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HALE-IAW PART 3: BROADENING OUR DEFINITION OF THE CAPITAL STOCK
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PART THREE: BROADENING OUR DEFINITION OF THE CAPITAL STOCK
5. Correcting GDP for natural capital
a Depletion of natural capital
b Climate change
6. Changes in human capital
a Formal education
b Early childhood development
d An alternative snapshot of net changes to the
natural and human capital stock
7. The distribution of income
5. Correcting GDP for natural capital
Both GDP and NNI are measures of the flow of annual income or production.
They measure the flow of economic value creation from year to year.
However, in creating an index of wellbeing we care not only about the value
we generate or receive today, but also what we can expect that level to be in
Such accounting is not done at all within GDP and is done only very partially –
with regard to physical capital such as buildings and equipment within NNI.
This leaves out other major sources of capital.
As Table 5 shows, the net worth of Australia’s capital stocks is many times
greater than annual levels of GDP or NNI.
Table 5: Real/volume measures of Australia’s economy ($ billion)
Key aggregate 2000-01 2009-10 % growth Value
(00-01 to as a % of net
09-10) worth (2009-10)
Real GDP 970 1,284 32.4 19
Real GNI 858 1,220 42.2 18
RNNDI 728 1,010 38.7 15
Net worth 5,562 6,888 23.8 100
Source: ABS, 2011. Australian System of National Accounts 2009-10, cat. no. 5204.0
Even given NNI’s allowance for changes in physical capital, two major sources
of capital are ignored – the economic value of our environment or ‘natural
capital’ and the economic value of the knowhow embodied in our economy or
We now examine these subjects in turn in this and the subsequent chapter.
a Depletion of natural capital
Environmental degradation can affect wellbeing in these ways:
1 The productivity of our natural resources can be impaired from
o resource depletion,
o land degradation and/or
o biodiversity loss
resulting from agriculture, mining or other development.
This can reduce the future productivity of natural resources.
2 Pollution can impose direct health impacts such as respiratory
diseases or impaired development from air-or water-borne pollutants,
poisoning or diseases.
3 The impacts above may also impair the amenity people enjoy
including from the ‘existence value’ of species or eco-systems
that have disappeared.
National accounting statistics poorly capture the last two sets of costs of
environmental degradation – pollution and amenity costs – even allowing for
a switch from GDP to NNI.
Loss of amenity will usually be invisible (12) while sickness from pollution
could increase GDP and NNI in the short term if it leads to the health sector
earning more income, although over time more of its full economic costs
will be registered if they lower participation or quality in the workforce.
These impacts can be better measured through including a separate
environmental domain as part of the overall wellbeing index.
However, we can use information in the current system of national accounts
to adjust for the most important forms of natural resource depletion and
GDP alone does not measure resource depletion satisfactorily.
Resource depletion is recorded as an economic benefit as extracted
resources are sold on the market.
But non-renewable resources are run down as they are exploited and this is
not captured in flow measures such as GDP or predominantly flow measures
It is worth illustrating what it would take for loss of amenity to be measured by national accounting.
It would require that the amenity available in the first instance be fully captured by the market.
For example, a national park might charge admission fees or attract travel costs that fully reflect its value to visitors.
Then, as a result of environmental degradation, demand to visit the park falls and income would fall along with it.
Simply to outline the kind of scenario in which national accounting might capture the value of amenity is to illustrate its
A great deal of the amenity we enjoy about places in our lives is enjoyed as a public good, available to all in the area
with fees being charged for the privilege that are either zero or some figure that is a small fraction of the true value
of the resource.
The World Bank has calculated that subsoil assets account for over 50 per cent of Australia’s natural capital, although it
does not formally include climate change liabilities in its wealth accounting estimates, given the lack of agreement over
who `owns’ carbon emissions.
Given the potential impacts of climate change on future wellbeing are very large, we consider this separately later in the
The balance sheet of the national accounts includes values for the stock of
certain natural resources – land (including rural and urban land), subsoil
assets (minerals), native timber and electromagnetic spectrum.(14)
In 2009-10, Australia’s natural resource assets were valued at almost
$3.3 billion in real volume terms,(15) and accounted for about 40 per cent of
total assets included on the national balance sheet.
Looking at changes in the national balance sheet from year to year gives us
important information about the use of natural resources.
In fact, the stock of Australia’s natural resources has increased over the past
This is because new mineral discoveries have exceeded rates of mineral extraction
and real land yields have increased, both from improved agricultural practices
but also the rezoning of land to allow higher value uses (see Table 6).
Table 6: Real/volume value of Australia’s natural resource assets ($ billion)
Type of asset 2000-01 2009-10
Land 2,506 2,749
Subsoil assets 485 638
Native timber 2 2
Total natural resources 3,044 3,397
Total assets 6,605 8,791
Source: ABS, 2011(a). Australian System National Accounts 2009-10 cat no 5204.0
Experimental estimates of natural resource depletion have been constructed by
the ABS in 2002 (for 1993-94 to 2000-01) and 2010 (for 2002-03 to 2006-07).
Both studies included an estimate of the annual incremental cost of land
This was imputed by the ABS from two national studies undertaken during the
early 2000s that reviewed the impact of accumulated land degradation on land
values and yield rates.
Other forms of natural capital, including renewable resources such as water, atmosphere and fish stocks, are not yet included in the
Natural resources are valued on the national balance sheet according to the net present value of identified subsoil and timber assets,
NPV is determined based on current production rates, prices, costs and discount rates, so that known mineral reserves that are
non-economic to exploit at current prices have an effective NPV of less than zero, and are excluded from the balance sheet.
Nominal increases in the value of Australia’s natural resource assets have been even higher, due to rising commodity prices due to the
While real asset values abstract from price rises, increasing commodity prices may increase the economic viability of known mineral
deposits, and so may increase the stock of economically useable mineral assets.
This annual cost was $377 million in 2006-07.
Assuming a constant rate of land degradation, this is equivalent to $406 million
a year in 2009-10 dollars.
The 2002 estimates calculated an annual net depletion adjustment that accounts
for the annual level of land degradation as well as subsoil depletions and
additions from new mineral discoveries.
To avoid double counting, the expenditure and depreciation associated with
mineral exploration is also removed from the underlying production or income
The updated estimates in 2010 calculated only a gross depletion adjustment
that does not take into account new additions to mineral resources.
The UN’s London Group on Environmental Accounting has recommended this
change because it does not consider that new mineral discoveries should be
classified as a produced asset and hence included in current year production
and income accounts.
Instead, under the UN standard new mineral discoveries are listed only on the
national balance sheet as a new asset (United Nations Statistics Division
Table 7: Previous ABS net resource depletion estimates
2002 Net depletion Land degradation +
estimates (18) adjustment Subsoil depletions -
Subsoil additions +
+$390m in 2000-01 cost of mineral exploration -
consumption of fixed capital
on mineral exploration
2010 Gross depletion Land degradation +
estimates (19) adjustment Subsoil depletions
-$4 billion in 2002-03
This distinction may make sense when the aim is to construct internally
consistent and complete sets of national accounts, or to isolate the cost
of using natural resources in creating current income.
The London Group has noted that recording depletions but not additions as a charge in environmentally adjusted production
and income account is asymmetrical.
However, it considers the objective of reflecting the cost of using natural resources in traditional economic accounts
through creating a measure of depletion adjusted value added and operating surplus is more important.
However, as we are concerned about the sustainability of our natural
resource use, the index should include a net depletion adjustment.
This would be calculated as the ABS did in 2002, as shown in Table 8.
Table 8: Calculating the value of net resource depletion
$ billion (real/volume terms) 00-01 05-06 06-07 07-08 08-09 09-10
Land degradation -0.4 -0.4 -0.4 -0.4 -0.4 -0.4
+ Subsoil asset discoveries 2.2 4.8 6.1 n/a n/a n/a
- Subsoil asset depletions(20) -2.5 -4.3 -4.2 n/a n/a n/a
- Cost of mineral exploration 0.5 1.4 1.9 2.4 2.2 2.2
+ Consumption of Fixed -2.2 -2.3 -2.4 -2.5 -2.7 -2.8
Capital (COFC) on mineral
= Net resource depletion -2.3 -0.7 1.1 -0.3 -0.6 -1.05
Source: Lateral Economics calculations based on ABS 5204.0 and 8412.0
N/a: Not available: not yet produced by ABS
It is noteworthy that in all but one of the years detailed above, there was net
depletion of natural capital.
That is, in each of those years other than 06-07 fewer resources were being
added to our stock of land and subsoil natural capital via new discovery than
were being subtracted from them by land degradation and mining extraction.
In 2009-10, net resource depletion was negative, subtracting $1.05 billion or
about 0.1 per cent of NNI to our economic welfare in that year.(21)
b Climate change
Though it has as hard an economic edge as resource depletion from mining or
land degradation from farming, the resource degradation humans may be
perpetrating on our planet from carbon emissions presents potentially much
larger, but also much more uncertain, costs.
Note the table is set out so that the numbers can be added together down each column to total to the net resource depletion adjustment.
The words in italics are intended to explain the calculation but invoke a double negative.
On this line we say that the calculation involves subtracting the sub-soil asset depletions, but the numbers in the table are already
We are technically proposing to add the negative numbers in the table, which is the equivalent of doing what is described in row four
– subtracting subsoil asset depletions.
Nevertheless, we have been unable to find a way of adding in the increases in the value of rural land owing to improved agricultural
Greenhouse gas emissions have been extensively modelled, and there is a
strong scientific consensus that human activity is warming the globe.
Nevertheless, it is unlikely we will ever be able to make predictions over
the long periods of time required that do not have relatively high levels
of uncertainty owing both to the complexity of weather systems themselves
and to the extent of feedback mechanisms.
Some of those mechanisms are negative and stabilising – for instance
photosynthesis of carbon dioxide into oxygen increases as the atmosphere
becomes more carbon rich.
Others more worryingly are destabilising – for instance warming releases
methane in the arctic permafrost, which will then generate more warming.
On top of this there is uncertainty about the impacts of climate change on
future economic wellbeing and more widely.
Nevertheless, considerable effort has been expended to arrive at ‘best guesses’
about most likely scenarios, and this gives us a basis on which to make
best guesses about the likely impact of climate change on our wellbeing
and the contribution we are making – or not making – to protect our future
wellbeing from global warming.
The fourth and latest report of the Intergovernmental Panel on Climate Change
(IPCC) has confirmed previous assessments that an increase in global mean
average temperature of 4 degrees Celsius (22) above 1990 levels is expected to
result in an average loss of 1 per cent to 5 per cent of global GDP by 2100.
The Copenhagen Accord agreed to target a reduction in global carbon dioxide
emissions to limit mean global temperature increase to 2 degrees.
There is a tension between including our own greenhouse gas emissions over
which we have direct control and what most directly affects our future
wellbeing, which is actual global temperature change, which is driven by global
Existing environmental indices have taken differing approaches.
The Australian GPI values the cost of Australia’s emissions by dividing the
expected cost to global GDP of global warming by the total projected amount of
carbon emissions, generating the estimated contribution of a tonne of
emissions to expected future damage.
No account is made for uncertainty about the global temperature outcome, and
tracking this variable would not tell us whether the risk of global warming was
rising or falling based on the actions of other countries.
The Yale EPI uses a distance to target approach.
This and all subsequent references to ‘degrees’ are degrees Celsius.
The 2010 EPI assumes the Copenhagen Accord reflects a global consensus
of a need to limit global average temperature increases to 2 degrees, and that
this will ultimately require a 50 per cent reduction in global GHG emissions by
2050, compared to 1990 levels, and calculates this to be equivalent to annual
emissions of 2.5 Mt CO2 per capita.
The EPI compares current per capita country emissions to this global target
of 2.5 Mt per person.
This approach would allow changes in both current Australian emission levels
and changes in the target value to be made as climate change policy evolves.
An alternative approach would be to focus on the likely impacts of future
wellbeing in Australia should significant global warming occur.
This method of calculation is set out in Box 4.
This approach would be more directly related to wellbeing, but changes
would be overwhelmingly due to international factors rather than Australia’s
Box 4:Valuing the cost of emissions
CSIRO and other scientific organisations have done significant work on the
economic impact of climate change.
This became an input into Treasury’s climate change modelling and that of
the Garnaut review to predict the future economic impacts of global warming.
The Stern Review suggested that, unmitigated climate change could reduce
global GDP by five to ten per cent in perpetuity (Stern, 2006, p. 9).
The Garnaut review concluded that Australia stands to be more affected than
most other developed countries.
It projected that the total the quantifiable economic impacts of unmitigated
climate change on Australia, such as reduced agricultural yields, more
frequent and severe natural disasters and greater prevalence of tropical
diseases would rise to reduce GDP by six per cent in 2100, compared
to the level it would reach if there was no climate change.
On Garnaut’s preferred welfare metric of GNP,(23) the cost of climate change
is even higher, reducing GNP by 7.5 per cent in 2100 (see Table 9).
Table 9: Garnaut 2008 Review estimates of the reduction in future GNP due
to climate change
Scenario Reduction in GNP (%)
2010 2030 2050 2070 2100
Unmitigated climate change 0.2 1.3 2.3 3.5 7.6
(5+ degrees warming by 2100)
Stabilisation at 550 parts 0.2 2.1 1.8 1.9 1.6
per million (pmm) CO2
Stabilisation at 450 ppm 0.2 2.1 1.75 1.7 1.3
CO2 (under 2 degrees)
Garnaut’s modelling focuses on the impact of climate change on GNP rather than GDP, because Garnaut considers GNP
a better measure than GDP of the welfare impacts on Australians of climate change and its mitigation.
This is because if Australian and global mitigation efforts include large international financial income flows from
permit trading, the income from domestic production, becomes even less relevant a measure of national consumption
possibilities (see Garnaut (2008) Economic Modelling Technical Paper 7: The net cost of climate mitigation for
Australia, p. 8 for further discussion).
Box 4(continued): Valuing the cost of emissions
The following formula can be used to calculate the impact of climate change on
Australia’s future wellbeing:
Risk-weighted cost of climate change
(NPV of the future cost to Australia from no significant mitigation scenario (a 5+
o warming) times the probability of no significant mitigation)
(NPV future cost to Australia from Copenhagen Accord scenario (a 2 o warming
times probability of significant mitigation)
(NPV future cost to Australia from 550ppm CO2eq scenario (a 2-3 o warming
times probability of moderate mitigation)
To estimate the risk-weighted depletion of natural capital through climate
change we need to calculate:
1 The net present value of future costs to Australia of various levels of
global mean temperature increases.
The recent estimates from the 2011 Update to the Garnaut review
confirm his original costs as set out in Table 9 above and so remain
The appropriate discount rate for future costs is discussed further below.
2 The most recent global emission projections.
As a starting point we compare the most recent emissions assessment
from the International Energy Agency (IEA) against the UNEP’s 2010
review of climate models.
The UNEP determined the Copenhagen pledges may just keep global
emissions within levels that provide a 50 per cent likelihood of staying
within the 2 degree limit (UNEP, 2010).
However, most recent IEA estimates are that energy-related GHG
emissions in 2010 were the highest on record and substantially reduced
the possibility of limiting temperature increases to 2 degrees.(24)
Given this evidence we have assumed that the probability of meeting
the Copenhagen target is perhaps only 25 per cent, with a 70 per cent
chance of moderate mitigation and a 5 per cent chance of no significant
The reduction in Australia’s net wealth due to climate change impacts also
depends critically on the discount rate assumed.
Box 5:How should we value costs we impose on future generations?
The full economic impact of climate change will not be felt until far into the
To determine the cost of climate change in today’s dollars we need to
apply a discount rate.
Both Garnaut and Stern used very low discount rates to value future costs of
Garnaut describes this as a normative discount rate, based on valuing the
wellbeing of a person born in future only slightly less than our own.
He uses a pure rate of time preference of 0.05 per cent and assumes real
per capita income growth in the future will be 1.3 per cent a year.
He concludes that the appropriate real discount rate should sum these two
figures to be 1.35 per cent, or 2.65 per cent if the marginal elasticity
of utility is assumed to be 2. (that is, less needs to be spent now to
benefit future, richer generations).(25)
In contrast, Nordhaus in earlier work used much higher rates of time preference
(1.5 per cent or more) to generate overall discount rates that matched the
overall cost of capital in the economy (Garnaut, 2008, p. 18–21).(26)
Using the midpoint of Garnaut’s normative discount rates, the NPV of future
reductions in GNP from unmitigated climate change is 86 per cent of GNP in
If the Copenhagen scenario is met, the NPV of future GNP losses is 57
per cent of today’s GNP.
The concept of marginal elasticity of utility is akin to the concept of the marginal utility of income discussed earlier in this report
and relates to the way we comparethe value of utility to two persons or communities – in this case one in the present and one in the
Garnaut illustrates this by reference to the following scenario.
Based on Stern’s figures, global per capita annual income today is about $7,000 whereas the growth of per capita incomes of
about 1.3 per cent until 2100 would increase that figure to per capita incomes of $100,000.
A marginal elasticity of utility of one would imply that the expenditure of one per cent of our income today (worth $70 on average for
each person on the globe) is a contribution of utility (or, if you like, economic wellbeing) that is equal to a contribution of one
per cent of the income of people in 2010, which would be $1,000.
With the appropriate discount rate being the sum of the pure rate of time preference (0.05 per cent) plus the growth rate in per capita
incomes times the elasticity of utility, an elasticity of utility generates a discount rate of (1.3 + 0.05)% = 1.35%.
It will be seen on inspection that if the elasticity of utility were 2, the appropriate discount rate would be 2.65 per cent.
The figures 1.35 per cent and 2.65 per cent provide Garnaut’s upper and lower bound for determining the appropriate normative
discount rate to apply for the purposes of comparing the costs of climate mitigation today with the benefits that mitigation
generates for later, richer generations.
Garnaut addresses criticisms of his low discount rate in his 2011 Update and concludesthat higher discount rates “would assert a
preference for equality of income distribution far more extreme than has ever been suggested as a basis for practical policy making,
for example on taxation or development assistance” (Garnaut, 2011 Update Paper 1: Weighing the costs and benefits of climate
change action, p. 21).
If the intermediate 550 ppm scenario is met, the NPV is equivalent to 60 per cent
of current GNP.(27)
Alternatively, if a real discount rate more reflective of our financial markets of,
say, four per cent was used,(28) the larger climate change impacts towards the
end of the century would be much less heavily weighted.
If so, future GNP losses from unmitigated climate change equate to 34 per cent of
today’s GNP, only slightly more than the two mitigation scenarios at about 30 per
cent to 31 per cent of current GNP.
Table 10: Risk weighted cost of climate change
Scenario Probability NPV
(% reduction in today’s GNP)
@ 2% @ 4%
discount rate discount rate
No mitigation 5% 86 34
Copenhagen target met 25% 57 30
Moderate mitigation 70% 60 31
Risk-weighted cost 61 31
As updated information becomes available on current global emissions trajectories,
we will update the probabilities of meeting the various climate change mitigation
Future updates would come from International Energy Agency’s annual World Energy
If current trends continue and the likelihood of meeting the Copenhagen Accord
target becomes less likely, then the likely damage to future economic wellbeing
will be greater, and the HALE Index of Wellbeing will fall accordingly.
Australia’s annual GDP for 2009-10 was $1,283 billion.
Using our methodology, the net present value of future climate change in 2009-10 would range from $731 billion under the moderate
warming (2-degree scenario) to $1,103 billion for unmitigated climate change.
These figures look extremely large, compared with annual GDP or GNP, but that is because we are comparing a stock with a flow.
The values we are looking at here are capital values or values of the extent to which climatechange might degrade our natural
environment considered as an asset.
Such damage being done over the nearly 90 years to the end of the century would equate to much smaller shares of annual GDP.
For example, even in the unmitigated climate change scenario, the negative effects of climate change would reduce annual GNP
in 2025 by 1.0 per cent, increasing over time to reduce annual GNP in 2100 by 7.4 per cent compared to a no climate change
four per cent was the discount rate used in the Garnaut-Treasury modelling of the pricing emission permits, based on a risk-free
real interest rate of two per cent and a risk premiumin the permit market of two per cent.
For illustrative purposes, we have assumed that from 2005 to 2010 the likelihood of
meetingthe Copenhagen Accord target has decreased by 5 percentage points each
year (from 50 per cent in 2005 to 25 per cent in 2010) and the likelihood of moderate
mitigation has correspondingly increased from 45 per cent chance in 2005 to 70 per
cent chance today.
The probability of the no mitigation target is assumed to have remained at 5 per cent
throughout this period.
Natural capital domain of the HALE Index
Resource National Apart from a brief period in 2007 when
depletion Accounts data subsoil asset discoveries exceed
depletion, net resource depletion is a
small but growing deduction to NNI
Climate Change in risk- Climate change costs have increased
change weighted cost slowly but consistently over the period.
of future They are small in value due to the slow
climate change rate of change and long time frame for
impacts to be felt
6. Changes in human capital
One prominent alternative measure of wellbeing to GDP, the Genuine Progress
Indicator (GPI), begins with GDP and corrects it for things that should arguably
be included in any comprehensive measure of wellbeing but that tend to reduce
However, as Gruen has argued (2006), while the GPI takes most opportunities to
deduct some of the less attractive things about recent economic growth from its
measure of economic wellbeing – like the costs of congestion, industrial accidents
and uninformative advertising – it pays scant attention to the positives that have
come our way as well.
This is well illustrated by the GPI’s deducting mineral depletion but not adding
new mineral discoveries.
Moreover, it makes no positive adjustment for improved life expectancy, better
road and workplace safety.
But the elephant in the room in this regard is accretions of human capital or the
knowhow embodied in Australia’s people and the technologies to which they
While the recurrent return to human capital is captured in GDP and NNI in people’s
wages, human capital itself is not directly tracked in the national accounts.
Wealth accounting exercises conducted by the World Bank have confirmed that
intangible capital, which includes human capital, technological progress and other
forms of social and institutional capital, has provided the largest wealth gains
during the 1990s and 2000s and accounts for 60 per cent to 80 per cent of total
assets – giving it many times the value of natural, physical or financial assets
(World Bank, 2011).(29)
The World Bank last calculated total wealth values for Australia in 2005.
At that time Australia's total wealth was $16.3 trillion in current dollar terms,
and had grown in real terms by $5.7 trillion, or 40 per cent, over the decade.
Intangible capital accounted for just under 75 per cent of total wealth in 2005,
more than three times the value of produced capital stocks.
The World Bank's work calculates a nation's wealth as the present value of sustainable consumption over the next 25 years.
As the present value of consumption is much higher than the book value of a nation's physical and natural capital stocks
(including net foreign assets), the World Bank imputes that the difference must be due to returns on intangible capital.
Table 11: World Bank estimates of Australia’s total wealth 2009-10
AUS$ trillion (% of total wealth)
Asset type 1995 2000 2005
Produced capital 2.5 (22%) 2.9 (20%) 3.5 (22%)
Net foreign assets -0.4 (-3%) -0.5 (-1%) -0.6 (-4%)
Natural capital (30) 0.8 (7%) 1.3(2%) 1.3 (8%)
Intangible capital 8.7 (75%) 10.5 (80%) 12.1 (74%)
Total wealth 11.6 14.2 16.3
Source: World Bank (2011), translated to 2008-09 AUD using PPP
from Penn World Tables
Australia’s human capital stock accumulates through formal education, on-the-
job training and the attraction of skilled migrants from overseas.
Similarly, skills are lost (due to emigration, unemployment, retirement from the
workforce and death).
While satellite human capital accounts are not currently produced for Australia,
ABS experimental estimates confirm that, on average, human capital stocks
have grown by well over $1 trillion during each five-year period between
In contrast, net worth as measured in the national accounts grew by only $1.3
trillion over the last decade.
It is outside the scope of this project to undertake a comprehensive human
capital stock accounting exercise.
However, we can use the World Bank’s estimate of intangible capital stocks in
2005 as a starting point.
Previous experimental estimates from the ABS valued Australia’s human capital
stocks at almost $5.6 trillion in 2001 (ABS, 2004, p. 26).
This is equivalent to about 85 per cent of the total value of Australia’s intangible
capital calculated by the World Bank for around the same time period.(31)
We have assumed that human capital itself is composed roughly from 25 per
cent early childhood learning, 25 per cent from school education, 40 per cent
from adult education, which would include both formal post-secondary
education and on-the-job learning.
The final 10 per cent is from other sources of innovation.
These relative weights are based on our judgements and on evidence gleaned
from the international literature.
The World Bank includes in natural capital subsoil assets, land devoted to cropping, pasture and timber and protected areas.
The World Bank calculated intangible capital in 2000 to be worth $10.5 trillion in 2008-09 constant dollars; this is equivalent
to $6.4 trillion in 2001 dollar terms.
The ABS’s estimate of human capital stocks in 2001 dollar terms was $5.6 trillion, or 85 per cent of total intangible capital
stocks around the same time.
For example, American research suggests that up to half of the inequality in the
present value of lifetime earnings is due to differences in development through
childhood up to the age of 18, and ABS analysis of lifetime incomes suggests
that bachelor degree qualified males earn a 68 per cent lifetime wage premium
over a person with no post-secondary qualifications (ABS, 2004, p. 21).
Once we have calibrated an opening value for Australia’s capital stock, we are
then able to track changes in the elements of human capital over time, and see
how it will change overall human capital stocks.
For example, if the quality of our school education improves so that Australian
students perform 2 per cent better on the next OECD PISA tests in 2012, we
would expect the value of our human capital from school education to increase
by 2 per cent as well.
Table 12: Human capital accumulation
Source of % of total 2004-05 Variable used to track
human capital stock $ trillion future change
Early childhood 25 3.0 Australian Early
development Development Index
School education 25 3.0 PISA test scores
Year 12 retention rates
Adult education 40 4.9 ABS Education and
Net innovation 10 1.2 Capitalised average
Intangible capital 100 12.1
While expenditure on education services forms part of our national accounts, it
cannot be assumed that every additional dollar of expenditure on education
buys a dollar of additional human capital accumulation.
Australia increased real school education spending per child by 258 per cent
between 1964 and 2003, but over the same period numeracy test results
deteriorated significantly (Jensen, 2011).
The focus on educational inputs rather than outputs is a hangover of poor metrics
on the effectiveness of educational expenditure, though like many services,
particularly those embodying professional expertise, output measures are often
far from straightforward.
Box 6 below summarises some of the means adopted to more comprehensively
track human capital growth.
Box 6:Existing approaches to tracking human capital
The OECD Better Life Index measures the quantity and quality of education
through two indicators.
Overall educational attainment is measured as the proportion of 25-to 64-year-olds
with at least a high-school qualification.
The quality of education is based on a country’s performance in the 2009
Programme for International Student Assessment (PISA) tests.
PISA is an OECD initiative that, every three years, tests the competency of
15-year-olds across OECD countries in reading, mathematics and science.
The Canadian Index of Wellbeing includes a large number of variables within
its Education domain.
These primarily relate to the different ways a person may develop human capital
depending on age.
Accordingly, human capital development of very young children is measured
through the availability of child care places and developmental health in kindergarten;
of school-aged children through student-educator ratios, PISA test scores,
high school completion rates and self-reported social and emotional competence;
and of adults through rates of post-secondary participation and attainment.
Human capital stock-flow accounts put a monetary value on a country’s
human capital stocks, based on the lifetime expected income generated by
people of different skill levels.
The ABS has created experimental human capital accounts based on information
from the Census.
Under the lifetime income approach human capital stocks will increase through
population growth and educational attainment and will decrease when a person
ages or is unemployed for long periods.
The ABS MAP headline indicator of educational progress is the proportion of
25-to 64-year-olds with a vocational or higher education qualification.
This has increased from 53.3 per cent in 2001 to 62.5 per cent in 2010.
MAP also reports education participation rates for 15-to 19-year-olds and
apparent school retention rates as supplementary indicators, as well as data
on the different types of training people receive, including work-related training
and informal training.
All data are sourced from the ABS survey of Education and Training or its annual
Even from this brief survey it is possible to conclude that all simple measures of
human capital formation are flawed in important ways.
Measures of simple inputs do not allow for the productivity with which educational
inputs are turned into human capital outputs, while measures of educational
achievement tend to be crude – focusing on the level of qualifications achieved
(whether a pass or fail was obtained) rather than the quality of those qualifications.
Our measure focuses on three different thresholds of educational attainment, giving
it at least some spread over the population.
We measure changes in:
1 rates of early childhood development;
2 schooling participation and learning outcomes; and
3 attainment of formal post-secondary school qualifications, as
summarised in Table 13 below.
An important component of human capital growth – informal and on-the-job
training – is not sufficiently well measured at present to be directly included.
Further work on such indicators through the MAP progress may provide a
sensible indicator that could be incorporated into later versions of the HALE
Index of Wellbeing.
Instead, we incorporate capitalised multi-factor productivity growth as explained
The most comprehensive measure of increases in human capital through
school-based education comes from Australia’s performance in the OECD’s
Programme for International Student Assessment [PISA].
The PISA tests are conducted every three years (latest 2009) on 15-year-olds
in all OECD countries and have been recommended by the SSF Commission
as one of the most relevant indicators for assessing the role of education for
Quality of Life (p. 164).
PISA tests the competency and accumulated learning of 15-year-olds across
literacy, mathematics and science.
Higher country test scores indicate that, on average, students in that country
have learnt more in these core subjects by the time they reach testing age.
On the PISA scale, a year’s worth of learning is equivalent to 38 points
(Ibid, p. 7).
OECD analysis suggests that increasing student participation and performance
on the PISA tests by one year of learning would lift long-run GDP by 1.4 per
cent to 2 per cent.
Australia’s PISA results in reading fell from 525 in 2003 to 513 in 2006, before
rising again to 515 in 2009.
Based on the OECD’s analysis, this 2-point increase would be equivalent to a
yearly 0.07 per cent increase in long-run GDP.
To supplement PISA results, which are updated only every three years, we also
track the apparent retention rate of secondary school students, from the ABS’s
annual Schools survey (ABS, 2011b).(32)
The years 7/8 to Year 12 Apparent Retention Rate is a measure of the number of school students in their final year of school education
expressed as a percentage of their respective cohort group in their first year of high school.
The year of commencement varies among jurisdictions (states and territories) and over time.
These variations are incorporated into calculation of ARRs at the Australia level.
b Early childhood development
Traditionally, educational interventions have been strongly influenced by
theories of education, which privilege cognitive over non-cognitive skills such
as motivation and self-confidence.(33)
However, as Heckman’s longitudinal analysis has shown, there is a strong
link between early age lack of development of non-cognitive skills like motivation
and self-confidence and subsequent dysfunction later in life as demonstrated
by higher levels of criminal activity, teenage pregnancy and educational and
employment underachievement (Heckman et al., 2006).
At the same time, improved non-cognitive skills compensate for poor
non-cognitive skills to some extent by helping to ameliorate the intergenerational
transfer of poor socioeconomic outcomes between parents and children.
In fact, Heckman’s research suggests that the return on investments in early
childhood development, such as support services for pregnant women and their
children, could be about 15 per cent to 17 per cent if savings from reduced crime,
welfare and increased taxes are taken into account.
This is far higher than the rates of return to investments in school-based or
It would be good to incorporate into our index of wellbeing a measure of the
human capital generated through the development of both cognitive and non-
cognitive skills in early childhood.
To do so we need both an accurate and timely measure of levels of early
childhood development and a sense of how to value this in terms of future
lifetime earnings and wellbeing.
The Australian Early Development Index (AEDI) is a national measure of early
childhood development, assessed by asking teachers about the development
of children in their first year of full-time schooling.
It has been adapted from a similar instrument used in Canada for almost a decade.
The first national AEDI survey was run in 2009 and measures development
across five domains –
1 physical health and wellbeing,
2 social competence,
3 emotional maturity,
4 language and cognitive skills
5 communication skills and general knowledge.
The 2009 AEDI found that 23.6 per cent of children were assessed as
developmentally vulnerable on at least one domain (34) and 11.8 per cent were
vulnerable across two or more (Centre for Community Child Health and
Telethon Institute for Child Health Research, 2009).
See for example Piaget and Inhelder (1969) as quoted in Feeny, T (2006) The Case for Investing in Early Childhood: A Snapshot
of research by James Heckman and Richard Tremblay Smith Family Research and Development Report
Developmentally vulnerable means the child’s development was in the bottom 10 per cent of scores.
Children scoring between the 10th and 25th percentile are classified developmentally at risk and those in the top 75 per cent
are considered developmentally on track.
Developmentally vulnerable children are more likely to be boys than girls,
come from low socioeconomic background or come from a non-English-speaking
background and not be proficient in English.
Table 13: AEDI 2009 Results
Domain Australian % %
average score Develop- Develop-
(out of 10) mentally mentally at
Physical health & wellbeing 9.6 9.3 13.0
Social competence 9.2 9.5 15.2
Emotional maturity 8.7 8.9 15.5
Language & cognitive skills 9.2 8.9 14.0
Communication skills and 9.4 9.2 15.8
Total number children with - 23.6 -
at least one developmental (246,421
Source: The Australian Early Development Index
Once a person is unemployed for a long period, they become less likely to
move out of unemployment than the newly unemployed (Jackman and Layard,
There is consensus in the academic literature that this is partially
explained by skills atrophy that occurs while people are unemployed.36
Skills atrophy can include both the loss of generic skills such as computer
literacy over time, as skills get rusty or become obsolete, and the loss of
firm-specific skills that are less highly valued by other prospective
employers of an unemployed person.
In 1993, the ABS found that persons unemployed less than 13 weeks had a 25 per cent chance of gaining employment in the
next month, more than double the probability of gaining employment if unemployed for 52 weeks (12 per cent) and over
three times the probability of someone who had been unemployed for more than three years (7 per cent) (see ABS (1994)
‘The Dynamics of Long-term Unemployment’ in Australian Economic Indicators, June 1994, cat. no. 1350.0
This can then be compounded by employers assuming that all longer-term unemployed have had their skills reduced by
unemployment, and so overlooking them for employment, even where some have adequate skills.
Consistent with the phenomenon of skills atrophy, evidence from the US,
Germany and the UK shows that when displaced workers do find work again,
their wages are significantly and persistently lower than similarly qualified
people who do not lose their jobs (Jacobson et al, 1993; Couch and Placzek,
This long-term wage penalty seems to average about 10 per cent to 15 per
cent of pre-unemployment wages.
People with multiple periods of long-term unemployment also appear to suffer
a compounding effect.
For the HALE Index we use this finding to value the reduction in human capital
from long-term unemployment, as proxied by this reduced lifetime earning
Box 7:Calculating skills atrophy from long term unemployment
International literature suggests that the wages of long-term unemployed
workers settle at about 90 per cent of their pre-unemployment levels when they
As we do not have detailed data on the pre-unemployment wages of the long-
term unemployed, we assume that, at least on average, this group would have
received a wage substantially below the average wage, and probably below the
We assume 90 per cent of the median wage for our calculations.
We also assume that, on average, long-term unemployed people would
otherwise work for 20 years until reaching retirement age.
A discount rate of 5 per cent is used.
We calculate the value of human capital lost to today’s stock of long-term
unemployed people using the following formula:
Human capital loss = NPV (10% x 90% x median wage for 20 years) x no. of
However, we also want to capture the permanent human capital loss from
people who have previously been unemployed for long periods but are now
back in the workforce.
To do this going forward we need to know the average outflows from long-term
unemployment each year.
On average, about 6 per cent of people unemployed for between one and two
years exit unemployment within a year.
So to crudely account for these people we scale up the value of human capital
loss by 6 per cent.
In December 2010, about 117,000 Australians had been unemployed for more
than 12 months.
Using the methodology outlined above, the NPV of lost human capital from
long-term unemployment was $8.1 billion.
This is equivalent to 0.05 per cent of our total intangible capital stocks at the
A 0.1 per cent increase in the long-term unemployment rate increases skills
atrophy by an amount that costs about $300 million a year.
The course of this cost over the last few years is provided in Figure 6 below.
Figure 6: Human capital depletion from long term employment
d An alternative snapshot of net changes to the natural and human capital stock
An alternative way of valuing the accumulation and depletion of capital that
goes unmeasured by the national accounts would be to capitalise the value of
current trends in multi-factor productivity (MFP) growth into an adjusted GDP
measure, on the assumption that existing trends are indicative of future trends.
This offers a possible way of finessing a number of problems in measuring
changes in capital stock.
Existing measures of human capital are very imperfect for the reasons
Further, anything that improves our productivity that does not result from
increasing deployment of resources – either from nature or physical capital
accumulation – must arise from improvements in knowhow or human capital
But much continual improvement in industry is not the result of improved
levels of education, so much as the result of imported knowhow, small
changes in operations, or on-the-job training and learning by doing, all of
which are extremely difficult to measure.
The approach finesses another problem.
Non-renewable resource exploitation produces two effects that pull in
Improved knowhow increases productivity while resource depletion leads
to progressive reductions in the productivity of resource extraction.
It is difficult to measure both of these effects on their own, but our real
interest in them as influences on economic wellbeing is in their sum
effects as captured in MFP.37
We can use MFP as an indicator by assuming that current trends in
MFP will continue to play themselves out in future.
Accordingly as MFP growth trended up or down, we could capitalise
the NPV of the value of MFP growth, assuming MFP would continue to
follow recent trends over a given time horizon.
An additional benefit is that focusing policy making on MFP growth would be
worthwhile as, in the much quoted words of Paul Krugman, productivity isn’t
everything, but in the long run it’s nearly everything.
Against these attractions, two problems undermine the case for capitalising
MFP growth as a means of capturing changes in capital.
Firstly, the methodology would yield very volatile results that would dominate
the index because of the scale of human capital in the index.
Yet it often takes a long time to understand exactly what MFP figures are
telling us as they are subject to significant variation through the investment
cycle and substantial revisions between measurements.
Secondly, the assumption that the current level of MFP growth is a predictor
of MFP growth over the horizon for which the value of MFP growth would be
capitalised is a strong one.
Our fear is that giving MFP growth a strong presence in the index would tend
to focus public interest in a guessing game as to what was moving MFP in
the short term, and the prospects of it being subsequently revised.
On the other hand, we think that the index might play a useful role if we
reduced its weighting substantially and incorporated it as a relatively minor
influence on our measurement of human capital.
Here it would play a useful role given the fact that the index does not directly
capture output measures of the increase in productivity owing to improvements
in human capital.
In addition, improving MFP growth should be a major preoccupation of micro-
Accordingly we use a forward-looking capitalisation of the NPV of MFP as
10 per cent of our measure of human capital.
MFP does not measure the effects of resource depletion in the short term because increased productivity may simply reflect
faster depletion of existing resources.
Further, productivity varies greatly through the investment cycle.
However, over any reasonably long period the industry must move from exhausted mines to open up new ones – or from the
most propitious parts of existing mines to less propitious mines – and so multi-factor productivity will capture both
effects and measure the extent to which one offsets or outweighs the other.
Human capital domain of the HALE Index
Early Track using While AEDI test scores have remained
childhood AEDI raw almost constant (except for a small dip in
development scores 2007) population growth has increased
overall human capital stocks
School Change in PISA test scores and school retention
education PISA test rates fell from 2003 to 2006/7, but have
scores and since recovered somewhat.
change in School-based human capital growth in
secondary 2005 was close to 0, due to falling PISA
school scores from 2005 to 2010, population growth
retention has increased overall human capital
School based human capital growth
in 2004-05 was unusually small, due
to little growth in the school population
Adult formal Proportion of Human capital from formal adult
education 25-to 64-year- education has increased consistently
olds with a over the period, due to increasing tertiary
post- education attainment and population
Net innovation Capitalised Falls over the period due to falling MFP
trend MFP growth.
Skills atrophy Long-term Skills atrophy from long-term
from long-term unemployment unemployment (LTU) has grown overall
unemployment rate x wage by $2 billion from 2005 to 2010. As LTU
penalty has declined since peaking in late 2009,
skills atrophy is also falling.
Overall, because of the higher weighting of the top three categories, and with
the highest (40 per cent) weighting given to adult education, the overall human
capital domain of the index grows strongly (if in a volatile manner) through the
period notwithstanding the fall over the period in the last two indicators.
7. The distribution of income
Like the happiness literature more generally, the Australian Unity Wellbeing
Index confirms common sense and the early marginal economists’
presumptions that the utility of additional income diminishes as income rises.
Thus if we take seriously the idea that income is just one input into the ultimate
objective of human wellbeing, we need to adjust additional increments of
income earned within the Australian economy for how it is distributed.
The advantage of such SWB studies is that they give us some empirical
evidence on which to base some calibration of this important effect.
For the lowest income households with incomes of under $15,000 a year,
subjectively reported wellbeing increases by one percentage point with
just $6,000 of additional income.
By contrast the same increment in happiness would require over $100,000
for a household already earning more than
$100,000 a year.
Table 14: The marginal utility of income in Australia
Gross $ for Relative Assumed % Relative
Household additional one value of of value FROM values,
Income percentage additional $ status adjusted for
($ '000) point (ppt) of assumed
wellbeing status effect
< 15 6,000 4.2 35 2.8
15-30 20,000 1.3 60 1.0
30-60 25,000 1.0 66 1.0
61-100 33,333 0.8 75 1.0
101-150 111,111 0.2 80 0.4
151-250 178,571 0.1 85 0.3
251+ 1,250,000 0.0 95 0.1
Source: Lateral Economics based on The Australian Unity Wellbeing Index
These relative values measure two things.
We know that people value income because of the commodities and services it buys.
They also value it because of its significance for their status among other
The positional significance of wealth is not a new phenomenon.
As Adam Smith argued more than two centuries ago, “[T]o what purpose is all the toil and bustle of this world? . . . Is it to supply the
necessities of nature?
The wages of the meanest labourer can supply them. . . . To be observed, to be attended to, to be taken notice of with sympathy,
complacency, and approbation, are all the advantages which we can propose to derive from it. It is the vanity, not the ease, or the
pleasure, which interests us.”
However, status is a zero-sum game – those who move up do so at the expense
of others moving down.
Thus there is no increase in total wellbeing across the community from the
status effect of income.
A survey of international literature concluded that about two-thirds of the
marginal utility of income is due to the status effect
(Clark et al., 2008, p. 111).
We are unaware of strong direct evidence from SWB studies that this proportion
varies greatly among people with relatively low or high incomes.
However, correlations between increased income and SWB do appear to be stronger
in poor than rich nations (Diener and Biswas-Diener, 2002), suggesting that the
absolute value of an additional dollar is more powerful for people on lower incomes.
If this is the case, then we should correct the marginal utility of income curve
suggested from the AUWI data in Table 14 to remove status effects.
Figure 7 shows how the marginal utility of income may change if status effects
are less important to low-income people than higher-income people.
The weighting given to status impacts have been set so that the average status
effect across all households is 66 per cent of the total value of additional
money, consistent with the literature cited above.
However it is only 35 per cent for the poorest Australian households, rising to 95
per cent for the richest households.
If the status effect is distributed evenly across all income levels, then the
marginal utility of income would remain the steeper blue line.(39)
The slope of the marginal utility lines can be interpreted as the elasticity of income.
The slope of the blue line is -7.5 and the red line -1.3.
An elasticity in the range of 1 to 2 is commonly found in literature.
Figure 7:Accounting for status effects in income
The latest ABS data on household income distribution is from the 2007-08
Household Income and Distribution Survey.(40)
The ABS reports data on a weekly equivalised disposable income basis, but
when annualised these household income quintiles roughly accord with the
first five income bands from the AUWI survey.
Table 15 below shows the growth in average weekly income for household
quintiles between 2005-06 and 2007-08.
On an unweighted basis, total household incomes grew by an average of
eight per cent a year from 2005-06 to 2007-08.
However, as this income growth flowed mainly to high income households
who value additional money less highly than low income households, the
weighted value of growth was six per cent, or just three-quarters of the
raw income increase.
This survey is updated every two years, with 2009-10 results likely in late 2011.
Table15:The marginal utility of income in Australia
Household 2005-06 2007-08 Annual Weights Weighted
income growth(%) annual
Lowest quintile 272 299 5.0 2.8 10.5
Second quintile 444 504 6.8 1.0 7.0
Third quintile 607 692 7.0 1.0 7.0
Fourth quintile 805 922 7.3 1.0 7.2
Highest quintile 1,368 1,646 10.2 0.4 3.8
All households 699 811 8.0 0.3 6.1
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