Month: July 2014

  • Of taxes and capital, of billionaires and poverty

    A review of Capital in the Twenty-First Century by Thomas Piketty

    JDN 2456946 EDT 13:15.

    I finished the book several days ago, but I wanted to give it a really thorough review because it is such an important book—and so closely linked to the kind of thing I do research on. I will abbreviate its name as Capital henceforth, which is also a nod to Marx’s Das Kapital. Many have accused Piketty of being Marxist, but actually most of what he says would draw agreement from Adam Smith. Competitive markets, transparent regulations, progressive taxes. The economic system Piketty wants is not the 1930s Soviet Union; it is the 1950s United States.

    Indeed, one of his central points is that the period from about 1945 to 1965 was the time of lowest inequality, most progressive taxes, and highest economic growth in any developed nation in history. Growth in Europe was especially rapid due to the catch-up after WW2, but even in the US growth was substantially higher then than it is now. It was the Golden Age of Capitalism, and we could go back there with just a few simple changes.

    And this is important to keep in mind as you read Capital and its many reviews and responses; Republicans and the likes of Forbes would have you believe that Piketty is some kind of far-left totalitarian Communist, but the truth is quite the opposite: Piketty is a moderate center-left economist, and the only reason he seems so far from mainstream is that our “mainstream” has veered astonishingly far to the right.

    We live in a nation that has privatized prisons and soldiers. If there are any functions of government more basic than these, I can’t think of them; the whole point of having a government is that it handles your law enforcement and military defense—it monopolizes violence to reduce violence. In fact, when we say we’ve “privatized” them, that doesn’t even make sense; a privatized service is one in which revenue is earned from customers subject to market forces. If you’re paying with tax revenue, you can’t privatize it, no matter how far you remove it from accountability or how many rich old White men you put in charge of it. In real economic terms, the US Postal Service—which makes all its revenue from customers, not taxes—is privatized; and no prison or military could ever be. All you can do by “privatizing” it is make it less efficient, less accountable, more corrupt. Again, I remind you: this is something that Adam Smith and Milton Friedman would agree with; there is nothing socialist about government control of military and law enforcement (or if there is, then there is nothing wrong with socialism).

    Privatization does make sense in some cases; and indeed when I wrote a development paper on Venezuela, one of the core themes was that Venezuela urgently needs to privatize most of its industries. When you are making a physical product that is bought by customers, privatization is only sensible; that’s the situation for which free-market capitalism was expressly designed, and it is the situation in which it shines. Obvious on the other side are forms of violence, like law enforcement and military; those must necessarily remain under government control. The only debate we should be having is about the intermediate cases, the service industries: banking, insurance, healthcare, software development. Since there is no physical product to be bought and sold, the standard rules of capitalism don’t quite work; this is especially obvious in the case of software development, in which a single “product” is actually a piece of information—really, a gigantic integer—that can be copied, modified, and redistributed indefinitely. I tend to favor more nationalization of these intermediate cases, as does Piketty; that is what makes us center-left. Favoring more privatization is a reasonable view to be argued, and that would be center-right.

    Indeed, there are features of Piketty’s Capital that may annoy some on the far-left, the most extreme Occupy Wall Street folk who demand a total dismantling of capitalism. Piketty is not anti-free-market; on the contrary, many of his complaints are about ways in which our free market is distorted by a taxation and regulatory system that favors the rich and powerful. One of the most worrisome is the way that the return on capital in our system actually increases with the amount of capital you have, which is inherently unstable. It’s supposed to be constant or decreasing; under this sort of increasing returns, once someone is richer they will continue to get richer by an ever-growing fraction until they own the whole economy or (more realistically) the system falls apart.

    This is why the central equation of the book (which has been made into a t-shirt) is r > g, the return on capital is greater than the growth rate of the economy. As long as this is true, capitalism will not be stable; the owners of capital will capture an ever-growing portion of the economy.

    Actually even this wouldn’t necessarily be bad, if capital endowments were evenly and fairly distributed. A prolonged period of r > g could in fact be a world in which manual labor is made obsolete by automation—and to some extent this is actually true. The problem is that our endowments of labor are relatively equal (some are smarter or stronger than others, but never by a factor larger than 10), while our endowments of capital are wildly unequal (some people literally own 1,000,000 times as much as other people!). As Piketty discusses in detail, much of this inequality is perpetuated through inheritance, in a system Piketty calls “patrimonial capitalism”. Personally I think this term is too soft; a system in which the rich and powerful today are the heirs of the rich and powerful yesterday isn’t capitalism at all, it’s feudalism. We speak as if the left is “socialism” and the right is “capitalism”, but in fact we’ve gone so far right that it’s more like the left is capitalism and the right is feudalism.

    If these capital endowments could be somehow equalized, the fact that r > g would be no cause for concern; and Piketty has a recommendation for how we might do this. He recommends a high progressive tax on capital directly; not on returns to capital, which are easily disguised by clever accounting, but on capital itself. And lest you fear he’ll raise your property taxes, actually he intends to lower them; he wants the tax to be on net capital, so if you have a house worth $200,000 with a mortgage balance of $150,000, he would tax the $50k you have, not the $200k you’d have if the house were paid off. If you were underwater, your property tax would drop to zero under Piketty’s system. Moreover, the very high rates he envisions would only apply to very large incomes; I think his example is about 5% above $1 million and 10% above $10 million. That’s quite high for a property tax; keep in mind that return on capital is usually in the realm of 7%, so if you are taxed 5% on capital stock that would be 71% of your capital income. Taxed at 10%, you may actually pay out more than you take in; but this is exactly the point, because Piketty does not think anyone deserves to maintain stocks of capital in the hundreds of millions or billions.

    And I must say… I’m inclined to agree. The only people I can think of whose contributions to the world were large enough that I would say they might deserve $1 billion were not billionaires; and contrapositively all the billionaires I know of are not people who made anywhere near that kind of contribution. Perhaps if our billionaires were Jonas Salk and Alan Turing instead of Bill Gates and Steve Jobs I would find the distribution more justified. Don’t get me wrong, Bill Gates and Steve Jobs contributed a great deal, and I think it is entirely fair that they be millionaires; but billionaires is something else entirely.

    This failure to distinguish millionaires—the merely rich—from billionaires—the mind-bogglingly wealthy plutocrats—is something that grates me, a symptom of our national innumeracy that goes all the way to the top. Obama will say things like “millionaires and billionaires should pay their fair share”; if you don’t see what’s wrong with that, that’s part of the problem. It would be like saying, “starving people and millionaires should pay their fair share”; while I suppose this is true, the fair share starving people should pay is probably zero if not negative. Don’t believe me? Well, the UN extreme poverty level is an annual income of $450 per year; anybody below that, it’s fair to say, is starving. A millionaire making 7% would have an annual income of $70,000 per year. Meanwhile, a billionaire making 7% has an annual income of $70,000,000 per year. The ratio between the starving child in Africa and the millionaire is 156:1. The ratio between the billionaire and the millionaire is 1000:1. To be fair, we still call someone like Mitt Romney a “millionaire” (or the awkward term “multi-millionaire”) if their net wealth is say $200 million, which is closer to the billionaire range. I think we should probably try to speak in terms of logarithms: A starving child lives on three figures (10^2), a sweatshop worker makes four figures (10^3), a middle-class American makes five figures (10^4), a doctor makes six figures (10^5), the inventor of Photoshop makes seven figures (10^6), Mitt Romney takes in eight figures (10^7), anyone in the Forbes 500 receives nine figures (10^8), and Bill Gates receives ten figures (10^9). So far, nobody takes in eleven figures, but the very richest billionaires are getting close.

    Piketty of course would never make such an error; indeed he meticulously distinguishes different levels and sources of wealth, and catalogues them all for over two centuries of history across the US and Europe. The book is absolutely a tour de force, and it is remarkable that a 700-page tome full of numbers and graphs has nonetheless managed to achieve bestseller status. At the very least, Piketty struck a nerve; and I think more than that, he finally gave people the rigorous economic analysis to prove what they had suspected all along.

    One of the choices Piketty makes that I found oddest is his tendency to focus on the ratio of capital stock to income. I think he did this because it’s easy to get good data on it—which is vital for the sort of large-scale long-term historical analysis he wanted to do. This always felt to me like not quite getting at the issue we really wanted to get at, sort of like how real GDP doesn’t capture the true prosperity of a society because it leaves out things like volunteer work, leisure time, psychological stress, and environmental impact. If the capital to income ratio is say 8 years, what does that mean exactly? Well, it means that it would take 8 years of the whole economy’s income to equal the amount of capital. If all income went to capital (no labor income at all, thankfully not a situation we’ve ever been in), this would necessarily mean that the return on capital is 1/8, i.e. 12.5%. That’s pretty high; if we assume instead the 7% ballpark I mentioned earlier, this would mean that 56% of the economy’s income is going to capital, which would still be horrible (this is about the state of the antebellum South if you count slaves as “capital” because their income goes to their owners).

    In the US today, about a third of our income is due to capital, which at 7% means our capital to income ratio is about 5 years. (And indeed it is; Piketty has some very nice graphs of this over time. The extremes: the US ratio has gotten as low as 3 years in 1940, while the Europe ratio was as high as 7 years in 1880.) I’ve heard many an economist declare that the 2/3 labor and 1/3 capital mix is some sort of fundamental law of capitalism, but Piketty demolishes that notion completely; the proportion of income that has gone to capital has varied from as low as 20% to as high as 50%. This “law” is in fact the contingent result of 20th century geopolitical events and government policies. Those same economists often try to make excuses for why the proportion of the economy going to wages has been falling since about 1970 (it’s always Reagan, curse his name); usually their excuse involves “labor costs” that include all sorts of benefits, but think about that for a minute: Where do benefit payments go? Not to the worker, that’s for sure; they go to hospitals or insurance companies. And if you think that workers get that value back in the form of healthcare, think again: The US spends twice as much on healthcare as France and our life expectancy is shorter.

    So as you can see, the capital to income ratio does tell you something about the distribution of income in society, but in a very indirect way. Theoretically one could have a very high capital to income ratio and still have most income go to labor, so long as the return on capital were low enough; in practice the capital to income ratio varies much more than the return on capital does.

    Piketty wants to tax all this capital away, and that’s the part that makes the right wing red with rage. He has no qualms about saying that the taxes are confiscatory; he explicitly wants to redistribute wealth from the rich to the poor. It’s rather refreshing, really; where so many liberals dance around the issue, Piketty just comes out and says that he thinks our distribution of wealth is unfair and needs to be changed.

    I actually think the tax rates he recommends may be too high; taking above about 70% of income (which a 5% capital tax might, and a 10% capital tax definitely does) actually puts you on the wrong side of the Laffer Curve and reduces your government revenue. The right wing tries to pull out the Laffer Effect when talking about hikes from 20% to 30%, which is absolutely ludicrous; but when it comes to hikes from 30% to 80% it’s actually a very reasonable concern. That’s the thing about economics; it’s quantitative. Everything is a matter of degree.

    Then again, these very high rates would directly reduce the inequality of wealth, and in particular pull some of the wealth from the very top of the distribution where a handful of billionaires own as much as entire nations. There definitely is something wrong with that state of affairs, and the Laffer argument also doesn’t seem all that compelling either.

    For those who think that say a 90% tax on all income above $10 million would damage the economy, I offer a challenge: Name me a profession that satisfies all three of the following constraints. 1. The work produces some real benefit to the world. This doesn’t have to be a physical product, or even anything particularly important; it just needs to be some real good or service that is beneficial to someone. Feel free to include art, music, research, software development, even insurance. 2. The income received by an individual worker can be in excess of $10 million per year. 3. If their income were significantly reduced, the worker would substantially reduce the amount of work they do.

    I can think of jobs that satisfy any two, but never all three; and all three is what you’d need to justify the Laffer argument. Software developers satisfy 1 and 2, but free software proves they don’t satisfy 3; likewise for professional athletes, actors, and musicians, because the vast majority of people in sports, acting and music make very little money at it, and just do it because they love doing it. Most jobs—take your pick, from coal miners to physicists—satisfy 1 and 3, but get nowhere near 2. And there are jobs like hedge fund managers and derivatives traders that satisfy 2 and 3, but I think you’d be hard-pressed to say they satisfy 1.

    If I am indeed right that there are no such jobs, or only a handful of them that aren’t particularly important, then here is what mathematically must happen under such a tax: Money that previously went to these rich workers now goes somewhere else (either the government or the rest of the economy, depending on how exactly things shake out), and the total amount of real goods and services in the economy does not change. The pie remains the same size, and they get a smaller piece of it; therefore the rest of us get a bigger piece. The Laffer Effect only happens if the pie gets smaller, and with a cutoff of $10 million I just don’t see that happening. Make the cutoff $100,000 and it would; call that 2B: An individual worker can receive more than $100,000 per year. Now there are jobs that satisfy all three of 1, 2B, and 3; for instance, neurosurgeons, university professors, engineers. But at $10 million? I just don’t see it.

    How much money would such a tax put back into the economy? It’s estimated that the super-rich take about 20% of our nation’s income, so that 90% tax would be like an 18% increase in GDP, or about $2.7 trillion. Yes, trillion with a T, yes, 10^12 USD, yes, enough to cover basically the entire federal budget on its own. We could eliminate taxes entirely for 99.9% of the population and still have a smaller deficit than we do now. That is how insanely unequal our income distribution has become.

    Hm… maybe this Piketty fellow is onto something after all?