation and the less to present con- capital formation was $208.9 billion, 15.0 percent sumption. The real cost of adding to the stock of gross national product. Because 1974 was a of capital to produce goods tomorrow is the recession year, these proportions are somewhat sacrifice of consumption today. below historical averages. It is important to note that if there are un- employed productive resources, society does not RaaZ investment must 6e distinguished from have to give up current consumption to obtain finan&aZ investment. more capital formation. That is, the unemployed In economic analysis, “capital formation” and labor, machinery, and other resources can be used “investment” are, used synonomously and the to increase production of both consumer goods terms are used’ here interchangeably. This point and capital goods. is stressed because in everyday language, “invest- Every society must somehow choose between ment” frequently refers to the accumulation of present and future consumption. In an economy financial assets-such as stocks and bonds-or such as ours, private capital formation-factories, existing real assets-such as real estate or machinery, houses, etc.-is essentially the result paintings. of individual decisions to save and invest, which For the economy as a whole, the accumulation are coordinated by a complex system of market of financial assets does not represent an increase institutions. Government policies-taxes, subsi- in real wealth. Every increase in financial assets dies, regulations-have an important effect on held by one household or business is exactly those private decisions to save and invest. offset by a reduction in financial assets held by, or increase in liabilities of, another economic unit. The problem of choice can be illustrated Similarly, the purchase of existing-that is, pre- graphicalzy. viously produced-real assets represents transfer If an economy is to increase its future consump- of ownership, not a net addition to the economy’s tion by devoting part of its productive resources stock of real capital. In the use of the term here, to capital formation, consumption must be reduced investment refers only to reaZ capital formation- in the present. This problem of choice may be illus- the current use of resources to produce new trated by the use of a “production possibility capital goods. curve” (chart 1). Suppose that an economy may use its resources ‘Although net capital formation is often the preferred for either consumption or capital formation. If concept, empirical studies generally use gross capital all resources are used to produce consumer goods, formation. Estimates of gross capital formation are more we may have 011 of consumption. If all resources accurate than those af net capital formation because it is very difficult to obtain reliable estimates of capital depre- are devoted to investment, we may have OE of ciation. capital formation. The curve ABCDE traces out 4 SOCIAL SECURITY CHABT l.-Production possibilities of capital formation CHART 2.-Effect of capital formation on production vs consumption possibilities over time Capital Capital Formation Formation A FA HK Consumption Consumption all possible combinations of consumption and wanted in period 2, the more consumption must capital formation that the economy could produce be given up in period 1. on a normally sustained basis by using all land, labor, and capital equipment. Its curvature reflects How does capital formation take place? the increasing opportunity cost of the alternative output and reflects the fact that resources are Capital formation requires resources-labor, not perfectly substitutable in the production of machinery, materials-to produce capital goods. consumer goods and capital goods. The graph How do the producers of capital goods obtain shows clearly that increased capital formation is these resources? obtained only at the sacrifice of present consump- tion. It should be noted that, if resources are Saving reZea8es resources-investment absor68 unemployed, and we ire at a point such as X, we resources. can increase both consumption and capital for- If individuals used all of their incomes for mation. consumption, all productive resources would be The problem of choice over time is brought involved in the production of consumer goods. out more clearly in chart 2, in which ABCDE However, individuals save part of their incomes. again represents the production possibilities of They save for a multitude of reasons-to provide period 1. If A is chosen, with all resources for retirement, to leave an estate, to provide devoted to consumption, capital wears out and for emergencies, or simply to accumulate wealth. is not replaced. With less capital, the production When individuals in the aggregate refrain from possibilities for period 2 are only FG.