Capital in the Twenty-First Century By Thomas Piketty, Harvard, £29.95
Thomas Piketty’s Capital in the Twenty-First Century is without question the most talked about book by an economist in several decades. Perhaps laypersons were attracted by the clever use of the word “Capital” in the title — an obvious reference to the Marxists’ Bible. But, Piketty has also become the favourite conversational topic in virtually every gathering of professional economists. The American Economic Association is even organizing a special session on the book in its forthcoming annual meeting. The interest generated by the book is easily explicable. The author is a leading mainstream economist who publishes regularly in the very best economics journals, and can probably join the faculty of any university in the world. And yet he has come out with a scathing criticism of the market economy, concluding that it contains forces “which are potentially threatening to democratic societies and to the values of social justice on which they are based”. This is sweet music to opponents of the market economy and deeply worrying to mainstream economists. Could he be possibly right?
Piketty’s Capital has two main components. The first part comprises a history of inequality and wealth, with the main thesis being that the growth of capital incomes is largely responsible for the upsurge in inequality in recent decades. The second element is an attempt to provide a theoretical explanation for the phenomenon of rising inequality through so-called fundamental “laws of capitalism”.
Piketty, along with the collaborators, Tony Atkinson and Emmanuel Saez, are acknowledged pioneers in the study of the historical trends in inequality. They realized early on that the usual source of data on incomes — annual income surveys — have their limitations because they typically underestimate incomes at the very top of the income scale and also do not go very far back in time. They turned instead to a radically different source of data — tax records. They developed techniques to merge tax data with other sources of information. A conceptual change was to focus on the incomes of the top 1 per cent of income earners since this gives a starker picture of income differences, particularly when the income distribution is highly skewed.
We all know that incomes are unequally distributed. However, the sheer magnitude of the problem unearthed by them is truly astonishing. For instance, the top 1 per cent of income earners in the US earned as much as 20 per cent of the national income in 2010. The corresponding figure for top 1 per cent of income earners in France is 10 per cent in 2010. Somewhat inconvenient for Piketty’s hypothesis of rising inequality is that the corresponding figure for France in 1910 was 20 per cent. Piketty explains this away by arguing that the two world wars were particularly disadvantageous to the super rich since they earn the bulk of their incomes and there was some destruction of physical capital. He argues that it has been “business as usual” since 1970, when income inequality has again been on the rise.
The main plank in Piketty’s theoretical argument — which he calls “the central contradiction of capitalism”— is the law which states that the rate of return on capital systematically exceeds the rate of growth of income. Piketty concludes from this that the income of owners of capital will rise faster than that from other sources of income. Start with an initial distribution of capital which is very unequal. Add the increasing domination of capital income in overall income and low or non-existent inheritance taxes. This will result in a progressive worsening of the distribution of wealth and inequality.
However, the validity of this argument has been questioned on both theoretical and empirical grounds. As far as the theoretical argument is concerned, several economists have pointed out that the rate of return on capital gives the level of capital income. That is, even if the rate of return on capital exceeds the overall rate of growth of income, all individual incomes could still be growing at the same rate. One needs some other phenomenon — such as the rich saving more than the poor — to explain the progressive domination of capital income over overall income. The validity of this is therefore an empirical issue and not an inevitable consequence of a market economy.
However, the long-term data are certainly not conclusive. One problem is that Piketty lumps together various forms of capital — “non-productive” assets such as housing and financial assets such as stocks and bonds are also included in his definition of capital. We know, for instance, that share prices on Dalal Street have a low correlation with equity incomes — any rise in share prices will typically result in unrealized capital gains. In much the same spirit is a recent study by a group of four French economists. The study demonstrates that housing prices have risen significantly faster than rents and income in many countries. If rental income replaces imputed incomes based on variation in housing prices, then the phenomenon of rising share of capital income goes away. Moreover, the ratio of “productive” capital to income also remains more or less constant in all countries the data of which has been analysed by Piketty, with the possible exception of Germany.
The role of — somewhat broadly speaking —human capital (as opposed to physical capital) in promoting inequality in incomes also seems to have been underestimated by Piketty. Hedge fund managers, bankers, top corporate executives, and even some academic economists have incomes which put them in the top 1 per cent of income earners. Much has been written about how their earnings jump at astronomical rates, even during recessions. Certainly, rapidly rising incomes of this class have also played a big role in the generation of growing of incomes inequality.
There are clearly several problems with Piketty’s explanation for the growing inequality in income distribution. But can the doctor find a cure for the disease even if he is not sure about the cause? The first prescription which comes to mind is a highly progressive tax on incomes. Piketty points out that most countries already have a moderate degree of progression in their income taxes. However, this has not had much effect in so far as correcting income inequalities is concerned, at least partly because “income is often not a well-defined concept for very wealthy individuals”. Piketty advocates a tax on wealth which is easier to measure. Of course, in this globalized world, it is easy to move financial capital across country borders. This prompts Piketty to suggest a global tax on capital. Unfortunately, this is a utopian ideal since each country will have an incentive to lower or abolish such taxes in order to attract global capital.
Capital in the Twenty-First Century is certainly not the last word on the evolution of global inequality in market economies. It is not even the definitive word on this topic. Nevertheless, this book is required reading for all serious scholars and policy-makers because of the issues it raises. Inequality will now be in the forefront of both academic research and policy discussions.