Sunday, April 27, 2014

The right way to look at inequality

By now there are many dozens of reviews of Thomas Piketty's new book about the "problem" of inequality, Capital in the Twenty-First Century. Liberals almost universally laud it, because it is an eloquent argument in favor of the progressive taxation of wealth, something they believe is necessary in order to prevent the excessive accumulation of wealth and income among the very rich, and the social unrest that might follow. Conservatives almost universally disagree, because capital is the ultimate source of our prosperity, and taxing capital only reduces living standards for all.

Garett Jones's review ("Living with Inequality") of Piketty's book is the best I've seen so far. Some excerpts and comments from him, me and other reviewers follow, but you should definitely read the whole thing: (HT: Don Boudreaux)

... the French economist Thomas Piketty claims to have uncovered "the central contradiction of capitalism." What is this flaw at the heart of the economic machine, a flaw that centuries of economists have overlooked? Simply that at some times and at some places, the interest rate is greater than the economy's growth rate.

Piketty sums it up with a simple equation: r > g. And if r > g for decades, he argues, capital contains the seeds of deep social conflict.

There are many ways in which to argue that, while Piketty's contribution to the inequality debate are substantial, he has left out many things which make the whole issue of inequality a lot less deserving of sensational headlines and breathless admiration.

In their zeal to avoid the supposed danger of increasing inequality, liberals—and Piketty—ignore one obvious remedy. As Holman Jenkins points out in his review, if capital is likely to continue to grow at a faster rate than the economy, as Piketty predicts it will, and at a faster rate than wages, then we should be doing everything possible to educate workers about the virtues of saving and investment, and to facilitate their ownership of that gift that keeps on giving—otherwise known as capital. We should privatize social security, as Chile did with much success beginning in the early 1980s, rather than extoll the virtues of consumption and allow politicians to spend our FICA withholding taxes. We should let workers put their money in an investment account where it can grow into a substantial asset that can be passed on to their heirs if they so wish (unlike Social Security, which is not an asset and pays out more to the healthy and wealthy than to the infirm and poor). Rather than envying, coveting or redistributing the wealth of the rich, we should encourage everyone to get rich the same way the rich do—by accumulating capital. Christopher Demuth agrees: "the earned fortunes of great entrepreneurs become dramatically large over time—but that is due to the value of time and the arithmetic of compounding, which are equally available to the most diminutive capitalist." 

Piketty overlooks the fact that the very wealthy and the very rich are not members of a closed club, but rather members of a club that gains and loses members all the time. Hirschl and Rank of Cornell tracked a large number of individuals from age 25 to 60 and found that there is a great deal of turnover within the top levels of income distribution: "Rather than talking about the 1 percent and the 99 percent as if they were forever fixed, it would make much more sense to talk about the fact that Americans are likely to be exposed to both prosperity and poverty during their lives. ... It is clear that the image of a static 1 and 99 percent is largely incorrect." And in any event, getting rich is not a zero-sum game. As the rich have gotten richer, so have the poor, a fact documented by Brookings' Gary Burtless.

Arnold Kling points out that, according to Paul Krugman's review of Piketty's book, Piketty has pulled off a bit of a bait-and-switch, by arguing that soaring inequality is a by-product of capital accumulation, when in fact it may be simply due to hard work. Krugman: "the fact is that the most conspicuous example of soaring inequality in today’s world—the rise of the very rich one percent in the Anglo-Saxon world, especially the United States—doesn’t have all that much to do with capital accumulation, at least so far. It has more to do with remarkably high compensation and incomes." Rauh and Kaplan of Stanford studied the composition of the Fortune 400 over time and found that Piketty's claim that too many of the rich inherit their money and too many CEOs award themselves the money unjustly is wrong.

Greg Mankiw suggests that Piketty's claim that inequality has increased may be due to faulty data:

Over the past few decades, there has been an amazing shift in how businesses are taxed. Businesses are more and more taxed as pass-through entities, where the income shows up on personal tax returns rather than on corporate returns. This phenomenon complicates the interpretation of tax return data. For example, when one looks at the growth of the 1 percent, or the 0.1 percent, in the Piketty-Saez data, that growth is likely exaggerated because some income is merely being shifted from corporate returns.

In a similar vein, Alan Reynolds in 2007 exhaustively analyzed the data, adjusted for changes in taxation regimes, and found that there is "little evidence of a significant or sustained increase in the inequality of US incomes, wages, consumption, or wealth since 1970."

Perhaps more importantly, we should also recognize that the two central factors of production in any economy—labor and capital—are intricately bound. When capital becomes abundant, labor becomes scarce; lots of wealth leads to increased prosperity and higher wages—more capital requires more labor. Anything that reduces the supply of capital makes labor redundant, restricting the growth of wages. Besides, it's very unlikely that the money that government taxes away from the rich will be put to more productive use, being more likely exposed to waste, fraud, and corruption. In his review of the book, Tyler Cowan agrees: "the best parts of his book argue that, left unchecked, capital and capitalists inevitably accrue too much power -- and yet Piketty seems to believe that governments and politicians are somehow exempt from the same dynamic."

The right way to look at inequality is that it's not a problem, except to the extent that politicians and statists think it is. As Jones argues, we should pay more heed to the Tenth Commandment, "a foundation of social peace." Furthermore:

The Nobel Laureate economist Vernon Smith noted the tenth commandment along with the eighth (you shall not steal) in his Nobel toast, saying that they "provide the property right foundations for markets, and warned that petty distributional jealousy must not be allowed to destroy those foundations. If academics, pundits, and columnists would avowedly reject covetousness, would openly reject comparisons between the average (extremely fortunate) American and the average billionaire, would mock people who claimed that frugal billionaires are a systematic threat to modern life, then soon our time could be spent discussing policy issues that really matter.

The last two lines of Jones' review sum things up perfectly:

... when it comes to capital, simple economic theory is right: the more, the merrier. And if we can reduce covetousness, we can say the reverse: the merrier, the more.

(Thanks to D. Gollaher for the inspiration for this post)

UPDATE: The Financial Times has challenged the validity of Piketty's data and his conclusions:

The data underpinning Professor Piketty’s 577-page tome, which has dominated best-seller lists in recent weeks, contain a series of errors that skew his findings. The FT found mistakes and unexplained entries in his spreadsheets, similar to those which last year undermined the work on public debt and growth of Carmen Reinhart and Kenneth Rogoff.
The central theme of Prof Piketty’s work is that wealth inequalities are heading back up to levels last seen before the first world war. The investigation undercuts this claim, indicating 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.


steve said...

one obvious solution is to tax cap gains at same rate as income. understand why this hasn't been done but I've always thought it somewhat unfair.

Scott Grannis said...

No. In an ideal world there should be no taxation of capital. Even today, with cap gains rates lower than income rates, don't forget that capital is triple-taxed: when the corporation earns a profit, when the shareholder receives a dividend, and when the shareholder sells for a gain. Cap gains taxes should be much lower than income tax rates.

Benjamin said...

I am astonished at the traction of Piketty's book, which strikes me as a pre-conceived and strained way to look at economies.

Not only would I not tax capital, I would try also to not tax income.

Tax consumption, pollution, Pigou vices, gasoline, but why tax productive behavior?

BTW, I am fine with cutting defense outlays in half, wiping out the USDA, wipe out the VA, maybe even go with a very simple single-payor health plan backstop for whoever wants to sign up.

Pollution falls outside of the classic market system, and needs to be addressed. I am not some cement-head conservative.

But Piketty's book?

I am trying to understand why it is such a hit.

NormanB said...

In 2013 four Americans had their net worth increase (increase, not become) &12B. For them it was being able to take advantage of our economic system. If you don't think this is going to come to haunt us politically somewhere down the road you have blinders on.

TWD said...

I do agree that the current extreme wealth inequality will only get worse until it ends badly for everyone. Hopefully this will be handled politically and not with violence and social collapse.

Scott Grannis said...

Why does this need to be "handled" politically? And how does a billionaire doubling his wealth hurt anyone? Wealth and prosperity go hand in hand; they aren't zero sum games where one wins at the expense of another.

steve said...

scott, you are deluded if you don't think this is and will be a huge problem. tax capital as income. cut government. not rocket science just common sense.

Ausgarry said...

The double taxation of income (company tax and personal income tax on dividends) has been removed in Aust by giving tax credits for any dividends paid out of taxed company profits.
If you have no capital gains tax wont you see a huge increase in capital gains at the expense of income?
For the extremely wealthy an estate tax might be efficient.

Roy said...

The top 1% is actually $350,000 and up.
That's meaningless.

Is anyone really talking about people who make 350k a year? The NYT article is very interesting in how it shows the flows between the income levels.

However, it is missing the part which focuses on those groups who are somewhat fixed in each percentage level. I'm sure someone will come up with that soon enough. Only then will we have the complete picture.

It says "Although 12 percent of the population will experience a year in which they find themselves in the top 1 percent of the income distribution, a mere 0.6 percent will do so in 10 consecutive years."

That 0.6% is key than. It's too bad they did not elaborate on its composition.

It would also bet interesting to go to a second level and follow the money, for example how many billions dropped from the 1% due to bad business and how many due to tax planning, passing assets to their children etc.

As for what Scott wrote "And how does a billionaire doubling his wealth hurt anyone?"

At a certain point wouldn't a large amount become a competitive advantage by itself and harm the competitiveness of the economy? (lets keep in mind that people are not robots)

Scott Grannis said...

I would like someone to explain to me how a multi-billionaire who doubles his wealth does any harm to me or to anyone else. Most of them only get that way because they have created a business or a product that is hugely successful and popular. (Think Steve Jobs)

I would like someone to explain to me how taxing away the money that a billionaire has is not akin to stealing and does not violate private property rights. And explain why it is Ok to do that to billionaires but not to the average person. (Think slippery slopes)

I would urge anyone who thinks that becoming a billionaire is easy as long as you just want to screw other people to do just that. I would wager that it is impossible.

The animus towards the rich is very disturbing to me, since I don't know how it is that they pose any threat to anyone. Indeed, if I were a billionaire I would be feeling threatened at this point by all the hatred and envy that is being encouraged by the left.

steve said...

scott, I think you're missing the point. not a matter of whether or not a billionaire doubling his NW "hurts " anyone. rather to the point that if capital grows faster than GDP then frankly to be FAIR that caital must be taxed at a higher rate otherwise more money will be concentrated in fewer hands AND that capital won't be used to increase GDP so we get a vicious cycle that will has and will have pernicious effects

Scott Grannis said...

steve: To be "fair" no one should be subject to punitive taxation. To be fair, property rights must be respected. It's far from clear whether the concentration of wealth has increased significantly, and even if it has it does not necessarily follow that that is a bad thing. The wealth of the very rich is ALWAYS working to boost GDP since virtually all of their wealth comes from the value of businesses and properties owned by the rich. If the value of a business goes up it is because it has become more profitable and more productive. Stealing money from the rich and redistributing it would, without question, weaken the economy.

randy said...

Steve -
GDP growth is a function of population growth and increases in productivity. Capital grows when the activity it is invested in in successful (significantly including increasing productivity - with the exception noted below). Since capital is critical for one part of GDP growth, and has no direct bearing on the other (population growth), in what manner is it "fair" or useful to penalize capital?

That is not a loaded question... I'm sincerely interested in the answer. I happen to agree that it's not good to have a growing divide. The truth about the divide, and it's causes are, however, difficult to understand because all of the pundits, from Krugman to the Heritage Foundation tell half truths.

My (not so well thought out) view is that a real problem we *do* have is the growth of non-productive financial manipulation as a significant accrue-er of wealth. However, to lump all capital in the same bucket would be a mistake. Re-instating the intent of Glass Steagall would be a good start though.


steve said...

"Stealing money from the rich and redistributing it would, without question, weaken the economy."

you are NOT stealing $ from the rich by increasing CG tax! why should CG get taxed at such a favorable rate Vs ordinary income? this not only makes no sense, it creates an obviously unfair environment and pits business against earners. just plain dumb.

randy said...

Addendum... The financial sector is roughly 18% of the larger market. That sector includes a lot of main street businesses - insurance, commercial loans, etc. So something considerably less than that 18% could potentially be attributed to non-productive purposes. To penalize the other 90%+ of capital investments would seem counter productive to GDP growth.

Scott Grannis said...

Capital today faces a very onerous tax burden since it is effectively taxed three times: first when a company generates a profit, second when a shareholder receives a dividend (a portion of that after-tax profit), and third if and when the shareholder sells his shares at a profit, even if a portion of the gain is due to inflation. The economy would be much better off if we reduced the taxation of capital, since capital is an essential ingredient for generating jobs and prosperity.

Capital today is effectively taxed at a rate higher than ordinary income. This is not only wrong but counter-productive.

Duncan said...

I wonder if even the most liberal economist would even agree that capital is good. Capital is prosperity. Capital is our standard of living. If we can agree on that, does it not follow that destruction of capital (tax, confiscation) for whatever reason, reduces our prosperity of the nation as well making disincentives to create new capital. Perhaps a liberal would think it is worth it to destroy capital for their cause. That is a different argument. But they can not argue that capital destruction will make the country more prosperous, quite the opposite.

Hans said...

Best thread in the trailing 12 months! Thank you, Mr Grannis.

steve said...

in an ideal world (which will NEVER happen) I'd cut government across the board by 25%, eliminate tax code as it is and replace with an X% (TBD) tax on ALL income (including CG's) with absolutely no deductions. freakin pols play favorites with tax code and it really pisses me off.also eliminate corp tax and have another X% sales tax. since all income and sales are taxed and since government cut 25%, the tax rate would be quite low. obviously polly anna but it would be fair, go a long way to eliminate concentration of wealth and be very pro growth. fact is, the tax rate on all income would not need to be much more than 15% or so with maybe a 10% sales tax. exclusions could be made for lower priced food/clothing.
even the gop is way too political with tax code, but the dems? off the charts with tax credit this and tax deduction that. total BS.