Care About Income Inequality At All? Read This Now.

2014-04-23 CapitalOne of the most useful things I learned about economics when getting my master’s was simply who to pay attention to. When I read an article and it references someone whose research was brought up not just once, but again and again in my classes, I know I’m reading about a serious economist. Well, this article[ref]Note: I left out the link in the original version of this post.[/ref] is written by Bob Solow about a book by Thomas Piketty based on research he conducted with Emmanuel Saez and Anthony B. Atkinson. That’s the most big-name economists I’ve ever seen in a contemporary piece, so even though I had a busy day today I took the time out to read this article.[ref]Solow invented the Solow model, which comprised about the first half of my macroeconomics coursework. I studied papers by the other three in my public finance courses.[/ref]

I was not disappointed. This is a really important article if you want to understand income inequality. Unfortunately, it’s also rather technical (although it tries not to be). So I’m going to attempt to give the plain English version of the simplified review of a French book on income inequality. Believe it or not, I think some really important core concepts will translate all the way through.[ref]Obviously I’m basing this just on my reading of the article, ’cause I haven’t read the book. I don’t even speak French.[/ref] So here are the take-aways:

  1. The question of rising income inequality cannot be fully explained by nation-specific laws or circumstances. It’s a broad-based problem, so we ought to be looking for a broad, comprehensive, long-range explanation. That’s what Piketty provides.
  2. The explanation is based on an unusual measurement of wealth that compares a country’s total wealth (at a point in time) with it’s total productive capacity (at a time) in what is called the capital-income ratio or the wealth-income ratio. So, for example, if the wealth-income ratio is 5 (in this case, for the UK in 2010) that means that it would take 5 years of accumulating all the income in a country to equal the amount of capital that nation has on hand. In very, very simplified terms: how many years of income would it take to buy all the factories and land in a country? When wealth-income is high, that means that there is a lot of wealth/capital (relative to the country’s income). When wealth-income is low, that means there is relatively little wealth/capital. The historical range is from more than 2 to less than 7, and we’re currently around 4.5-6 (depending on what country you live in). If you can’t remember the details, just remember this: high capital-income means lots of capital.
  3. Countries have a natural resting point of capital-income that depends on two things: s (the amount that everyone in the country saves by buying more capital every year) and g (the rate of economic growth for the country). This is important, because if s and g are relatively stable, you know how much capital the country is going to move towards. Piketty has estimates for s and g, and based on that he believes that modern, developed countries are trending towards 6.5. In other words: we have lots of capital now, and we’re going to get more.
  4. Once you know how much capital a country has and you also know what the return on capital is (that’s a number that is fairly stable over the long run), you can determine how much of a country’s income comes from capital as opposed to labor. And, since return on capital is relatively stable, the more capital a country has, the more profitable it is to have capital.
  5. Here’s the final point: wealthy people always own proportionally more capital.

You should be able to put points 3, 4, and 5 together to reach this simple conclusion: all developed nations are on track to have more capital, which will make owning capital more lucrative, which will disproportionately favor the rich, which will continue to drive income inequality.

Thomas Piketty, the author of "Capital."
Thomas Piketty, the author of “Capital.”

This is pretty important. It’s important because it tells us that income inequality is going to continue to increase towards levels not seen since the late 1800’s.[ref]This isn’t mentioned, but on the bright side it also says they won’t go any higher than that.[/ref] It’s also important because it explains why this is happening, and it does so in terms of cross-cultural, international, non-partisan (mostly) terms. It’s not as simple as the Democrats or the Republicans selling you out to corporate America (although that probably doesn’t hurt). It’s driven by fundamentals.

Lastly, it’s important because it suggests a policy solution. Unfortunately, the policy solution is politically impossible. I mean, if you think that consumption tax would be a neat idea but you don’t think it’s realistic, that’s trivial compared to what would be required to combat this trend. Basically: you need to make capital less profitable. And that means you need to tax it. But, in order to be effective, this tax has to be international. Otherwise, if the UK taxed their capital, they would just be shooting themselves in the foot because all their rich folk would invest in French and American capital and legally avoid paying taxes.[ref]That’s called tax avoidance. It’s called tax evasion when you’re breaking the law.[/ref] So not only would the EU, US, Japan (and others) all have to agree to an incredibly unpopular tax, they’d also have to figure out how much to tax, how to enforce it, and what to do with the revenue. As Solow (the one doing the review says): Not. Going. To. Happen.

In simple terms, this means y’all should buckle in because we’re in for a bumpy ride. Income inequality foments radicalization and discontent, and so things could very well could ugly and even revolutionary.

Now, some caveats.

First, and obviously, if the forecasted numbers don’t pan out, neither do the results. Significantly change how much a country chooses to invest, or the rate of economic growth, of the long-run return on capital and the model veers off in one direction or another. Second, there is a contention that many wealthy Americans are already “the working rich” who get their compensation in labor rather than wealth. This would appear to contradict a key point (#5), but Piketty addresses that, Solow is convinced by it and so am I. (Although up until reading this article that was actually something I took seriously in my qualms with income inequality arguments.)

I have two unknowns of my own, however, which don’t come up in the model. First, I’d like to know more about the impact of international economic growth. We’re focusing on income inequality among people in the developed world. That’s what we tend to focus on because of what liberals would ordinarily call ethnocentrism.[ref]Not a dig. Just an observation.[/ref] While income inequality in that sense of the word is rising, income inequality globally is actually falling, and has been for decades. This is because the poorest countries are getting richer (in aggregate) faster than the richest among the developed world are getting richer than the poor among the developed world. And this advance of the poor countries is not just the mega-rich within those countries. As China has shown (again), you don’t get sustained economic growth without creating a middle class. The rise of the rest (as Fareed Zakaria dubs it) has important economic, ethical, and policy implications.[ref]Just to name one: if you think a capital tax regime is hard with just the EU, US, and Japan, what happens when you have to think about including the BRICS, too?[/ref]

But my biggest concern with this whole article is the focus on income taxation. In simple terms, you have to tax capital-based income so that it looks like labor-based income to mitigate the effects of rising income inequality. Not only is this politically infeasible, but it would also very negatively impact economic growth.[ref]If you tax factories, there will be less factories. If there are less factories, there will be less economic growth.[/ref] But do we really care so much about income? Or should we care more about consumption? Is it morally problematic that Bill Gates possess billions of dollars, or is it what he gets from those billions (yachts, influence, and safety) that causes the problem of income inequality? It seems, although this is just a first-glance at the issue, that a strong safety net and consumption based taxation goes a long way towards mitigating the problem of income inequality by looking at the problem in a new way.


10 thoughts on “Care About Income Inequality At All? Read This Now.”

  1. “Obviously I’m basing this just on my reading of the article, ’cause I haven’t read the book. I don’t even speak French.”

    The author is French, but it is published by Harvard University Press in English.

  2. What are the technical implications if, instead of increasing capital income taxation to mirror labor income, we reduce the labor income to mirror the capital income? I’m guessing maybe, at least in the U.S., this isn’t feasible because, federally at least, the current labor income is already 0%?

    In any event, I hope to read more on your thoughts on taxing consumption. I’ve been thinking about this a lot lately, but mainly in moral terms. It will be nice to read some technical arguments for it.

  3. I can give you the short version of consumption tax right now.

    1. It’s more efficient than taxing income because taxing income basically discourages work. It also bypasses the capital/labor distinction that gives everyone a headache.

    2. A lot of consumption tax ideas are kind of kooky. The sales tax idea is, from an implementation standpoint, a nightmare. I really wish it wasn’t so popular because it’s a distraction. The simplest way to implement this would be to just retrofit our existing income tax. Take all your income. Subtract all your savings (e.g. money you invested in stocks and bonds). The rest, by definition, is your consumption. Tax it. It would reduce taxation to basically a postcard. Another approach is to use a VAT. VAT’s are equivalent to consumption taxes and, because of the multiple layers, they are very hard to cheat. It would be tougher to implement, but then no one would ever have to file taxes again for any reason.

    These are no-brainers from a policy standpoint. They are hopeless from a political standpoint.

  4. Ah, thanks Chris. I didn’t realize Belknap was part of HUP. Now I do! And I was only referring to the French version to say that I hadn’t read it, so I don’t think it was so impressive! :-)

  5. you have to tax capital-based income so that it looks like labor-based income to mitigate the effects of rising income inequality

    Does this mean anything more than taxing returns on investment at the same rate and for social security, medicare, etc. as our labor is?

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