by Michael Porter
Michael Porter is Professor of Economics and Director
of the Centre of Policy Studies at Monash University.
''The prime element in the value of all property is the knowledge that its peaceful enjoyment will be publicly defended.'' Without this legal and public defence ''the value of your tall buildings would shrink to the price of the waterfront of old Carthage or corner-lots in ancient Babylon.''
- Calvin Coolidge as quoted in Paul Johnson, ''Modern
Times'', Harper and Row, NY, 1985, page 222.
Measuring Community Wealth
IN popular usage wealth is taken to be synonymous with assets and reflected in affluence, luxury, opulence, prosperity, abundance and command over money. People are perceived as wealthy when they have large observable measures of capital. Conversely, people associated with large observable assets are taken to be wealthy.
While these observations may often be instructive, statistical rankings of assets held do not tell us anything reliable about the relative income earning capacity of individuals. People with significant observable holdings of assets, while possibly able to spend more in the short-term, are not necessarily able to command greater resources over the longer run than those whose wealth is embodied in non-observable forms. And as we shall see, a correct economic definition of wealth makes it intrinsically non-observable.
To the economist wealth is a precise concept, at least in theory. Following the writings of Irving Fisher we may define wealth as the capitalised value of expected future income streams -- where ideally these income streams include the financial and non-financial benefits accruing to an individual. However, while market values of corporations are struck every day on the stock exchange, individuals are (since slavery) free of such valuations, and so there is no market reporting of human wealth. What we do know is that wealth is not measured simply by adding up estimates of the worth of factories, buildings and so on, since these are merely devices for assisting in the production of income.
As a start, our efforts to compute wealth can focus on measures of cash income capitalised into a measure of wealth by discounting those expected future flows by some subjective discount rate. The problem is that not merely do we not know the future, let alone how long people will live, we also have no obvious way of adding up dollars today with dollars next year or dollars at the time a person dies. Thus, even if one uses a definition of wealth based on income flows, the discounting and time horizon issues make sure measurements difficult.
But, it is also not possible to offer any objective measure of individual wealth based on statistical records. While we can record some specified account balances, such balances, once specified, become assets to avoid, particularly if wealth taxation is proposed, or may be expected to flow from the political process once such wealth measurements are published. If we restrict ourselves to looking at assets in personal or group balance sheets, we miss many of the other components of wealth which determine spending power or command over resources -- the ultimate purpose of wealth.
Consider a person who is cash rich, who owns a house and a boat, but who for some medical or other reason has an incapacity to generate future income flows. Such a person in reality is relatively poor in terms of future command over resources (because his future income flows are limited to returns from his investments), even though his measured financial assets may be large. On the other hand, his neighbour may have many resources above the shoulders, if not below the ground or in the bank, such that he has ideas and knowledge which are likely to generate very considerable future income. Such a person may be a millionaire or a billionaire in prospect, but could be totally immune from any accounting for wealth -- and would clearly avoid any taxation of observable wealth. And were he taxed in the expectation of wealth, he may lose the desire to take the risks inherent in generating the wealth. A tax on such ''wealth'' would, in effect, make sure it is never created!
Partly because of all these ambiguities economists have devised the term ''human capital'', to refer to the human dimension of wealth (popularised in the 1960s by Professor Gary Becker at the University of Chicago), with human capital being intended to summarise the income flows capitalised over their life. ''Human capital'', so defined, is enhanced by investments in training and education, by experience on the job or elsewhere, by exposure to smart people and concepts. Arguably the sum of these ''human capitals'' -- allowing for interactions -- is the national wealth, and it varies with our state of confidence and knowledge and is affected by our discounting of the future.
It is clear, for example, that for most people, and for most of their lives, their human capital is far greater than any financial or physical capital (such as a house) over which they may have command. A major difference between human and physical (or financial) forms of capital is that, traditionally, it has been more difficult to borrow against actual or potential human capital, which many believe accounts for a degree of under-investment in human skills.
As an example of a ''human capital'' calculation, take the person who at age 20 earns an income of $20,000 but is expected to earn an income to age 70, with a growth rate of seven per cent per annum. The total earnings will add to $8.7 million to the year 2038, with an implied asset value (at five per cent discount) of $1.6 million.
Indeed, for many people today the capitalised value of such an income stream would be in excess of $1 million. Yet such a person would never be properly represented, at age 20, in a survey of income and wealth, whereas a 50 year old who has battled all her life, raised a family and faced sickness and other adversities, but happens to have a significant superannuation policy, for example, may be defined as being a wealthy person if she has something like $300,000-$400,000 in assets, including a house, superannuation and other assets, far less than the wealth of the 20 year-old son! A wealth redistribution, necessarily based on observable assets, would threaten to penalise those who may simply not be fleet of foot in relocating their (modest) assets.
Measuring Community Wealth -- The Physical Capital Stock
A given set of factories which are otherwise identical may be worth nothing in India or Afghanistan, yet generate massive income streams in Japan, because of the ''human capital'' and the institutional environment in which they work. Put in other terms, equipment working with a smart labour force and operating under competitive conditions with good management and an environment sympathetic to enterprise, may generate enormous incomes for workers and shareholders in Japan, but be an embarrassing source of rust in Afghanistan.
Any stock market which values these assets, through the ownership of a firm, would indicate great wealth in Japan and relative poverty in Afghanistan. But if one wishes to generate income to remove poverty, the strategy is not to tinker with the ownership of observable capital stock or ''wealth'', but to foster the process whereby all can accumulate wealth by the most efficient and fairest means possible. Relative wealth calculations will, of course, be fascinating, but they are capable of generating more policy mischief than almost any other attempt to statistically summarise society. Some might be led to conclude on the basis of so-called wealth statistics that one country is intrinsically well off and the other poor on the basis of observed asset structures. The real issue is the quality of management and incentives to create wealth. What is poor in this Afghanistan situation is, of course, the quality of management and labour, and the institutional environment. There is, by definition, no shortage of observable physical capital in this hypothetical example, yet such a point would be missing from any survey of income and wealth in Afghanistan.
Similarly, if we compute a ''high'' observable wealth in the form of pension funds, equities and other observable assets, there always exists a set of economic policies which can grind the value of such a measured capital stock to zero, and make retirement incomes worth very little. A redistribution of wealth based on the resulting and miserable financial asset values, which left aside the management and incentive issues causing a collapse into banana republicanism, would be a distraction from the needed analysis of those policies capable of extracting the maximum value from the nation's physical and human assets. Indeed, such a redistribution would likely reduce wealth as properly measured by reference to future income flows.
It follows that there is no point in making spurious ''wealth'' surveys. Nor is there any point in comparing the results of such surveys across countries, given the possible, indeed likely, misinterpretations and resulting policies and their potential for perpetuating poverty.
Government Ownership of Capital
A characteristic of government ownership, documented in various studies (see the recent issue of Spending and Taxing II -- Taking Stock, edited by Freebairn, Porter and Walsh) is that the chains of command and patterns of control over government assets are rarely clear or predictable. There is no single profit line guiding the management of state enterprises which command the state's capital stock, and thus there is no simple bench mark by which we can value performance. Furthermore, narrow interest groups, most of whom are far from poor, have a capacity to capture for themselves many of the benefits which flow from state enterprises, and this means that any valuation of the capital stock in the hands of government is contingent on definitions of the beneficiaries.
There are many cases in which the prime items of government capital stock -- such as the factories of British Steel -- have been valued at zero or even negative sums, because of the obligation to take on a workforce which was out of all proportion to the labour needs of the enterprise, and which made the combination of capital and labour a losing proposition, for which no rational bids would be received. There are many Australian government enterprises which, when bundled together with an inappropriate and excessive labour force, and subject to government policy controls, have a negative valuation, with the cost of what they provide in the way of goods and services being in excess of the price individuals are willing to pay.
Because government-owned enterprises have a unique capacity to price below cost, partly because of deficit funding through government, the fact that certain government enterprises have a negative valuation means that in any proper census of wealth they should not appear. On the other hand, some government enterprises may be valued highly, not necessarily because of the physical capital value, nor because of the quality of management (which could be very high), but because they live under regulatory or monopolistic privilege granted by government, which has the effect of jacking up the prices they charge and thus increasing the capitalised value of the income stream. Accordingly, where there are examples of highly valued government enterprises -- for example, Telecom in Australia and the UK -- it should not always be assumed that the valuation of these enterprises stems from the enterprise itself -- since the real source of wealth to some individuals may be monopolistic privilege allocated by government. It may turn out that the advantages which flow from this high valuation of wealth are captured largely by unions on their feather beds, or by those consumers who are cross subsidised by the profitability of the enterprise.
An Ideal Measure of National Wealth
The potential wealth of Australia would be the sum of all individual wealth calculations, which would capitalise the potential income streams available to the respective individuals. This potential measure of wealth would assume no unemployment and, for those who choose not to participate in the marketplace, would nevertheless capitalise their potential income streams which would be an understatement of the value of their preferred activities. Such a conceptual measure would bear little or no relationship to the sum of physical and financial assets observable in Australia since such calculations are inherently backward looking and focus on only those items which happen to be measured.
Such ideal calculations (see below) would demonstrate quite dramatically the wealth consequences of policies which obstruct young people from gaining jobs, which prevent the acquisition of skills, and which accord privileged work status to some while excluding others owing to occupational licensing. All these interferences in the marketplace have the effect of lowering wealth of individuals by hundreds of thousands of dollars, and of the nation by tens of billions of dollars. Of course, it is quite infeasible accurately to compute such measures of wealth, given the difficulty of measuring potential income. I would suggest that it is entirely likely that taxes on observable forms of wealth, even more than high marginal tax rates on income, would have the effect of suppressing the income streams, reducing the employment opportunities, frustrating the training and education of individuals, all with the effect of lowering our real national and individual wealth.
An ''Economic Rationalist'' Wealth Creation Package for Australia
In the table below we set out the likely wealth implications of certain economic reforms which would have the capacity to raise significantly economic growth in Australia. Our methodology is to adjust the rate of growth of income, starting from average annual earnings in 1988 ($25,000), at differing rates according to the extent of economic reforms. The overall income calculations are applied to 16 million Australians, 10 million of whom are assumed to be in the workforce.
We assume that the combined effect of policies to reduce regulatory distortions, to remove barriers to employment, to minimise tax distortions and to abolish tariff and other industrial protection measures, is to raise the growth rate by 1.5 per cent. This fairly conservative assumption is based on general deregulation and privatisation enabling 0.5 per cent increase in the growth rate, liberalisation of labour markets, with shifts towards enterprise unions, productivity agreements and other work place oriented measures also contributing 0.5 per cent to the growth rate. Lower marginal tax rates across-the-board are also conservatively assumed to add 0.25 per cent to the growth rate, as is generalised reduced protection of industry.
Starting from the basis of average earnings of $25,000 in 1988, a growth rate of, say, 2.5 per cent per annum would produce community wealth of $7,074 billion (in 1988 purchasing power) if future income streams are discounted at a real rate of five per cent. Using the same real rate of discount the ''Wealth Creation Package'' would add $2,576 billion (in 1988 purchasing power) to community wealth, bringing it to $9,650 billion. This wealth calculation for the nation can be individualised to generate a per worker increase of $257,600 in 1988 terms.
To see this most clearly, and to emphasise the role of discounting hi these calculations, the current average of annual earnings in Australia would, by the year 2038, add to $85,928 if the growth rate is 2.5 per cent but would be almost $177,667 at a growth rate of four per cent (all valued in 1988 purchasing power). If we take a shorter time horizon, for example the year 2000, average annual earnings would be $40,000 at a four per cent growth rate as opposed to $33,600 at a 2.5 per cent growth rate. The magic of higher growth rates is that they compound; just as the evils of distortions and regulations combine and compound to sap initiative and distort possibilities for increasing the standard of living in our community.
It is, of course, difficult to put accurate numbers on the effects regulation, taxes and tariffs may have on economic growth. And many will disagree as to the likely relative size of these effects. But it should be noted that growth rates of around four per cent are achievable, and have indeed been exceeded in other countries where rational economic policies have been pursued. And countries with Australia's spectacular endowments and opportunities should, we argue, achieve much higher growth rates.
In the context of the Bishops' inquiry into wealth, we suggest that the orientation needs to be towards those measures which are capable of generating higher incomes, which in turn will generate improved calculations of wealth. The table below also demonstrates that those who would further regulate the Australian economy, could lower the growth rate by, say, one per cent, with an associated wealth effect of nearly $2,000 billion in 1988 dollars.
''Economic Rationalist'' Wealth Creation Projections, (courtesy of Irving Fisher & Co). Real discount rate 5.00%
Assumes workforce of 10 million Suggested effects of deregulation and lower taxes on wealth estimates.
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