What is human capital theory in political economy?

Human capital theory begins from a simple observation: that much of a country's productive power lives in the knowledge, skills, and health of its people.¹ The theory treats the money spent developing those abilities, through education, training, and health care, as an investment rather than a cost.² Such investment tends to raise what individuals earn over their working lives, with longer-term gains expected for the wider economy.³ This way of thinking is more recent than the idea itself. It took shape in the 1950s and 1960s, when economists such as Theodore Schultz and Gary S. Becker began to treat skills and health as a form of capital, much like machines or factories, that a person builds up over time and draws on for the rest of their working life.²,⁴,⁵ In the decades that followed, Nobel laureate James J. Heckman added new empirical weight to the theory, showing that investment in people pays off most when it begins early in life.⁶ Over time, this way of thinking has reshaped public policy, and many governments now treat spending on schools and health care as an investment with a long-term return rather than a yearly expense.¹

Human capital theory sits at the intersection of labor economics, growth theory, and political economy It studies how investments in people, in their schooling, skills, and health, raise the wages they earn and support a country's long-term growth.¹,³ Traditional economic models often assumed that all workers contributed in the same way. Human capital theory instead looks at the stock of abilities each worker builds up over a lifetime and brings to work.³,⁷

James Heckman made two major contributions in the field. In 2000, he shared the Nobel Memorial Prize in Economic Sciences with Daniel McFadden for statistical methods that removed a major source of bias in measuring the effects of education and training on income and employment.⁸ Heckman's later research made the economic case for starting these investments early in life. That evidence now shapes policy debates on important areas, such as early childhood funding and programs for disadvantaged families.⁶,⁹

People often talk about types of human capital, but it is more accurate to think of it as one set of abilities with several dimensions, where each dimension grows through a different kind of investment.³,⁶

Education and knowledge

Education and knowledge cover the formal learning people acquire through school, university, and other studies. Knowledge and skills are hard to observe directly, so researchers rely on what they can see: time spent in school.

Mean years of schooling has become one of the most widely used measures of human capital in research on growth.³,⁷ It is also how economists know the payoff. On average, each extra year of schooling pays back around 9% a year in higher earnings. That figure comes from more than 1,100 estimates across 139 countries collected since the 1950s.¹⁰

Skills and training

Skills and training are the practical abilities people build at work, through vocational programs or simply by doing the job. The OECD counts this informal and on-the-job learning as human capital investment alongside formal education.³

This kind of learning helps explain why earnings tend to rise with experience. Economist Gary Becker pointed to on-the-job training as an important source of the earnings growth workers see over their careers.² But how fast that human capital builds depends on the kind of work.

The World Bank estimates that young people in formal jobs with training and mentorship build human capital by about 3.9% a year, nearly double the 2.0% gained by those in self-employment or casual work. The same gap holds for older workers, at 3.0% against 1.8%.¹

Health

Physical and mental health decide how long and how well people can work. Becker also ranked health with education and training as the most important investments in human capital.¹,²

Poor health in childhood can limit that capacity before working life even begins. In 2024, more than one in five children under 5 worldwide, about 150 million, were stunted, a condition that can cause lasting physical and cognitive damage.¹¹

Socio-emotional skills

Socio-emotional skills refer to traits such as self-control, sociability, and other noncognitive abilities. Research by James Heckman and his colleagues shows that these skills play an important role in labor market outcomes, with effects on wages, employment, and occupational choice that are often comparable to cognitive ability.⁶,¹²

More recent research supports that conclusion and suggests these skills are becoming even more valuable. In the United States, economist David Deming finds that the pay reward for social skills more than doubled between workers entering the labor market in the 1980s and those entering in the 2000s.⁷

Human capital does not behave like the machines, buildings, and financial assets of conventional economic models. A few features set it apart, starting with the fact that it cannot be separated from the person who holds it.

It cannot be separated from the person

A factory can be sold, pledged, or handed to a new owner, but education cannot. Becker put it simply, writing that people "cannot be separated from their knowledge, skills, health, or values in the way they can be separated from their financial and physical assets."²

It builds on itself

Skills learned early make later learning easier and more valuable. Heckman's research finds that investing early in disadvantaged children yields especially high economic returns, an idea now known as the Heckman curve.⁹ Putting a number on it, his team estimates that high-quality birth-to-five programs for these children return around 13 percent per year.⁹,¹³

It fades without use

Skills erode when they sit idle. The World Bank estimates that people who are not working lose skills at about 1.25 percent a year.¹ Technological change adds to this, and technical skills tend to age faster than people skills, such as communication and leadership.¹⁴ Training and lifelong learning can offset the loss, which is why many governments now encourage learning throughout working life rather than only in school years.³,¹⁴

Its distribution shapes society

Skills and health drive earnings, so the way human capital is spread across a population helps decide who earns what. Differences in human capital explain at least a third of earnings gaps within countries, and at least half of the earnings gaps between countries.⁷ Seen this way, debates about schools and health care are also debates about who shares in a country's growth.

Like any powerful framework, human capital theory has its blind spots, and economists are candid about them. Even the institutions that have done most to advance it, such as the OECD and the World Bank, acknowledge where the model falls short.

The measures capture only part of a person

While years of schooling serve as a useful indicator, they mostly measure the time people spend in education and say little about how much they actually learn. The OECD warns that the same years of schooling can mean very different knowledge, depending on quality.³

The World Bank makes a similar point about its own human capital index, which it says should not be read as the final word.¹ And some of the most valuable skills, such as teamwork and critical thinking, are the ones researchers know least how to measure.⁷

Education may signal ability as well as build it

Part of a degree's payoff may come less from what a graduate learned and more from what the degree tells employers about them: that they were capable enough to get in and finish. If that is true, then some of the higher pay that comes with education reflects the ability the person already had, not skills that schooling added. That is a challenge for human capital theory, which assumes education raises earnings by building skills.

Nobel laureate Michael Spence formalized this idea, showing how education can serve as a signal of ability in labor markets where employers cannot directly observe worker quality. He shared the 2001 Nobel Prize with George Akerlof and Joseph Stiglitz for their work on markets with asymmetric information.¹⁵ As Spence put it, "what you get in return is really two things... one is what you learn, and the other is the signaling effect."¹⁶ Researchers still debate how much of education's payoff comes from each channel, although Deming argues that the signaling component is relatively small.⁷

Society may invest too little on its own

Education benefits more than just the person who receives it. Some of its gains are external, reaching the wider community. For example, a fuller accounting would ideally capture benefits like a woman who, after more schooling, adopts better sanitation at home, lowering disease and potentially saving lives around her, though such external benefits are rarely measured.¹⁰ Benefits like these are hard to measure, so they rarely show up in the standard estimates. That creates a gap in decision-making.

They also rarely enter people's own decisions. When someone weighs how much schooling to pay for, they count what they will gain while leaving aside the benefits that spill over to others. So individuals tend to buy less education than would be best for society as a whole, which is the classic economic argument for public funding of schools. And even measured this way, with those spillover benefits left out, the return to society from schooling stays high, generally 10 percent or more.¹⁰

It can mirror the inequality it describes

Children do not start with the same chances. Heckman argues that what children inherit from their parents goes beyond money. It includes human capital itself, the skills, culture, and values picked up at home, and children in disadvantaged environments inherit less of it.⁶

The timing is also important. Skills built early make later learning easier, so a child who starts behind tends to stay behind, and early gaps can compound over time.⁹,¹²

People are more than capital

A final limit is about the idea itself. Calling a person capital, and their education an investment, can suggest that the value of learning and health ends with the paycheck. Human capital theory measures the economic side of skills and health, and that side is real and important. What lies outside it, the personal, civic and moral worth of an education, is simply a question the theory was never built to answer.

Human capital theory gave governments a new way to see spending on people. In this view, money for schools, training, and health care is an investment, with returns that can be measured and compared like any other.¹,³ The idea now anchors policy around the world. As of October 2024, 95 countries at all income levels were working with the World Bank's Human Capital Project to plan and improve their investments in people.¹

The theory works best when its limits travel with it. It tells us how skills and health turn into earnings and growth, and it tells us when and where investing in people pays off most. What people make of their abilities, and what those abilities mean beyond the labor market, are questions it leaves open. That is not a weakness. It is simply the line where economics hands over to everything else.

For insights into political economy and related fields by James Heckman and other Nobel laureates, visit UBS Nobel Perspectives & Economic Views.

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What is human capital theory in political economy?