Mind the Gap

“Capitalism automatically generates arbitrary and unsustainable inequalities that radically undermine democratic societies.” — Thomas Piketty, Capital in the 21st Century

French professor Thomas Piketty’s new book — ranked #1 on Amazon and the New York Times — is a thick volume with the same title as Karl Marx’s 1867 magnum opus, Capital. Many commentators have noted the Marxist tone — the author cites Marx more than any other economist — but that’s a distraction.

The author discusses capital and economic growth, and recommends a levy on capital, but the primary focus of the book is inequality. In mind-numbing minutiae of data from Europe and the United Staes, Piketty details how inequality of income and wealth have ebbed and flowed over the past 200 years before increasing at an “alarming” rate in the 21st century. Because of his demonstrated expertise, his scholarship and policy recommendations (sharply higher progressive taxes and a universal wealth tax) will be taken seriously by academics and government officials. Critics would be wise to address the issues he raises rather than simply to dismiss him as a French polemicist or the “new Marx.”

According to his research, inequality grows naturally under unfettered capitalism except during times of war and depression. “To a large extent, it was the chaos of war, with its attendant economic and political shocks, that reduced inequality in the twentieth century” (p. 275, cf. 471) Otherwise, he contends, there is a natural tendency for market-friendly economies to experience an increasing concentration of wealth. His research shows that, with the exception of 1914-45, the rate of return on property and investments has consistently been higher than the rate of economic growth. He predicts that, barring another war or depression, wealth will continue to concentrate into the top brackets, and inherited wealth will grow faster with an aging population and inevitable slower growth rates, which he regards as “potentially terrifying” and socially “destabilizing.”

His proposal? Investing in education and technical training will help, but won’t be enough to counter growing inequality. The “right solution” is a progressive income tax up to 80% and a wealth tax up to 10%. He is convinced that these confiscatory rates won’t kill the motor of economic growth.

One of the biggest challenges for egalitarians like Piketty is to define what they mean by an “ideal” distribution of income and wealth. Is there a “natural” equilibrium of income distribution? This is an age-old question that has yet to be resolved. I raised it in a chapter in “Economics on Trial” in 1991, where I quoted Paul Samuelson in his famous textbook, “The most efficient economy in the world may produce a distribution of wages and property that would offend even the staunchest defender of free markets.”

But by what measure does one determine whether a nation’s income distribution is “offensive” or “terrifying”? In the past, the Gini ratio or coefficient has been used. It is a single number that varies between 0 and 1. If 0, it means that everyone earns the same amount; if 1, it means that one person earns all the income and the rest earn nothing. Neither one is ideal. Suppose everyone earns the same wage or salary. Perfect equality sounds wonderful until you realize that no economy could function efficiently that way. How you could hire anyone else to work for you if you had to pay them the same amount you earn?

Even social democrats William Baumol and Alan Blinder warned in their popular economics textbook, “What would happen if we tried to achieve perfect equality by putting a 100% income tax on all workers and then divide the receipts equally among the population? No one would have any incentive to work, to invest, to take risks, or to do anything else to earn money, because the rewards for all such activities would disappear.”

So if a Gini ratio of 0 is bad, why is a movement toward 0 (via a progressive income tax) good? It makes no sense.

Piketty wisely avoids the use of the Gini ratios in his work. Instead he divides income earners into three general categories, the wealthy (top 10% income earners), the middle class (40%), and the rest (50%), and tracks how they fare over the long term.

But what is the ideal income distribution? It’s a chimera. The best Piketty and his egalitarian levelers can do is complain that inequality is getting worse, that the distribution of income is unfair and often unrelated to productivity or merit (pp. 334–5), and therefore should be taxed away. But they can’t point to any ideal or natural distribution, other than perhaps some vague Belle Époque of equality and opportunity (celebrated in France between 1890 and 1914).

Piketty names Simon Kuznets, the 20th century Russian-American economist who invented national income statistics like GDP, as his primary antagonist. He credits Kuznets with the pro-market stance that capitalist development tends to reduce income inequality over time. But actually it was Adam Smith who advocated this concept two centuries earlier. In the Wealth of Nations, Smith contended that his “system of natural liberty” would result in “universal opulence which extends itself to the lowest ranks of the people.”

Not only would the rich get richer under unfettered enterprise, but so would the poor. In fact, according to Smith and his followers, the poor catch up to the rich, and inequality is sharply reduced under a liberal economic system without a progressive tax or welfare state. The empirical work of Stanley Libergott, and later Michael Cox, demonstrates that through the competitive efforts of entrepreneurs, workers, and capitalists, virtually all American consumers have been able to change an uncertain and often cruel world into a more pleasant and convenient place to live and work. A typical homestead in 1900 had no central heating, electricity, refrigeration, flush toilets, or even running water. But by 1970, before the welfare state really got started, a large majority of poor people benefited from these goods and services. The rich had all these things at first — cars, electricity, indoor plumbing, air conditioning — but now even the poor enjoy these benefits and thus rose out of poverty.

Piketty and other egalitarians make their case that inequality of income is growing since the Great Recession, and they may well be correct. But what if goods and services, what money can buy, becomes a criteria for inequality? The results might be quite different. Today even my poor neighbors in Yonkers have smartphones, just like the rich. While every spring the 1% attend the Milken Institute Conference in LA that costs $7,000 or more to attend; the 99% can watch the entire proceedings on video on the Internet a few days later — for free. The 1% can go to the Super Bowl for entertainment; the 99% gather around with their buddies and watch it on an widescreen HD television. Who is better entertained?

Piketty & Co. claim that only the elite can go to the top schools in the country, but ignore the incredible revolution in online education, where anyone from anywhere in the world can take a course in engineering, physics, or literature from Stanford, MIT, or Harvard for a few thousand dollars, or in some cases, for absolutely nothing.

How do income statistics measure that kind of equal access? They can’t. Andrew Carnegie said it best, “Capitalism is about turning luxuries into necessities.” If that’s what capital and capitalism does, we need to tax it less, not more.

A certain amount of inequality is a natural outcome of the marketplace. As John Maynard Keynes himself wrote in the Economic Consequences of the Peace (1920), “In fact, it was precisely the inequality of the distribution of wealth which made possible those vast accumulations of fixed wealth of and of capital improvements which distinguished that age [the 19th century] from all others.”

A better measure of wellbeing is the changes in the absolute real level of income for the poor and middle classes. If the average working poor saw their real income (after inflation) double or triple in the United States, that would mean lifting themselves out of poverty. That would mean a lot more to them than the fortunes of the 1%. Even John Kenneth Galbraith recognized that higher real growth for the working class was what really mattered when he said in The Affluent Society (1959), “It is the increase in output in recent decades, not the redistribution of income, which has brought the great material increase, the well-being of the average man.”

Political philosopher James Rawls argued in his Theory of Justice (1971) that the most important measure of social welfare is not the distribution of income but how the lowest 10% perform. James Gwartney and other authors of the annual Economic Freedom Index have shown that the poorest 10% of the world’s population earn more income when they adopt institutions favoring economic freedom. Economic freedom also reduces infant mortality, the incidence of child labor, black markets, and corruption by public officials, while increasing adult literacy, life expectancy, and civil liberties. If market-generated inequality is the price we pay to eliminate poverty, I’m all in favor.

I have reservations about Piketty’s claim that “Once a fortune is established, the capital grows according to a dynamic of its own, and it can continue to grow at a rapid pace for decades simply because of its size.” To prove his point, he selects members of the Forbes billionaires list to show that wealth always grows faster than the average income earner. He repeatedly refers to the growing fortunes of Bill Gates in the United States and Liliane Bettencourt, heiress of L’Oreal, the cosmetics firm.

Come again?

I guess he hasn’t heard of the dozens of wealthy people who lost their fortunes, like the Vanderbilts, or to use a recent example, Eike Batista, the Brazilian businessman who just two years ago was the 7th wealthiest man in the world, worth $30 billion, and now is almost bankrupt.

Piketty conveniently ignores the fact that most high-performing mutual funds eventually stop beating the market and even underperform. Take a look at the Forbes “Honor Roll” of outstanding mutual funds. Today’s list is almost entirely different from the list of 15 or 20 years ago. In our business we call it “reversion to the mean,” and it happens all the time.

Prof. Piketty seems to have forgotten a major theme of Marx and later Joseph Schumpeter, that capitalism is a dynamic model of creative destruction. Today’s winners are often tomorrow’s losers.

IBM used to dominate the computer business; now Apple does. Citibank used to be the country’s largest bank. Now it’s Chase. Sears Roebuck used to be the largest retail store. Now it’s Wal-Mart. GM used to be the biggest car manufacturer. Now it’s Toyota. And the Rockefellers used to be the wealthiest family. Now it’s the Waltons, who a generation ago were dirt poor.

Piketty is no communist and is certainly not as radical as Marx in his predictions or policy recommendations. Many call him “Marx Lite.” He doesn’t advocate abolishing money and the traditional family, confiscating all private property, or nationalizing all the industries. But he’s plenty radical in his soak-the-rich schemes: a punitive 80% tax on incomes above $500,000 or so, and a progressive global tax on capital with an annual levy between 0.1% and 10% on the greatest fortunes.

There are three major drawbacks to Piketty’s proposed tax on wealth or capital.

First, it violates the most fundamental principle of taxation, the benefit principle. Also known as the accountability or “user pay” principle, taxation is justified as a payment for benefits or services rendered. The basic idea is that if you buy a good or use a service, you should pay for it. This approach encourages efficiency and accountability. In the case of taxes, if you benefit from a government service (police, infrastructure, utilities, defense, etc.), you should pay for it. The more you benefit, the more you pay. In general, most economists agree that wealthier people and big businesses benefit more from government services (protection of their property) and should therefore pay more. A flat personal or corporate income tax would fit the bill. But a tax on capital (or even a progressive income tax) is not necessarily connected to benefits from government services — it’s just a way to forcibly redistribute funds from rich to poor and in that sense is an example of legal theft and tyranny of the majority.

Second, a wealth tax destroys a fundamental sacred right of mankind — financial privacy and the right to be left alone. An income tax is bad enough. But a wealth tax is worse. It requires every citizen to list all their assets, which means no secret stash of gold and silver coins, diamonds, art work, or bearer bonds. Suddenly financial privacy as guaranteed by the Fourth Amendment becomes illegal and an underground black market activity.

Third, a wealth tax is a tax on capital, the key to economic growth. The worst crime of Piketty’s vulgar capitalism is his failure to understand the positive role of capital in advancing the standard of living in all the world.

To create new products and services and raise economic performance, a nation needs capital, lots of it. Contrary to Piketty’s claim, it’s good that capital grows faster than income, because that means people are increasing their savings rate. The only time capital declines is during war and depression, when capital is destroyed.

He blames the increase in inequality to low growth rates, when, says, the economic growth rate falls below the return on capital. The solution isn’t to tax capital, but to increase economic growth via tax cuts, deregulation, better training and education and productivity, and free trade.

Even Keynes understood the value of capital investment, and the need to keep it growing. In his Economic Consequences of the Peace, Keynes compared capital to a cake that should never be eaten. “The virtue of the cake was that it was never to be consumed, neither by you nor by your children after you.”

If the capital “cake” is the source of economic growth and a higher standard of living, we want to do everything we can to encourage capital accumulation. Make the cake bigger and there will be plenty to go around for everyone. This is why increasing corporate profits is good — it means more money to pay workers. Studies show that companies with higher profit margins tend to pay their workers more. Remember the Henry Ford $5 a day story of 1914?

If anything, we should reduce taxes on capital gains, interest, and dividends, and encourage people to save more and thus increase the pool of available capital and entrepreneurial activity. A progressive tax on high-income earners is a tax on capital. An inheritance tax is a tax on capital. A tax on interest, dividends, and capital gains is a tax on capital. By overtaxing capital, estates, and the income of our wealthiest people, including heirs to fortunes, we are selling our country and our nation short. There’s no telling how high our standard of living could be if we adopted a low-tax policy. What country has advanced the most since World War II? Hong Kong, which has no tax on interest, dividends, or capital.

Hopefully Mr. Piketty will see the error of his ways and write a sequel called “The Wealth of Nations for the 21st Century,” and will quote Adam Smith instead of Karl Marx. The great Scottish economist Adam Smith once said, “Little else is required to carry a state from the lowest barbarism to the highest degree of opulence but peace, easy taxes, and a tolerable administration of justice.” Or per haps he will quote this passage: “To prohibit a great people….from making all that they can of every part of their own produce, or from employing their stock and industry in the way that they judge most advantageous to themselves, is a manifest violation of the most sacred rights of mankind.”