Capital in the Twenty-First Century, by Thomas Piketty, transl Arthur Goldhammer, Harvard University Press, 696 pp, £29.95, ISBN: 978-0674430006
The British economic historian and political activist RH Tawney wrote in 1913 that “what thoughtful rich people call the problem of poverty, thoughtful poor people, with equal justice call a problem of riches”. Adam Smith, Ricardo, Marx, Malthus and John Stuart Mill all regarded the distribution of income and wealth as a central concern of economics. But as neo-classical economics largely displaced political economy the questions of the distribution of income and wealth were dismissed as irrelevant because it was argued that economic growth would improve the lot of everybody. Today in the USA, even raising questions about the distribution of income is regarded as subversive. Thomas Lucas, who won the Nobel Prize for his work in macroeconomics, wrote in 2004: “Of the tendencies that are harmful to sound economics the most seductive, and in my opinion the most poisonous, is to focus on questions of distribution.”
Lucas’s comments indicate the huge gulf that separates economics theorists and ordinary people on what are the most important economic issues. The fact that most people consider that the distribution of wealth is a vital issue surely explains why Thomas Piketty’s Capital in the Twenty-First Century has become an unlikely bestseller. Piketty’s book consists of almost 700 pages of complex argument, illustrated by enormous quantities of data with several graphs in every chapter. It is however, engagingly written, drawing support for its arguments from such diverse sources as the novels of Jane Austen and Balzac and the US television series Damages and The West Wing. It is the most important book on economics published so far this century and the economic model it proposes has profound implications for the future of both the wealthy and the developing countries.
Thomas Piketty is a prodigiously talented French economist who was appointed a professor at MIT at twenty-three. After two years, he became disillusioned with what he calls “the childish passion for Mathematics” of the leading US economists and returned to France, where he became an indefatigable researcher on income distribution. Piketty showed that studies of the distribution of income based on household surveys often fail to capture the incomes of the wealthiest and he revived the approach of using fiscal data, pioneered by Vilfredo Pareto and Simon Kuznets. He showed that in France the share of the top ten per cent of income recipients had risen steadily from 1800 to 1918, fell between 1918 and the late 1970s and had been rising steadily since 1980. Studies, inspired by Piketty’s work, of income distribution in the UK and other European countries and the USA showed the same pattern.
From the Second World War until the 1980s, the top 10 per cent of American income recipients received one-third of total income while the top one per cent received about 10 per cent. Since the 1980s, inequality in the USA has soared, with the top 10 per cent now receiving half of total income and the top 1 per cent receiving almost a quarter; in Europe and Japan the top 1 per cent receive about 10 per cent. Research by Prof Brian Nolan of UCD shows that the top 1 per cent of wealth holders held 12 per cent of total wealth before the Second World War. Their share fell to about 6 per cent by the 1970s but climbed to 12 per cent during the boom. By 2009 the share of Ireland’s richest 1 per cent in accumulated capital had fallen back to 10 per cent which is the average for Western Europe. In terms of the distribution of wealth, Ireland is closer to Berlin than Boston.
The work of Piketty and his colleagues was becoming well known as the Great Recession began, and the fact that while incomes around the median had stagnated for over forty years in the USA, the share of the top 1 per cent of income recipients had increased dramatically, influenced the Occupy movement and gave it its slogan of 99 per cent vs 1 per cent.
Piketty argues that the fundamental force driving all market economies is the relationship between the rate of economic growth and the return on capital. The return on capital is based on the ratio of capital to income. This was high from 1800 to the First World War, fell sharply for the next fifty years and has risen again over the past forty years and is now at the same level as at the beginning of the twentieth century.
The share of capital income in total income is the rate of return on capital multiplied by the ratio of capital to income. This is a well known identity but Piketty’s central argument is that if the rate of return on capital exceeds the growth rate of output, the share of capital income in national income rises without limit. Piketty also argues that inherited wealth is rising as a share of total wealth and that Western societies are returning to what he calls “patrimonial capitalism” where, as in Edwardian Britain or the France of the so-called belle époque, most of the economy will be controlled not by individuals who made it to the top on merit but by family dynasties who have inherited their wealth.
While Piketty’s work is a masterly work of economic history, it is also a comprehensive theory of capitalism, like that of Marx, in that it integrates the theory of economic growth with the distribution of income and wealth. Piketty’s most disturbing argument is that the rise of the income share of the top 1 per cent is an intrinsic feature of market economies and that the reduction in this share in the mid-twentieth century was due to the huge destruction of capital in the two world wars and the gains made by the middle class due to redistributive policies implemented by social democratic governments in the aftermath of the Second World War. These gains have been partly reversed since the 1980s as governments since the time of Thatcher and Reagan have reduced taxes on higher incomes and on wealth and inheritance and have “rolled back the state”. The collapse of the centrally planned economies gave a powerful boost to those economists and politicians who argued that unfettered markets are the only means of achieving economic growth and that redistribution reduces growth by diminishing “incentives”.
In addition to the destruction of capital in the two world wars and the redistributive policies of social democratic governments, inflation redistributed wealth from creditors to debtors and greatly reduced the burden of government debt in the middle years of the twentieth century, which was a time of low unemployment, moderate inflation and sustained economic growth. In the late 1970s inflation began to rise rapidly and Keynesian policies seemed powerless to deal with it. The wealthy were determined not to have inflation erode their wealth again, and supported the rise to power of Ronald Reagan and Margaret Thatcher, who made the control of inflation the main aim of economic policy regardless of its cost in terms of unemployment. Piketty points out that labour’s share of national income in the UK and the USA has declined steadily since the 1970s, as governments used unemployment and attacks on the power of trades unions to halt, and in the case of the USA, to reverse the gains labour had made in the period 1945 to 1975. Alan Budd, an economic adviser to Margaret Thatcher, was quite explicit about this strategy when he explained, in an interview, that the anti-inflation policies he advocated were “a very good way to raise unemployment and raising unemployment was an extremely desirable way of reducing the strength of the working classes … what was engineered in Marxist terms was a crisis of capitalism which recreated a reserve army of labour and has allowed capitalists to make higher profits ever since”.
Piketty points out that from 1980 onwards, the top rates of income tax were reduced in the UK and the USA and capital gains were taxed more lightly than earned income (as they are in Ireland today). These policies were touted as a means of increasing economic growth, which would benefit those on low incomes through the “trickle-down effect”. What actually occurred was an increase in the flow of income to the top 1 per cent while growth rates remained low in most developed countries. Growth in most Western countries was higher in the 1970s than in the 1980s and 1990s, despite the higher inflation and higher tax rates of the period. The increased flow of income to the wealthy while the incomes of those in ordinary jobs stagnated, has since led to a decrease in demand. In the US the solution to the fall in demand was the explosion of credit, including the growth of sub-prime mortgage lending. Even Larry Summers, former chairman of President Obama’s Council of Economic Advisers and an ardent apostle of free markets, recently stated that “capitalism is posting growth but it is not feeding through to the people”.
When Lehmann Brothers collapsed, bringing the US and much of the global banking system down with it, the wealthy were bailed out at the expense of taxpayers. If a core tenet of capitalism is that when risks do not pay off, the risk taker suffers the losses, then, as Joseph Stiglitz has argued, in the US there is socialism for the rich and capitalism for the poor. In Ireland Nama was established to relieve banks of the loans of property developers who had borrowed recklessly, while taxpayers bore the cost of rescuing not only Irish banks but the German, French and UK banks who had lent them money. Since the banking collapse of 2008, the concentration of wealth has probably increased in Ireland. Globally, profit rates are higher than before the banking crisis, and multinational corporations are sitting on vast mounds of cash which they jealously guard from attempts by any government to tax it.
The most profitable multinationals are the new digital-based corporations whose growth over the past twenty years has contributed to the dramatic increase in the share of income going to the top 1 per cent. The “robber barons” of late nineteenth century America became enormously rich by extracting oil and by building railroads, steel mills and cars, but those industries created well-paid jobs for huge numbers of workers, both unskilled and skilled. The digital firms that now dominate the global economy, such as Microsoft, Google and Facebook, generate enormous wealth for their founders but employ only a small core of highly paid software engineers and a larger number of fairly well paid analysts and sellers of advertising. The share of the revenue going to the owners of such companies is much larger than the share going to the workers when compared to the manufacturing industries of the past. As the profits of these companies are lightly taxed or hardly taxed at all as in the case of Microsoft, those profits are not redistributed in a way that reduces income inequality.
Piketty argues that in the mid-twentieth century it seemed that the owners of capital no longer dominated market economies as they had up to the First World War. The new capitalists were self made “entrepreneurs” who built businesses rather than inheriting fortunes. Economic growth was adequate to ensure rising living standards for the majority. Talented people who inherited no wealth could earn high incomes in professions such as law and medicine. The development of the welfare state also softened the more brutal aspects of capitalism and the increasing misery of the working class predicted by Marx seemed to have been avoided. Piketty’s central argument is that this period was made possible only by a confluence of trends which have ended, and that slow economic growth, which he considers inevitable in the wealthy countries, will lead to a return to the dominance of inherited wealth.
While the title of Pikkety’s book echoes Marx, he says he has not read Capital. Yet his “law” of the ever increasing share of income going to the top 1 per cent is reminiscent of Marx’s “law” of the declining rate of profit. In contrast to Marx, Piketty does not seek the overthrow of capitalism but rather a radical redistribution of its benefits. His arguments have caused some discomfort to those economists who believe than only entrepreneurial capitalism, facilitated by low taxes, will generate economic growth, because he considers that this version of capitalism is rapidly being replaced by patrimonial capitalism, under which heirs rather than entrepreneurs will dominate market economies.
Most people with a cursory knowledge of history know that inequality of income and wealth was on a very large scale up to the First World War and greatly decreased in the twentieth century. Piketty’s central theory that the rate of return on capital will always exceed the growth rate is based on his observation that the long run return on capital is about 5 per cent, regardless of the rate of growth. He does not offer a convincing theoretical basis for this trend.
Piketty’s use of the term “capital” is confusing because he includes physical capital (plant and machinery), financial capital and land, houses and furniture in his definition. Economists usually use the term capital to refer to productive assets or the financial capital generated in business and would think of Piketty’s definition as the broader concept of “wealth” or assets. The return on the productive assets component of wealth is central to Piketty’s thesis that the return on capital inevitable exceeds the growth rate.
While Piketty is rightly sceptical of the abstract theorising which most economists consider to be their role, he formulates three “laws” of capitalism, all of which are problematical. The first relates the return on capital to the capital-output ratio and capital’s share in income. The distinguished development economist Debraj Ray points out that this relationship is an accounting identity rather than a “law” and therefore does not have the explanatory power which Piketty attributes to it.
Piketty’s second “law” is a version of the Harrod-Domar model of economic growth which explains the growth rate in terms of the savings rate and the capital-output ratio. The Harrod- Domar model has explanatory power when it is assumed that the capital output ratio is constant, or changes along a production function as in the Solow Growth model. Piketty makes neither assumption, which, as Debraj Ray argues, leads him into contradictions, such as explaining a rise in the capital-output ratio by a fall in the growth rate.
Piketty’s third and most important ” law” states that the rate of return on capital systematically exceeds the rate of growth of income and that this explains why the share of the top one per cent in total income rises continuously. This is a genuinely falsifiable theory but Debraj Ray argues that, firstly it is not new and secondly it does not necessarily predict that the income share of the top 1 per cent will inevitably rise. Debraj Ray considers that technological change and globalisation are the main drivers of this trend rather than a fundamental law of economic growth. He also points out that Piketty’s theory is consistent with the rise in the share of the returns to capital in total income, but that in the USA a significant number of those in the top I per cent receive enormous labour incomes, which suggests huge returns to “human capital”. A further problem with Piketty’s conclusion arises from his use of the term “capital” to cover houses as well as productive assets. When house prices are removed from the definition of capital, the share of capital income in total income is greatly reduced.
A more easily understood criticism of Piketty’s work is his use of income before taxes and transfers, or primary income, to estimate the distribution of income. The distribution of primary income is clearly much more unequal than the distribution after taxes and transfer payments. In Ireland, income before taxes and transfers is more unequally distributed than the EU average but after taxes and transfers, Ireland’s income distribution is less unequal than the EU average. This is because the top 5 per cent of income earners pay 46 per cent of all income tax, while the top 20 per cent pay 79 per cent. Much of this tax revenue is used to fund social welfare payments, which are generous by EU standards.
Piketty has assembled an enormous volume of data on the distribution of income for many countries over two hundred years. Critics of his work claim that this vast array of data contains errors. Some errors are almost inevitable in transcribing such a vast volume of data. These have been seized upon by those who wish to reject Piketty’s conclusions. Chris Giles, in an article in the Financial Times on May 23rd, 2014 argued that unexplained adjustments for some figures and inconsistent use of source data were used to bolster Piketty’s thesis that inequality in the distribution of wealth had been increasing more rapidly since 1980 than the data suggest. Piketty states, for example, that the top 10 per cent of British wealth owners hold 77 per cent of total wealth, while the UK National Statisitics Office puts the figure at 44 per cent. Piketty has rebutted Giles’s criticism and points out that his estimate of the share of wealth held by the top 10 per cent is the UK is based on tax data, which is more reliable than the survey data on which the National Statistics Office figure is based.
Piketty’s solution to the increasing share of the top 1 per cent is a global tax on wealth agreed between all the wealthy countries in order to prevent capital flight. This proposal seems hopelessly Utopian in a world where governments vie with each other to attract the wealthy with tax incentives rather than taking a substantial part of their wealth in taxes. Piketty was an adviser to Ségolène Royale in her bid for the presidency of France and may have influenced the increase in France’s wealth tax which has led to an exodus of the country’s wealthy to Switzerland and Belgium ‑ even to Russia in the case of Gérard Depardieu. But most European politicians of even left of centre parties seem eager to associate with the very wealthy and to facilitate their accumulation of wealth rather than taxing it.
While a universal wealth tax would be very difficult to implement, greater international co-operation on taxing corporate profits may be easier to achieve and OECD countries are making some progress on such co-operation. International co-operation on inheritance taxes would also reduce the opportunities for tax evasion and reduce the possibility of a return to patrimonial capitalism. The introduction of high inheritance taxes in the UK and France, as Piketty points out, reduced inequality in the distribution of wealth in those countries in the years after World War 1.
The Sunday Times survey of the rich in the UK and Ireland shows that the two hundred and fifty wealthiest people in Ireland now own wealth equivalent to one-third of national income. A significant number of these are tax exiles who pay little or no tax in Ireland yet are feted and fawned on by government ministers who are always eager to associate with Ireland’s wealthiest man and tax exile, Denis O Brien, despite the findings of the Moriarty Tribunal on the award by the state of a mobile phone licence to him. Since the collapse of the centrally planned economies, most Western politicians have decided that their appropriate attitude towards the very wealthy is timid adulation.
In 1973, Ireland introduced a wealth tax in response to a study by Patrick Lyons which showed that the top 10 per cent of wealth owners held 40 per cent of the nation’s wealth. (No reliable study of the distribution of wealth in Ireland has been undertaken since Lyons’s work) Although it was one of the most lenient of the wealth taxes then applied, the tax was fiercely resisted, and one of the first acts of Charles Haughey on becoming taoiseach was to abolish it. Defenders of Mr Haughey argue that he did not grant any favours to the wealthy businessmen who funded his seigneurial lifestyle, but he certainly ensured that little of their income or wealth was taken in tax. The recently introduced “property” tax is misnamed since it applies only to housing. As the only wealth most people on middle incomes own is their house, it is a tax on those who own a modest amount of wealth in the form of housing while the very wealthy hold mainly financial assets, which are hardly taxed at all.
Winston Churchill defined civilisation as “rich men dwelling peacefully in their habitations”. By this definition Ireland is a very civilised country, as rich men and women may dwell peacefully in their grand Irish habitations for one hundred and eighty days each year, while paying little or no tax. The present government’s implementation of a “domicile tax” on those with more than €5 million assets in Ireland, regardless of their domicile, seems to have been very easy to avoid as it has raised very little revenue.
Whether or not Piketty’s central thesis that the share of the top 1 per cent of income recipients will grow without limit is correct, Capital in the Twenty-First Century is a masterly account of the development of capitalism since the Industrial Revolution and the most comprehensive survey of economic inequality, its causes and consequences ever published.
Piketty’s work also shows that many of the assertions of neo-classical economics are more ideology than science. Most neo-classical economists for the past fifty years assumed that the distribution of income between profits and wages had remained constant. If they had examined the data, they would have seen that the share of profits had been steadily rising. Piketty’s work also shows that some the core tenets of free market economics, such as that economic growth will benefit all without government intervention, or that equality of opportunity will lead to an optimum distribution of income, are not supported by the huge quantity of data which he presents.
Piketty forcefully reminds us that the financial power of the super wealthy in the USA enables them to dominate governments to ensure that redistributive policies are not implemented. Rick Santorum, a possible Republican candidate in the next US presidential election has described the term “middle class” as “Marxist talk” and Supreme Court judge Antonin Scalia said that he could not accept an argument made to the Supreme Court because it seemed to be based on the principle of “from each according to his ability”. As Gore Vidal said of American society, “It is not enough to succeed. Others must fail.”
Piketty’s belief that without a universal wealth tax or faster economic growth, the income share of the top 1 per cent will grow without limit assumes that globalisation will continue apace with no major upheavals to impede it. The grandees of Edwardian Britain and belle époque France were dwelling peacefully in their habitations on June 28th, 1914, when Gavrilo Princip fired two shots in Sarajevo, igniting a war that would destroy much of their world. The First World War ended the first era of globalisation and globalisation is currently facing challenges and conflicts that may halt or even reverse the trend of ever increasing inequality in the distribution of income and wealth.
Sean Byrne lectures in Economics at the Dublin Institute of Technology. His main areas of interest are International Economics and Globalisation.