(This essay was published in Hong Kong Economic Journal on 18 September 2013)

 

There is a growing belief in rich developed societies that the trickle down effects of economic growth are not working to help the poor. This has fed skepticism about the effectiveness of markets in alleviating poverty. Yet in last week’s essay I cited overwhelming evidence that economic growth and globalization have played an enormous role in alleviating poverty, especially in poor developing societies. What is the correct understanding of why poverty lingers on in rich developed societies?

 

Human capital investment in these societies plays an enormous role in promoting economic growth. At the individual level it determines to a great extent the lifetime income and wealth of each person. Clearly any inequality of income and wealth in a population is predominantly a result of the unequal distribution of human capital. For this reason, how society invests in human capital can have a decisive impact on growth and poverty alleviation in today’s world. This applies to Hong Kong as well.

 

Investment to Augment Human Capital Deficiency

 

In many rich developed societies, the measured inequality of household and individual income has grown. This is well documented. What is less well known is how we identify and account for the sources of the growth in income inequality.

 

I surmise the main sources to be, in order of importance: (1) the large increase in returns to education and other human capital skills, (2) the rapid growth in elderly households due to ageing, (3) the significant increase in single parent households due to rising divorce rates, and (4) the growth in income maintenance programs that have induced some workers to leave the labor force or only work on a casual basis. Unfortunately proper and precise quantitative and empirical measurements of these sources have yet to be undertaken in Hong Kong.

 

It is not possible to consider all the factors contributing to income inequality in one essay so I shall concentrate only on the acquisition of human capital skills.

 

The amount of human capital one acquires depends on the “ability” of the person and what “opportunity” he faces. Those with higher “ability” tend to invest more in human capital and those with lesser “opportunity” tend to invest less. “Ability” is often associated with genetic endowment, while “opportunity” in most societies is associated with parental income and family background. In addition, some of the cost and technology features inherent in the human capital investment process can magnify the effects of “ability” and “opportunity” on the dispersion of income and wealth.

 

There are two primary costs of education. First, there are the direct outlay costs – tuition fees, transportation costs, books, computers, and other expenses. Second, there is the indirect cost of foregone income from not working. A person who goes to school gives up work and the income from working is lost. This is often a very substantial cost because poor families often rely on the contributions of children to help support the family. The issue of foregone cost is of course only relevant for older children for whom working is an option.

 

In general, a person with greater “ability” will invest more in human capital and a person with lesser “opportunity” will invest less. Government education subsidies often cover the direct outlay costs but seldom provide support for indirect foregone income. This means that a child from a rich family faces a better “opportunity” and is more likely to invest in more human capital than a child with similar ability who comes from a poor family. A corollary of this result is that a child with lesser ability from a rich family can invest in at least as much human capital as a child with higher ability who comes from a poor family.

 

Under such circumstances there will be some pressure for the existing inequality to be reproduced in the next generation. The prospect of inequality to continue from generation to generation is real. This will be especially true if the rates of return to investing in education and other skills are rising as they have been doing since the 1980s. As a consequence, small differences in educational attainment can lead to large differences in income and wealth.

 

For this reason, to reduce the rise of intergenerational inequality, there is a good case for administering merit scholarships to support students of high “ability” beyond that provided by government subsidies covering direct outlay costs only. Merit scholarships would be open to all income classes but would provide an additional subsidy to reduce the cost of education in favor of the poor. This would improve the “opportunity” faced by children from poor families.

 

The phenomenon of unequal “opportunity” is fundamentally a problem of “capital market imperfections”. A talented student with meager means cannot get an education loan on the market even though his potential future income is likely to be high because he cannot offer himself as collateral. Credit evaluation on human capital talent is not the sort of high risk business banks do.

 

Who should provide merit scholarships is a debatable question. I believe private charity donations or even private equity firms could play an important role, and government should not be the only provider of such scholarships.

 

Intervention Best in Early Childhood

 

But what is “ability”? What is a person’s initial human capital endowment? There are several considerations. First, the initial genetic endowment of a person matters. This depends partly on parents’ genetic endowment and also a random element of chance. Parents’ genetic endowment is not randomly determined. We know better educated individuals tend to marry better educated spouses. Positive sorting by personal attributes in marriage tends also to reproduce intergenerational inequality.

 

Second, the growth environment of a foetus also matters. A mother under emotional distress, who smokes and uses drugs, is undernourished or otherwise health compromised, and so on, would probably provide a poor physical and emotional environment for a foetus.

 

Third, the community a pregnant mother lives in may also be relevant, for example, health and sanitary conditions in a poverty stricken area or a war zone would be very different from a clean and safe environment. All these factors can have an impact on a person even before birth.

 

Initial human capital endowment is best regarded as endowment at time of conception rather than that at birth; and certainly not at 6, 12, or 18 years old, when most tests of “ability” like IQ and physical ability tests are administered. This is because a person’s human capital formation process begins from the time of conception, through birth, childhood, adolescence, and into adulthood. It is obvious a person with poor parents who grows up in a poor community, like the protagonist in American Dreams in China (中國合夥人), has to face more costly opportunities to augment his human capital and therefore puts less effort into it.

 

For this reason, policy interventions to mitigate against the adverse effects of lesser “opportunity” on human capital investments must start at an early age. In effect early interventions are preferable and more efficient at early ages. This result is underscored by a peculiar property of the relationship between human capital and learning. Learning is a process that combines one’s own time and other inputs to augment human capital. These other inputs include teachers’ time, parents’ time, classrooms, libraries, internet resources, and so on, including especially other students’ time. But the most important critical feature of all learning activities is that it must involve utilizing one’s own time in considerable amounts.

 

Investment Time and the Compounding Effect

 

Learning therefore unavoidably and automatically utilizes the accumulated human capital due to past learning activities. Since one’s own time is made more productive from past learning activities, hence, investment in human capital becomes more efficient the more one augments it.  Put simply, learning is more efficient the more one does it and the more learned one becomes.

 

Human capital improves not only our productivity at work and play, but also our ability to learn more efficiently. A more educated person learns faster than a less educated one. This result is evident from many diverse experiences we have observed in the adoption of new ideas or products. Farmers with more education tend to adopt hybrid corn and miracle rice earlier than less educated ones. Women with more education tend to use birth control contraceptives earlier than less educated ones. Consumers of the same age with more education tend to try new consumer gadgets earlier than less educated ones.

 

What is the significance of this result? It means human capital investment is like a compounding process. The more you invest in human capital the more productive you become and this lowers the cost of making further human capital investments. Table 1 below shows an important result. Two persons A and B starts off in year 1 with the same initial human capital endowment equal to 1.0 unit. But person A and Persom B spends different amount of time investing in human capital each period. The amount of time Person A spends is 20% less than Person B. After one year Person A’s human capital increases to 1.20 units while Person B’s increases to 1.25 units. This differential investment pattern continues each year. Over time Person B’s human capital becomes increasing greater than Person A’s.

 

Table 1: Accumulated Human Capital through a Compounding Process

 

 

Compounding Process

 

Same Initial Human Capital Endowments, but with

Different Amounts of Time Spent in Investment

Age/Year

Person A

Person B

1

1.00

1.00

2

1.20

1.25

3

1.44

1.56

12

7.43

11.64

18

22.19

44.41

% Gap at 12

56.7%

% Gap at 18

100.2%

 

After 12 years their relative human capital gap increases to 56.7% and in 18 years it is 100.2%. Differential investments in human capital can quickly produce very large differences under a compounding technology. The differential between them would have been even greater if they had started with unequal initial human capital endowments such that Person A has a lower level thsn Person B. On the other hand it also means that Person A could make up for his lower initial stock of human capital by spending more time investing in it so that eventually he could catch up and even overtake Person B.

 

These results show why early intervention is extremely important in building up the human capital stock of those with low initial endowments, often associated with having lesser “opportunities”, because human capital learning technology is multiplicative. How children utilize their time out of school and during summers is highly relevant for the formation of human capital among young children. Under a multiplicative learning technology, the relative human capital gap can quickly become very large even with very modest differences in the amount of time spent in learning.

 

Learning to Escape from the Underclass

 

Economic growth in the second-half of the 20th century increased the demand for highly skilled labor – those with intensive human capital. Economists have surmised that this is the consequence of the rise of new technologies in both manufacturing and service industries. This is in contrast to the experience of the first-half of the 20th century when the rise of manufacturing industries increased demand for modestly skilled labor.

 

In the transition between the two, many countries failed to extend higher education to a broader population base. This created a shortage of highly skilled manpower that fed into large increases in the rate of return to higher education. Empirical estimates from many countries have confirmed the rate of investment return to higher education have been rising since the 1980s. This effect when combined with the multiplicative human capital learning technology has produced greater income inequality across the population and reduced intergenerational upward social mobility.

 

Professor James Heckman, Nobel Laureate in Economics 2000, has shown empirically that early childhood learning, including pre-school learning, is the most critical determinant of subsequent lifetime income and wealth attainment.  His path-breaking work on inequality, human development and lifecycle skill formation, with a special emphasis on the economics of early childhood, has completely transformed our understanding of the emergence of the underclass in the U.S. and Western Europe.

 

The underclass emerges when a host of unfortunate circumstances converge on a household: the parents are poor, it’s a single parent household, there is an inability to invest in health and education in early childhood, there’s a failure to improve non-cognitive skills or correct bad habits in adolescence, there’s prolonged overdependence on handouts from the government, and finally, this same sad predicament is passed on to the next generation. Poverty then becomes locked into a vicious circle that is difficult to break out of.

 

Professor Heckman has shown empirically how both cognitive and non-cognitive skills are important forms of human capital that contribute to a person’s income. Cognitive skills refer to the ability to process thoughts and includes things such as level of consciousness, memory, awareness, ability to learn new information, speech, understanding of written material, analytical abilities, problem-solving and motor skills. These are developed before the age of eight and appear to plateau afterwards.

 

Non-cognitive skills include interpersonal skills, persistence, self-discipline, adaptability, reliability, communication skills, and other “soft” skills that are not objectively measured. Some individuals do not develop these skills early on in life, but fortunately these skills can be acquired subsequently. Heckman shows that persons with high non-cognitive skills may outperform those with high cognitive skills in the market place.

 

Policy interventions that are focused on keeping families together and supporting them appear to be crucial for helping children develop cognitive skills in early childhood. Programs targeted at enhancing learning opportunities for more deprived children are important for keeping them on the human capital investment trajectory. These interventions have to come early in life before it is too late. For this reason, I have long believed that separating cross-border families with young children by limiting entry into Hong Kong to 150 per day will contribute to the creation of a future social underclass.

 

The outcome of learning on human capital formation depends not only on one’s own time, but also others’ time. Peer effects are important. Students learn from each other. Who studies with who matters. So how schools are organized makes a difference. Recent controversies over the St. Stephen’s Girls College proposal to convert to a Direct Subsidy School is an interesting case to consider. This will be next week’s essay.

 

Reference:

 

James J. Heckman and Alan B. Krueger, Inequality in America: What Role for Human Capital Policies? MIT Press, 2005

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