Inequality and the Piketty debate
29 May 2014
Thomas Piketty is the French “rock star” economist whose magnum opus, Capital in the Twenty-First Century, has become a surprise bestseller on both sides of the Atlantic and one of the most talked about books on economics in recent times. It has also attracted a fair amount of controversy. Chris Giles of the Financial Times is the latest to wade in with arguments that there are some errors in the data used by the author, which could undermine his conclusions, although Piketty has disputed that this would change anything of significance in his analysis.
In this blog, two of PwC’s senior economists give their view. John Hawksworth reviews Piketty’s book and Andrew Sentance provides additional comments.
The battle against inequality goes mainstream
by John Hawksworth, chief economist
Piketty’s work would be fascinating for the historical data alone, which mines income tax and estate tax records for France, the UK and the US going back more than two centuries (although the FT analysis suggests that the wealth data may need some refinement). He charts the evolution of a ‘rentier society’ with rising levels of wealth inequality up to 1914 (particularly in Europe and to a lesser degree the US) and its subsequent destruction due to two world wars and the rise between the 1930s and the 1970s of progressive taxation and the welfare state. He then discusses how income inequality has risen again since the early 1980s due to a combination of a gradual retreat from progressive taxation, declining trade union bargaining power, and the rise of a highly paid ‘supermanager elite’ against a backdrop of increasingly globalised and liberalised markets, facilitated by new communications technologies. This analysis chimes with themes from our own ongoing megatrends research.
The most controversial part of Piketty’s story concerns his tax policy proposals, but first let me consider some key empirical issues about how he projects forward his historical data.
Empirical issues – will inequality continue to rise?
The observation that income inequality is rising across the world economy is not a new one. This phenomenon has been analysed in major reports by the OECD, the IMF and International Labour Organisation. Piketty’s explanation, however, is that this is an inexorable trend if left unchecked by policy or major shocks like the two world wars. His argument rests on a number of empirical hypotheses, as listed below, which challenge conventional economic thinking. The evidence he presents is not conclusive, but it will certainly be a stimulus to more research in these areas.
1. He argues that the elasticity of substitution between capital and labour is significantly greater than 1 (maybe around 1.5 based on the academic studies he refers to, although other studies point to lower estimates). If this is true, it implies that a rising capital-income ratio will only be partly offset over time by a declining real rate of return on capital (r). This overturns the familiar result of stable labour and capital shares of national income, which is a feature of our own World in 2050 modelling of long-term growth and many other similar studies.
2. Piketty also projects that global growth (g) will decelerate significantly in the long run, particularly after 2050 when the catch-up process will be much closer to being complete for the large emerging economies like China and India. He therefore argues that r > g during the next century (particularly after 2050), which will tend to push up the capital-income ratio and the share of capital in national income.
3. He also argues that the rate of return on capital (r) will generally be higher on average for larger portfolios, thus accentuating the trend towards ever greater wealth inequality. He doesn't present a lot of hard evidence on this, other than some analysis of relative returns on US university endowment funds of different scales. This requires more research as it plays an important role in his overall argument for a progressive wealth tax to help to level the playing field at the post-tax return level.
Policy issues – a global approach to progressive taxation
Turning from analysis to policy, Piketty sees the need for a regulated form of capitalism to put some limits on the rising inequality seen over the past 30 years. He recognises the value of the free market economy and is not advocating widespread renationalisation or protectionism, but he does argue for stronger social protection for lower income groups. He sees progressive taxes on wealth and unearned income in particular as the fairest way to fund this provision.
Piketty notes that, during the period from the New Deal era of the mid-1930s to the late 1970s, the average top rate of marginal income tax in the US (typically on unearned income) was in fact around 80% and average real GDP per capita growth in the US was similar to, or even slightly higher than, in the following 30 years. Given how much else was changing over this period, such a correlation is no proof that such high marginal taxation would not be damaging to future growth, but he has argued this case more formally in past academic research with Emmanuel Saez and others.
This research suggests that sharp falls in top rates of tax help to explain the move from the 1980s onwards towards ever higher executive salaries in the US and the UK, since before then there was less incentive for senior executives to 'game the system' through corporate remuneration committees where many participants have a mutual interest in ever rising executive rewards. This story has a ring of truth to it, but he does seem to downplay other potentially less favourable incentive effects of such high marginal income tax rates on entrepreneurship.
Piketty’s primary and most radical proposal, however, is for a progressive annual wealth tax that would (roughly speaking) be zero on the first 1 million euros of wealth, 1% on the tranche between 1-5 million euros, and 2% on wealth above 5 million euros. He acknowledges, however, that governments could only do this on a co-ordinated international basis with much greater financial transparency to prevent the flight of wealth (and wealthy people) to lower tax regimes. Taxing the rich more unilaterally, as the French government has tried to do in recent years, is likely to fail.
He describes his policy suggestions as 'utopian', but argues that they are a useful reference point in setting a direction of travel, particularly on the issue of international financial transparency. This would build on the US FATCA legislation, earlier EU Directives and the OECD's work on tax havens, but take them further with the help of modern computer technology. A recent Economist article indicated that progress on this agenda has accelerated as 47 leading countries have signed a pact on financial data sharing to combat tax avoidance.
Piketty’s proposals remind me of how many economists argue for a global carbon tax as the ideal solution to the negative climate change externalities associated with carbon emissions, while accepting that (in the real world without a global government) a more gradual and piecemeal approach is needed to edge you in the same direction. Although Piketty does not express it in this way, his argument amounts to suggesting that rising income and wealth inequality is an unintended negative externality of a free market economy, which requires a progressive global wealth tax to correct this tendency and set capitalism on a more sustainable path in the long run.
However, you could dismiss all of Piketty's specific tax suggestions and still feel there was a lot that could be done on the policy agenda to combat inequality as set out, for example, in a recent IMF paper. These could range from boosting early years education for lower income families to increased building of affordable housing and paying a decent living wage. Piketty may be its radical prophet, but the battle against inequality is going mainstream.
Right issue – wrong solution
by Andrew Sentance, senior economic adviser
Thomas Piketty has done us a good service by writing a book on rising inequality of income and wealth – albeit a rather long one. His translator, Arthur Goldhammer, also deserves a lot of credit. His translation has contributed greatly to the readability of the book, which was virtually unknown before it appeared in English. For example, I’m not sure what French word he has translated as “worrisome”!
But the book flatters to deceive. Ultimately, it does not provide any new insights or policy conclusions into the important subject it aims to address. In fact it is a throwback to old Marxist ideas from the 19th century.
Rising income inequality in the western economies has been a concern for many decades. As John Hawksworth notes, the OECD, IMF and other international bodies have been writing about this for some time. The main conclusion of their analysis is that the forces of globalisation and new technology have played a major part in the trend to increased dispersion of incomes. In the UK and other western economies, globalisation and technological progress have advantaged people with high skills and scarce capabilities relative to those with low skills – particularly if they are relying on basic manual labour. Even though our economies have systems designed to redistribute income from the rich to the poor, and help the disadvantaged improve their economic prospects, these mechanisms may not be adequate in the face of the accelerating pace of economic change.
In the UK, analysis by the Institute for Fiscal Studies (IFS) confirms the growing importance of insecure employment prospects and low wage growth to the issue of poverty in the UK. IFS economists note that until the 1970s, the main causes of poverty in the UK were old age and persistent unemployment. More recently, they conclude:
"Poverty has become much more of an in-work phenomenon since the 1970s,as increased earnings inequality in the 1980s and relatively slow growth in earnings since have pushed more low and middle earners into poverty. This shift in poverty from something concentrated among the old and workless to something increasingly felt by employed and self-employed working-age adults is a major socio-economic change.”
These issues feature in Piketty’s book but they are not the centrepiece of his analysis. Rather, his thesis is that there is an inherent tendency to the accumulation of wealth in fewer and fewer hands because the returns to capital exceed economic growth. Implicitly he is also assuming that wealth accumulates as it is passed on through the generations.
This may make sense as an analysis of the 18th and 19th centuries, when land and physical capital were the main sources of wealth. But it does not make sense for the 21st century. High earners in modern western society are generally exploiting skills and technology – intangible capital – rather than the accumulation of physical capital. They have to invest their high income somewhere – so rich people do have large holdings of land and other physical assets. But the ultimate driver of inequality has little to do with the accumulation of physical wealth.
You can see this clearly by looking down the “rich lists” published frequently in the press. The rich are generally “nouveau riche”, as the French describe them. They have earned a lot by exploiting their skills, some new innovation or a lucky break. The old Marxist ideas of accumulation of capital have little to do with it.
If the analysis is wrong, then so are the policy prescriptions. Punitive taxation of unearned income and wealth is Piketty’s remedy. We have been here before – in the 1960s and 1970s. The leading western economies regenerated themselves in the 1980s and 1990s by moving away from this model. As John Hawksworth says in his review above, we need a much more diverse set of policies targeted on helping raise skill levels, improving access to basic needs – including housing, and helping disadvantaged groups in the population.
The popularity of Piketty’s book may have helped to raise the profile of income inequality. But it has not advanced the search for the right analysis or helped us find a practical and effective set of remedies.
 Living standards, poverty and inequality in the UK: 2013 by Jonathan Cribb, Andrew Hood, Robert Joyce and David Phillips. Institute for Fiscal Studies Report R81, June 2013