Thursday, August 21, 2014

21/8/2014: Thomas Piketty: Powerful Questions, Questionable Answers

This is an unedited version of my article for the Village magazine, August-September 2014

Thomas Piketty's "Capital in the Twenty First Century" (Harvard University Press, 2014) has ignited both public and professional debates around economic theory of income and wealth distribution not seen since the days of the Interwar period a century ago when applied Marxism collided with the laissez faire economics.

To give the credit due to the author and his book, this attention is deserved.

Like Marx's opus, Pikkety's volume is sizeable enough to provoke an instantaneous submission of the readers to its perceived academic (meticulously factual and theoretically all-encompassing) virtues. Like "Das Kapital", "Capital in the Twenty First Century" is impenetrable to anyone unequipped with an advanced degree in political economy and understanding of economic theory. Like Marx's tome, Piketty's work is an attempted herald of a New Revolution; the one that, in the end, boils down to exactly the same Revolution that Marx foresaw: the dis-endowed against the endowed. Like Marxist debates of the 1930s, Piketty’s thesis comes at the time of a major upheaval and crisis.

Thus, Piketty's work is destined to stay with us for a long, long time. Looming at the horizon line, its thesis of the coming age of chaos rising from the chain reactions of growing wealth inequality will be fuelling activists' imagination for decades into the future.

Yet, perhaps to the surprise of the majority of non-specialists, the book has, within a month of its publication, faded into the background in the world of economics. The reason for this is the book’s comprehensive ambition at creating a unified theory of future economic development renders it an easy target for criticism, challenge and, ultimately, negation.

Before diving deeper into Piketty's work, let me state three facts.

Firstly, I admire Piketty for his audacity to challenge the orthodoxy of macroeconomics and tackle a broad-ranging set of targets. 99.9 percent of economics literature explores the minutiae of some empirical or theoretical cul-de-sac in a specific sub-division of a sub-field of economics. Piketty falls into the 0.1 percent of economists who pursue the big picture.

Secondly, witness to the vitriol with which Piketty’s book was greeted in the economic policy circles, I have defended his work in the media and on my blog.

Lastly, having read Piketty's academic publications and working papers in the past, I found his book to be inferior to his academic publications. "Capital in the Twenty First Century" is too long and stylistically un-engaging to be worth returning to it in the future.

The last fact means that you should read Piketty's thesis and be aware of his core evidence, as well as the growing evidence of its shortcomings.  The best means for acquiring this information is by reading Piketty's articles and interviews, as well as taking in the debates surrounding his book. But you should not buy "Capital in the Twenty First Century", unless you are endowed with a desperate propensity to impress your image of a couch intellectual onto the receptive minds of your friends and colleagues. In the latter case you should avail of Flann O'Brien's gentlemanly service that can get the tome thumbed, marked and annotated for you with scientifically-sounding marginalia.

Core Theses

Piketty's core thesis is based on what he defines to be the 'fundamental laws' of Capitalism. Both of these laws stem directly from his view that the economic inputs can be grouped into only two categories: capital (something that can be bought and sold, and thus accumulated without a bound) and labour (something that cannot be sold, although it does collect wage returns, and cannot be accumulated without bounds). Incidentally, beyond undergraduate economics, this division remains valid only in the literature pre-dating the 1980s.

Piketty’s First Law states that capital's share of income is a ratio of income from capital (or return to capital times the quantum or stock of capital) divided by the national income (for example, GDP).

As anyone with a basic knowledge of economics would know, this is not a law, but an accounting identity. Furthermore, any undergraduate student of economics would spot a glaring problem with the above definition: it applies to all forms of capital, including the ones that Piketty omits.

This brings us to the first major problem with Piketty's core thesis: capital itself is neither homogeneous, nor yields a deterministic and singular rate of return. Instead, capital takes various forms. There is financial capital - the one to which the rate of return is measured in form of equity returns, bond returns, financial portfolio returns and so on. There is also intellectual capital that can be traded. This generates financial returns to the holders/investors, but also yields productivity gains to its users, including workers. There is human capital - which generates (alongside other inputs into production) returns to labour (wages and performance-related bonuses), but also returns to entrepreneurship, creativity of employees and so on. There is managerial and technological know-how that can be invested in and transferred or sold, albeit imperfectly, in so far as it often attaches to labour and skills.

To measure income share of all of these forms of capital, one simply needs to divide income from the specific form of capital by total income. Ditto for labour's share and for any other input share. This is neither Piketty's discovery, nor a law of Capitalism.

The problem is that in many cases we cannot easily measure returns to the more complex forms of capital. And a further problem is that returns to one form of capital are linked to returns to other forms of capital. A good example here is urban land. Return to this form of capital is strongly determined by the returns to human capital that can be deployed on this land, as well as by know-how and technology that attaches to economic activity that can take place on it.

Piketty's second fundamental law is a theoretical proposition derived from the mainstream macroeconomic theory. The author claims that the ratio of the stock of capital to income will be equal to the ratio of the savings rate to the sum of growth the growth rates in technology and population. Together with the first law this implies that income share of capital equals to the ratio of the product of the return on capital and savings rate to the combined growth rate in technology and population.

Piketty's main thesis is that over time, as growth rates in technology and population fall, capital's share of income will rise resulting is a sharp rise in inequality.

The core corollary of this is Piketty's call for a global tax on capital (or wealth) coupled with a massive rise in the income tax on super-earners. These measures, in his view, can ameliorate the increase in the income share of capital triggered by slower growth.

Mythology of the Piketty’s ‘Laws’

There are numerous and significant problems with Piketty's analysis and even more problems with conjectures he draws out of data.

Although Piketty presents numerous factual arguments describing the rise and fall and the rise again in income and wealth inequalities, his factual arguments are tangential to his theoretical proposition. Per Krusell (Stockholm University) and Tony Smith (Yale University) pointed out that "Piketty’s forecast does not rest primarily on an extrapolation of recent trends that he has uncovered in the data..."

Krussell and Smith go on to show that Piketty’s second 'fundamental law' relies not on data, but on an assumption that the ‘net’ saving rate is constant and positive over time. This means that capital stock rises by an amount that is a constant fraction of national income.

Now, suppose that Piketty is correct. And suppose that the growth rates in population and technological progress fall to near-zero. Piketty’s assumption then implies that ever greater share of economy’s output will have to be used to maintain capital stock. This will crowd out investments in education, health or new technologies. Eventually capital formation will have to consume the entire GDP. This has never been observed in the past and cannot be true in the future.

Now, personally, I do believe we are staring into the prospect of diminished rates of growth in the advanced economies. But I also believe that savings follow growth over the long run, implying that, the gross investment - investment including replacement of capital depreciation and amortisation - is relatively constant as a ratio to national income. At times of structurally slow growth, therefore, savings are also low.

This belief is supported by historical evidence and contradicts Piketty's conjecture. Furthermore, this evidence is supported by data from individual consumers’ behaviour. In cyclical recessions, households do engage in increased savings, known as precautionary savings. But this phenomena is short-lived and does not contribute to increased investment. Over time, slower growth in income equals lower rates of savings.

Piketty’s Tax Fallacy

Aside from the above, Piketty's suggestion that a wealth tax can stem the rise of inequality is illogical.

Wealth taxes tend to decrease the quantity of capital, thus raising the scarcity and the quality of it. The result - higher returns to capital in the long run that will at least in part neuter the wealth tax effects on stock of capital. More scarce goods tend to command higher prices.

The problem with wealth inequality rests with the distortionary nature of taxation, not with tax levels per se.

To see this, take three forms of capital: financial assets, intellectual property and human capital.

Tax rates on financial assets normally run close to zero, due to availability of various off-shore schemes for tax optimisation for those well-off enough to afford legal and financial engineering services required to attain such rates. Each 1 percentage point in return to financial assets held by a wealthy Irish owner attracts a tax of under 10 percent (inclusive of costs of tax optimisation). For the mere mortals, capital gains rates run also well below income tax rates. In Ireland today, the headline rate is 30%. Intellectual property is facing an effectively near-zero tax rate.

Whereby professional or institutional investors in traditional capital collect roughly 85-90 cents on each euro of gains, intellectual property investors collect closer to 90 cents and retail investors pocket around 70 cents. On the other hand, human capital returns are taxed at an upper marginal tax. Thus a professional consultant will collect around 45 cents on each euro returned to her from added investment in education and skills upgrading.

The result of this asymmetric treatment of returns from various forms of capital is that households simply have no surplus income left to invest and accumulate wealth. Instead, wealth accumulates in the hands of those who can afford living off rents and start their lives with inherited capital.

To make things worse, Peketty also calls for raising dramatically upper marginal tax rate - to hit the high earners. This too is directly contradictory to the objectives he claims to pursue.

Upper marginal income tax rate hits those who live off the wealth of the businesses they built and skills they acquired. Capital gains tax hits those who either dispose of the businesses they built or sell capital they accumulated or inherited. Two of these groups of earners are collecting on value added they created. One is collecting on what others created for them. Treating them all with one brush will simply reduce future rates of growth and/or reduce rates of return on non-capital income. In other words, Piketty's income tax policy proposal will lead to higher wealth and income inequality in the long run under his own model.

The solution to this dilemma is not to tax all capital more, but to equalise the rates of taxation on all capital: physical, financial, technological and human. And focus on what Jacob Hacker of Yale University calls 'pre-distribution' of labour income. The latter requires simultaneously addressing three determinants of market wages: education and skills (increasing skills of the low income segments of population), focused enterprise policy (supporting demand for these skills) and improved mobility and efficiency of the labour markets (increasing returns to skills and human capital).

The Economic ‘Bad’ of Inequality

Piketty's work deserves huge credit for bringing to the fore of the economics debate legitimate concerns with inequality. However, here too the book is open to criticism for being based on occasionally thin evidence.

"Capital in the Twenty First Century" is premised on the assumption that wealth inequality is tearing societies apart, leading to violent conflicts and breakdowns of the civic and state institutions. There is very little evidence to support this assertion amongst the advanced economies. Extreme inequality, measured in absolute terms, can be exceptionally dangerous. So much is true. But relative inequality to-date has not been a major flashing point for revolutions whenever such inequality is anchored in some meritocratic foundations for wealth distribution. All of the recent disturbances in the advanced economies have referenced income and wealth inequality if one were to listen to activists involved in these events. But all have been linked to either public policies relating to income and opportunities available to the less well-off groups or to diminished growth rates in the local economies.

More importantly, current research shows that individual perceptions of relative income and wealth inequality strongly depend on which reference group one selects for benchmarking against.

For example, Daniel Sacks, Betsey Stevenson and Justin Wolfers paper "The New Stylized Facts About Income and Subjective Well-Being (published by CESIfo in 2013) find that there is little evidence to support theories of relative income. In simple terms, if you are concerned with inequality, you should focus on increasing the rates of growth in the economy, not depressing the rates of return on capital.

Another study, by Maria Dahlin, Arie Kapteyn and Caroline Tassot, titled "Who are the Joneses?" (CESR, June 2014) shows that individuals are "much more likely to compare their income to the incomes of their family and friends, their coworkers and people their age than to people living in the same street, town, …or in the world." We reference our own wellbeing against wellbeing of those close to us socially. In this case, Piketty's policy prescription should call for taxing rich people with greater familial networks at a higher rate than those with fewer familial ties. Which, of course, is absurd.

The World is Non-Marxian

Perhaps the greatest error in Piketty's logic is the failure to account for other forms of capital – an error exactly identical to that committed by Marx.

I named these forms of capital above in the discussion of Piketty’s two Fundamental Laws. Ricardo Hausmann from Harvard ("Piketty’s Missing Knowhow", Project Syndicate) shows that Piketty's argument completely falls apart at the national accounts level in the case of advanced and emerging economies. Furthermore, his argument dovetails with my view that hiking upper marginal tax rates to combat income and wealth inequality is simply counterproductive.

Piketty's assumption that the rate of return to capital is following a historically constant trend of 4-5 percent per annum is also questionable. Dani Rodrik of Princeton University reminds us that the return to capital is likely to decline if the economy becomes too rich in capital relative to labor and other resources and the rate of innovation slows down. So if innovation were to fall, as Piketty assumes, rate of return to capital is likely to decline in line with diminished economic growth. This decline is going to be further accelerated by the rise in the quantum of capital accumulated prior to the economic slowdown.

Lastly, since capital is non-homogenous, even constant average return can conceal wide variations in returns to various forms of capital. For example: agricultural land vs industrial property, private equity vs listed shares and so on – all command different and over-time varying returns. Imposing a uniform tax on all wealth will raise cost of investing in more productive and less certain (thus 'pricier') capital associated with new technologies and new industries. In turn, this will only reduce mobility of wealth in the society, increasing, not lowering long-run wealth inequality and supporting currently endowed elites at the expense of any challengers.

Truth is, Marxian world of the epic confrontation between labour and capital has been surpassed by reality. Today, we live in a highly complex, more dynamic and less homogenous economy. This does not mean that the burdens of rising income and wealth inequality should be ignored. But it does mean that policy responses to these challenges must be based on more complex, behaviourally and macroeconomically-anchored analysis.

Piketty’s "Capital in the Twenty First Century", spectacularly succeeded in raising to prominence the debate about income and wealth distributions. But it also failed in delivering both the analytical frameworks and policy responses to these twin challenges.

Tax and reallocation measures - whether through aid or charity, force of compulsion or financial repression - are neither sufficient to restore balance between returns to physical capital, technology and human capital, nor conducive to delivering continued growth of human-centric economic systems. Instead, there is a dire need for direct, markets-based repricing of the sources of value added in the society. This repricing must recognise the simple fact of nature: people add value to capital, not the other way around, and people with skills and productive attitudes to work do so more than those without both or either.

There is a need for closing tax incentives that favour physical capital over human capital, and there is a need for rebalancing our tax system to allow for greater rewards to flow to those creating new value in the economy. But there is also a need for the state systems to stop treating workers as captives for tax purposes, whilst capital remains highly mobile and tax efficient.

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