French economist Thomas Piketty’s magnum opus, Capital in the Twenty-First Century, has inspired volumes of commentary, much of it favorable. Piketty has done a great service in compiling data that identify the rise of inequality in wealthy nations, thereby putting inequality on the political agenda. The debate has focused on Piketty's argument that extreme inequality is inherent in unregulated capitalism, but commentators have overlooked a central mechanism of this theory: that rich people try to create multi-generational dynasties of the sort that existed in aristocratic countries in nineteenth-century Europe. Piketty supports a global wealth tax in order to counter the accumulation of capital over generations. But this intergenerational aspect of Piketty’s theory fundamentally misses the mark.
The extreme inequality plaguing the United States today is not an outgrowth of the accumulation of capital in dynasties. Piketty’s own data show that it arises primarily from enormous salaries earned by a small business and financial elite. Nor is the real problem with these salaries their size, a problem that could be tackled by the taxes Piketty advocates. Instead the real danger is the way they reflect and stimulate a dramatic shift in the sorts of careers pursued by talented individuals in the United States—away from modestly-paying, public-spirited research, education, and engineering jobs, and toward lucrative careers in business and finance. The right solution, therefore, is not to shackle capitalism with a blunt wealth tax but to channel its energies into more productive, diverse activities.
Piketty’s theory, like many great theories, is extremely simple. According to him, the natural growth rate of a capitalist economy is relatively low—around one to two percent per year. Meanwhile, people who own physical capital (factories, housing, farms, and so on) earn a rate of return of about five percent per year, or higher. Both of these numbers are based on historical data and some extrapolation.
To understand why Piketty believes that these two facts inevitably generate inequality, consider an extreme case. If all of this return on capital is captured by the person who owns the capital and if that person saves it all, then the capital owned by that person will grow, relative to the broader economy, at around 3 percent per year. This means that a single person’s fortune could grow by about 20 times in 100 years, relative to the economy. A fortune of $50 billion, like that accumulated by Warren Buffet, could become the equivalent of a trillion dollars by the year 2100. Piketty argues, and we agree, that the prospect of fortunes growing at this explosive rate could be destabilizing economically and politically.
But is such an explosive inequality dynamic plausible? Barring a miraculous life-extending technology, Buffet will not be alive in the year 2100. A $1 trillion fortune derived from Buffet’s wealth will exist only if a single (great-)grandchild owns it all and Buffet and heirs did not consume or give away much of this money between now and then.
Let’s therefore consider a more realistic example. A person inherits a fortune of a billion dollars at the age of 50, and lives until 80. Let us assume (optimistically) that she can earn a 6 percent real return on her capital (say, 8 percent minus 2 percent inflation) and that the economy grows at a 1 percent rate. Her (real) return is then $60 million per year.
Suppose she spends $10 million per year on houses, cars, and yachts for herself and her family. She must also pay taxes on her 8 percent return; those taxes will cost her another $20 million or so. If she is like most wealthy Americans, she’ll want to influence politics, and give money to charity. Say that would cost her another $10 million. She is thus left with a mere $20 million dollars in savings, or a 1 percent return relative to the economy, each year. (If the economy grows 1 percent per year, then her fortune must increase by $10 million annually to maintain a constant share of the economy.) While these particular assumptions are unavoidably arbitrary (consumption could be a bit higher or lower, taxes may rise or fall, etc.), it seems hard to imagine a typical individual worth a billion dollars saving much more of her income than this.
In such a scenario, her fortune would increase only by 35 percent relative to the economy over the 30 years of her accumulation. The government would then take 40 percent of her fortune in inheritance taxes, leaving her heirs with only 80 percent of what their mother inherited relative to the economy. If she divides her fortune between two children, each would end up with only 40 percent. If they kept consuming at the rate they grew accustomed to as trust-fund babies, they would begin to eat into their capital, eroding their fortunes ever more quickly.
Even if we take the extreme case in which the person in question saves her entire disposable income, existing taxes alone will ensure that each of her children will inherit only 73 percent of their mother’s wealth, relative to the economy. Only very extreme scenarios, where every wealthy individual does all of the following at the same time can lead to the sort of explosive inequality dynamics Piketty fears:
- Marries someone at least as wealthy or bequeaths all wealth to one child.
- Consumes very little.
- Avoids paying most taxes.
- Contributes little to charity or politics.
- Invests optimally while avoiding Bernie Madoff and his ilk.
And it is hard to imagine why anyone would care about the existence of such an inbred, self-denying, and politically-removed class, if it could ever exist.
Piketty’s famous references to the novels of Honoré de Balzac and Jane Austen are not merely literary embellishments. Piketty argues that our society will end up like the societies described in those novels, where a small number of socially and politically powerful families owned vast fortunes and everyone else toiled in poverty or schemed to marry an heir. The elites were parasites who lived off returns on the capital accumulated by their ancestors. Returns are a synonym for rents: those elites are the “rentiers,” a term of opprobrium for Piketty as it was for Marx. Piketty warns that while the form of capital has changed over the last 200 years—agriculture is less important, industry more important—the basic role and effect of capital have remained the same. Capital generates inequality that distorts people’s behavior and ultimately sows cataclysmic political conflict between the have-nots and the haves.
But in Balzac’s France and Austen’s Britain, strong cultural norms and strict legal rules helped keep fortunes in a single family. There are dynasties in the U.S. today—the Rockefellers, the Pritzkers, the Waltons—but dynasties like these have existed for a long time. They do not seem more numerous or influential than in the past. The old world of people scheming to marry wealthy heirs isn't prevalent in our world. Yet suppose we run with Piketty’s imagination for a while. Would the resulting society be such a bad place to live?
Undoubtedly, competition to marry into the elite of rentiers would be intense. But that means that very few rentiers would marry within their caste. Besieged by beautiful or handsome and talented suitors, and without any need to accumulate additional wealth, rentiers would end up spreading their wealth far and wide through marriage. The size of the rentier caste would at least double with each generation, through marriage and the birth of even just two children. Meanwhile, as Piketty acknowledges, at least half of fortunes are self-made rather than inherited. So through marriage and entry by outsiders, the rentier class would multiply by as much as four in each generation.
This would truly be an explosive dynamic, but the opposite of the inequality dynamic that worries Piketty. If rentiers currently account for one tenth of a percent of the population, within a century they would account for nearly 10 percent, and in a century and a half they would account for more than half of the population! In fact, this growth appears in Piketty’s data: the rentier classes in various countries have grown in size over the last decades much more than have the size of the fortunes of the wealthiest rentiers. Piketty is an enthusiastic extrapolator from past data, but he does not extrapolate from this data. The force of Piketty’s argument rests on the exponential accumulation of capital returns held by individuals, but exogamy and childbearing produce a similar, in fact greater, exponential spread of capital into the hands of many.
In such a world, as the capital stock grows (likely in the form of robots), more and more people will be able to live comfortable lives without doing any work, or very little. It will become easier for people to work part-time, to take low-paying jobs in the nonprofit sector, to stay home with young children for extended periods of time, to volunteer. To quote Piketty’s great predecessor, who had a very different economic system in mind: “…to hunt in the morning, fish in the afternoon, rear cattle in the evening, criticize after dinner, just as I have a mind, without ever becoming hunter, fisherman, herdsman or critic.”
What, then, is the source of the vast and growing inequality of income we see in the United States today, and should we worry about it?
As Piketty not only concedes, but documents himself, most of this inequality arises from labor income, not capital income—from compensation earned by executives at big firms, entrepreneurs, and financial wizards. Almost none of these ultra-high income earners are the teachers, engineers, and academics that, according to data collected by Harvard economists, used to be the core of a modest-income social elite in the 1960s and 1970s. This should be troubling. Economic research shows that the medical advances sparked by the research done by medical academics added $3.2 trillion to the value in the economy, in terms of improved health, each year since 1970. Yet all academics in the United States—including all the researchers in other fields—were paid less than $100 billion. Financial workers earned five times that amount.
A system that delivers rewards in such poor proportion to the benefits society derives will stifle economic growth as well as sharpen inequality. Thus, the fundamental problem facing American capitalism is not the high rate of return on capital relative to economic growth that Piketty highlights, but the radical deviation from the just rewards of the marketplace that have crept into our society and increasingly drives talented students out of innovation and into finance.
If that perspective is correct, Piketty’s prescriptions are not oriented toward the right problems. Piketty supports a higher income tax and a progressive wealth tax. We agree that a higher income tax would be desirable. But broad taxes, while useful absent better policy in other areas, are poorly targeted, because they do not distinguish clearly between people who are undercompensated for their social contributions (researchers, teachers, engineers) and those who receive excessive pay (financiers, lawyers).
While reforms are needed in many areas of the economy, the most important goal is to reward people for developing and spreading new ideas that benefit society. Unfortunately, the law does a poor job of rewarding innovators and teachers. New, fundamental ideas do not receive intellectual property protection. Funding for basic research is constantly being axed. Prizes for outstanding scientific contributions are paltry and rare. Reform should focus on these problems—above all, on rewarding scientific research and taxing lucrative but socially useless endeavors like high-frequency trading—not on long-term inequality.
Piketty’s conjecture that we will reach the same or worse levels of wealth inequality than in the nineteenth century is implausible. Moreover, his focus on inequality misses that something great is also going on—that more and more people can live off society’s accumulated wealth and so don’t have to work. The real danger is not inequality per se but bad policy that suppresses growth and thus the accumulation of wealth, delaying this utopia for the masses longer than necessary. So while progressive taxes may serve as a short-term palliative, we should focus on giving the most capable part of the population better incentives to innovate, while allowing everyone else to benefit from their brilliance as rentiers.
Eric Posner is a professor at the University of Chicago Law School; follow @EricAPosner on Twitter. Glen Weyl is an economist at the University of Chicago, currently on leave with Microsoft.