Tom Clark

Capital in the 21st Century
December 2014

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Throughout the late summer and fall I worked away reading through Capital in the 21st Century, (Belknap Press, 2014) by Thomas Piketty. This substantial volume takes a social scientific look at economics. It is scientific in its careful assembling and examining of national macro economic data like income and capital, and of their evolution over time – especially 1890-2012. And it explores social consequences of extending the most likely trends into the future. This is remarkable coming from an economist whose PhD was, as is typical of latter day economists, based on a mathematical formula. As a bright young scholar he was whisked from France to the USA to teach in Boston. He developed new insights there and returned to France with a growing appreciation of the importance of reflecting on economic trends relevant for the politics of human society – and a desire to do that. The book is the remarkable result. Who would have thought I would be reading about economics and finding it highly relevant?

The opening chapter in Part 1, Income and Capital, introduces and explains economic concepts and laws: gross data on national income (a tuned-up GDP) and capital. Capital, a stock, is measured in terms of percent of annual national income, a flux. Around 2010 it was close to 600% or six years worth of income in Europe. Surprisingly, the book manages to make all this readable. He introduces laws about rate of return on capital and relationships between the rate, income, savings, and GDP growth. For example (2010), the income from capital (30% of overall income) is the rate of return (average 5%) times the capital to Income ratio (that 600%). So 70% of overall income is from labour. He shows the evolution of global production by continent, the population evolution by continent, and the corresponding evolving GDP per capita. He then tables population, GDP and corresponding per capita average monthly income over these world regions. This measures global inequalities. An examination of economic growth from early times reveals that the overall global growth rate has likely peaked and will settle at 1% or less in the 21st century.

Capital as percentage of national income year by year in charts features in chapter 3. Components of capital are agricultural land, housing, other capital and foreign capital. The graphs show a shift of capital away from agricultural land into housing and other (stocks etc.) from the 19th to the 21st century. The graphs show a rise then fall of foreign capital ownership in Britain and France up to the 1960s - from the rise and then loss of colonies. The graphs show a dramatic fall off of overall capital from about 700% of national income around 1910 to 250% around 1950 following the two major wars. There is an examination of private and public wealth and public debt. Public capital is currently around 5% of overall capital in France and is more or less offset by public debt. Chapter 4 turns to a commentary on related (and broadly similar) graphs in Germany, Europe, US, and Canada and adds a look at the effect of slavery as capital in the US. Chapter 5 shows the long-term evolution of capital in major countries – revealing a steady climb in private capital back towards the 1910 levels of 700% of national income. Chapter 6 looks at how labor income and capital income have varied year by year, first in Britain and France and then on to a range of countries. The capital income to labour income ratio has been assumed to be fixed, but Piketty argues that the ratio is greater than 1 and that there is no self corrective mechanism to prevent the steady increase of the capital to income ratio together with the steady rise in capital’s share of national income. And human ingenuity and new technology do not significantly impact the long-term trend of capital’s share. Along the way we are shown how Marx’s notion of infinite accumulation of capital can apply, but only when there is no structural growth and the population and productivity growth rate is zero. It has been subsequently shown that long term growth is possible because of productivity growth. In the long term the capital to income ratio adjusts to the savings rate and structural growth rate of the economy. The return to a period of low growth and zero or negative population growth leads Piketty to suggest a return of the relative importance of capital and a rising in the capital to income ratio.

In Part 3 Piketty moves into reflections about the structure of inequality, beginning with a preliminary chapter 7 and going on to explore the evolution of income and capital in more detail. He begins with stark information from 19th century France. At that time one could attain a higher standard of living from inherited wealth than from income from labour alone. By contrast, our society assumes talents and hard work will be rewarded. Then there are some hard general facts. The top 10% in the labour income distribution get 25-30% of total labour income. The top 10% of capital income recipients always get more than 50% of all capital wealth generated – and sometimes up to 90%. This arises from the social processes shaping wealth and its distribution. And it is mainly inherited wealth and the large possible returns on invested wealth that account for it. Over a range of societies 50% of the population owns almost nothing, i.e. has almost no capital. The propertied or true middle class was a structural transformation of the mid-20th century and it shows as a small but significant change. Essentially 40% of the population owns something that totals quarter to a third of the national wealth. In parallel with this change, the wealth owned by the top 1% halved. Piketty’s analysis explores such evolutions in time of capital held by fractions of the population. How does the capital held by the top 10% and top 1% of the capital holders behave over time? The fraction of national capital held by these becomes larger – fewer and fewer own more and more. Two worlds are possible, as chapter 9 explores. The world to which things are currently drifting is a return to the old world where inherited wealth counts for more than labour with talent or hard work. But the novel world of the mid 20th century, with more of the population sharing wealth, could be chosen.

Chapter 9 also examines the origins of wage inequality and the early 21st century phenomenon of high paid managers. In the long run, the best way to reduce inequalities in labour, to increase average productivity and to increase the growth of the economy is to invest in education. Education and technology are decisive determinants of wage levels. Minimum wage has an impact on the bottom of the wage distribution – but not the top. The US has now greater income inequality than the countries of Europe. Inequalities in the newly emerging economies like China, India and South Africa are also lower than current inequality in the US. The increase in inequality in the US is mainly from increased pay at the very top – the top 1% and even the top 0.1%. And education, important though it is, has had a limited effect on the “explosion of the topmost incomes” in the US since 1980. Moreover the “rise of the super manager” is an “Anglo-Saxon” phenomenon. (It occurs to lesser extent in UK, Australia, Canada.) It is not explained by theories of marginal productivity or the race between technology and education. Self-interest of the managers and some evolving toleration in those societies are Piketty’s suggested factors. This emergence of the super salary is a force for social divergence.

Chapter 10 uses the data on capital wealth from France, UK, Sweden and the US because it is reliable. From 1810 -1910 the European countries had more inequality in capital ownership than the US has now. The top 1% held a growing 50 – 70% of the total capital. That fell to around 20% between 1950 and 1970, and has risen since to around 25%. The US top 1% of owners amount of capital ownership rose from an 1810 level of 25% to a 1910 level of 45% before falling to a 1950 30% and growth since to a 35% level in 2010. The chapter asks how this came about. For most of human history the rate of return on capital (approx. 5%) has been greater than the economic growth rate. The world growth rate rose in the industrial revolution period to 3.5% in the late 20th century, but now is falling to 1%. The late 20th century brought an unusual drop in the rate of return to 3% followed by a rise to above 4%. With 5% (net) return and 1% growth, the wealthy only have to reinvest 1% to ensure their capital will grow faster than average income. The taxes of the 20th century (taken into account in these projections) modified things. Piketty wants us to note that tax on capital does not reduce wealth accumulation, but changes its distribution. For example a 0 - 30% progressive tax on capital can reduce return from 5 to 3.5% and will decrease the upper 1%’s share of wealth and increase the middle class wealth.

Chapter 11 explores the impacts of merit and inheritance over the long haul. By now it will be clear that so long as annual growth is lower than the annual rate of return on capital, inherited wealth will dominate over wealth from income from merit and hard work. There follows an examination of factors accounting for inheritance and gift flows of capital. There is an “aging” of wealth with age of mortality and its rejuvenation by war in the 1914-1945 era. In passing we learn that the “rent” or rate of return is not an imperfection of market but a normal feature. Then there are graphs showing the increasing inheritance flows in France, UK and Germany. Inherited wealth will be important there too, but to a lesser degree than in the US. Given the higher growth rates in emerging economies like China, the impact of inherited wealth is still quite limited there.

Chapter 12 explores the global inequality of wealth. Not all returns on capital are equal. Larger amounts of capital do better than smaller amounts. Sources like Forbes show the world’s number of billionaires and their wealth growing rapidly. There is a fascinating look at returns on US University endowments that shows the top endowed with 10% return net of fees and inflation and the lower endowed at 6.2%. Sovereign wealth funds do less well - ranging from the open reports of Norway and opaque Saudi Arabia at around 3%. Since these capital amounts are huge, the lower return is presumably because the public nature makes for greater caution in investing. Piketty notes that these huge pockets of wealth will likely grow and bring uncertainties about future public responses in other countries. Then Piketty gives his likely scenario for evolution of world private capital. It shows a shift from Europe and America to Asia and Africa as century 21 moves to its close. Finally, he adds a caveat. A substantial fraction of global financial assets is already hidden in various tax havens making analysis difficult.

The final section of the book is about regulating capital, where Piketty ends up arguing that a policy initiative is needed not so much to raise money but simply to save capitalism from itself. But first, in chapter 13, he looks at the welfare state and current taxes. He talks about the welfare state with health and education and pensions that he calls “rights based” and the “modern redistribution around certain goods deemed fundamental.” These draw 30-50% of national income among developed countries. He suggests this “social state” needs modernizing but should not be otherwise changed. It is still widely accepted in broad terms, but expansion would be unrealistic and undesirable in current economic times. An intriguing discussion of higher education shows that it does not necessarily lead to higher income mobility. Access can be limited by high fees. Then there is a good discussion of PAYGO pensions (workers pay in now and that pays some current retirees’ pension; when these workers retire the workers then paying in pay the earlier workers’ pension). This is compared with pensions from returns on investments. PAYGO has been affected by big changes in life expectancy. He points out that the transition is difficult for the people who already paid in! And anything paid from interest suffers from the uncertainties of capital returns. Looking beyond the West, it is not clear whether the current Western social states will be followed elsewhere in the developing world.

Chapter 14 gives us a useful review of the range of taxes and especially the story of progressive income and progressive wealth taxes – major 20th century initiatives reducing inequality. Tax competition for free flowing capital has recently led to cuts in corporate taxes and exemption of interest dividends and other financial revenues. These have made current taxation regressive – the top 1 percent now pay a lower rate than the bottom 50%. This is in large part on account of low capital income taxes. This situation is surprising given a history of special high tax rates for the highest incomes across Western countries. There is also a surprising mid 20th century phenomenon of high one-time estate tax, in particular in the UK, where it was higher than the progressive tax on earned income. (It mitigated social inequality stemming from historic inherited wealth of an aristocratic class.) At this point, since globalization has disproportionately hurt the cohort of least skilled workers, a more steeply progressive income taxation could be justified. The chapter ends suggesting an optimal top marginal tax rate around 80%.

At last chapter 15 explores the value of – or need for – a global tax on capital. This is not to replace taxes on income and the like that together finance the major national programs around health and education and social security. These are now generally accepted in Western nations. He proposes a progressive tax on capital and a high level of fiscal transparency. The obstacles are legion. A beginning would be international disclosure by banks of wealth held. The purpose is to defuse the otherwise inevitable focusing of the world’s capital onto fewer and fewer individuals. After some discussion, he favours some blend of tax on income from capital and tax on the wealth itself. Finally, he examines whether regional groupings of nations like the European Union might pull off some kind of wealth tax.

The final substantive chapter is about public debt, capital tax, inflation and austerity. An exceptional tax on capital is the best way to reduce a large public debt. Inflation is at best a poor substitute, requiring too much time and being hard to control, and the consequential redistribution of wealth is uncertain. Austerity is counter-productive. There is a critical account of “The Euro: A Stateless Currency …”. There is discussion of public debt and the accepted wisdom of “the golden rule” that favours public debate with wider range of factors. A short discussion of climate change and public capital and the 2006 Stern Report follows. The report suggests spending an annual 5 points of GDP beginning now to offset environmental damage anticipated by the end of the century. This seems to mean a search for forms of renewable energy sufficiently abundant to enable the world to do without hydrocarbons. This, and the need to increase educational capital are more important than the public debt. The debt is much smaller than the total private wealth. Piketty notes the complexity of working out the details of public investment in response to climate change. For example, who owns any patents arising? Does a county need to restrict hydrocarbon use?

And then we come to the conclusion. The market cannot be left by itself. Although it has forces of convergence in knowledge and skills it also has forces running counter to principles of social justice on which societies are based. The private rate of return on capital can be significantly higher than the growth rate of labour income, and from output, for long periods of time. This means that past wealth grows more rapidly than output and wages. “The past devours the future.” Such divergence of wealth is occurring currently on a global scale. A progressive annual tax on capital will make it possible to avoid an endless inegalitarian spiral and to preserve incentives for new instances of capital accumulation. Assembling the necessary international cooperation is the challenge. And finally, Piketty points out that the science of economics in a society is important. His book full of relevant insights into economics and our societies aptly underscores his point.

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