Income inequality: Piketty and the neo-Marxist revival.

• Jurisdiction: United States
• Date: 01 January 2015
• Author: Mayor, Thomas H.

Karl Marx formulated his ideas in the middle of the 19th century when much of Europe, particularly England, was well along in what is often referred to as the Industrial Revolution. The central Marxist idea was that those who had wealth would reap the benefit of this revolution and become ever more wealthy while those who lived from their labor alone would be relegated to a bare subsistence. In his view, capital accumulation and increases in productivity do not benefit those who work for a living. Allegedly, those who own the means of production (wealth) and supposedly perform no work, receive all of the benefits.

It has, of course, long been obvious that this idea is false. Marx apparently did not understand that as capital and wealth increase and innovations occur, workers become more productive, and firms have an incentive to offer higher wages so as to compete away workers from rival firms. Thus, far from being antagonistic to the interests of workers, innovations and the accumulation of wealth (regardless of who owns that wealth) increase the demand for labor, raise real wages, and are a boon to workers. Those effects, although not recognized by Marx, are standard features of all introductory textbooks in economics.

The Marxist view that increases in wealth accumulation, productivity, and economic growth benefit only the owners of capital has been and should be resoundingly rejected given the enormous increase in the incomes of workers in advanced countries over the past two centuries. Such facts cannot be ignored.

Nevertheless, the last few years have witnessed an upsurge in populist rhetoric espousing the view that the economic system is somehow rigged to benefit the wealthy at the expense of the general citizenry and that the resulting income inequality is an urgent issue. These populist arguments have been a key characteristic of political movements in many parts of the world and doubtless an important explanation for economic stagnation or disintegration where those movements have been able to implement their policies. Yet, despite this long and dismal record of failure, similar views appear to be gaining traction in the United States. The "top 1 percent" has become a common pejorative in social media.

U.S. politicians talk about business owners not being responsible for their own success. Even columnists in the Wall Street Journal write about how workers are not keeping up with increases in productivity (implying, of course, that wealth holders are more than keeping up).

A recent addition to the populist upsurge, Thomas Piketty's Capital in the Twenty First Century, is headed to be one of the all-time best-selling books in the field of economics. Members of the populist community who have rushed to purchase a copy apparently regard the book as confirmation of their world view. Reduced to its essence, the Piketty argument is that a free market economy systematically favors the wealthy by causing the share of national income accruing to wealth holders to increase over time. To counteract this alleged tendency, Piketty proposes punitive taxes targeted at those with high incomes and wealth. As an important intellectual rationale for the modern populist cause, the book's core conclusions and arguments deserve close scrutiny. (1)

Well, is the system rigged in favor of the wealthy at the expense of the general public? The short answer is no, not even close. To show why, let us examine the Piketty argument in more detail. Although the book is quite lengthy, its main points are succinctly summarized in the author's concluding chapter (Piketty 2014: 571) where he states the following:

* The principal destabilizing force has to do with the fact that the private rate of return on capital r, can be significantly higher for long periods of time than the rate of growth of income and output, g.

* The inequality r > g implies that wealth accumulated in the past grows more rapidly than output and wages. This inequality expresses a fundamental logical contradiction. The entrepreneur inevitably tends to become a rentier, more and more dominant over those who own nothing but their labor. Once constituted, capital reproduces itself faster than output increases. The past devours the future.

* The consequences for the long-term dynamics of wealth distribution are potentially terrifying, especially when one adds that the rate of return on capital varies directly with the size of the initial stake.

Well, there you have it. According to Piketty, Marx was right after all. (2) The free market is rigged in favor of the wealthy, and the future of a system of free and voluntary cooperation, is "terrifying. But is Piketty right? Let us answer this question by first examining the logical basis for his r > g inequality. We can then examine the empirical evidence for r and g. Following Piketty, this article defines r and g in real terms net of inflation. Thus r is the rate of return on capital or wealth over and above the rate of inflation, and g is the rate of growth in national income or output over and above the rate of inflation.

The Fallacy of Piketty's Basic Proposition

Piketty argues that r > g implies that the typical passive owner of capital (what he calls the rentier) will claim over time an ever increasing share of income and output. But this inequality is false; it implies no such thing. It is easy enough to see why. Piketty apparently believes that r > g necessarily indicates that wealth is growing faster than output, and therefore an increasing share of national income is going to the owners of capital. But this will only be true if r does indeed measure the rate of growth of capital or wealth. Piketty's r, however, does not measure the rate of growth of capital or wealth because it does not take into account subtractions from wealth such as (1) investment expenses, (2) taxes paid on investment income, (3) personal consumption out of that income, or (4) contributions to charity. No matter how large r may be relative to g, if all of r is taxed, consumed or donated to philanthropic causes, there can be no growth in wealth due to investment income, and hence the outcome that terrifies Piketty cannot come to pass. The correct condition for an expanding share of income going to the owners of capital (at least as a first approximation) is the following:

r - e - t - c - d > g,

where r is the real rate of return on wealth net of inflation, e is the rate of investment expenses as a percent of wealth, t is the tax rate as a percentage of wealth, c is the personal consumption rate as a percentage of wealth, and d is the rate of donations and charitable giving as a percentage of wealth. The left-hand side of the inequality represents the percentage of wealth that can be reinvested each year after accounting for that portion of the investment income stream that is diverted for expenses, taxes, consumption, and donations.

It is clear that Piketty's inequality condition is false except in the limiting case where expenses, taxes, personal consumption, and donations are zero. This does not, of course, mean that the typical rentier is not able to expand his share of national income over time if the values of r, e, t, c, d, and g are such that the corrected inequality holds. To resolve this issue, we need to examine evidence regarding the likely values for these six parameters. To do so, this article focuses on U.S. data. (3)

Can Rentier Income and Wealth Grow Faster than the Economy?

A few examples will illustrate why the corrected inequality is far less scary than what Piketty imagined and why it is extremely unlikely that the typical wealth holder can grow his income and wealth faster than the overall economy. Over the past 50 years or so U.S. Treasury bills, the asset often referred to in the financial literature as the risk-free asset, have yielded an average annual nominal return of a little less than 5.5 percent according to U.S. government data. With an average inflation rate of about 4 percent over this period, the real, after-inflation rate of return on Treasury bills was about 1.5 percent. (4) Income taxes are, of course, assessed on nominal, not real, returns. The combined state, local, and federal tax rate on income from these very safe investments would likely have averaged close to 50 percent over this period for wealthy individuals. Thus, the applicable tax rate as a percentage of wealth would have been close to 2.75 percent (half of the nominal return of 5.5 percent), indicating a real after-tax return of minus 1.25 percent per year (1.5 percent less 2.75 percent). On Treasury bills, expenses (e) would be negligible. We have no readily available estimate for what is a likely value for personal consumption (c) and donations (d), but in this example it makes no difference. Even if wealthy individuals spend nothing on personal expenditures or donations, the rate of growth of wealth is decisively negative because the tax more than consumes any real income, particularly if we add in state and federal inheritance taxes. So much for the rentier growing ever richer over time without taking on any risk.

Of course very wealthy families are not likely to place the bulk of their investments in risk-free assets, so let us take an example at the opposite end of the risk spectrum. A portfolio invested 100 percent in U.S. common stocks, according to the best available evidence, would have produced a long-run average return of about 7 percent per year over the rate of inflation. (5) Needless to say, the long run was liberally sprinkled with lengthy periods of zero and negative returns. Piketty's wealthy rentier, even if he had resisted the urge to sell during these periods, would nevertheless have had a difficult time achieving this average return because it does not account for the costs of brokerage, bid-and-ask spreads, and management. A net real return of 6 percent per year may be more realistic. State, local, and...