The Magazine

Taxes, Social Security & the Politics of Reform

From the November 29, 2004 issue: A Reaganite plan for Reagan's heirs.

Nov 29, 2004, Vol. 10, No. 11 • By JOHN D. MUELLER
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TWO CENTRAL ECONOMIC REALITIES of everyday life are as true in 21st-century America as when Aristotle first pointed them out in 4th-century B.C. Athens: Most wealth is owned by families living in households, not the government, and this wealth is of two kinds, people and property--or as University of Chicago economist (and later Nobel laureate) Theodore W. Schultz dubbed them in 1960, "human and nonhuman capital." But there's a key difference. Since the ownership of property can be subdivided almost indefinitely and transferred in competitive markets, everyone receives the same rate of return (other things, like risk, being equal). But human capital is embodied in people, for whom (since the abolition of slavery) there is fortunately no longer a market, and its rate of return varies with the age of the person in whom it is embodied. For example, in 1999-2000 the real rate of return on college tuition at age 20 was about 16 percent, compared with the stock market's long-term average return of 6 to 7 percent. But by age 40 your money would be better invested in property, and at about age 50 the return on tuition turns negative. (The main reason is that four years of college roughly double average annual earnings, but as we get older, those earnings can be realized for fewer years.)

Such differences between people and property have always existed, but two important changes have occurred mostly within the last century: the separation of the household and business firm, and the unprecedented increase in human lifespan. In December 1861, Abraham Lincoln could accurately report that, "In most of the southern States, a majority of the whole people of all colors are neither slaves nor masters; while in the northern a large majority are neither hirers nor hired. Men with their families--wives, sons, and daughters--work for themselves, on their farms, in their houses, and in their shops, taking the whole product to themselves, and asking no favors of capital on the one hand, nor of hired laborers or slaves on the other." In other words, human and nonhuman wealth were still mostly owned and produced by family households.

Since then, the two kinds of production have become specialized. The modern business firm, historically speaking, is a recent offshoot of the household and specializes in producing and maintaining productive property, while the modern household specializes in "producing" and "maintaining" human persons. One or both adults in every household (if not employed by a government or nonprofit organization) are typically employed by a business, which combines the services of workers and of productive property (buildings, land, raw materials, machines, patents) to produce new goods and services for sale in the market. Though most such property is directly owned by businesses, families still own it indirectly, by owning the shares and bonds issued by those companies. When the firm's product is sold--for example, when a family purchases a new car or computer--the money is paid out entirely as income to the producers: labor compensation (wages, salaries, and fringe benefits) to workers and property compensation (interest, dividends, and retained earnings or capital gains) to property-owners. In the final analysis, there is nothing else to tax.

The other key change is the unprecedented increase in the human lifespan. From ancient Rome to 15th-century Europe, human life appears to have averaged just 24 years. This meant that most people experienced only two phases of life, dependent childhood and active parenthood. As Angus Maddison has shown, it also meant there was no economic growth, because a high birth rate merely offset a high mortality rate, and most people didn't live long enough to accumulate more property than they used up. Steady advances in medicine and public hygiene increased life expectancy at birth to about 38 years in the United States in 1850 and 47 years in 1900. Since then, life expectancy at birth has risen by more years than in the previous five centuries combined--to about 80 for women and 75 for men. As a result, most people now experience four distinct phases of life: dependent childhood, active parenthood, the "empty nest," and retirement. Longer life has caused a sharp increase in investment in both people and property, and thus faster economic growth, because the returns can now be realized for many more years. These basic facts account for the pattern of lifetime earnings shown in the chart on the following page.