â€œWhen the rate of return on capital exceeds the rate of growth of output and income, as it did in the nineteenth century and seems quite likely to do again in the twenty-first, capitalism automatically generates arbitrary and unsustainable inequalities that radically undermine the meritocratic values on which democratic societies are based.â€
Thomas Piketty – Capital in the Twenty-First Century
The rich get richer. That’s the shortest possible summary of the arguments made by Paris School of Economics Professor Thomas Piketty, in one of the most talked about economics books of the decade.
While much of the twentieth century saw a decline in wealth inequality, Piketty argues that it was nothing more than an aberration. Says Piketty, â€œThe sharp reduction in income inequality that we observe in almost all the rich countries between 1914 and 1945 was due above all to the world wars and the violent economic and political shocks they entailed (especially for people with large fortunes).”
Much of the book centres around the formula R > G, where R is the rate of return on capital (wealth), and G is the growth rate of the economy. The consequence of R > G is that those with investment income will get further and further ahead of those who rely on employment income, a relationship shown in the following chart. (Chart data compiled by Bloomberg Businessweek)
From Piketty’s perspective, not only will this investment income vs wage income disparity increase the gap between the very well off and everyone else, it will – in the absence of policy intervention – heighten the influence of inherited wealth.
Though this may seem like a new problem, Piketty effectively looks to history for facts that fly in the face of established economic narratives and shows that we have faced similar circumstances before. For example, while America has long been seen as the land of hyper-capitalism and low taxes, Piketty points out that the top marginal tax rate (the tax paid on the highest increment of income) in the United States averaged 81 per cent between 1932 and 1980. Even before the great depression, Piketty writes, the United States was determined to avoid the levels of inequality seen in much of Europe. â€œThis fear of growing to resemble Europe was part of the reason why the United States in 1910â€“1920 pioneered a very progressive estate tax on large fortunes, which were deemed to be incompatible with US values, as well as a progressive income tax on incomes thought to be excessive. Perceptions of inequality, redistribution, and national identity changed a great deal over the course of the twentieth century, to put it mildly.â€
Whether you agree or disagree with Piketty’s thesis, the historical perspective he brings to the issue of wealth inequality is a great service to our collective knowledge. Piketty points out that rising inequality is not inevitable. Policy matters. While capitalism may – in Piketty’s opinion – naturally create growing inequality, he points out that the state can implement policies to create a more egalitarian society.
While the policy options proposed by Piketty may seem simple enough – a tax on capital, higher marginal tax rates, increased estate taxes, implementing those policies is no easy feat. Tax competition between countries means that if one jurisdiction raises taxes on the wealthy, people could simply go to a lower tax jurisdiction. The interplay of these competing tax rates can lead to a race to the bottom that exacerbates inequality.
For that reason, Piketty points out that – in the absence of global coordination – policies to reduce wealth inequality will have to be implemented by large economies such as the European Union, China, and the United States – economies large enough to exert global influence and which wealthy individuals are unlikely to leave en masse.
It should be noted that many economists disagree with Piketty’s conclusions. While a further discussion of those opinions will have to wait for another post, I highly recommend Capital in the Twenty-First Century to anyone interested in a deeper understanding of wealth inequality. Piketty has not ended the discussion with his book, and his perspective is one of many, but it is a deep, insightful, and heavily researched look at one of the most important issues of our time.