Order Code RL32987
CRS Report for Congress
Received through the CRS Web
Long-Term Growth of the U.S. Economy:
Significance, Determinants, and Policy
June 27, 2005
Craig K. Elwell
Specialist in Macroeconomics
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

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Long-Term Growth of the U.S. Economy: Significance,
Determinants, and Policy
Summary
The rate of long-term economic growth is the salient measure of the nation’s
ability to steadily advance its material living standard. The pace of long-term
economic growth is likely to be a center of attention in the decades just ahead, as the
U.S. economy confronts the need to undertake unprecedentedly large generational
transfers of income to pay for the retirement of the huge baby-boom generation as
well as large transfers to the rest of the world to meet the debt service costs of the
United States’ large and still growing foreign debt.
For the United States, the long-term growth of real GDP per-capita over the
last 125 years has revealed remarkable steadiness, advancing decade after decade
with only modest and temporary variation from a trend annual average rate of
growth of 1.8%. Overall, the limited variability of the rate of U.S. long-term growth,
despite major changes in economic conditions, as well as economic and social
policies, suggests that U.S. long-term growth may be governed by forces other than
typical economic variables and may not be easy to alter with conventional economic
policy. Nevertheless, the evidence of some degree of medium-term variability
suggests the possibility of using economic policy to exert some influence. It is
important to recognize that even relatively small differences in the rate of economic
growth will steadily cumulate to have large effects on the scale of improvement in
future living standards. Such an improvement would make the burden of future
transfers on workers less onerous.
Given a supporting social infrastructure that encourages and enables production
of goods and services, economic theory and evidence make it reasonably clear that
countries that have achieved sustained long-term growth such as the United States
are those that invest a sizable fraction of current income in the accumulation of
physical and human capital and have and continue to accumulate large stocks of
both. As importantly, they are also economies that have been able to steadily raise the
productivity of these two inputs through a steady advance of technical knowledge.
There are reasons to believe, despite its evident economic success, that the United
States, due to varying degrees of market failure, may under invest in each of the three
determinants of economic growth. In theory, correcting that under investment
through some form of government intervention could lead to an optimal increase in
the rate of accumulation of each determinant, and through that to an acceleration of
the economy’s rate of economic growth. Knowing that there is the potential for
improving on certain market outcomes is one thing. Designing economic policies
that will efficiently induce these improvements is another thing. The information
shortcoming about what, where, and how much to invest with which the policymaker
would have to contend will often be substantial, and greatly raises the risk that the
policy will be so blunt and misdirected that it will generate more economic costs than
benefits.
This report will not be updated.

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Contents
Definitions, Measurement, and Goals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
The Growth Record . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
The Determinants of Long-Term Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Physical Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Human Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Technological Knowledge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
The Infrastructure for Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Natural Resources and the Limits to Growth . . . . . . . . . . . . . . . . . . . . . . . . 17
Policy Implications of Long-Term Economic Growth . . . . . . . . . . . . . . . . . . . . 18
Policies to Increase Investment in Physical Capital . . . . . . . . . . . . . . 20
Policies to Increase Investment in Human Capital . . . . . . . . . . . . . . . 23
Policies to Increase Investment in Technical Knowledge . . . . . . . . . . 24
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

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Long-Term Growth of the U.S. Economy:
Significance, Determinants, and Policy
Introduction
The rate of long-term economic growth is the salient measure of the nation’s
ability to steadily advance its material living standard. That living standard advances
by increasing the economy’s capacity to produce goods and services and thereby
expanding the range of choices open to society. Today’s level of gross domestic
product (GDP) per person is 15 to 25 times that of a person alive in 1895. This
degree of improvement in material well-being is not only the result of today’s far
lower cost relative to income of directly comparable products (such as an hour of
illumination, a new suit of clothes, or a chair) but also the availability of an array of
products that defines our current standard of living (such as a cd player, air
conditioning, tv, and air travel) that were not available at any price in 1895.
Aside from the creation of new products, economic growth has also meant a
dramatic change in what we do. Agriculture has gone from the principal occupation
to that of a tiny share of the labor force. The automobile has transformed how we
move about and where we live. Higher education has become an endeavor of the
many rather than the few. Hours of work have decreased while hours of leisure have
increased.
The pace of long-term economic growth is likely to be a central focus of
attention in the decades just ahead, as the U.S. economy must confront the need to
undertake unprecedentedly large generational transfers of income to pay for the
retirement of the huge baby-boom generation. Faster economic growth leads to a
larger economic pie from which to make such transfers and makes this redistribution
less onerous for future workers.1
Another element of concern about the future burden on workers grows out of
the United States’ large accumulation of foreign debt stemming from a long
succession of large trade deficits. With a net foreign debt that now exceeds $3 trillion
and could plausibly approach $10 trillion in the decade ahead, the United States
could expect to have to make annual debt service payments to foreign creditors of
$80 to $100 billion. This means that a significant share of future output growth will
be transferred to foreigners and will not be available to improve the future living
standard of domestic consumers. Again, the eroding effect of these transfers on
1See CRS Report RL31498, Social Security Reform: Economic Issues, by Jane Gravelle and
Marc Labonte.

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future living standards of workers will be less if the annual rate of long-term growth
is greater.2
Although the trend growth rates of mature industrial economies have historically
not shown great variability, even relatively small differences in that growth rate
steadily cumulate to have sizeable effects on the scale of improvement in future
living standards. An economy in which output per capita grows at an average annual
pace of 2.0% will double in size in 34 years, while growth at 3.0% leads to a
doubling in size in only 24 years. Put another way, beginning at the 2004 level of
real GDP per capita of about $37,000, at the end of 24 years a 3% annual growth rate
generates a level of per capita real GDP of about $75,000, as compared to a level of
only about $59,000 generated by a 2% annual growth rate for the same time interval.
That extra $16,000 confers a substantial broadening of economic choices and the
ability to achieve any given spectrum of economic and social goals with less
sacrifice.
Despite its importance for future living standards, long-term growth is seldom
the explicit interest of economic policy. Nevertheless, many policies directed at more
immediate goals are likely to have implications for the speed of economic growth.
Tax policy, labor market policy, science and technology policy, education policy,
budget policy, as well as legal and regulatory policy can all have effects on the rate
of economic growth and the level of future income. If a more explicit concern with
the rate of long-term growth is thought appropriate by policy makers, then it will be
important to understand: what the salient determinants of long-term growth are;
whether the decisions of economic agents in private markets lead to a economically
optimal allocation of resources to each determinate; how could economic policy
most successfully correct for a particular market failure; and what admixture of
particular economic policies are likely to offer the best chance of achieving an
optimal rate of improvement in future living standards.
Definitions, Measurement, and Goals
There are some other distinctions about long-term growth that should be
understood before proceeding. First, long-term growth refers to an economy
increasing its productive capacity or what is usually called “potential output.” This
is somewhat distinct from short-run changes in economic activity over the course of
the business cycle, such as recovery from recession. The short-term goal is to have
the economy operate near potential output, while the long-term goal is to steadily
increase potential output.
Short-term performance is certainly going to have an effect on long-term
economic performance, but there will also be important differences in the forces
governing each, as well as different policy implications presented by each. For
example, in the short run in an economy operating below potential output due to
slack demand, monetary and fiscal policy can stimulate aggregate demand, accelerate
2See CRS Report RL31032, The U.S. Trade Deficit: Causes, Consequences, and Cures, by
Craig K. Elwell.

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economic growth and push an economy towards potential output. But these policies
may have little impact on the rate at which potential output expands. The distinct
forces that govern the growth of potential output — or aggregate supply — are the
concern of this report.
Second, analysis of long-term growth focuses on the growth of per capita
output, most often measured as real (or inflation adjusted) GDP divided by the
nation’s population, as more GDP per capita will likely be the essential requirement
for a higher standard of living. It is possible to increase real GDP per capita by
increasing the percentage of the population in the labor force or the average hours
worked by the labor force. But both of these actions are bounded in that you can only
increase the labor force up to the size of the population (and realistically the upper
bound will be well short of that) and increase the average hours of work up to 24
hours a day (and, again, realistically the upper bound will be well short of that).
Therefore, these are not actions that can cause a sustained increase in the rate of long-
term growth. This is probably particularly true for a mature economy such as the
United States’ where these labor force parameters tend to be relatively stable. More
fundamentally, one can question whether increases in per-capita GDP by such means
represents a true rise in the standard of living. As we will see, a focus on per-capita
output points to a critical requirement for long-term growth and a rising standard of
living — increased efficiency, or productivity, that is, doing things that enable each
worker to steadily produce more in any given time period.
The standard measure of economic growth — increased real GDP/population
— does not always function as a precise gauge of changes in economic welfare.
Many valuable things are simply not measured in GDP. For example, leisure time,
child rearing, and volunteer work all contribute to our well-being but they are not
reflected in GDP. Therefore, if parents decided to work fewer hours to spend more
time rearing their children, measured GDP would fall but general well-being would
not necessarily fall.
Also, many negative things can occur with economic growth that subtract from
our well-being but are not counted as decrements in measures of real GDP.
Environmental damage, increased income inequality, decreased quality of public
education, or falling public health decrease economic well-being, but do not
necessarily result in a corresponding reduction of measured GDP.
Conversely, there are things measured in GDP, such as more prisons, more locks
on doors, and expenditures to protect against terrorism, that do not easily correlate
with a rising living standard. Nevertheless, while greater GDP does not assure a
higher living standard, it provides the potential means for achieving greater well-
being by making the various elements of how we choose to define that well-being
more affordable. If we choose to work fewer hours or reduce environmental damage
then we can do so with less sacrifice of other things if GDP is greater.3
3For more discussion on the task of measuring GDP see N. Gregory Mankiw, Principles of
Economics. (Fort Worth TX: Dryden Press, 1997), pp. 477-494.

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Another important economic distinction between growth and economic welfare
is that society’s economic objective is not likely to be reaching the maximum rate of
growth that is possible, but rather, achieving the optimal rate of growth. That
economic policy has the ability to accelerate the rate of long-term growth does not
necessarily mean that it should. Because faster future growth usually means that the
economy must divert resources from the production of goods for current consumption
and toward growth-generating activities, the growth rate consistent with an optimal
balance between the level of current consumption and the raised level of future
consumption will likely be far short of the greatest possible rate.
Super-fast growth would have little appeal if the fruits of that achievement are
never consumed because they must be continuously diverted to sustaining that
growth rate. Private economic agents will make decisions in the market place that
establish a relative valuation of current versus future output, but if there is some
degree of market failure, this outcome will not be the optimal one and economic
policy can potentially improve on the market outcome.
The Growth Record
Sustained economic growth, anywhere, is a relatively recent historical
phenomenon. While our knowledge is imperfect, before 1500 there is no record of
any increase in output per capita anywhere in the world for millennia. And only after
1800 is there consistent evidence of sizeable sustained increases in living standards
across the globe. Between 1800 and 1900, output per capita in the industrializing
economies probably grew on average at 1.0% per year. Between 1900 and 2000, that
rate of growth likely accelerated to about 2.0%. This may seem to be a modest pace,
but its was a sharp break from the stagnation and poverty that had prevailed for
centuries before, and because it was a sustained rate of increase generating
cumulative gains, it was sufficient to steadily advance standards of living and
ultimately transform the world economy.4
We also observe over the last 100-year span that the rates of economic growth
across the then emerging industrial nations were fairly tightly clustered around this
2.0% pace. At the high end was Japan with an annual rate of growth averaging about
2.7%, while at the low end was Great Britain with an annual growth rate averaging
1.4%. The United States, which grew at a 1.8% average annual rate, was slightly
below average. In general, this convergence of growth paths among the industrial
economies has meant that the differences in average growth rates of per-capita output
are typically only a few tenths of a percentage point.5
For the United States, the long-term growth of real GDP per capita over the last
125 years has revealed remarkable steadiness, advancing decade after decade with
4J. Bradford DeLong, Macroeconomics, ( New York: McGraw-Hill Companies, 2002),
Chapter 5.
5Angus Maddison, Dynamic Forces in Capitalist Development: A Long-run Comparative
Study. (Oxford: Oxford University Press, 1991)

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only modest and temporary variation from the observed 1.8% annual rate of increase.
This constancy is not absolute, however. There has been short-run variability caused
by the business cycle, but on balance these short-run effects do not deflect the
underlying long-term trend.
There has also been some medium-term variability, however, that demarcates
some distinct sub-periods for U.S. economic growth. Growth decelerated to a 1.4%
pace in the 1929-1950 period, a slowdown primarily reflecting the large and
pervasive crippling effects of the Great Depression on economic activity throughout
the 1930s. From 1950 to 1973, economic growth accelerated to an above trend
average annual pace of 2.1%, as the United States (and the world) experienced a
strong economic rebound after WWII. The most pronounced deviation from the
long-term trend occurred from 1973 to 1995, with the growth rate of per-capita GDP
slowing to 0.6%. (Other industrial economies also experienced similar or larger
decelerations of economic growth.) Unlike the period of the Great Depression this
slowdown was not a matter of persistent slack demand, for the economy was most
often operating at capacity.6 The U.S. economy’s productive capacity was just
expanding at a much slower rate. While some slowing from the post-war boom could
be expected, this degree of deceleration went well below the long-term trend and why
it did so remains an economic mystery. Since 1995, the speed of U.S. economic
growth accelerated once again, reaching a pace similar to that of the immediate post-
World War II period.7
Overall, the limited variability of the rate of U.S. long-term growth over such
a long time period, despite major changes in economic conditions, as well as
economic and social polices, suggests that U.S. long-term growth may be governed
by forces other than typical economic variables and may not be easy to deliberately
alter with conventional economic policies.
Nevertheless, the evidence of some degree of medium-term variability suggests
the possibility of using economic policy to exert some influence. The reasons for
those medium-term decelerations and accelerations may reveal the do’s and don’ts
of accelerating economic growth. In the next section, the report examines the current
economic understanding of the determinants of long-term economic growth and what
the behavior of those determinants suggests to be possible channels by which
economic policy might be able to accelerate economic growth.
The Determinants of Long-Term Growth
A rising living standard is the result of increasing the productive power of
workers, causing over time an increase in the amount of goods and services the
average worker can produce per hour, or what is most often called — increased
6There were four recessions in this period, but the economy recovered from each and quickly
returned to full capacity output.
7DeLong, op. cit. For more discussion of the mid-1970s growth slowdown, the mid-1990s
growth acceleration, and prospects for the future see CRS Report RL32456, Productivity:
Will the Faster Growth Rate Continue? by Brian Cashell.

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productivity. Economists have isolated a series of factors, which through
accumulation and interaction, are thought to play critical roles for generating steady
increases in productivity and sustained long-term growth. Three factors: physical
capital, human capital, and technological knowledge are seen playing a direct role
in magnifying the worker’s productivity.
Other factors of importance play a more indirect role. These include the laws,
government policies, and institutions that come together to create a growth
infrastructure that encourages, enables and co-ordinates the economic behavior that
causes steady accumulation of physical capital, human capital, and technical
knowledge, which, in turn, together generate sustained long-term growth.
Physical Capital
Equip a worker with better tools and her productive power rises. She will be
able to dig more in an hour with a shovel than with a stick, and more still with a
backhoe than a shovel. Such tools that leverage the productive power of the average
worker the economist calls physical capital and the process of providing the average
worker with more powerful tools is termed capital deepening. To accomplish capital
deepening an economy must divert some resources from producing goods for current
consumption to the production of capital goods such as factories, machine tools,
computers, or transportation equipment. In themselves capital goods do nothing to
satisfy current wants and needs, but their use will expand the economy’s capacity to
produce goods in the future. A deferral of current consumption is the economic cost
of increasing consumption in the future. The calculation that economic agents have
made that warrants incurring this cost is that what is given up today is more than
compensated for by what is gained tomorrow.
This use of current resources for capital deepening is what the economist defines
as investment. High rates of investment lead to faster accumulation of the stock of
physical capital, and that ultimately translates into a more rapid expansion of the
economy’s productive capacity. The necessary economic corollary to investment is
saving, diverting a share of current income from current consumption. Therefore,
economies with high rates of investment will also tend to have high rates of saving.
Because it is possible for a nation to borrow from (use the saving of ) other nations,
there does not have to be an exact concordance of domestic saving and investment,
but over the long run the two do tend to be highly correlated.
The importance of investment for economic growth is suggested by the very
strong historical correlation in cross country data between rates of investment (as a
share of GDP) and rates of economic growth. For example, over the last 50 years
countries such as Japan, Singapore, and South Korea, which have had high saving
rates (25% to 35% shares of GDP) have also had high growth rates (5% to 7% annual
rates of increase in per-capita GDP). On the other hand, countries such as Rwanda,
Bangladesh, and India, with low investment rates (5% to 15% shares of GDP) have
also had low growth rates (1% to 1.5% annual rates of increase in per-capita GDP).
The United States’ rate of investment averaged about 20% of GDP over this 50
year span and, as already noted, per-capita GDP grew at an average annual rate of

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nearly 2% per annum. However, in recent years the U.S. investment rate has fallen
to about 15% of real GDP. While correlation does not necessarily indicate causation,
and the causation could run from growth to investment, most economists would
judge that there is a strong positive linkage between investment, capital deepening,
and economic growth.
Interestingly, for most of the post-war period, economic analysis of the sources
of U.S. economic growth attributed a relatively modest contribution to capital
deepening. Estimates at that time indicated that only 10% to 15% of the observed
growth rate was the consequence of the accumulation of physical capital.8 Moreover,
in the standard theoretical model used to analyze economic growth, it was not
possible to sustain an acceleration of the long-term growth rate through capital
deepening alone.9
In the standard theory of economic growth, the force that steadily dissipates
physical capital’s impact on long-term growth is diminishing returns. Successive
additions to the stock of physical capital yield steadily smaller increases in worker
productivity, to the point where there will be little growth-boosting effect remaining.
Capital deepening can temporarily boost the rate of productivity and raise the level
of income, but it cannot permanently increase the rate at which they grow. This
temporary acceleration of growth would most likely stretch out over a period of many
years, and it would, of course, leave the economy at a higher level of income than
would have otherwise occurred. In early formulations of this standard model of
economic growth, however, this temporary boost was not thought to be particularly
large.
Similarly, diminishing returns to capital also help explain why many other
economies grew much faster than the United States over the last 50 years. Whether
recovering from the devastation of World War II (such as Japan and Germany) or just
beginning the transition to an industrial economy (such as Korea and Singapore), the
undertaking of a process of capital deepening was occurring to a far smaller existing
stock of capital than that of the United States. As a result, it was incurring little or
no attenuation of productivity growth because of diminishing returns, so that equal-
sized rates of investment had a larger impact on worker productivity in these capital-
poor countries then they did on the capital-rich economy.10 Therefore, a slower
growing U.S. economy was not necessarily underperforming in relation to these
faster growing economies, rather it was just moving at the slower pace consistent
with its much larger stock of physical capital.
In the last decade and a half there has been a large increase in research on the
question of what propels long-term economic growth. One of the important
outcomes of these recent explorations has been a sizeable upgrading of the estimated
8Edward Denison, Accounting for United States Economic Growth 1929-1969.
(Washington: The Brookings Institution, 1974).
9Robert Solow, “Technical Change and the Aggregate Production Function,” Review of
Economics and Statistics, August 1957, pp. 70-92.
10CRS Report 95-900, Rapid Growth of the Asian NICs: Economic Menace or Model?, by
Craig K. Elwell. No longer in circulation but available from the author.

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effect of capital deepening on the long-term growth rate of the U.S. economy. That
effect is now judged to be near 50% of the observed growth rate of output.11 This
boost in the estimate of the productive contribution of physical capital reflects two
changes in thinking: one, an increase in the estimates of physical capital’s relative
importance in the productive process, which translates into any given increase in the
size of the capital stock causing a larger initial impact on output; and two, a slowing
down of the rate of dissipation of that initial impact by the advance of diminishing
returns due to an output-boosting complementarity effect from associated increases
in human capital,e.g. new skills.12
The likely importance of complementarity effects between the individual
determinants of economic growth points to the importance of their overall pattern of
accumulation. There is likely to be a pattern of joint accumulation that generates the
greatest boost to output. Physical capital is not only important in its own right, but
new technology will often only be applied to the production process embodied in new
capital equipment. That new machine, embodying the new technology, will be most
efficiently used if workers also have the boost in skills needed for its effective
operation. Similarly, some portion of improvements in human capital will occur
through a process of learning by doing as workers have access to the new physical
capital embodying the new technology. 13
Also, the accumulation of physical capital embodying new technology may
induce further advances in technical knowledge not likely to be captured by the
initiating investor. This type of external benefit may manifest as a learning by
observing effect as initial investors incur the costs of figuring out the best
organizational patterns for using the new technology and subsequent investors
replicate these patterns at much lower cost. For example, “mass production” was
initiated and perfected by a few firms, but once the productive benefits of this new
process were clearly evident it was quickly adopted by other firms, bringing sizeable
economic benefits to the wider economy that were not included in the initiating
investors’ profit-loss calculation.
At the microeconomic level there is evidence in the case of adoption of new
information technology (IT) technology, that a few firms will undertake significant
reorganization and make large initial investments in physical capital to take
advantage of the new technology. Once they have settled on a form that successfully
incorporates that technology in their operation, it will then be replicated in a far less
costly undertaking by competitors.
11See Dale W. Jorgenson and Kevin J. Stiroh, “Raising the Speed Limit: U.S. Economic
Growth in the Information Age,” Brookings Papers on Economic Activity, no.1
(Washington: 2000) pp. 125-211.
12N. Gregory Mankiw, David Romer, and David Weil. “A Contribution to the Empirics” of
Economic Growth.” Quarterly Journal Economics 1992, no. 107, pp. 407-438.
13Kenneth J. Arrow, “The Economic Importance of Learning by Doing.” Review of
Economic Studies, 1962, 29, pp. 153-173; and Claudia Golden and Lawrence Katz, “ The
Origins of Technology-Skill Complementarity,” Quarterly Journal of Economics 113 (3),
pp. 693-732.

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Another manifestation of production complementarity is the learning by using
effect, whereby the propagation of a new technology embodied in new investment
goods generates a burgeoning of derivative technological advances. A good example
of this effect occurred with the widespread diffusion of electrical power into
American industry, bringing with it an expanding opportunity for learning and
experimentation with this new technology, through which further technological
advances, such as the small electric motor, were developed.14 In many economies
this correlation has been found to be particularly strong for investment in machinery
and equipment.15
The probable complementarity of physical capital with human capital and
technological knowledge in the production process has possible implications for
economic policy. Because a portion the total economic benefits of investment in
physical capital are spillovers to other firms that will not be taken into the profit —
loss calculation of the potential investor, there is a likelihood that the actions of
private investors will, from society’s point of view, lead to under-investment in
acquired capital.
When there is such a divergence between the social and private rate of return
from an action, there is a possibility that public policy can be used to affect a better
economic outcome than what the private market alone would achieve. (Specific
policy responses are discussed in a later section of the report.)
Human Capital
A worker’s productivity can also be magnified by increasing the knowledge and
skills he brings to the job, or as economists call it, through increases in the stock of
human capital. In terms of the example used in the previous section, giving a worker
a backhoe who previously only had a shovel, will not boost the worker’s output until
she has also acquired the skills needed to operate the enhanced physical capital.
Human capital is most often augmented through education, not only formal education
such as grade school, high school, and college, but also on-the-job training, both
formal and informal.
As such, human capital investment is analytically distinct from increased
technical knowledge. Human capital refers to the various abilities that allow the
worker to understand and apply new productive knowledge. Technical knowledge
can be likened to the books in the library, and human capital to the ability to read and
understand what is in those books. (The invention of calculus added to the stock of
technical knowledge, whereas, taking a calculus course adds to the stock of human
capital.)
Other than its direct application to the production of goods and services,
increases in human capital in the form of researchers, scientists, and engineers will
14Warren Devine, “From Shafts to Wires: Historical Perspectives on Electrification.”
Explorations in Economic History, 63 (2), 1983, pp. 347-372.
15Bradford J. DeLong and Lawrence H. Summers, “Equipment Investment and Economic
Growth,” Quarterly Journal of Economics 115 (2), 1992, pp. 445-502.

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also likely influence the creation of technological knowledge and exert an indirect
influence on the growth of worker productivity.
Human capital is the same as physical capital in that it is also produced by
diverting resources (students, teachers, schools, and libraries) from the production
of goods for current consumption. Therefore, the accumulation of human capital is
also a form of investment: a deferral of current gain in anticipation of a greater future
gain. Also like physical capital, the accumulation of human capital will be subject
to diminishing returns.

The magnitude of human capital investment is most often measured by years of
educational attainment. By that standard, the United States over the last 125 years has
undertaken substantial investments in human capital. For the entire population the
educational attainment for members of the population who had completed their
education increased by 6.7 years for cohorts born between 1876 and 1975. 16 The rate
of increase in educational attainment was fastest from 1875 through 1951, with a
gain of 6.2 years. However, there was a sizeable slowing of this rate of increase over
the next 24 years, with a total gain in this recent period of only about 0.4 years.
The 75-year period of rapid increase in educational attainment was broadly
reflective of the nation’s steadily rising commitment of resources, beginning in the
19th century, to mass education. This occurred first at the elementary grade levels and
subsequently at the high school level, leading to better-educated young cohorts
replacing less well-educated older cohorts as time passed.

For the purpose of accounting for economic growth, however, the more
appropriate measure of human capital growth is the educational attainment of the
labor force. Trends in the educational attainment of the labor force differ from those
of the total population because of differences in the size of age cohorts and
differences in the labor participation rates by age and sex. However, data on
educational attainment of the U.S. labor force are available only from 1940. Those
data reveal a rapid gain in the educational attainment of the labor force from 1940 to
1980 followed by a substantial slowing of the rate of increase from 1980 to 2000.
Average years of schooling increased 4.4 years — rising from nine years to 13.4
years. In 1940, 70% of the labor force had less than a high school education and less
than 6% had a college degree. In 2000, only 11% had less than a high school
education and 28% had a college degree. Increases in college education have been
an important source of the rise of educational attainment in recent decades.
Nevertheless, the two decades since 1980 saw the slowest gains in educational
attainment of the labor force of any 20 year interval.
16 This discussion of educational attainment the contribution to economic growth follows
that found in: J. Bradford DeLong, Claudia Goldin, and Lawrence H. Katz, “Sustaining
Economic Growth,” in Henry Aaron, ed., Agenda for the Nation (Washington: Brookings
Institution, 2003). Studies that find similar results are: Dale Jorgenson, “The Quality of the
U.S. Work Force, 1948-1995” unpublished paper, Harvard 1999, and Daniel Aaronson and
Daniel Sullivan, “Growth in Worker Quality.” Economic Perspectives 4Q (Chicago:
Federal Reserve Bank, 2001).

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Increases in educational attainment of the average worker for the time period
1915 to 2000 is estimated to have directly contributed, on average, about 0.35 % per
year to the rate of growth of per capita real output, or about 20% of the 1.8% trend
growth rate of per-capita output.17 This contribution, however, does not include any
estimate of the hard-to-calculate indirect benefits that the growth of educational
attainment might have had on the growth of new technology and through that on
productivity.
In contrast to physical capital, a large proportion of human capital accumulation
in the U.S. economy has been the result of some form of government subsidized
schooling. This reflects an explicit or implicit belief that human capital investments
would be under supplied by the private market. The chief economic rationale for
public provision of education is that capital market imperfections and financial
liquidity constraints of lower income families would cause sub-optimal investment
in many types of human capital.
It can also be also argued that education generates external benefits that are not
going to be tallied in the rate-of-return calculation of the private investor, leading to
an undervaluation of the rate of return to education, and from society’s viewpoint an
under investment in human capital. These external benefits could include facilitation
of the exchange in ideas, expansion of opportunities for imitation, and learning by
doing.
Another potentially important externality associated with human capital
investment was discussed in the previous section on physical capital —
complementarity in the production process. In this case, it is a result of investments
in human capital having positive effects on the investment of physical capital. For
example, an entrepreneur may not be willing to make a substantial investment in
physical capital unless there is also a sufficiently large pool of skilled labor for the
new enterprise to draw upon. Again the implication is that the private market by itself
is likely to under invest in education and human capital accumulation.
Despite ongoing large public investments in education could there still be
significant degree of market failure that causes the U.S. economy to under invest in
human capital? Given the historical importance of education in generating U.S. long-
term economic growth, it is reasonable to be concerned that the recent slowing of
the growth of educational attainment may undercut the United States’ ability to
sustain the pace of economic growth in the future. Also, evidence of very high rates
of return to specific types of education, and education support programs for sub-
groups of the population, suggest that it may still be possible to boost the rate of
economic growth through further corrective public policy initiatives in these areas
of human capital accumulation.
17 See DeLong, Goldin, and Katz, op.cit., and Jorgenson and Stiroh, op.cit.

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Technological Knowledge
In economics, the phrase ‘technological knowledge’ refers to the way scarce
inputs are brought together to produce desired goods and services. Whether the
growing of wheat, the manufacture of automobiles, or the development of a new
drug, the steady improvement of technology over time, by allowing the production
of more and better output from any given endowment of economic resources, is the
“engine” that drives long-term growth and sustains improvement in the nation’s
economic well-being.

In the analytical framework of the most widely accepted models of economic
growth, advancing technological knowledge plays the critical role of pushing back
the onset of the diminishing returns that would otherwise steadily reduce over time
the productivity-raising and growth-sustaining ability of successive additions to the
economy’s stocks of physical and human capital.
The magnitude of the contribution of advances in technological knowledge to
long-term economic growth has recently become a matter of some debate among
economists. The issue is not whether a steady improvement in technological
knowledge is what ultimately sustains long-term growth, but rather the size of its
effect and what factors determine that improvement. The seminal post-war literature
on growth generally attributed about 75% of the growth in output per labor hour to
technical progress. In these studies technical knowledge and its output impact were
not estimated directly, but derived as a residual that remained after the easier-to-
measure contributions of physical and human capital to economic growth were
estimated. It was recognized that this residual was probably also picking up the
contributions to output of other unmeasured forces such as resource re-allocation,
economies of scale, and unmeasured capital and labor. Nevertheless, advancing
knowledge was still thought to be the most important force generating U.S. economic
growth.18
Moreover, from the standpoint of economic policy, this model of economic
growth indicated that technical progress was determined by extra-economic forces
such as the progress of science, demographic patterns, and the existence of cultural
attitudes and socio-economic institutions that govern incentives to save and invest.
In general, these are determinants of technical progress and long-term growth that are
unlikely to be significantly influenced by economic policy.
More recent research has changed this picture somewhat. As already noted
above, more recent investigations have led to an increase in the estimated
contribution to economic growth attributable to both the accumulation of physical
and human capital and, in turn, a commensurate reduction of the estimated size of
technological knowledge’s contribution. It is still very important, however, as it
likely accounts for 40% to 50% of the rate of growth of real GDP per worker hour.
18 See Solow, op.cit. and Denison, op.cit.

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Recent research on economic growth has also taken a closer look at the likely
determinants of technical progress, looking to explain this phenomenon as the
consequence of purposeful economic behavior, influenced by typical notions of risk
and reward, and perhaps open to influence by economic policy. The various versions
of these new models are categorized under the heading: endogeneous growth
theories. This simply means that the advance of technical progress is explained by
the theory and not just taken as an unexplained external force.19 It would be
inaccurate to say that endogenous growth theories have supplanted the standard
model, but they have induced a more economically realistic rendering of the very
important process of accumulating a stock of technical knowledge.
The recent economic analysis of advancing technological knowledge proceeds
very much like the analysis of physical and human capital. At any point in time, the
economy possesses a given stock of technological knowledge. By continually adding
to that stock it continually expands the productive potential of the economy, that is,
generates sustained long-term economic growth. These actions taken to add to the
stock of productive knowledge are also a form of investment in that the accumulation
only occurs by channeling some of society’s scarce productive resources away from
the current production of final goods and services. Scientists, engineers, research
facilities and equipment are scarce productive resources that could otherwise have
been used for the current production of final goods and services, and are the
opportunity cost of producing technological advance and sustaining long-term
economic growth. It is the prospect of future gain that will exceed these costs that
drives the accumulation of technical knowledge in a market economy.
Measuring the stock of technological knowledge is a problematic undertaking,
however. A more tractable task is an accounting of the flow of endeavors that most
likely lead to additions to that stock. Factors thought indicative of investment in
technological knowledge that can be measured include changes in the number and
share of scientists and engineers in the labor force, the level and intensity (share) of
spending on research and development (R&D), and the rate of issue of new patents.
Based on such measures, the United States (and other industrial economies) has
demonstrated over the last century a rising commitment of resources to creating
technical knowledge, but there is some evidence of a waning of some elements of
these efforts in recent years.
The most basic input to the production of knowledge is the number of heads
devoted to the task: more thinkers tend to generate more ideas. The number of
scientists and engineers engaged in R&D in the United States has increased
dramatically. From 1950 to 1990 the number grew from less than 200,000 to nearly
1,000,000, or an increase from about 0.25% of the labor force to nearly 0.75%.
A more comprehensive indicator of the resource commitment to the production
of technical knowledge is economy-wide expenditures on R&D. R&D expenditures
have also steadily increased, rising from about $25 billion in 1953 to over $250
19See Paul Romer, “Endogenous Technical Change.” Journal of Political Economy, 89 (5),
1990, pp. 71-102; and Charles I. Jones. “R&D — Based Models of Economic Growth.”
Journal of Political Economy,103 (August, 1995)pp. 759-784.

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billion in 2002. As a share of GDP, however, R&D expenditures have not shown a
sustained upward trend, rising from about 1.4% in 1953 to a peak value of nearly
2.9% in 1964, but since then fluctuating around 2.5% of GDP, standing at 2.6% of
GDP in 2002. The steadiness of this share indicates that the United States has not
increased the intensity of its research efforts in step with the size of the economy.
This steadiness also masks a significant change in the source of funding for R&D.
Industry share has risen and that of government has fallen. This change likely has
implications for the type of research being funded and the social return forthcoming
from the investment.20
There is an imperfect understanding of the nature of the translation from
resource inputs, to knowledge creation, and then output growth, making evaluation
of the economic significance of these efforts imprecise and generally qualitative in
nature. For example, while economists may be reasonably confident that here is a
positive causal relationship running from the level of resource commitment in R&D
to the rate of advance in technical knowledge, the exact character of the
transformation is not known.
It is known, however, that the inherent characteristics of knowledge create a
substantial bias against market-driven behavior investing enough in its creation.
Improving technology is largely a process of generating new ideas. To the extent that
new ideas lead to profitable outcomes, and those profits can be secured by a private
firm or individual, the market economy will generate new ideas and foster
technological change.
An inherent attribute of ideas, however, is that they are non-rival, as my using
an idea does not preclude someone else from using it. Further, ideas often have the
attribute of limited excludability, meaning the owner of the idea will find it difficult
or impossible to collect a fee from others who benefit from it. These attributes cause
a divergence of private benefit and social benefit, meaning what the creator of the
idea can expect to gain less than what the overall economy can expect to gain. In this
situation (as already observed with investment in physical and human capital) we
would expect the rate-of-return calculation that guides the investment in idea
production decision of the private investor to undervalue projects’ true benefits and
bring forth less than the socially desirable level of R&D effort.
Therefore, the creation of technical knowledge is an activity likely subject to a
significant degree of market failure. This will usually mean that it is an activity that
may warrant some level of government support if it is to be done on a socially
optimal scale.
20 Data on science related employment and research spending was taken from: Science and
Engineering Indicators — 2004, National Science Foundation.

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The Infrastructure for Growth
While accumulations of capital and knowledge are the instruments that directly
determine the pace of medium-term and long-term economic growth, they are not by
themselves sufficient to assure that an economy will be on a path of sustained
improvement in economic well-being. That outcome will also likely be the
consequence of the existence of an interlaced group of conditions and attributes that
form an “infrastructure for growth” that enables and encourages the forward-looking
acts of accumulation and invention that propel economic growth. This infrastructure
is comprised of laws, government policies, socio-economic institutions, and cultural
attitudes that are conducive to the entrepreneurial activity that generates sustained
long-term economic growth.21
Economic history provides examples of the critical role of the growth
infrastructure. In the fourteenth century, China stood far ahead of Europe in its
inventiveness, accumulation of technical knowledge, and capacity for the
accumulation of physical and human capital. Yet by the sixteenth century, it was
Western Europe that was set to initiate the “industrial revolution” and China had
lapsed into a state of economic stagnation. While there is disagreement about the
complete explanation for China’s failure to sustain long-term growth, economic
historians see a key factor being the emergence in the Ming dynasty, that had come
to rule in this period, of a general lack of institutional support for enterprising
behavior. The admixture of a large controlling bureaucracy, the absence of political
opposition, and the Ming rulers’ preference for stability over surprise were likely
inimical to economic growth.22
A more recent example of the adverse effect of an unsupportive growth
infrastructure is the case of Argentina. At the end of the 19th century Argentina had
one of the world’s highest levels of per-capita income. But by the end of the
twentieth century, it had fallen to less than half that of the United States. Again, the
decline is thought to be, in part, the consequence of government policies that
discouraged investment and invention, and undermined economic growth.
Examples of the obverse, growth miracles rather then growth disasters, can also
be cited. The biggest example of the favorable interaction of capital and knowledge
accumulation with the concurrent development of an growth-enabling infrastructure
is post-World War II Japan. That country had been an industrializing economy since
the 1870s, but its rate of growth of per-capita output had been no better than
moderate in this pre-war period, with per capita output never surpassing 25% of the
U.S. level. After the war, however, the initiation of significant institutional reforms
improved that economy’s growth infrastructure and was likely a major reason for the
dramatic acceleration in the pace of Japanese economic growth over the next 40
years, far outpacing that of the United States and increasing Japan’s per-capita
income to nearly 70% of that of the United States. Other east Asian economies such
21For a more extensive discussion of growth supporting infrastructure see Charles I. Jones,
Introduction to Economic Growth. (New York, Norton & Company: 1998)pp. 127-145.
22See Joel Moyker, The Lever of Riches. (New York, Oxford University Press: 1990)

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as South Korea, Singapore, and Hong Kong are more recent examples of the positive
influence of a well conceived “growth infrastructure” on long-term growth.
An institution seemingly of central importance to economic success in general
and achieving sustained economic growth in particular, is the market. A system of
markets is a social mechanism widely revealed to greatly facilitate making the basic
economic decisions all societies face: deciding what to produce (including decisions
about investment in physical capital, human capital, and technological knowledge),
deciding how to produce it, and deciding how to distribute what is produced.
At root, markets are an information gathering and dissemination system that
directs and coordinates the actions of myriad economic decision makers with great
efficiency, leading to outcomes that are consistent with maximum economic welfare.
The former Soviet Union is a clear example of the economic inefficiency and poor
economic performance of a non-market economy. It was certainly able to accumulate
capital and generate some measure of economic growth, but in general the outcomes
were well short of any reasonable reckoning of a steadily rising living standard for
the average citizen. Of course, the poor performance of the Soviet economy was an
important reason for the ultimate collapse of the communist regime there.23
The discussion above has implied that government is likely to be an institution
with a potentially strong influence, good or bad, on the structure and operation of an
economy’s growth infrastructure, and through that an influence (good or bad) on
long-term economic growth. The positive role of government is likely to involve
matters of prescription as well as proscription. While there is no single template for
success, many economic historians think that when governments create an
infrastructure that on balance encourages production and investment, economic
growth occurs. On the other hand, if government on balance encourages diversion,
economic growth is imperiled. Investors will not invest if there is not reasonable
confidence that the returns on that investment will be theirs and not diverted to others
by government.
Government as the maker and enforcer of laws can militate against the corrosive
effects on economic incentives of corruption, bribery, fraud and theft. A function of
law of central importance for all economic transactions is the establishment of
property rights and the conditions of their transfer from one economic agent to
another. This is of importance not just for real property, but also intellectual property.
As we know, new ideas are the engine of long-term growth, but due to non-
excludability the social return will often be greater then the return to the creator of
the idea. Patent laws and copyright laws serve to bring the private return closer to
the social return and thus encourage idea creation.
Modern government can also contribute to the growth infrastructure through
the pursuit of macroeconomic stability. Inflation, by essentially raising the “noise
to signal ratio” in price information, degrades the market’s ability to efficiently
23For a fuller discussion of the role of markets as effective tools for efficient decision
making by countless economic agents see Thomas Sowell, Knowledge and Decisions,. (New
York , 1984).

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CRS-17
allocate economic resources, including those that determine the pace of economic
growth. Recession and depression deflate the incentives for investment and other
forward-looking economic activity. While the swings of the business cycle are
unlikely to be avoided, macroeconomic policy can modulate its amplitude and
minimize its potential negative effects on economic growth.
The problem of the business cycle reminds us that markets do not always
function perfectly, that there will be instances of market failure. As was discussed
above, markets can fail at the microeconomic level. Physical capital, human capital,
and technological knowledge can all have varying degrees of the properties of being
non-rival and of limited excludability so that the social benefit of investment in these
factors of production may exceed the private benefit (i.e., return to the investor). In
this circumstance the market will not accurately price these factors and there will be
a tendency for the acts of economic agents in the markets to lead to an under
allocation of resources to these endeavors. Therefore an important aspect of
government’s role in the operation of a growth infrastructure would be to forestall
or compensate for such market failures.
Of course, the practical task facing government in correcting for market failure
is likely formidable because the properties that prevent accurate pricing by the market
will also likely mean that government policy makers will find it difficult to accurately
target the source of the market failure and accurately gauge the extent of the under
allocation. The risk in a large highly interdependent market system is that an
inaccurate or poorly calibrated attempt by government policy to correct for market
failure in one area may cause more costly distortions in an other area.
A government’s tasks extend beyond promoting long-term economic growth,
of course. But the other things government does are often likely to have some
economic repercussion. Taxation, regulation, operation of the legal system, social
safety-net programs and national defense all represent some use of resources that
otherwise could be directly applied to investment and economic growth. These are
actions that may tend to lower economic growth, but also raise overall welfare of
citizens. Issues of importance for long-term growth due to such activities are likely
to be the magnitude of the diversion and the degree of neutrality of the diversion on
economic decision making, particularity the decisions to save and invest24.
Natural Resources and the Limits to Growth
Does depletion of supplies of exhaustible natural resources place a limit on
economic growth? This has been a recurring critique of the economists’ view of a
seemingly unlimited upward path for living standards. While it is a possibility,
economists see it as an improbable event. Despite strong economic growth for more
then a century, most commodity prices (adjusted for inflation) have not risen and
many have fallen, suggesting that supplies of most commodities are at least keeping
up with demand and preventing any increase in relative scarcity of commodities. Part
of the reason for this has been the steady discovery of new reserves of many natural
24See Stilitz, op.cit., Chapter 1, for more discussion of the economic roles of government.

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CRS-18
resources. Finding new reserves, however, is likely to be a bounded process that can-
not be relied upon to increase the supply of particular natural resources forever.
There have been other important offsets to resource scarcity, however. The
form of many of the advances in technical knowledge are innovations in machines
and methods that eliminate or greatly reduce the need in the productive process for
commodities that have grown in relative scarcity. Plastic replaced tin in containers,
fiber optic cable replaced copper, and more fuel efficient engines replaced gas
guzzlers. These are cases where market incentives have likely induced advances in
technical knowledge. As the relative scarcity of a natural resource increases and its
market price rises so does the economic incentive to find less costly alternatives. A
current example is the sharp increase in the use of hybrid automobiles in response to
rising gas prices. One cannot guarantee that technical knowledge will always be able
to forestall running out of commodities, but the record so far has been very good.
Another counter-force to the rising scarcity of exhaustible resources is
economies of scale. In many instances, productive processes exhibit increasing
returns to scale: as output rises there is a less than proportionate increase in the use
of inputs. So with economic growth, the resource intensity of output falls, causing
a slowing of the drain on commodity supplies. Historically for the United States,
economies of scale have contributed around 10% to output growth. Again, what was
true in the past need not carry into the future, but the record cannot be ignored either.
Markets can also take into account considerations of future resource needs and
allocate resources efficiently between the present and the future. If the owner of a
resource anticipates that rising scarcity will push its price much higher in the future,
then he could hold those resources for sale at that future date. Thus the use of some
of today’s supplies of resources gets pushed forward in time. The market is making
provision for the future’s need for this resource. Of course, looking into the future
is a task filled with uncertainty, and it is possible for market failure to occur. It is
unclear, however, that government intervention in this case would do a better job of
predicting future resource needs.
Policy Implications of Long-Term Economic Growth
Understanding what determines long-term economic growth does not
necessarily mean that economic policy should be used to affect it. That faster
economic growth is possible does not necessarily mean it is desirable. There is
always a strong presumption in the efficacy of the “market” to get things right,
including the rate of investment in physical capital, human capital, and technological
knowledge. Market failure can occur, however, when goods have attributes that
preclude market prices from fully reflecting the economic value of an activity. If a
market failure is present, economic policy can, in theory, be used to improve on the
market outcome and raise economic welfare.
In thinking about using economic policy to overcome some form of market
failure, it is important to recognize there will often be a distinction between a market
failure’s “economic relevance” and its “policy relevance.” Economic analysis may

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CRS-19
indicate that a significant market failure is occurring and its correction could generate
large economic returns. This, however, does not mean that it will be particularly easy
or even possible to craft a policy to correct for the market failure without also causing
distortions and other inefficiencies that will lead to the policy generating more
economic cost than economic benefit. The often incomplete information about the
market failure’s precise location, extent, and degree of interconnection with other
economic activities elevates the risk of the policy creating more inefficiency than
efficiency and doing more economic harm than a good.25
In the preceding section of the report on the determinants of economic growth,
economic theory and evidence established reasons to suspect that, due to various
forms and degrees of market failure, the U.S. economy under invests in physical
capital, human capital, and technical knowledge. Therefore, the potential likely exists
for various forms of economic policy, by correcting or compensating for these market
failures, to accelerate the rate of economic growth and boost future living standards.
In the cases of physical and human capital, economic analysis indicates that the
growth-accelerating effect may be temporary, but it would endure long enough to still
lead to a significant permanent increase in the level of GDP.
Most economists would agree that the “engine of long-term economic growth,”
the force that sustains a rising living standard decade after decade, generation after
generation, is the production of new ideas, or what this report has subsumed under
the term “technical knowledge.” There is less agreement over what governs the rate
of advance of technical knowledge and how it might be influenced by economic
policy. Some would argue that the level of resource commitment to R&D is an
important determinant of the long-term growth rate and also an activity where a
greater degree of public support is warranted.
On the other hand, the acceleration of economic growth commencing in the last
half of the 1990s occurred without any increase in R&D intensity. Also the marked
historical stability of the U.S. long-term growth rate of real per capita GDP (at a
1.8% average annual rate) for more than 125 years, despite significant changes in a
broad array of economic circumstances and policies over this long time span,
suggests to others that the generation of technical knowledge and, in turn, the long-
term growth rate may be propelled by deeply embedded social forces that are not
likely to be manipulated by economic policy.
Of course, if a boost in R&D activity only leads to a temporary medium-term
increase in the pace of economic growth it will still have a beneficial effect on future
living standards.
As regards the invariability of the long-term growth rate, it is also true that the
United States has never really pursued a well-defined and orchestrated long-term
growth policy. The closest approximation was the 1950s and 1960s, when the
confluence of high rates of investment in physical capital, human capital, and
25For further discussion of market failure and the public policy response to it see Joseph E.
Stigler, Economics of the Public Sector, Second Edition (W.W. Norton & Company,
NewYork: 1988) pp.71-89.

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technical knowledge was also a period when economic growth was significantly
above trend. Even here it is hard to isolate specific economic policies that
contributed to this higher rate of growth. We do observe in this period, however, a
rising government commitment to R&D spending, although a sizable share of this
R&D was for defense related programs. It was also a time of increased government
support for higher education through the GI Bill and other programs. There were
also periodic attempts to use the tax code to encourage business investment in
physical capital. It was also a period when maintaining economic stability became
a central task of government.
The remainder of this section will examine specific economic polices to boost
investment in the three principal direct determinants of economic growth and, in turn,
accelerate economic growth.
Policies to Increase Investment in Physical Capital. The first question
to be answered in regard to investment in physical capital is whether the market
failure to be countered is a problem with the investment goods themselves (i.e.,
complementarities with other factors in the production process) or with the saving
behavior (i.e. a saving rate that is to low) that finances investment. The economically
appropriate policy response would likely be different for each.
Raising the Saving Rate. The low saving rate of the U.S. economy has been
a matter given considerable scrutiny over the last 25 years. The economy’s overall
saving rate is the confluence of saving undertaken by businesses, households, and
government, but only the last two have been the source of the fall of the overall
saving rate. The more dramatic change and the least understood is the precipitous fall
of the household saving rate, down from around 7% of GDP in the 1970s and 1980
to near zero today.
The fall of the household saving rate has been the object of much economic
research, but the reasons for the decline remain problematic. No single theory can
fully account for the phenomenon, but three have considerable plausibility. First,
capital gains on real estate, stocks, and other investments, particularly in the 1990s,
have greatly increased household wealth. Economic theory predicts that a rise in
wealth can reduce the need to save and increases the tendency to spend. Second,
increased government outlays for Medicare and Social Security transfer income from
a relatively high saving segment of the population to a relatively low-saving segment.
Third, more streamlined credit market vehicles, such as credit cards and home equity
loans, have removed constraints on household liquidity and prompted increased
spending (and reduced saving).26
The fundamental issue, of course, is whether the decline of the saving rate is
largely the result of optimizing behavior by households to establish a preferred
balance between current and future consumption. If it is the result of optimizing
behavior on the part of households, the size and abruptness of the fall of the
household saving rate suggests a quite startling reduction in the value placed on
26 See CRS Report for Congress RS20224 , The Collapse of Household Saving: Why Has
It Happened and What Are its Implications?, by Brian Cashell and Gail Makinen.

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future consumption, or with the risk associated with realizing that future
consumption. Some doubt that such a change could be the exclusive result of
optimizing behavior and further suggest that it is at least as likely to be the
consequence of an imprudent rise in economic impatience or myopia resulting from
changes in institutions or social conventions. At present, economists can give no
definitive answer to the question of whether the low household saving rate is optimal
or sub-optimal.
If it is judged to be sub-optimal, then the issue becomes: how can economic
policy best affect an increase in the U.S. saving rate? The debate about raising the
household saving rate has centered on the U.S. system of taxation as it works as a
disincentive for saving, or as it could be used to raise the incentives for saving. The
concerns have included high tax rates on interest income, the double taxation of
dividend income, and the inheritance tax. All are widely cited characteristics of the
tax system that are disincentives to save. Incentives for saving are provided by the
deferred tax liability offered by IRAs, 401(k), and Keogh plans. Expanding the
availability and flexibility of such plans is seen by some as a means for raising
household saving. Elaborations on this same theme are proposals to shift the basis
of the whole tax system from an assessment against income to an assessment against
consumption, thereby exempting all household saving from taxation.
One criticism of such proposals for raising the incentive to save is that they will
also lead to a sizeable reduction of the tax burden on higher income households, who
tend to save a larger share of their income, and a sizeable increase in the tax burden
on lower income households, who tend to save a smaller share of their income. This
result is in conflict with many people’s notion of fairness.
Another criticism made by many economists of private saving incentive policies
is their doubtful effectiveness at raising total saving. There are doubts about whether
there is a significant positive effect on private saving and there are doubts about the
ultimate effect on total saving, even if the private saving rate is increased. Doubt
about a positive effect on private saving arises first because of the apparent
inelasticity of saving to changes in the rate of return (i.e., raising the after-tax rate
of return will not induce large increases in saving); and second, because such
incentives will have two opposite impacts on saving behavior. A substitution effect
stemming from the raised rate of return, which tends to increase saving, and an
income effect stemming from the increased wealth of the household, that tends to
reduce the need to save and raises current consumption. Studies indicate these two
effects may be very close in size, so that such saving incentive programs may have
little net effect on the saving rate.
Doubt about the ultimate effect of private saving incentives on total saving arise
because tax breaks for encouraging private saving will, through their effect on the
balance of the government budget, reduce public saving (or increase government dis-
saving) and leave the prospect of a positive overall effect further in doubt.
The effect of changes in the public saving rate on total saving are far less
problematic and may be a more effective route by which economic policy can raise
saving and investment. The policy maker can be confident that policies that move
the government budget away from budget deficits and toward budget surpluses will

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raise both public saving and total saving. The change will not be one-for-one due to
some induced consumption spending, but it will be positive with an added $1 dollar
of public saving typically leading to an increase of $0.50 to $0.80 in total saving.27
The question about optimizing behavior that had potential policy relevance in
the case of the household saving rate is not an issue in regard to the current low
public saving rate. The state of budget balance is the result of a series of policy
decisions that reflect numerous social, political, and economic problems and goals
whose relative importance can change over time. If higher saving, higher investment,
and faster economic growth are seen as a high priority, then most economists would
judge one of the surest ways for government to support that goal is to raise the rate
of public saving by moving the budget balance from deficit to surplus.
Investment Incentives. Economists have a strong suspicion that physical
capital has positive external effects on the efficiency of the productive process due
to the effect of complementarity on other factors of production. These extra benefits,
however, will unlikely be taken into consideration by the private investor, leading
to some degree of under-investment in physical capital. In theory, this market failure
could be overcome by government policy with an appropriate investment incentive.
In practice, however, correcting this market failure is far from straightforward.
It is true that the structure of the tax system can have an influence on the
decision to invest, potentially affecting the rate of accumulation of the stock of
physical capital as well as the allocation of resources across different classes of
investment. Therefore the argument is made from time to time that the structure of
the tax system should be shaped to promote investment in physical capital so as to
accelerate the rate of economic growth. Pro-investment policies might involve more
rapid rates of depreciation, investment tax credits, or altered tax treatment of capital
gains or corporate profits. But as already discussed above, the economic issue is not
a question of whether such proposals can increase the rate of investment in physical
capital, but whether that increase is economically optimal.
The prevailing view among economists is that while the tax system should not
unduly discourage investment in physical capital, neither should it be used as a
mechanism to directly intervene to promote it. In the absence of a true market failure
economists argue that the tax system should be neutral in its effect on all forms of
economic behavior. In the presence of some form of market failure, the daunting
information requirements for implementing an efficient investment tax incentive
policy make it likely that such a policy would cause distortions in the pattern of
investment in types of physical capital, distortions in the allocation of resources
between physical capital and other economic ends, and inefficient rent seeking
behavior. The ultimate economic effect would most likely be to decrease overall
economic efficiency and reduce economic welfare.28
27See William Gale and Peter Orszag, “Budget Deficits, National Saving, and Interest
Rates.” Brookings Papers on Economic Activity 2, 2004.
28 For further discussion of the structure and effects of the U. S. tax system see Joseph E.
Stiglitz, op. cit. pp. 534-590; CRS Report RL32808, Overview of the Federal Tax System,
(continued...)

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On the other hand, as discussed in regard to saving incentives economic theory
and evidence indicates that by running budget deficits (outside of periods of
recession) government generates a dis-incentive to private investment spending by
diverting a share of the economy’s saving away from private investors.29 There is no
economic presumption that this diversion is economically optimal. Therefore,
inclining the budget towards surpluses that add to the nation’s flow of saving and
tend to stimulate investment spending is probably the surest and least distorting way
the government can provide incentive for investment in physical capital.
Policies to Increase Investment in Human Capital. The government
has long played a large and active role in support of education. It is the dominant
supplier of elementary and secondary education and also provides sizable support for
higher education. A steady rise in the quality of the labor force has been an important
force behind U.S. economic growth over the last century, but a source of concern for
sustaining the rate of growth is the decline in the average educational attainment of
the labor force evident since 1980. Not reversing this decline is likely to ultimately
have a negative effect on the pace of economic growth and the future level of
economic well-being.30
The economic literature on education policy and human capital accumulation
is vast and it is beyond the scope of this report to relay in full. There are a couple of
issues, however, that seem to be of particular significance as they seem to offer
potentially high rates of return. High rates of return are guides to areas where an
increased allocation of resources will improve economic efficiency and raise social
well-being. From the standpoint of economic efficiency, the great likelihood of
market failure in these areas means they are likely candidates for some enhancement
of economic policies to induce an increase in the allocation of resources to these
areas.
One prominent corollary to the decrease in average educational attainment of
the U.S. labor force since 1980, has been a steady rise in the college wage premium.
Economics tells us that such a persistently high rate of return is evidence of an under
allocation of resources to an endeavor. In this case, from the standpoint of economic
efficiency, too few students are seeking college degrees. The share of high school
graduates who attend college has increased over this time period, but there are sizable
28(...continued)
by David L. Brumbaugh, Gregg A. Esenwein, and Jane G. Gravelle; and CRS Report
RL31235, The Economics of the Federal Budget Deficit, by Brian Cashell.
29In an economy such as that of the United States, that is open to international trade in
assets, inflows of foreign capital can compensate for some of the shortfall of domestic
saving, allowing the undertaking of domestic investment at a higher rate than would
otherwise occur. But in most circumstances, there will still be some dampening of domestic
investment. Moreover, the future returns of that externally financed investment will largely
accrue to foreigners and to that extent not effect an increase in domestic living standards.
30Policies to increase human capital will often have a dual benefit of improving not only the
level of output and income, but by generally having the greatest positive impact on those at
the low end of the income distribution, improve its distribution as well.

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differences in these enrollment rates across family income levels. This would suggest
that financial constraints continue to be a barrier to higher education for low to
moderate income youths and that policies that increase opportunities for financial aid
for such youths could yield large economic returns. 31
Another area that current research suggests offers large social and economic
returns would be expansion of programs that raise the quality of early childhood
education for children from low-income families. Good educational outcomes in
general are the result of a cumulative process that begins in the earliest childhood
years. Poor results in the earlier stages make subsequent success much less likely.32
Good ultimate labor market outcomes from educational enrichment programs are also
likely to depend on the enhancement of non-cognitive skills (i.e., persistence, self-
discipline, reliability, etc.) as well as cognitive skills. There is also evidence that an
important constraint on access to quality education and human capital growth by
children of low-income families is a lack of housing mobility. How to best enhance
early childhood education remains a matter of debate, however.33
Policies to Increase Investment in Technical Knowledge. Steadily
advancing the economy’s stock of technical knowledge is acknowledged by
economists to be the element of central importance for achieving long-term economic
growth. While the accumulation of physical and human capital are important
contributors to this process, it’s only in conjunction with advances in technical
knowledge that these two factors can forestall the growth-slowing onset of
“diminishing returns” that they would otherwise be subject to, and sustain long-term
growth.
But from a policy perspective, advancing technical knowledge has been
somewhat of an enigma. A sizable share of the literature on economic growth does
not deny its importance but tells us that it is a phenomenon propelled by forces
largely out of reach of economic policy. On the other hand, many economists argue
that improvements in technical knowledge are likely to be the result of purposeful
behavior and whether motivated by greed, ambition, curiosity, or altruism that
behavior is more likely to occur in an economic environment conducive to invention
and innovation. This suggests that considerations of market-determined outcomes
relating to risk and reward will influence this behavior.
It is also likely that because of the nature of ideas, private markets by themselves
will likely cause a less than optimal commitment of resources to their creation.
31See OECD, Education at a Glance 2004. (Paris, OECD: 2005); and Alan B. Krueger and
Mikael Lindahl, “Education for Growth: Why and For Whom,” Journal of Economic
Literature 39 (4), pp. 1101-1136.
32 See Pedro Carneiro, James Heckman, and Dayanand Manoli, “Human Capital Policy.”
NBER Working Paper, no. 9494, Feb. 2003.
33See CRS Report RL31123, Early Childhood Education: Preschool Participation, Program
Efficacy, and Federal Policy Issues, by Gail McCallion and CRS Report RL32871, Youth:
from Classroom to Workplace?, by Linda Levine.

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Therefore, an optimal level of investment in new technical knowledge may require
action by government to overcome this market failure.
Research by Business. Research and development is the activity thought
most closely linked to the development of technical knowledge. Business firms
undertake R&D on a substantial scale; nevertheless, they likely do less than is
socially optimal. Under investment in R&D is suggested by the estimated high rates
of social return relative to private return on a wide spectrum of research projects.
Research suggests that the level of investment in R&D undertaken by firms may be
only 25% of the economically optimal scale.34
Can economic policy entice firms to increase their R&D spending? The patent
system is one manifestation of government’s attempt to encourage inventive
behavior by providing “property rights” over new ideas. This is a well developed set
of laws in the United States but there are some questions about the patent system’s
impact on R&D activity and economic welfare. It is clear that the functioning of the
patent system involves an economic trade-off. There is an economic gain from
patents inducing more R&D by companies, but there is an economic cost to
consumers of the patented product because the limited monopoly power conferred
to the patent holder will result in the product being priced above what would prevail
in a competitive market. The magnitude of this cost to consumers will, of course,
increase with the length of time the patent is in force. In theory there will be an
optimal term for the patent that just balances the social benefit of inducing invention
and innovation with the cost of the temporary monopoly power afforded by the
patent. Some economists argue that the current patent system is out of balance, giving
too much weight to the rights of the inventor and not enough to the wider society that
bears the cost of the limited monopoly and that shorter patent terms are needed.35
There is also concern by some economists about how efficient the current
structure of the patent system is at inducing invention and innovation. The focus of
concern is the patent system being in some situations an impediment to the process
of information transfer that drives the accumulation of new knowledge.36 At one
level the patent system aids the process of information transfer. For in order to get
a patent an inventor must make a full disclosure of the details of their invention,
making the knowledge that is inherent to the invention readily available to all who
are interested. Therefore, while imitation is not allowed, others may be encouraged
to “invent around” the patent or build upon that knowledge to develop other unique
products or ideas. And the possibility of “licencing” can allow use of the new
knowledge by others. However, for some types of information important to the
34 Charles I. Jones and John C. Williams, “Measuring the Social Return to R&D,” The
Quarterly Journal of Economics, 63 (4) (Nov., 1998) pp.1119-1136.
35See Michele Boldrin and David Levine, “The Case Against Intellectual Property,”
American Economic Review, May 2002; and Adam B. Jaffe and Josh Lerner, Innovation and
Its Discontents: How the Broken Patent System is Endangering Innovation and Progress
and What to Do About It, (New York: Princeton University Press, 2004).
36See Thomas Mandeville, Understanding Novelty: Information, Technology, and the Patent
System, (Ablex Publishing, 1996).

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process of innovation, the “arm’s length” market-oriented exchange that patents
encourage are perhaps less efficient then various non-market mechanisms. The
problem arises because of the often collective and cumulative nature of information
use in the process of innovation. It is collective in that an innovation will often be
the result of of information flows between several participants, some of whom might
be business rivals. Patents may tend to rigidify and slow these types on information
transfers. It is cumulative in nature in that a current innovation will often be an
essential input to the development of subsequent “generations” of a technology.
Because of this characteristic there is concern that a patent system that strongly
protects the rights of the first generation innovator can impede the information flow
necessary for emergence of the subsequent generations of the innovation.
In general, these information transfer issues suggest that, as well as an optimal
term for the patent, there will also be an optimal “breadth” of the patent’s coverage.
Some are concerned that the current patent system is inclined toward creating an
overly wide breadth for patents and is slowing down the process of innovation. In
cases where a patented “idea” is judged likely to carry particularly large social
benefits, the government may better serve general economic well-being by buying the
patent from its creator and allowing a quicker and wider dissemination and use of
this valuable new knowledge.37

Also, in an increasingly globalized economy where the size of the market
needed to assure the profitability of a new endeavor often require foreign as well as
domestic sales, the patent systems of other nations become relevant to the domestic
business firm’s willingness to undertake some research projects. There is the prospect
that improvement in the establishment and enforcement of property rights
internationally could have a positive effect on domestic R&D activity.
Another policy device that attempts to coax more R&D out of business firms is
the R&D tax credit.38 As currently structured, the tax code allows a 20% tax credit
on R&D expenditures, with the putative effect of stimulating such expenditures by
increasing the after-tax return on research projects. While the evidence indicates that
the research tax credit does raise R&D spending by firms, many economists have
significant doubts about how well the tax credit does at targeting and inducing R&D
projects with large social benefits. It is likely that even with the credit, the investing
firm will still be inclined to undertake the research projects that offer the company
the greatest return rather than those that would offer the largest social return.
Why not use direct grants by government to firms to undertake R&D projects
that offer large social benefits relative to private return? Again, as discussed above
in regard to incentives for investment in physical capital, the information
requirements for operation of an efficient grant program is likely well beyond what
government could hope to muster. The economic risk is that a program of direct
37For further discussion of the patent system and innovation see CRS Report RL31281,
Patent Quality and Public Policy: Issues for Innovative Firms in Domestic Markets, by John
R. Thomas.
38See CRS Report RL31181, Research Tax Credit: Current Status, Legislative Proposals,
and Policy Issues, by Gary Guenther.

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grants would, by distorting the patten of investment and by encouraging rent-seeking
behavior, generate more inefficiency than efficiency.
A curious aspect of firm behavior and the production of ideas is that in
situations where the initial R&D investments for a new idea are very high, but where
once created the marginal cost of replication is very low, firms will not undertake this
endeavor unless they can expect to charge prices that exceed marginal cost.
Otherwise, insufficient profits would be earned. The first copy of the Windows
operating system cost hundreds of millions of dollars, but the cost of producing all
subsequent copies (the marginal cost) is near zero. Pricing above marginal cost,
however, violates one of the basic conditions for efficient market outcomes and
connotes the presence of monopoly power and the attendant loss in consumer
welfare. Government anti-trust policy is predicated on preventing such behavior.
Yet, in this circumstance anti-trust action would be antagonistic to invention,
innovation, and economic growth.
Research by Government. Despite government incentives, large areas of
economically beneficial research are unlikely to ever be undertaken by private, profit
seeking business firms. Most often this new knowledge will, in addition to having
large economic benefits, also have the attributes of being both highly nonrival and
unexcludable. Therefore, such research, usually called basic research, will only
emerge through government funding. Moreover, the beneficial outcomes of basic
research are often unanticipated, arguing for casting a wide net of research support
rather than a highly focused funding strategy. The fruits of past basic research have
included the development of longitude and quantum physics, the discovery of DNA
and penicillin, and the invention of the transistor and the laser.
Basic research is currently supported through the budgets of many government
agencies including the National Science Foundation, National Institutes of Health,
NASA, the Department of Energy’s Office of Science, and the Department of
Defense. Much of the actual research is done at major universities across the
country.39
One policy issue for basic research is determining the appropriate level of
government funding. The rate of accumulation of technical knowledge is likely to
rise with the level of resources devoted to it, but the speculative nature of basic
research makes it all but impossible to judge what the economically optimal size of
government spending on such research would be. The absolute level of inflation
adjusted government spending on basic research increased from about $1.4 billion
in 1953 to about $21.6 billion in 2002. The intensity of government funded basic
research, however, has fallen, decreasing from about 0.7% of GDP in 1953 to about
0.2% of GDP in 2002. International evidence has shown that there is a positive
correlation between the intensity of government-funded basic research and economic
growth. Nevertheless, the understanding of linkage between basic research and
economic growth is not well specified, making it difficult to predict the precise pay
39For an overview of current federal programs supporting R&D see CRS Issue Brief
IB10088, Federal Research and Development: Budgeting and Priority Setting Issues, by
Genevieve Knezo.

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-off in economic growth from a given increase in spending on basic research. This,
in turn, makes it difficult to say what the optimal level of such spending should be.

A second policy issue with government funded basic research is the mix of that
funding across areas of scientific inquiry. The share of government research spending
in health related areas has risen steadily for the last 30 years and has increased
dramatically over the last 10 years. Funding for life sciences now accounts for 60%
of the government’s basic research expenditures. In contrast, inflation-adjusted
funding for basic research in the physical sciences has not risen over the last 30 years
and accounts for only 10% of the government’s budget for basic research.40 Some
argue that this disparity in funding is inconsistent with the often interdisciplinary
nature of major innovations, and is a movement away from the balanced basic
research portfolio that is most likely to yield the maximum long-run return. This
argument is not that research funds should be reallocated away from health areas,
rather that there should be a more balanced increase across all areas of basic research.
Conclusion
Sustained long-term economic growth is a defining characteristic of the highly
successful U.S. economy and, perhaps more significantly, it is also a basic
presumption that undergirds American society. Economic well-being is expected to
improve for the current and each successive generation. To be able to realistically
hold such an expectation is reflective of a momentous economic achievement. Over
the long course of history, sustained economic growth has been a rarity and even
today all too many nations struggle to achieve it.
Economic historians suggest that one thing that likely demarcates past failure
from current success at achieving sustained growth, as well as the current disparities
between rich and poor nations, is the development of an infrastructure for growth.
This is an amalgam of laws, government policies, and institutions that form an
environment that, on balance, encourages production and economic transactions.
Given this supporting infrastructure, economic theory and evidence make it
reasonably clear that countries that have achieved sustained long-term growth such
as the United States are those that invest a sizable fraction of current income in the
accumulation of physical and human capital and have accumulated large stocks of
both. More importantly, they are also economies that have been able to steadily raise
the productivity of these two inputs through a steady advance of technical
knowledge.
There are reasons to believe, despite its evident economic success, that the
United States, due to varying degrees of market failure, may under invest in each of
the three basic determinants of economic growth. In theory, correcting that under
investment through some form of government intervention could lead to an optimal
increase in the rate of accumulation of each determinant, and through that an
acceleration of the economy’s rate of economic growth. In some instances, the
40See data in: National Science Foundation, Science and Engineering Indicators 2005.

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induced boost in the rate of growth may not be permanent but the level of future
income and output will be higher, nevertheless.
Knowing that there is the potential for improving on certain market outcomes
is one thing. Designing economic policies that will efficiently induce these
improvements is another thing. The information shortcoming about what, where, and
how much to invest that the policymaker would have to contend with will often be
substantial, and greatly raise the risk that the policy will be so blunt and misdirected
that it generates more economic costs than benefits.
This risk is probably the greatest with policies aimed at increasing private
investment and saving. This leads most economists to argue that the surest and most
efficient way to raise investment and saving is for the government to run budget
surpluses rather than budget deficits. This provides a general incentive to investment
in physical capital through its favorable effects on interest rates, but leaves the
decision on particular investments with the individual business firm. This may not
extract the greatest social benefit, but what is extracted is done with a minimum of
the economic cost that would result from the distortions and rent seeking that a more
focused investment incentive policy would likely cause .
The government has been a longstanding supporter of human capital
accumulation through large scale funding for education programs. These efforts have
had a substantial positive effect on economic growth. However, the slipping
educational attainment of younger labor force cohorts evident over the last 20 years
raises concern about slowing human capital investment leading to a future decrement
in the pace of long-term growth. Based on estimates of likely high economic return,
policies to improve access to higher education by minorities and members of low
income households, and policies to enhance early childhood education may warrant
more attention.
New ideas and the accumulation of technical knowledge is what ultimately
propels long-term economic growth. The production of new ideas is a process that
is unlikely to occur on an economically optimal scale without government support.
R&D activities do receive public support, but there is still concern about whether this
support is accurately targeted and undertaken on an optimal scale. Of particular
concern for public policy is spending on the basic research that is likely an important
well-spring for new ideas. Such research is largely dependent on public funding and
by some measures, that funding has been steadily waning, and tends to be very
skewed in its distribution across research disciplines. This would seem to be a
movement away from policies that have a high probability of helping to sustain or
accelerate economic growth.41
In trying to boost the long-term rate of economic growth, the policy maker faces
what is often a thankless task in that he is asking citizens to incur costs today for
gains that will only fully accrue decades into the future. In addition, given the
41It bears repeating that support for basic research alone does not produce new knowledge.
It must interact with an educated and well-prepared mind and be sustained by an
infrastructure encouraging free inquiry.

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maturity and existing strength of the U.S. economy, as well as the revealed historical
steadiness of the economy’s rate of long-term growth, it may be that economic
policies aimed at an acceleration of the economy’s long-term growth rate will boost
that rate by only several tenths of a percentage point. Nevertheless, that would be
a significant achievement and, as discussed earlier, those seemingly moderate
increases cumulate to a substantial improvement in the level of national income 25
to 30 years from now. The bulk of the benefits could be seen as largely a gift from
one generation to the next generation.
Finally, policies that encourage one growth determinant at the expense of other
determinants are unlikely to accelerate the rate of economic growth. For example,
a reduction of the budget deficit that occurs through reductions of government
spending that supports investment in education and R&D is not a pro-growth policy
mixture. Moreover, the likely interdependencies of the determinants of economic
growth suggests that a successful overall growth policy is most likely to occur by
generating a balanced advance of investment in each determinant of economic
growth so as to gain the fullest benefit from their complementary influence on each
other.

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