In Greg Mankiw and Laurence Ball’s “What Do Budget Deficits Do?” the economists discuss the impact that deficits have on capital stock (the amount of investment in machines, computers, and equipment):
"According to the standard theory of factor markets, the marginal product of labor determines the real wage, and the marginal product of capital determines the rate of profit. When deficits reduce the capital stock, the marginal product of labor falls, for each worker has less capital to work with. At the same time, the marginal product of capital rises, for the scarcity of capital makes the marginal unit of capital more valuable. Thus, to the extent that budget deficits reduce the capital stock, they lead to lower real wages and higher rates of profit."
Instead of focusing on the deficit, I want to focus on the effect the level of capital has on the economy. The key takeaway from this paragraph is that the capital stock, or level of investment in production, drives the profitability of workers and investors.
Capital is a tool that helps make workers more productive. Capital can be something as simple as a hammer or as complex as a factory. Generally, the more capital we have, the more effective we are as workers, the higher wages we earn, and the more prosperous we are as a society.
Think of a reporter having to use a typewriter instead of a laptop. The reporter hears a story about a man biting a dog. He hops in his car and heads to the scene of the incident to get his story. He talks to the elderly lady who was out walking her cat across the street when she saw it happen. He talks to the veterinarian charged with taking care of the dog. He talks to the police officer who responded to the call. Then he rushes home to type up the story on his typewriter. After he’s done with the story, he hops in his car and drives the down to the newspaper to turn it in. It’s taken all day, but he’s filed his story, so he collects his paycheck.
Now, let’s suppose the newspaper publisher buys the reporter a laptop to use instead of that immobile, old typewriter. The reporter hears about another story. This time the man’s wife has bitten the neighbor’s ferret. The man rushes down to the scene, gets his interviews, and is off to the local coffee shop to type up the story. He finished the story, sends it to his editor, and starts on his second story for the day. He finishes two stories and collects two paychecks.
There are many things that determine the amount of investment in capital in an economy, but one of the main deterrents to creating additional capital is taxes on savings and investment. These include capital gains taxes, dividend taxes, and corporate and businesses taxes.
When there is a high taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. on capital gains, dividends, and businesses, investors might choose to use their money to go on vacation, instead of investing in businesses. This damages a country’s long-term level of well-being, as future wages, jobs and GDP diminish.
The lower level of investment leaves companies less money to invest in pencils, computers, machines, and equipment. Due to the limited number of computers, the company’s workers produce less, so they are paid less.
On the other hand, if there were no tax on capital, the capital becomes cheaper to investors. This makes the investors more willing to take risks, because the reward is higher and less expensive.
The additional capital from the more willing investors means businesses have more money to invest in their workers, be it computers for a reporter, assembly lines for a car factory worker, or riding lawn mowers for a landscaper.
The additional equipment enables to worker to do more work, at a lower cost to the employer. The increased number of news stories, car parts, or mowed lawns that the worker is able to produce means more money to the worker and more prosperity for society.
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