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Why Economists Disagree With Piketty's "r - g" Hypothesis On Wealth Inequality

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Justin Wolfers at the New York Times has written an insightful new article reporting the recent University of Chicago Institute on Global Markets survey finding that a majority of economists surveyed (over 81%) disagree with Thomas Piketty’s "r > g" hypothesis on wealth inequality (the idea that a gap between the after-tax return on capital “r” and the economic growth rate “g” has been the most powerful force pushing towards greater wealth inequality in the US since the 1970s). The discussion surrounding the arguments in Piketty’s recent bestseller Capital in the Twenty-First Century reached a climax earlier this year with a “Pikettymania” Bloomberg Businessweek cover article and countless economists and journalists weighing in on the book which has stirred much debate over the origins and measurement of inequality.

Thomas Piketty, author of Capital in the Twenty-First Century and Paris School of Economics Professor (Photo credit: Charles Platiau/Reuters/Landov).

University of Chicago Initiative on Global Markets Survey of Economists

Wealth inequality versus income inequality

It is important to note a few things before getting into further details. First, the debate around “r > g” is about wealth inequality and not so much about labor income inequality (which is a much better documented issue). Second, what’s really important to highlight is how scarce data on wealth really is. We don’t have wealth data for European countries beyond the U.K., France and Sweden, yet Piketty and others are already making sweeping statements about European wealth inequality as a whole compared to the U.S. Third, very little of the inequality analysis presented by Piketty and others includes data on the wealth or incomes of developing countries (it is almost entirely limited to measuring the dispersion of wealth and incomes in Europe and the US). Including such developing world data in a global analysis tells a different story (that income inequality is falling globally).

Economic theory and empirics suggest that returns to capital will decrease over time contrary to the r>g hypothesis

Going back to basic economic modelling, Matt Rognlie, an MIT graduate student, made this extensive argument back in June that Piketty’s analysis erroneously predicts the rise in capital’s share of income and the rising gap between r – g by neglecting the reality of diminishing returns of capital accumulation. Furthermore, he points out that Piketty’s prediction of the return on capital to exceed the GDP growth rate in the long-run, this assumes the elasticity between capital and labor must be greater than one. However, standard empirical estimates of the elasticity between capital and labor are well below 1, thwarting the argument that owners of capital will own an increasingly disproportionate amount of wealth as noted by Obama economic advisors Larry Summers and Jason Furman.

Matt also points out how home price dynamics play a dominant role in recent wealth and income inequality trends, which have vastly different underlying mechanisms than the r>g mechanics laid out in Capital in the 21st Century.

Bill Gates suggests adopting consumption taxes in the U.S. and moving away from high income taxes rather than a tax on capital

Bill Gates offers this excellent critique of the French economist’s recent bestseller at his blog:

“More important, I believe Piketty’s r > g analysis doesn’t account for powerful forces that counteract the accumulation of wealth from one generation to the next. I fully agree that we don’t want to live in an aristocratic society in which already-wealthy families get richer simply by sitting on their laurels and collecting what Piketty calls “rentier income”—that is, the returns people earn when they let others use their money, land, or other property. But I don’t think America is anything close to that.

Take a look at the Forbes 400 list of the wealthiest Americans. About half the people on the list are entrepreneurs whose companies did very well (thanks to hard work as well as a lot of luck). Contrary to Piketty’s rentier hypothesis, I don’t see anyone on the list whose ancestors bought a great parcel of land in 1780 and have been accumulating family wealth by collecting rents ever since. In America, that old money is long gone—through instability, inflation, taxes, philanthropy, and spending.”

Slate offers a self-defeating response article to Wolfers and Gates stating that even Piketty would disagree with the tenet that the gap between r and g is the driving force of income and wealth inequality. In responding to Slate, Piketty said yesterday:

“I think the book makes pretty clear that the powerful force behind rising income and wealth inequality in the US since the 1970s is the rise of the inequality of labor earnings, itself due to a mixture of rising inequality in access to skills and higher education, and of exploding top managerial compensation (itself probably stimulated by large cuts in top tax rates), So this indeed has little to do with r>g.”

For those who have actually read Capital in the Twenty-First Century, they know how central the r-g > 0 hypothesis is to the theory of capital accumulation that inspires the namesake of the book. It is the backbone behind the tax on capital (the wealth tax) proposed in Part IV of Capital. Bill Gates interestingly proposes rather than adopt a wealth tax as Piketty suggests, that the U.S. should adopt greater consumption taxes and move away from high income taxes:

I agree that taxation should shift away from taxing labor. It doesn’t make any sense that labor in the United States is taxed so heavily relative to capital. It will make even less sense in the coming years, as robots and other forms of automation come to perform more and more of the skills that human laborers do today.

But rather than move to a progressive tax on capital, as Piketty would like, I think we’d be best off with a progressive tax on consumption. Think about the three wealthy people I described earlier: One investing in companies, one in philanthropy, and one in a lavish lifestyle. There’s nothing wrong with the last guy, but I think he should pay more taxes than the others. As Piketty pointed out when we spoke, it’s hard to measure consumption (for example, should political donations count?). But then, almost every tax system—including a wealth tax—has similar challenges.

Income Inequality Is Falling Globally When Including Data From Developing Countries

Piketty examines rising inequality within individual countries and limits almost all of its analysis to developed countries included in the World Top Incomes Database (WTID). When you include incomes from the developing world, as Tyler Cowen notes at the New York Times, the data tells a much different story, one of falling global income inequality. The Economist provides an excellent graphic using data from the OECD, primarily drawn from the work of the great economic historian Angus Maddison:

Global Income Distribution (number of people at each level of income)

*Income per person is measured in 1990 $ at purchasing-power parity

Source: The Economist, OECD

Piketty’s Income and Wealth Inequality Data

Piketty deserves much credit and praise for starting a rich discussion about inequality. The data on income inequality is far more comprehensive and much to Piketty’s credit, we have the largest database of household incomes (the WTID), thanks to him and many other researchers.

This data also, by in large, points to rising income inequality within many developed countries over the recent period. This fact is almost impossible to refute. Harvard economist Greg Mankiw in a recent paper offers a somewhat optimistic view that rising income inequality in developed countries is a consequence of massive innovation, which ultimately benefits society. Liberal economists like Nobel Laureate Joseph Stiglitz argue that income inequality is a result of “our policies and our politics” which should be corrected.

Income Inequality: Top 10% Income Shares In Europe and the U.S. (1900-2010)

Source: Capital in the 21st Century (Figure 9.8)

With respect to wealth inequality, which has not demonstrably risen over the same period, is it possible that we live in a world where wealth rises at a much slower pace than incomes? What if the wealth of high earners are decayed through inflation, taxes, divorces, giving to charities, political campaigns, and consumption as Glen Weyl and Eric Posner suggest in their article at The New Republic? Such a dynamic runs against the Piketty’s rentier hypothesis of capital accumulating to the top.

Wealth Inequality: Top 1% and Top 10% Wealth Shares In Europe and the U.S. (1810-2010)

Source: Capital in the 21st Century (Figure 10.6)

The fact is we are only beginning to scratch the surface of wealth and income dynamics. The vast amount of theory and evidence so far accumulated do not support the Piketty r>g hypothesis.