Capital in the Twenty-First Century —An Extended Review

Kurt C. Schaefer is Professor of Economics at Calvin College.

A young economist working at a new school writes a 696-page book. It is based on fifteen years of research codifying eighteenth- and nineteenth-century probate and tax records. This does not sound like a recipe for commercial success. Yet within a month Capital in the Twenty-First Century was number one on the New York Times bestseller list. The Economist called it “the economics book taking the world by storm.”¹

In a literal sense, there is nothing new in it. Using data from the last three hundred years and several century-old tautological equations, Capital advocates policy popularized in the mid-nineteenth century. So why all the fuss? The data had been unavailable, at least in a usable form, and their recovery feels like a Rosetta Stone moment: A record of levels and distributions of wealth has been unearthed. Piketty aims to reveal what wealth is, how its nature changes over time, who owns it, how it is transferred, why so many people have virtually none of it, and how it is related to income. He also gives a straightforward explanation of why these things change over time, and that explanation implies that our present situation is unusual, not likely to continue. Yet wealth and its distribution change in comprehensible, predictable ways that are subject to our control.

Capital considers the momentous questions that economists have historically pondered: the distribution of wealth and income, the nature of rights, the meaning of justice, the long-term viability of democracy. Piketty leans against “common sense” rationalizations, using the simplest of models—their transparency suggests indisputability. And Capital’s prose is generally judicious, witty, restrained, and engaging. The book bristles with unexpected data, counterintuitive deductions, and sober reminders of the limits of our knowledge.

The Message

Marie raises sheep for market. Her marketed flock grows 1.67% bigger each year, because every January she places 10% of the marketed flock in a separate “breeding” flock. In a few years her breeding flock will surpass the marketed flock. Eventually the ratio of flock sizes will hit a stable equilibrium.

That is Capital’s framework. Let g be the rate at which economies grow— around 1.67% per year on average—and let s be the savings rate—the percent of production reserved to become part of capital for future production, historically about 10%. This capital is “wealth,” whereas annual production is “income.” Owners of wealth receive income as a percentage rate of return on their investment (call it r), historically around 5%. If g and s are stable, the wealth/income ratio (call it β) stabilizes. Historically, national wealth is about 600% of annual national income. This all implies a stable fraction of income (α) going to capital owners—around 30%, usually.

In symbols:

1. The ratio of wealth relative to annual income converges to the ratio of savings to economic growth: β = s/g. (In our example, 6 = 10 / 1.67). This is Piketty’s “second fundamental law of capitalism,” though it is true of any economic system.
2. Wealth-owners’ share of income approaches the rate of return on capital times the capital/income ratio: α= r x β. In our example, 30% equals 5% of 600%. This is Piketty’s “first fundamental law of capitalism.”
3. Piketty argues that usually r is greater than g, and that the greater the difference, the more rapidly the capital/income ratio will grow.
   

Wealth belongs to people who have saved, or whose ancestors saved (or stole) on their behalf. These capitalists own six times the value of annual national income, and receive 30% of all that income as a result. The large majority of this wealth has usually been inherited, not saved up from one’s own wages.

As it happens, not many people save much, and even fewer have the foresight to inherit well. Thus the income from capital is distributed very unevenly. The bottom half of the income distribution “everywhere and always” owns virtually nothing; the top 10% of wealth owners always own at least half of the wealth, and sometimes as much as 90% (244). The top 1% of wealth owners currently hold around a quarter of all the wealth. Thus if α and β increase, so does income inequality.

These α and β proportions are not fixed in stone, moving through three basic eras of wealth ownership. Prior to 1914, wealth was largely land-related and extremely unequally owned: Even in the United States, then relatively egalitarian, in 1910 the top 10% owned 80% of wealth, the top 1%, 45%. Then came the cataclysms of 1914-1945: The 10% and 1% shares eventually fell to around 60% and 20% in Europe, and inheritances significantly declined in influence. A true propertied middle class emerged for the first time (260). Since 1980 these wealth trends have begun to reverse, and super-high incomes have increased, especially among managers.

Piketty’s forecast: g will fall from unusual post-war rates, and the wealthiest will receive an r greater than commoners. Thus the capital/income ratio, the income share of wealth owners, and the importance of inheritance will grow. There is no natural limit on this inequality; great wealth unrelated to effort, and the attendant political influence without transparent accountability, challenge the viability of democracy.

Piketty’s antidote: an international, annual, progressive tax on capital, parallel to property taxes on real estate. 1-10% of the largest fortunes should be taxed away annually. This amounts to a 20%-200% tax on the income from savings, coupled to Piketty’s proposed 80% tax rate on high incomes. He repeatedly acknowledges that these taxes would generate little revenue, because they significantly suppress productive activity (e.g., 505, 512). They are intended to be punitive, to equalize wealth and income by removing wealth and income, much as wars and economic depression did at mid-twentieth century. The capital tax’s primary virtues are making ownership transparent and accountable to law, and bringing r closer to g. This restrains the otherwise limitless expansion of inequality. He acknowledges that this proposal is utopian, a benchmark for evaluating other proposals.

Nothing but the Truth?

Most economists gives us three things to evaluate: data, theory (or “model”), and prose. Concerning data, Piketty represents his work as the dogged, nonpartisan pursuit of previously-unavailable data, raising the stakes for data integrity. The trustworthiness of his empirical work has been questioned. Chris Giles famously concluded that “there is little evidence in Prof Piketty’s original sources to bear out the thesis that an increasing share of total wealth is held by the richest few,” citing transcription errors, incorrect spreadsheet formulas, cherry-picking of data, and “data lacking an original source reference.” ² The differences are significant: Piketty places 71% of British wealth among the top 10%, whereas the Office for National Statistics reports the figure as 44%. Piketty replied that the diversity of historical sources required adjustments to allow commensurate comparisons, and that some other wealth data confirm his.

Piketty has recently indicated that his data on wealth in the United States should be replaced by the “much more systematic” and “more reliable” data of his colleagues Zucman and Saez who reach different conclusions, available online as a March 2014 Power Point presentation.³ But many have pointed out basic errors in both data sources: Tax-law changes required more capital income be reported for the wealthiest than for others, and drove business income into personal tax returns;⁴ Piketty’s data also generally exclude government redistribution activities, treat capital gains as one-year windfalls, enumerate tax units rather than households, don’t count owned housing services as a return on capital, and exclude non-taxable capital gains like home sales and 401K distributions. All of these choices exaggerate recent inequality increases. The cumulative effect of these errors remains unmeasured.

Turning to theory, Capital is unusual for an economist, because there is almost no theory. There are only data, tautologies, and ratios. This is a problem. The book’s fundamental point is that no mechanical law restrains inequality, but theory-free tautological “law” equations create an even more mechanical view of the economy.

For example, since β = s/g, if growth g slows, β (and wealth inequality) inevitably rises, right? And since α= r x β, as β grows, so will capital’s income share, oui? Well, that depends on whether β, s, r, and g are independent of each other, each able to change without affecting the others. To know if this is true, you need a theory. If g shrinks in β = s/g, so might the incentive to save, leaving β unchanged. Or consider β, the ratio of capital’s value to current income: Why should these two be independent of each other, so that β could expand limitlessly? Piketty’s data suggest that β is limited in the long run: Capital (the numerator) gets its value from its ability to produce income in the future, and current income (the denominator) usually has a fairly stable relationship to future income. So you would expect the value of capital to be a stable percentage, β, of current income. In α= r x β, if β were indeed to grow, the increase in capital should drive down r, since capital experiences diminishing returns; rising capital levels could reduce α, the income share of capital owners.⁵

Though Piketty argues there is no “magical equilibrium” limit on α and β, the claim is not supported by his data. β and α were remarkably stable throughout the turmoil of the eighteenth and nineteenth centuries. Only an all-out world-wide war on capital in the twentieth century shook the ratios, which are now returning to long-run levels.

The equations also cannot consider social mobility. They suggest a static
wealthy class, replicating itself via inheritance. But in the United States 73% of households eventually reach top 20% incomes, and 39% reach the top 5%.⁶ Wealth does not persist very well within wealthy families, even within single generations.⁷ Even if r>g, wealth accumulated in the past need not “devour the future.” Democracies can probably handle inequality if coupled with social mobility.

Concerning Piketty’s prose, it is generally gracious. But nothing turns his Champagne to brine quite like the mention of economists. He mocks “their absurd claim to greater scientific legitimacy, despite the fact that they know almost nothing about anything.” He is particularly harsh toward other growth theorists and the “human capital” tradition. This is unfortunate. Such an attitude dulls one’s capacity for fair contemplation of alternatives. Piketty repeatedly claims that his tax proposal is democracy’s best, only hope (e.g., 439-44).

The Whole Truth?

What alternatives? Let me suggest a few that seek an egalitarian, fair society.

Surely increases in α and β are harmful not because there is more capital, but because its ownership has been concentrated. That is an entirely different problem from the processes described by Piketty’s equations. Capital is unequally distributed because only a few people save. More saving reduces the influence of inheritances (402-8), especially if saving is widespread.

If an eighteen-year-old quits his pack-a-day smoking habit, and saves that daily $5 in a Russell 3000 equity index account, then—given the future stability of r that Capital expects—he will retire at 68 with around $1,370,000 of wealth, knocking on the door of the top 1%. If he leaves it there another 20 years, as Piketty says the wealthy do, he will have $7 million, well into the top 0.1%. Nearly anyone can do this, because nearly anyone can afford to smoke, and because access to equity investing has become radically democratic. Why do so few people save even this much—just 3.5% of a typical household income? If even half the low-wealth population did this, capital ownership would be radically equalized.

The fact is that all working Americans do save—over 15% of their wages—as required by law. They believe this is being invested as a nest-egg. But the Social Security Trust Fund holds no assets to fund future spending—the money has been spent—and its deficits will rapidly accelerate after 2017. As I write the sum of all assets in the United States—all American wealth—is $111.5 trillion; unfunded retirement promises sum to $121.9 trillion.

This is not the time to destroy assets in the name of social equality. Yet Piketty would, and excuses the entitlement crisis: earlier generations at least had a stable retirement (392), and the transition to a rational system would be difficult. (489-90) Less difficult than an annual progressive international tax on capital! Entitlement reform, done well, is a more urgent and effective route toward equality than a confiscatory international capital tax.

And we could encourage growth, which Capital quietly concedes would encourage equality: “Hierarchies largely determined by inherited wealth… can arise and subsist only in low-growth regimes” (84). Or we could strengthen anti-trust enforcement to limit unfair capture of wealth. Or acknowledge that human capital clearly has growing importance relative to physical capital (222-4, 306-7, 419) by encouraging stable family structures and improving education opportunities. This would increase the returns to labor relative to capital, and slant technological improvement toward labor’s advantage: “The principal mechanism for convergence (i.e. equality) at the international as well as the domestic level is the diffusion of knowledge… often hastened by international openness and trade… education and training of the population… stable legal framework… legitimate and efficient government” (71). These are all difficult projects, but, as Piketty affirms, maintaining democratic institutions is always difficult.

The Truth?

Beneath data, theory, and prose, what are the epistemological, ethical, and metaphysical commitments at work in Capital? Piketty’s ethical refrain is concern for the viability of democratic institutions. Economic inequality—not poverty or human rights or religious liberty, for example—is the contemporary challenge to democracy. These democratic concerns are grounded by references to the United States’ Declaration of Independence (1776) and the French Declaration of the Rights of Man and the Citizen (1789), with brief reference to John Rawls’ ethical theory for resolving disputes among rights. Though frequently compared to Marx, Piketty’s analysis and prescriptions closely parallel those of John Stuart Mill. Since democracy, the American and French revolutions, the work of Rawls, and the legacy of Mill have all received serious consideration by Christian scholars, there is a rich tradition for evaluating Piketty’s work theologically.

Is Capital telling the truth? Let us acknowledge that this is the overture to a new opera. We have not heard most of the score yet. Piketty has opened the door to new information, fresh analysis, and provocative policy options that will take some time to hear, appreciate, and evaluate. As Lawrence Summers suggested, “Thomas Piketty’s tour de force analysis doesn’t get everything right, but it’s certainly gotten us pondering the right questions.”⁸ For this scholars of all stripes can be grateful.

1. A. R. “Thomas Piketty’s “Capital,” summarized in four paragraphs.” The Economist, May 4, 2014 www.economist.com/blogs/economist-explains.
2. Giles, Chris. “Piketty findings undercut by errors.” Financial Times, May 23, 2014.
3. http://gabriel-zucman.eu/files/SaezZucman2014Slides.pdf.
4. Most will find jarring Piketty’s claim (256) that the United States is the most inequitable nation at any time or place. European Gini income coefficients fall in the .25-.35 range; the United States is around .45, and about half the difference from Europe is explained by the much larger size of the United States. The .45 coefficient puts the United States in the middle 50% of the world’s countries; Gini coefficients elsewhere go as high as .65. Wealth is relatively unequally distributed in the United States, but still more egalitarian than, for example, Denmark, which Piketty admires for its egalitarian income distribution.
5. Lawrence Summers, Secretary of the Treasury under President Clinton, and Director of the National Economic Council for President Obama, has argued that this is a significant problem for Piketty’s case: Summers, Lawrence. “The Inequality Puzzle: Piketty Book Review.” Democracy: A Journal of Ideas (Spring, 2014). http://larrysummers.com/2014/05/14/piketty-book-review-the-inequality-puzzle/.
6. Mark R. Rank, Thomas A. Hirschl, and Kirk A. Foster, Chasing the American Dream: Understanding What Shapes Our Fortunes (Oxford: Oxford University Press, 2014).
7. For example, there is remarkable turnover within lists like the Forbes 500, and remarkably low rates of return after one appears on the list.
8. Summers, Lawrence. “The Inequality Puzzle: Piketty Book Review.” Democracy: A Journal of Ideas (Spring, 2014), abstract.