Piketty Roundup and the Non-Contradictions of Capitalism

I don’t have time to do a review of Thomas Piketty’s magisterial work on income and wealth inequality, Capital in the Twenty-First Century, but fortunately, everyone who’s anyone has already done it for me. While I continue to slog my way through its 700 pages, here are several illuminating reviews:

  • Randall Holcombe’s continuing series of posts at The Beacon are generally good, but his second was the best, pointing out the most fundamental problems with Piketty’s analysis: first, capital is heterogeneous, and second, its value is contingent on its revenue stream, not vice-versa. This matters because the value of capital depends on what it is and how it is employed. There is no fixed stream of revenue attached to assets merely by virtue of their existence.

Capital does not have some value, which then earns a return to provide income to the owners of capital. Rather, capital consists of productive assets that generate a return, and the value of the stock of capital is determined by the return it generates, rather than, as Piketty depicts it, the return being determined by its value.

This makes a difference because it misrepresents how capital owners earn their incomes. In fact, capital must be allocated to productive uses in order to generate a return, and the job of the capital owner is to allocate that capital as productively as possible.

…  This general idea that capital does not just earn a rate of return, but has to be employed in productive activity by its owner, plays no role in the way Piketty analyses his extensive data set on inequality. Piketty makes it appear that earning a return on capital is a passive activity in which, by virtue of owning capital that has some value β, capital owners receive a flow of income α.

  • Larry Summers‘ review is one of the best, and I believe he fairly characterizes Piketty’s historical research on capital, income, and inequality as Nobel-prize worthy–and his doomsday prophecies about the inherent contradictions in capitalism as largely unfounded. I hesitate to summarize it here, but Summers points out some questionable assumptions in Piketty’s thesis: it assumes that the returns to capital are constant (or decline very slowly), that returns are reinvested, and that all capital is income-generating.

Economists universally believe in the law of diminishing returns. As capital accumulates, the incremental return on an additional unit of capital declines. The crucial question goes to what is technically referred to as the elasticity of substitution. With 1 percent more capital and the same amount of everything else, does the return to a unit of capital relative to a unit of labor decline by more or less than 1 percent? If, as Piketty assumes, it declines by less than 1 percent, the share of income going to capital rises. If, on the other hand, it declines by more than 1 percent, the share of capital falls.

…But I think he misreads the literature by conflating gross and net returns to capital. It is plausible that as the capital stock grows, the increment of output produced declines slowly, but there can be no question that depreciation increases proportionally. And it is the return net of depreciation that is relevant for capital accumulation. I know of no study suggesting that measuring output in net terms, the elasticity of substitution is greater than 1, and I know of quite a few suggesting the contrary.

… The largest single component of capital in the United States is owner-occupied housing. Its return comes in the form of the services enjoyed by the owners—what economists call “imputed rent”—which are all consumed rather than reinvested since they do not take a financial form. The phenomenon is broader. The determinants of levels of consumer spending have been much studied by macroeconomists. The general conclusion of the research is that an increase of $1 in wealth leads to an additional $.05 in spending. This is just enough to offset the accumulation of returns that is central to Piketty’s analysis.

  • Tyler Cowen’s review in Foreign Affairs brings up the flaws that others noted–notably, that risk determines return return, that returns are not automatic, that capital is not homogeneous–and tackles Piketty’s policy recommendation to solve rising inequality through a global wealth tax.

Furthermore, even if one overlooks Piketty’s hazy definition of the rate of return, it is difficult to share his confidence that the rate, however one defines it, is likely to be higher than the growth rate of the economy. Normally, economists think of the rate of return on capital as diminishing as investors accumulate more capital, since the most profitable investment opportunities are taken first. … The more prosaic reality is that most capital stays in its home country and also has a hard time beating randomly selected stocks. For those reasons, the future of capital income looks far less glamorous than Piketty argues.

… Piketty’s focus on the capital-to-income ratio is novel and worthwhile. But his book does not convincingly establish that the ratio is important or revealing enough to serve as the key to understanding significant social change. If wealth keeps on rising relative to income, but wages also go up, most people will be happy. Of course, in the past few decades, median wages have been stagnant in many developed countries, including the United States. But the real issue, then, is wages — not wealth.

… A more sensible and practicable policy agenda for reducing inequality would include calls for establishing more sovereign wealth funds, which Piketty discusses but does not embrace; for limiting the tax deductions that noncharitable nonprofits can claim; for deregulating urban development and loosening zoning laws, which would encourage more housing construction and make it easier and cheaper to live in cities such as San Francisco and, yes, Paris; for offering more opportunity grants for young people; and for improving education. Creating more value in an economy would do more than wealth redistribution to combat the harmful effects of inequality.

  • Martin Feldstein’s review in the Wall Street Journal argues that Piketty’s analysis of income using tax return data (which is truly a valuable contribution to the literature on inequality) ignores the fact that taxable income is not equivalent to real income and that major changes to the tax code in the 1980s accounts for much of the perceived rise income inequality by causing income earners to shift their compensation mix from different income categories, like tax-sheltered C-corporations, exempt government bonds, or health benefits, to taxable categories. Moreover, looking at pre-tax income levels excludes the effect of progressive taxes and transfer payments, which is how our system is already designed to reduce inequality. (Jared Bernstein at the NYT dismisses this moderating effect because… well. Read it yourself.)

These changes in taxpayer behavior substantially increased the amount of income included on the returns of high-income individuals. This creates the false impression of a sharp rise in the incomes of high-income taxpayers even though there was only a change in the legal form of that income.

…  Mr. Piketty’s practice of comparing the incomes of top earners with total national income has another flaw. National income excludes the value of government transfer payments including Social Security, health benefits and food stamps that are a large and growing part of the personal incomes of low- and middle-income households.

  • Scott Winship’s review in Forbes raises many problems Piketty’s use of tax return data for incomes below the top 10% because it misses a lot of non-taxable income and non-monetary compensation, but also because it looks at individual tax returns, not households. He takes to task equality warriors who use Piketty and Saez’s tax data to argue that the bottom 90% of incomes have stagnated since the 1970s. He finds that using Census Bureau data for households and controlling for taxes, benefits, and transfers, median incomes have risen quite a bit in the last three decades.

When I incorporate these improvements using the Census Bureau data, I find that median post-tax and -transfer income rose by nearly $26,000 for a household of four ($13,000 for a household of one) between 1979 and 2012. If you don’t like the household-size adjustment, the non-adjusted increase was over $20,000 at the median.  If you think that valuing health care as income is problematic, that figure drops to $10,400 under the implausible assumption that third-party health care benefits have no value to households. The income of the bottom 90 percent rose nearly $12,000 under that assumption instead of dropping by $3,000 as in the Piketty and Saez data, and it rose by nearly $21,000 if health benefits are included. For a household of four, median market income for non-elderly households (not counting employer-provided health care as income) rose $9,400.

Prof Piketty, 43, provides detailed sourcing for his estimates of wealth inequality in Europe and the US over the past 200 years. In his spreadsheets, however, there are transcription errors from the original sources and incorrect formulas. It also appears that some of the data are cherry-picked or constructed without an original source.

For example, once the FT cleaned up and simplified the data, the European numbers do not show any tendency towards rising wealth inequality after 1970. An independent specialist in measuring inequality shared the FT’s concerns.

I’ll continue to update this post with any other worthwhile discussions of Pikettyism.