Mike Kueber's Blog

October 15, 2014

Sunday Book Review #147 – Capital in the Twenty-First Century by Thomas Piketty

Filed under: Book reviews,Economics — Mike Kueber @ 6:23 pm
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My first exposure to Capital in the Twenty-First Century by French economist Thomas Piketty was a few months ago in a Time magazine book review. The review suggested three main points:

  1. Based on Piketty’s review of historical records going back hundreds of years in 30 countries, he has concluded that income inequality almost always gets worse because, “Since the rate of return on capital is naturally greater than the rate of growth in the economy as a whole, people who get most of their wealth from investments inevitably grow richer compared with those who get their money from economy and wages.” The only exceptions are war or direct governmental intervention. That makes sense.
  2. Reform in the tax code must do more than tinker with progressivity; rather, it must consider wealth as a whole, such as real property and intangible assets. Warren Buffet’s tax rate should not be less than his secretary’s. That makes sense.
  3. Other measures to reduce inequality include boosting access to education, increasing capital-gains taxes, and closing corporate tax loopholes. That makes sense.

I recently skimmed the 577-page book and noted the following additional insights:

  1. Progressive taxation. There are four principal types of taxes – taxes on income, capital, and consumption, plus a relatively new tax for social-insurance programs, like social security and unemployment compensation. Surprisingly, these taxes, when combined, are not progressive or even proportional in most countries. In fact, they are regressive.
  2. Obscene executive compensation. Studies show that obscene executive compensation results not from value-added performance, but rather from low tax rates on high salaries – i.e., because executives in low-rate countries get to keep so much of their high salary, they are motivated to negotiate hard for a higher salary. By contrast, if their marginal tax rate was set in the area of 80%, they would continue to work as hard, but wouldn’t care so much about being paid more money. Instead this money would go toward the salaries of their underlings. Piketty specifically rejects my pet theory: “Similarly, the idea that skyrocketing executive pay is due to lack of competition, and that more competitive markets and better corporate governance and control would put an end to it, seems unrealistic. Our findings suggest that only dissuasive taxation of the sort applied in the US and Britain before 1980 can do the job.
  3. Growth of government. Before 1920, most first-world governments taxed about 10% of their national income and provided only “regalian” services – i.e., police, national security, and courts – plus schools and infrastructure. Between 1920 and 1980, government services expanded greatly into social services like health and income replacement (pensions, unemployment, and welfare) and their taxes increased to 30% in US, 40% in England, and 45%-55% in Europe. Since 1980, taxes have plateaued at those rates. Future expansion of government will depend on (a) whether the world economy can resume the robust growth it experienced between 1940 and 1980, and (b) whether governments can prove they can effectively manage their current role in the economy.
  4. Income redistribution. In modern society, income is not redistributed in a direct way, but rather indirectly by government providing baseline services to everyone – e.g., pensions, public schools, and access to medical care. Means-testing these services would threaten their public support.
  5. Education and social mobility. No government has solved the problem of unequal/unfair access to educational opportunities. Some even argue that a meritocracy is inherently unfair because it will continue to reward the upper class and “preserve their hegemony.” Now, that sounds like a bomb-thrower.
  6. Pay-as-you-go pensions (PAYGO). PAYGOs are plagued by low economic growth and plateaued populations. Individuals would be much better off if they had been able to invest their retirement savings because capital grows at a much faster rate than economies or population. But we are where we are, and reforms will need to increase the taxes or decrease the payouts. “One often hears that a public pension is the patrimony of those without patrimony. This is true, but it does not mean that it would not be wise to encourage people of more modest means to accumulate nest eggs of their own.”
  7. Public debt. “There are two main ways for a government to finance its expenses: taxes and debt. In general, taxation is by far preferable to debt in terms of justice and efficiency. The problem with debt is that it usually has to be repaid, so that debt financing is in the interest of those who have the means to lend to the government. From the standpoint of the general interest, it is normally preferable to tax the wealthy rather than borrow from them.” Although Piketty doesn’t specifically describe the “justice” issue, I suspect one major component of injustice would be the disconnect between one generation benefiting from the assumption of debt and a later generation having to repay the debt. Paradoxically, rich nations have more public debt (about 90% of GDP) than poor nations (around 30%).
  8. Paying down public debt. Realistically, public debt can be reduced by (a) a special tax, (b) inflation, and (c) austerity. Unrealistically, public debt can be repudiated. And because public assets are approximately equal to public debt, hypothetically governments could pay off the public debt by selling off the public assets, but that is not realistic. According to Piketty, a special, progressive tax is preferable to the other realistic options in terms of justice and efficiency, but for political reasons, nations often resort to inflation to solve their debt problems. A major problem with inflation is that it is hard to control. An advantage is that it falls primarily on those holding idle money. By far the worst option is austerity, although that is what Europe is currently employing. Fascinating facts – national wealth in Europe is about six times more than national income; private wealth is about 50% real estate and 50% financial assets; Europeans own approximately the same amount of the rest of the world as the rest of the world owns of Europe.
  9. What is the ideal level of national capital? “The maximum level of capital is attained when so much has been accumulated that the return on capital, r, supposed to be equal to its marginal productivity, falls to be equal to the growth rate, g.” This brings us full circle back to Piketty’s initial point that income inequality will become more severe because the return on capital (4-5%) currently far exceeds long-term growth (1.5%). Currently, the most capital-intensive countries have capital that is about six to seven times greater than income. Piketty guesses that capital would need to be 15-30 times income before return on capital would sink to the level of the economic growth rate.

Piketty’s book has caught the attention of the world. As an article in the NY Times reflects, Piketty has become a bit of a rock star (see Bill Gate’s favorable book review), but most economists are skeptical, especially about his signal formula, r>g. I am hopeful, however, that his other insights will result in a more just and efficient world economy.






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