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VILLAGEAugust/September
quantum or stock of capital) divided by
national income (for example, GDP).
As anyone with a basic knowledge of eco-
nomics would know, this is not a law, but
an accounting identity. Furthermore, any
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 does it
yield a deterministic and singu-
lar rate of return. Instead, capital
takes various forms.
There is financial capital
– where the rate of return is
measured in the form of equity
returns, bond returns, finan-
cial portfolio returns and so
on. There is intellectual capital
that can be traded. This gener-
ates financial returns to holders/
investors, but also yields produc-
tivity gains to its users, including
workers. There is human cap-
ital – which (along with other
inputs into production) gener-
ates returns to labour (wages and
performance-related bonuses),
but also returns to entrepre-
neurship, creativity of employees and so
on. There is managerial and technological
know-how that can be invested in and trans-
ferred or sold, albeit imperfectly, in so far as
it often attaches to labour and skills.
To measure the income share of all of
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 that the comprehen-
siveness of the book’s ambition – of creating
a unified theory of future economic devel-
opment – renders it an easy target for
criticism, challenge and, ultimately, nega-
tion amongst economists.
Before diving deeper into Piketty’s work,
let me state three facts.
Firstly, I admire Piketty for his audacity
to challenge the orthodoxy of macroeco-
nomics and tackle a broad-ranging set of
targets. Ninety-nine point nine percent of
economic literature explores the minutiae
of empirical or theoretical cul-de-sacs in
specific sub-divisions of sub-fields of eco-
nomics. Piketty falls into the . percent of
economists who pursue the big picture.
Secondly, witnessing the vitriol with
which Piketty’s book was greeted in eco-
nomic 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 aca-
demic publications. ‘Capital in the Twenty
First Century’ is too long and stylistically
un-engaging to be worth returning to in
the future.
The last fact means that you should read
Piketty’s thesis and be aware of his core evi-
dence, as well as the growing evidence of its
shortcomings. The best means for acquir-
ing 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 determined
to impress your friends with your economic
scrupulousness, in which case you had bet-
ter avail of Flann O’Brien’s gentlemanly
service that can get the tome thumbed,
marked and annotated for you with scien-
tific-sounding marginalia.
Piketty’s core thesis is based on what he
defines as the “fundamental laws” of cap-
italism. Both of these laws stem directly
from his view that economic inputs can be
grouped into only two categories: capital
(something that can be bought and sold, and
thus accumulated without limit) and labour
(something that cannot be sold, although
it does collect wage returns, and cannot be
accumulated without limit). Incidentally,
outside undergraduate economics, this divi-
sion remains valid only in the pre-s
literature.
Piketty’s First Law states that capi-
tal’s share of income is the ratio of income
from capital (or return to capital times the
T
HOMAS Piketty’s ‘Capital in the
Twenty First Century’ (Harvard
University Press, ) has ignited
both public and professional debates about
the economics of income and wealth distri-
bution not seen since the inter-war period a
century ago, when applied Marxism collided
with laissez-faire economics.
To give the credit due to the author and
his book, this attention is deserved.
Like Marx’s ‘Das Kapital’, Piketty’s
volume is sizeable enough to induce unwa-
vering submission from the reader to its
meticulously factual and theoretically all-
encompassing virtues. Like Marx’s opus,
‘Capital in the Twenty First Century’ is
impenetrable to anyone unequipped with an
advanced degree in political economy and
understanding of economic theory. They
both aim to herald a Revolution, indeed
essentially the same revolution: the dis-en-
dowed against the endowed. Like Marxist
debates of the s, Piketty’s thesis comes
at a time of major upheaval and crisis.
And Piketty’s work is destined to stay
with us for a long, long time. Its thesis of the
coming age of chaos rising from the chain
reactions of growing wealth inequality will
be fuelling activists’ imaginations for dec-
ades. Yet, perhaps to the surprise of the
Impenetrable, focused
on the wrong kind
of inequality and
economically flawed
but timely and
essential.
By Constantin
Gurdgiev
Picking
at Piketty
Piketty’s First
Law is not a
law, but an
accounting
identity and
applies to
all forms
of capital,
including the
ones that he
omits
“
Thomas Piketty
POLITICS
SPECIAL
August/September VILLAGE
of savings.
Aside from the above, Piketty’s sugges-
tion that a wealth tax can stem the rise of
inequality is illogical.
Wealth taxes tend to decrease the quan-
tity of capital, thus raising the scarcity and
the quality of it. The result is higher returns
to capital in the long run that will at least in
part neuter the wealth tax effects on capi-
tal stocks. Scarcer goods tend to command
higher prices.
The problem with wealth inequality is the
distorting nature of taxation, not tax lev-
els 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 since
those well-off enough to afford
the financial engineering serv-
ices required to attract such
rates in the first place usually
deploy off-shore schemes for
tax optimisation. Each percent-
age point in return to financial
assets held by a wealthy Irish
owner attracts a tax of under
percent (inclusive of costs
of tax optimisation). Capital-
gains rates run also well below
income-tax rates. In Ireland
today, the headline rate is %.
Intellectual property attracts an
effectively near-zero tax rate.
Whereas professional or insti-
tutional investors in traditional
capital collect roughly -
cents on each euro of gains,
intellectual property investors
collect closer to cents and retail inves-
tors pocket around cents. On the other
hand, human-capital returns are taxed at
high marginal rates. Thus a professional
consultant will collect around cents
on each euro returned to her from added
investment in her education and skills.
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 from which to accumulate
wealth. Instead, wealth grows in the hands
of those who live off rents and start their
lives with inherited capital.
To make things worse, Piketty also calls
for dramatic rises in upper marginal tax
rate – to hit high earners. This too is directly
contradictory to the objectives he claims
to pursue.
Upper marginal income tax hits those
who live off the wealth of the businesses they
built and the skills they acquired. Capital
on super-earners. These measures, in his
view, can ameliorate the increase in the
income share of capital triggered by slower
growth.
There are numerous and significant prob-
lems with Piketty’s analysis and even more
problems with conjectures he draws out of
data. Some of these have been discovered by
other researchers, few are the result of my
own assessment of Piketty’s work.
Although Piketty presents numerous fac-
tual arguments describing the rise and fall
and the rise again in income and wealth
inequalities, his factual arguments are tan-
gential to his theoretical proposition. Per
Krusell (Stockholm University) and Tony
Smith (Yale University) have pointed out
that “Piketty’s forecast does not rest pri-
marily 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 frac-
tion of national income.
Now, suppose that Piketty is correct. And
suppose that population growth and techno-
logical progress fall to near-zero. Piketty’s
assumption then implies that an ever-
greater share of economic output will have
to be used to maintain capital stock. This
will crowd out investments in education,
health and new technologies. Eventually
capital formation will consume the entire
GDP. As a number of observers pointed out,
this has never been observed in the past and
cannot be true in the future.
Now, personally, I do believe we are star-
ing 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 gross invest-
ment – investment including replacement
of capital depreciation and amortisation
– is relatively constant as a proportion of
national income. At times of structurally
slow growth, therefore, savings are also
low. And when it comes to demographics:
older and shrinking populations imply
dissaving.
This is supported by historical evidence
and contradicts Piketty’s conjecture.
Furthermore, this macroeconomic evi-
dence is supported by data from individual
consumers’ behaviour. In cyclical reces-
sions, households do engage in increased
savings, known as precautionary savings.
But this is short-lived and does not con-
tribute to increased investment. Over time
slower growth in income brings lower rates
these forms of capital, one simply needs to
divide income from the specific form of capi-
tal by total income. It is the same for labour’s
share - and for any other input share. This is
neither Piketty’s own 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 cap-
ital 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 cap-
ital that can be deployed on this land, as
well as by know-how and technology that
attaches to the economic activity that can
take place on it.
Piketty’s second fundamental law is a
theoretical proposition derived from main-
stream macroeconomic theory. The author
claims that the ratio of the stock of capital to
income will be equal to the ratio of the sav-
ings rate to the sum of the growth rates in
technology and population. Together with
the first law this implies that the income
share of capital equals the ratio of the prod-
uct 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 popula-
tion fall, capital’s share of income will rise,
resulting is a sharp rise in inequality.
The core corollary of this for Piketty is
his call for a global tax on capital (or wealth)
coupled with a massive rise in income tax
Piketty’s
Second Law
relies not on
data, but on
an assumption
that the ‘net’
saving rate is
constant and
positive over
time. Instead,
savings follow
growth over the
long run
“
VILLAGEAugust/September
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-homogeneous,
even a 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 the 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 the mobility of
wealth in society, increasing, not
lowering, long-run wealth ine-
quality and supporting currently
endowed elites at the expense of
challengers.
The truth is that the Marxist
world of the epic confrontation
between labour and capital has
been bypassed by reality. Today,
we live in a highly complex,
dynamic and less heterogene-
ous economy. This does not mean that the
burdens of rising income and wealth ine-
quality should be ignored. But it does mean
that policy responses to these challenges
must be based on more complex analysis,
anchored in macroeconomic and behav-
ioural theory.
Piketty’s ‘Capital in the Twenty First
Century’ spectacularly succeeded in rais-
ing to prominence the debate about income
and wealth distributions. But its analysis
and recommendations are awed. •
depend on which refer-
ence group is selected
for benchmarking
against.
For example, a
paper by Daniel Sacks,
Betsey Stevenson and
Justin Wolfer, ‘The New
Stylized Facts About
Income and Subjective
Well-Being’ finds that
there is little evidence
to support theories that
emphasise the impor-
tance 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 depress-
ing the rates of return on
capital.
Another study, by Maria Dahlin, Arie
Kapteyn and Caroline Tassot, titled ‘Who
are the Joneses?’ (CESR, June ) shows
that individuals are “much more likely to
compare their income to the incomes of
their family and friends, their co-workers
and people their age than to people living
in the same street, town … or in the world”.
We reference our own wellbeing against
the 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.
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.
Ricardo Hausmann from Harvard
shows that Piketty’s argument com-
pletely falls apart at the national accounts
level in the case of advanced and emerg-
ing economies. Furthermore, Haussman’s
argument dovetails with my view that hik-
ing 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 - 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 labour
and other resources and the rate of innova-
tion slows down. So if innovation were to
fall, as Piketty assumes, the rate of return
to capital is likely to decline in line with
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 collect-
ing on value they created. One is collecting
on what others created for them. Tarring
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 ine-
quality in the long run.
The solution to this dilemma is not to tax
all capital more, but to equalise the rates
of taxation on all capital: physical, finan-
cial, 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: educa-
tion and skills (for those with low incomes),
enterprise policy (supporting demand for
these skills) and mobility and efficiency of
the labour market (increasing returns to
these skills).
Another part of the solution is to expand
the holdings of capital (financial, physical,
intellectual and human) across populations
by levelling the playing-field for household
investments relative to professional and
institutional investors.
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 crit-
icism 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 civic
and state institutions. There is very little
evidence to support this assertion amongst
the advanced economies.
Extreme poverty, measured in absolute
terms, can be exceptionally dangerous. So
much is true. But relative inequality to-date
has not been a major flash-point for revolu-
tions whenever such inequality is anchored
in some meritocratic foundations for wealth
distribution. All of the recent disturbances
in advanced economies have been about
income and wealth inequality according
to activists and the media. But looked at
closely, all have been linked to either public
policies relating to income and opportu-
nities available to the less-well-off or to
diminished growth rates in the local econ-
omies, or both.
More importantly, current research
shows that individual perceptions of rela-
tive income and wealth inequality strongly
POLITICS PIKETTY SPECIAL
Its thesis of
the coming
age of chaos
rising from
growing wealth
inequality will
be fuelling
activists’
imaginations
for decades
“
