Capital in the Twenty-First Century
Thomas Piketty’s Capital in the Twenty-First Century was received with much fanfare in the United States in the spring of 2014. The book has become a best-seller, and Piketty has been interviewed extensively, even on The Colbert Report. Many words have been written about Capital in the Twenty-First Century in conventional and electronic media, including reviews by prominent economists.
Piketty is a well-known 43-year-old French economist, with an extensive body of published research. He is perhaps unusual in that he can grapple with the technical complexity of high-end economic theory, but is also willing to get his hands dirty working with large data sets. However, even for an unusual economist, Capital is a highly unusual project. The economics profession is sometimes criticized for being insular—the Steven Pinkers and Stephen Hawkings of the economics profession seem nonexistent. Few practicing economic researchers, and particularly no young academic economist, has appeared willing to take on the job of explaining complex economic ideas to the lay person.
But, along comes Piketty. He has written a very large (685 pages!) volume which reaches out to lay people, to social scientists outside of the economics profession, and to policymakers, in an attempt to address an interesting and pressing issue—the causes and consequences of the distribution of income and wealth. The timing for publication of such a book is certainly right. The recent global financial crisis brought to the fore issues of income and wealth disparity, and the implications for economic power and government intervention in the economy. In some quarters, people who accumulated substantial wealth in the financial industry were blamed for its collapse.
What is Capital about? In part, Piketty aims to summarize research he has published in peer-reviewed journals, which includes extensive data collection to document the evolution over time of income and wealth distribution in a set of countries. For the United States, the evidence indicates that the dispersion in income and wealth was high at the turn of the 20th century, and proceeded to decrease during the 20th century, but has increased substantially since about 1980. Basically, from the late 20th century, the share of national income in the United States accounted for by top income-earners has risen substantially. For example, in 1980 the top 1 percent of income-earners in the United States received about 8 percent of total national income, but by 2010 that group was receiving about 18 percent of national income. Wealth is even more concentrated among the extremely wealthy.
Piketty downplays the importance of human capital to a fault. A key lesson of the economics literature on economic growth is the importance of knowledge, education, and the accumulation of skills in determining the level of a nation’s economic welfare.
But why should the average American be concerned with the incomes and wealth of the very rich? Why is it my loss if my neighbor is rich? If my neighbor is rich because she invented a piece of software, profited from selling it, and society also benefitted, then more riches for my neighbor is associated with more riches for me. If my neighbor had not bothered to invent this software, I would be worse off. However, if my neighbor is rich because he breaks into my house at night and steals my TV, then obviously the fact that my neighbor is rich is of no net benefit to society, and has made me worse off. Thus, maybe I should feel good about the fact that Bill Gates is rich, but a rich Bernie Madoff should not make me happy.
So, perhaps we want to think carefully about whether the increasing riches of people at the top of the income and wealth distribution are ill-gotten, or simply rewards to socially beneficial innovations. That, however, is not what Piketty is concerned with. Piketty appears to view the concentration of very high wealth in a few hands as unjust, and he thinks that view is widely shared. Thus, according to Piketty, if income and wealth become even more concentrated at the top end, a destructive class struggle would ensue. Unlike Karl Marx, who saw class struggle as inevitable, leading ultimately to a communist utopia, Piketty would like to save the capitalist system through government intervention, before it is too late.
Why would income and wealth become more concentrated in the future? Piketty has a theory. If you know little economics and start to think about this problem, you might think that Piketty’s theory would have to be very complicated. To grapple with the problem of income and wealth distribution, we need a dynamic economic model in which we can think about a heterogeneous population of people, how they accumulate skills so that they can earn income and accumulate wealth, and what motivates them to pass this wealth on to their descendants. Ultimately, we might hope to use such a model to try to replicate the distribution of income and wealth we actually observe in the population, so that we can uncover the major forces at work. Then, it is hoped, we can try to understand what optimal distributions of income and wealth are, from society’s point of view, and how government policy might help us achieve those optima. For an overview of how some economists analyze these problems, a good reference is Quadrini and Rios-Rull (2014).
Indeed, Quadrini and Rios-Rull’s piece is a chapter in the second volume of the Handbook of Income Distribution. The fact that there is something called a “handbook” on this topic tells us that this is a well-defined field of study in economics—Piketty is of course not the first economist who ever thought about the distribution of income and wealth.
What does the economics profession think it knows about income and wealth distribution? With respect to post-1980 trends in the United States, the thrust of research on the widening gap between the rich and the poor is that much of this can be explained by supply, technology, and trade. First, the supply of high-skilled workers is limited by the scarcity of high-ability people, and the high costs of acquiring skills. Second, technological change has increased the demand for high-skilled workers relative to low-skilled workers. Third, the reduction in global barriers to trade has acted to reduce the wages of low-skilled workers in the United States. But these three factors do not explain all of what is going on. In particular, it is hard to account for the economic forces behind the huge increases in compensation to top managers in the United States. And Piketty makes the case that the compensation of top managers is important to what is going within the top 1 percent of wage earners.
What else do economists know about the income and wealth distribution? We know a lot, I think, about what accounts for differences in per-capita incomes across countries. For example, Hsieh and Klenow (2010) summarize the research in this area as concluding that we can account for the differences in per capita incomes across countries in the world through differences in human capital (10-30 percent), physical capital (20 percent), and productivity (50-70 percent). Human capital is defined to be the stock of skills and education possessed by the labor force, physical capital comprises the stock of buildings, machines, and software used to produce gross domestic product, and productivity represents the current state of knowledge about how to organize production, both at the micro and macro levels. If we thought that the distribution of income among individuals in an economy is determined in a similar manner to the distribution of income across countries in the world, we would then look primarily for explanations which attach importance to knowledge, education, and skills.
But Piketty’s theory of income and wealth distribution, contrary to what we might anticipate, is startlingly simple, and can be boiled down to a couple of “laws.” Piketty first argues, by appealing to the data, that capital income is more important than labor income in concentrating income and wealth at the top of the distribution. Further, the ratio of capital to income, in the aggregate, is an important variable, as he argues that a higher capital/income ratio increases the share of capital income in total income, which in turn will concentrate income at higher levels of income. In addition, if the rate of return on capital, r, is greater than the growth rate of the economy, g, and if g falls during the 21st century, as Piketty anticipates, then the capital/labor ratio could become very large, and disparities in income and wealth could become much greater, thus causing social discord. The intuition here is that, if we imagine a wealthy individual who does not consume, his or her wealth will be growing at rate r, and so will become increasing large relative to gross domestic product, which is growing only at rate g < r.
So, Piketty sees powerful economic forces that will propel us into ever-widening income and wealth gaps and social instability. What does he recommend we do about it? Basically, Piketty would like us to bring about massive changes in taxation. The marginal income tax rates of the very rich should be increased, to 80 percent or more, and there should be a global graduated wealth tax.
What is wrong with Piketty’s analysis? There are four issues at hand.
First, over the period in which dispersion in incomes was increasing in the United States and other countries, the dispersion in incomes in the world as a whole (which, presumably, is what we should care about) was falling. This development was driven primarily by the very high rates of economic growth in China and India, which account collectively for more than a third of the world’s population. Indeed, as noted above, lower wages of less-skilled workers in the United States has been driven in part by import competition. To the extent that the poorest Americans were poorer relative to their richer fellow-citizens, some citizens of other countries were becoming richer.
Second, Piketty downplays the importance of human capital to a fault. A key lesson of the economics literature on economic growth is the importance of knowledge, education, and the accumulation of skills in determining the level of a nation’s economic welfare. (See Hsieh, C. and Klenow, P. 2010. “Development Accounting,” American Economic Journal: Macroeconomics 2, 207-223.) If we were to apply this to the problem of poverty in the United States, for example, we might come to the conclusion that the way to solve such problems is through investment in public education. Indeed, the work of James Heckman, for example, suggests that the most productive public educational expenditures—in terms of reducing long-term poverty—would be those directed at early childhood education.
Third, Piketty seems overly distracted by income and wealth concentrated in the hands of the top 1 percent, and connects this to capital income and inheritance which, he argues, makes this concentration of wealth persist. But, if one peruses the list of the top 20 richest Americans, most of these are people, such as Bill Gates and Mark Zuckerberg, became rich on labor income, not inheritance. To the extent that they inherited something, as did the Walton family, they are working in a going concern (e.g., Walmart), and should not be characterized as members of the filthy-rich leisure class. Further, for every Zuckerberg, there are many more people who took risks and failed. But they took those risks knowing that there was a slim chance of an extremely large reward. With extremely large rewards taxed at 80 percent or more, the attraction of innovating and taking risks would be considerably reduced. As well, the rich have very strong incentives to avoid taxation, and can afford to pay accountants to help them do it. In addition, as Piketty admits, international agreement on a global wealth tax is extremely unlikely. Thus, rather than wasting our effort in attempts at extracting more from the extremely rich, we should focus on poverty. Solving the problem of poverty—in the United States or in the world—is difficult, but that is where the payoff is. As discussed above, making inroads in reducing poverty is more likely to involve investment in public education rather than redistributing income through the tax system.
Fourth, and finally, as Krusell and Smith (2014) have pointed out, there is a fundamental flaw in Piketty’s theory of income and wealth distribution. Given what we know about consumption and savings behavior at the individual level, and about the modern theory of economic growth, even if the rate of economic growth dropped to very low levels, or zero, in the current century, this would have little effect on the distribution of income and wealth.
Capital is noteworthy as one of the best-selling economics books of recent history. It’s also noteworthy as the least-read book of the summer of 2014, and you only have to attempt to read it to understand why. What Piketty took almost 700 pages to get across could easily be condensed to less than 200 pages, and it is unclear who he is writing for. Professional economists will find the analysis superficial and overly speculative, while lay people may feel snowed-under by statistics, and bored with digressions. Definitely not beach reading.
