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.