Capital in the Twenty-First Century. A Critical Reflection of Growth and Inequality

Contents

Table of figures

Table of abbreviations

1 Introduction
1.1 A Brief Introduction to the General Laws of Capitalism
1.2 Aim and Structure of the Paper

2 A Brief Introduction to Capital in the 21st Century
2.1 Introduction
2.2 The Role of Growth in Capital in the 21st Century
2.2.1 The Forces of Divergence
2.2.2 The Forces of Convergence
2.2.3 Limitations of Growth
2.3 The Role of Inequality in Capital in the 21st Century
2.4 An economic policy for the 21st century

3 Main Arguments against the Understanding of Growth
3.1 Criticism of r - g as the main force of injustice
3.2 Criticism of the First Fundamental Law of Capitalism
3.3 Criticism of The Second Fundamental Law of Capitalism
3.4 Criticism of the Main Forces of Convergence

4 Main Arguments against the Understanding of Inequality
4.1 The role of institutions
4.2 The role of labor market dynamics and innovation
4.3 The role of social mobility and redistribution preferences
4.4 The converging living standards argument
4.5 Implications of Piketty's political suggestions
4.6 Selected impacts of inequality on the individual utility function

5 Conclusion

References

List of Figures

1 The relationship between capital return and growth rate of output

2 Rate of return on capital versus growth rate output at the world level

3 The First Fundamental Law of Capitalism

4 The Second Fundamental Law of Capitalism

5 Qualitative model of inequality, political power and institutions

6 Two period individual's budget constraint concerning redistribution, social mobility preferences and cost of inequality .

Table of abbreviations

a Share from capital income in national income

P Capital / income ratio

6 Rate of capital depreciation

g Growth rate of output (annual)

r Rate of return on capital (annual)

p Individual's time preference

a Elasticity of (factor) substitution between capital and labor

t Marginal tax rate

1. Introduction

1.1 A Brief Introduction to the General Laws of Capitalism

For everyone who has wil l be given more, and he wil l have an abundance. But the one who does not have, even what he has wil l be taken away from him.

— Matthew 25:29

The question of income and wealth inequality is not a mere economic question but also a political with a social dimension. The distribution is chaotic, unpredictable and can change rapidly under different institutional conditions. Nevertheless, growth and inequality are central components of capitalism, as there have always been profiteers and losers from the distribution issue. Since the beginning of the industrial revolution in the 19th century, economists have been examining the question of how demand and supply balance each other. In 1821, David Ricardo recognized the problem of a growing population and the necessity to satisfy needs by meeting an increasing demand with limited resources. For Ricardo, the development of capitalism was obvious: A growing population leads to an increasing demand for land. The landowners can now react to the increase in demand with price increases in order to increase their wealth. In subsequent periods, this return on capital will then take up an ever greater share of national income. According to Ricardo, this inevitable accumulation of capital would result in an inevitable downfall of capitalism because of immeasurable rich landowners followed by an immeasurable poor rest of the population (Ricardo, 1821). Karl Marx also had to recognize that this economic order proved to be comparatively resistant. For Marx, the downfall was inevitable due to income and wealth inequality. The few hands of the bourgeoisie, in which much of the wealth is concentrated, face the masses of the almost destitute proletariat. Thus this class struggle is a necessary consequence of the separation of capital property from the ownership of one's own physical labor (Marx, 1890). Due to Marx, the dynamics of private wealth accumulation inevitably lead to concentration of wealth in ever fever hands. Furthermore, Marx argues that low rates of population and productivity growth, increase the significance of wealth accumulation. Especially in phases of high capital accumulation, wealth becomes socially destabilizing, resulting in a clash of classes between the proletariat and bourgeoisie. Notwithstanding the success of the economists of the 18th and 19th centuries, neither Marx, Ricardo, Smith nor Malthus succeeded in justifying the theses on economic mechanisms with data (Piketty, 2014). This changed in the middle of the 20th century with Simon Kuznets, who was able to present the income and wealth situation in the United States from 1850 to 1950 on the basis of tax data and it is described as the first attempt, to measure inequality on a large scale (Piketty, 2014). While in the period between 1850 and 1914, the upper decile of income distribution hold between 45% and 50%, while the share decreased in the late 1940s to 30% and 35% (Kuznets & Jenks, 1953). Therefore, the income inequality shrank after the second World War. In contrast to previous theories, the bell-shaped curve took technological development into account, which improved living standards for a large part of the population (Kuznets, 1955). Kuznets argues for the balancing forces of growth, competition and technological process leading after the income inequality climaxes to a decrease in later stages of development to reduced inequality and social stability. While distribution of income and wealth in the 20th century was coined by the two World Wars, it is worth asking to extent the reducing inequality according to Kuznets or the clash of classes takes place. Taking the contemporary example of Thomas Piketty's book "Capital in the 21st Century", the questions of growth as well as inequality is discussed in the following paper.

1.2 Aim and Structure of the Paper

In contrast to other bestsellers, Piketty (2014) is widely discussed because the book contributes a serious and discourse changing view on the question of inequality (Krugman, 2014). Piketty caused a great stir, especially among conservatives, in the course of 2014 and sparked manifold discussions not only among economists, but also in a broader public. Piketty's work has thus contributed significantly to the fact that the distribution of income and wealth has become more important on the economic and political agenda. Krugman (2014) claims that there has not been a substantial counterattack to Piketty but a rather ideological argumentation, for example by the book a "Marxist Work". Henceforth, this seminar paper does not only highlight Piketty's most important theses but also presents the selected opposing positions in order to provide a balanced perspective on growth, distribution and inequality. "Capital in the 21st Century" can be differentiated between its historical contribution as well as the extrapolation of the past in order to predict future developments concerning growth and inequality as well as implications for the institutions in the 21st century (Krusell & Smith Jr, 2015). The aim of the following paper is therefore not to examine the historical correctness, but the general theoretical approach as well as the political implications. Accordingly, Piketty's explanations on growth and inequality are elaborated in chapter 2. Chapter 3 reflects "Capital in the 21st century" from the perspective of growth, while chapter 4 focuses on inequality. The paper concludes in chapter 5 with a summary of Piketty's arguments and a selection of counterarguments. Furthermore, limitations and an outlook are discussed.

2. A Brief Introduction to Capital in the 21st Century

2.1 Introduction

According to Piketty, inequality is not an accident but a central feature of capitalism and he argues that "capitalism automatically generates arbitrary and unsustainable inequalities that radically undermine the meritocratic values on which democratic societies are based" (Piketty, 2014, p. 1). An example of this is the enforcement of particular interests of the elite in order to undermine democratic principles. In order to support his thesis, Piketty has collected a large data set from various sources for 20 countries in general and for nine countries in the very detail from 1700 to 2010.¹

The author builds his statements on the difference between the growth rate of income² and the growth rate of capital, while claiming that an increased difference, leads to higher inequality³. Piketty defines this differences fundamental in capitalism and as a general basis for the Two Laws of capitalism which will be discussed in chapter 2.2.1. The author admits that the inter-war period was accompanied by a reduction of inequality which was initiated by an equalizing distribution policy in order to cope with the shocks of war. The "Trente Glorieuses" (Piketty, 2014, p. 20) between 1945 and 1975 lead to a decreasing inequality. This argumentation is in line with Kuznets (1955) claiming that after the a climax, inequality decreases after 1945. In Europe, the following post 1975 period was accompanied by an average growth of GDP per capita of 4%. Those years are followed by the "pitiful years" (Piketty, 2014, p. 96) which are marked by slow growth in the OECD countries. This brief history of capital in the 20th century illustrates the influence of income and wealth growth as well as convergence and divergence-promoting forces. Therefore, the role of growth will be described in the following chapter 2.2 while the role of inequality will be described in chapter 2.3.

2.2 The Role of Growth in Capital in the 21st Century

2.2.1 The Forces of Divergence

One of the major force for increasing inequality is, according to Piketty the rate of return on capital (r) and the growth rate of output (g).

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Figure 1: The relationship between capital return and growth rate of output Source: Piketty (2014, p. 25)

"The inequality r > g implies that wealth accumulated in the past grows more rapidly than output and wages. This inequality expresses a fundamental logical contradiction." (Piketty, 2014, p. 571) He continues by arguing the correlation between income from labor and capital as a "principal destabilizing force" (Piketty, 2014, p. 571). According to Piketty, the inequality between r and g holds true for the past, present and the future. Piketty predicts that return on investment adjusts to a level between 4.0% and 5.5% per annum while the growth rate of output increases from the antiquity over the middle ages. In the early industrialization, it passes the 1% mark. Especially after the World War II, g approaches r but not exceeds the return on capital. This development is shown in the following figure 2.

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Figure 2: Rate of return on capital versus growth rate output at the world level Source: Piketty (2014, p. 352)

Piketty admits that a determination of a long term average return on capital is problematic. While on the one hand, the return on different asset classes varies and on the other hand individual risk preferences are significant in terms of the return on capital employed. (Markowitz, 1952) Piketty provides an exemplary portfolio composition of the years 1872 and 1912, in which it becomes clear that investments in the financial market (financial assets including equity, private and public bonds as well as other financial assets) have gained in importance (Piketty, 2014, p. 371). While in 1872 55% of the portfolio consisted of financial assets, the share rose to 65% in 1912. Therefore, the individual return on capital is determined by the efficiency on the markets. According to Piketty, a more efficient market leads to a higher difference between r and g. Frequent anomalies in the era between 1913 and 1950 for example the financial crisis in 1929 followed by the Great Depression in the 1930s and distortion due to the two world wars are responsible for the plateau in the capital return one can observe in figure 2.⁴ Furthermore, a higher return correlates with the nation's share of income from capital. If r displays a stable long-term tendency exceeding the rate of growth of income and production, then it is likely that the distribution of wealth will be skewed in favor of the fraction of national income derived from capital. That result leads inexorably to an increase in the fraction of income (a) derived from capital in an economy's annual income flow and, thus, to a cumulative process of enrichment and capital accumulation. This condition is expressed in the following formula.

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Figure 3: The First Fundamental Law of Capitalism

Source: Piketty (2014, p. 52)

Where a describes the share of income from capital in national income and P describes the long run ratio of capital stock and national income and g the growth rate of output.⁵ This relationship is possible due to a high elasticity of substitution between capital and labor (Syll, 2014).⁶ In combination with the relationship between capital return and growth rate, one can conclude that in periods of a high capital return and a given p, the share of income from capital in the national income increases. Given that r is relatively stable over the long-term, any sustained slowdown in g accelerates the rate of capital accumulation with respect to other economic factors. The composition of P is explained by Piketty with his dynamic law of accumulation (Second Fundamental Law of Capitalism) which is described in the following.

Abbildung in dieser Leseprobe nicht enthalten

Figure 4: The Second Fundamental Law of Capitalism

Source: Piketty (2014, p. 166)

where p is the long run ratio of capital stock and national income, s the savings rate and g the net growth rate of output, where depreciation is already subtracted.⁷ According to figure 4 wealth accumulated in the past due to for example inheritance gains high importance in periods of slow growth.

By inserting the Second Fundamental Law of Capitalism in the First Fundamental Law of Capitalism, one can conclude that either an increasing rate of capital return or a higher savings rate yields to a higher share of income from capital in the national income if the growth rate remains constant. Moreover, if a increases, the share of national income of the top percentile or the upper decile increases which is for Piketty the main measure for increasing inequality. Therefore, in periods with a high return of capital and high net savings rate, inequality increases, as a increases, ceteris paribus. One example for this condition is the Pre-World War I period, the top in terms of capital income was largely unaffected by taxes because of a laissez-faire policy, which reduced in an increased individual return on investment.

2.2.2 The Forces of Convergence

Besides the forces of divergence, Piketty names three forces of reducing inequality. The first force is the diffusion of know ledge. This "major force of convergence" (Piketty, 2014, p.71) is characterized by converging standards of living due to an equal distribution of access to education. Especially, the education policy guaranteeing access to training as well as the acquisition of appropriate skills is understood to ensure self-determination. Piketty adds that knowledge transfer is important in this context to prevent the poor from becoming the poor of the rich. The second force of convergence is the "rising human capital hypothesis" (Piketty, 2014, p. 21). In case of drastic technological advances, a higher number of skilled workers is needed, whereas the labor's share of income will rise and the capital's share of income will fall. The third force of convergence is the decreasing "marginal productivity of capital" (Piketty, 2014, p. 69). Developed countries with a decreasing marginal productivity of capital tend to invest in countries with a high marginal productivity of capital. With foreign direct investments the worldwide free flow of capital reduces inequality between countries because of competitive advantages between the countries and competition among capital owners. In the context of marginal capital productivity Piketty identifies two problems being contradictory to its general understanding of being a force of convergence. The first problem is that free flow of capital doesn't necessarily have to provide converging income per capita but output per capita. In this scenario, the developing countries may be owned by the countries suffering under marginal capital productivity.⁸

2.2.3 Limitations of Growth

Not only since the report from Meadows et al. (1972), the question of growth limits has been discussed. Accordingly, it is promising to describe Piketty under the aspects of growth limits. He admits that from Antiquity to the modern ages, the annual growth (g) did not exceed 1.5%. Between year 0 and 1700 Piketty postulates no significant growth at all. In contrast, European economies grew with 1.0%, American economies with 1.1%, Asian economies with 0.7% and African economies with 0.5% annually (Piketty, 2014, p.94). In contrast to authors like Gordon (2012), Hodgson (2002) or Jackson (2009), Piketty argues against steady-state economies because of technological advancements. He argues for growth rates between 0.5% up to 1.2% per year. Moreover, he emphasizes that economies with a long term growth beyond 1% change rapidly. Therefore, other forms of inequalities and social dynamics. Wealth can be allocated to fast growing sectors in order to increase the accumulation of wealth. Therefore, the future does not necessarily have to be accompanied by converging standards of living. Piketty concludes that "economic growth is quite simply incapable of satisfying this democratic and meritocratic hope, which must create specific institutions for the purpose and not rely solely on market forces or technological progress." (Piketty, 2014, p. 96) In the following chapter, this question of increasing inequality will be discussed further.

2.3 The Role of Inequality in Capital in the 21st Century

As described in chapter 2.1, Piketty focuses the question of inequality especially due to accumulation of capital. Atkinson et al. (1970) describes the gini coefficient as a distribution function for measuring inequality in income and wealth. Litchfield (1999); Deininger & Squire (1996); Piketty (2014) extend this perspective focusing on group shares from national income. Deininger & Squire (1996) define inequality as the ratio of the top and the bottom quintile's share in national income. Piketty focuses explicitly on "inequality with respect to labor and capital" (Piketty, 2014, p. 244) by concluding that capital has always been more unequally distributed than labor. Hence, he has two senses of inequality: Firstly, he focuses on the split between income from work and income from capital and secondly he argues that income from capital is more concentrated than income from labor among the wealthier part of the society (Solow, 2014). For a further analysis, he divides the population into three strata being the lower class (bottom 50%), the middle class (next 40%) and the upper class (top 10%) which again is separated into the sub strata "dominant class" (top 1%) and "well-to-do-class" (other 9% of the share in upper class).

Piketty argues that on a worldwide scale, P approaches 650% in the late 21st century at a stabilizing savings rate "around 10 percent of national income" (Piketty, 2014, p. 460). The a high capital/income ratio in the long run at a given slow rate of growth is a high capital accumulation accompanied by anti-democratic trends (Field, 2014; Solow, 2014).

2.4 An economic policy for the 21st century

As an institutional counterweight, Piketty attempts to design a social state for the 21st century. He interprets the role of the social state by the standard welfarist approach where the government aims at a maximization of the weighted sums of individual utilities (Piketty & Saez, 2013). This is achieved through a distribution mechanism by imposing taxes on the upper class in order to increase transfers for the remaining share of the population, especially for the lower class. His proposals for the regulation of capital include a stronger welfare state with resources such as progressive income taxes and a global capital tax. Increased public income uses transfer payments, mostly health, education, pensions as well as general income support, as a distribution mechanism. Following Mirrlees (1971); Piketty & Saez (2013) view optimal taxation as an optimization problem of the individual social welfare function with respect to the governmental budget constraint as well as the incentives for the individual rising from the taxation.⁹ Piketty & Saez (2013) express this problem as the Second Welfare Theorem where the government is able to set a set of lump-sum tax corresponding to individual attributes (e.g. taxation of intrinsic abilities) under standard perfect market assumptions. Due to the strong implications, Piketty (2014) argues for a progressive tax on income, whose marginal tax rates are lower on lower incomes than on high incomes. Accordingly, he argues against a linear tax. Piketty et al. (2014) admit that taxation in combination with welfare programs discourages work under low incomes. Hence, a lowered marginal tax rate decreases the elasticity of labor supply because the incentives to work are increased (Blundell & MaCurdy, 1999).

The proposed model of a progressive income tax has the problem of any tax, namely tax evasion. Although the payment of taxes is enshrined in law, there is a phenomenon where tax revenue stagnates or even decreases as tax rates rise (Slemrod, 2007). Tax evasion has resulted in international competition over undercutting tax rates and establishing "tax havens". Piketty contrasts this with a global capital tax that negates a shift in income or wealth. Although he describes this idea as an "utopian ideal" (Piketty, 2014, p. 471), he argues that tax transparency would be a solution to the problem. An example of this is the Swedish system, where tax registers are open to public inspection, thus bringing into the public eye natural or legal persons who have an unusually low real tax rate.

[...]

¹ The empirical contribution of "Capital in the 21st Century" is broadly challenged because of its incomplete data set (Giles, 2014) or methodological problems (Feldstein, 2017; Magness & Murphy, 2017)). Since this paper the evaluates the underlying concepts of growth and inequality, the empirical issues are not discussed further.

² Piketty defines income from labor (g) as "wages, salaries, bonuses, earnings from non-wage labor, and other remuneration statutorily classified as labor related" (Piketty, 2014, p. 18). In contrast, income from capital (r) are "rents, dividends, interests, profits, capital gains, royalties and other income derived from the mere fact of owning capital in form of land, real estate, financial instruments and industrial equipment."(Piketty, 2014, p. 18).

³ As a measure for inequality, Piketty uses the share of national income of the top percentile or upper decile as well as the market value of private capital in relation to the national income. The capital/income ratio will be further discussed in chapter 2.3

⁴ In contrast to Piketty, Fama (1998) argues that a higher market efficiency, respectively if every available information is considered in financial asset's price, the return of capital decreases. This is tantamount to saying that the market has rational expectations. A rational expectation does not necessarily mean that the majority of market participants need to be rational (or even informed), but merely that the overall assessment (expectation value) of market participants is rational. In a market where one can always buy/sell at prices that reflect all information, one can assume that one never buys too dearly and never sells too cheaply. As a consequence, it would also follow that no one can expect to achieve permanently higher profits than the market (average). The application of the market efficiency hypothesis generally refers only to capital markets. Information on companies, states and commodities leads to consequences in the prices already seconds after becoming known, which is an indication for the fact that the prices represent very fast the information conditions of the market.

⁵ Piketty provides the example of d = 600%, so that the capital stock is six times higher than the national income, r = 5%, so that the share of income from capital equals 30%.

⁶ Arrow et al. (1961) found the theory of a constant elasticity of substitution (a). Chirinko (2008) provides and overview of different a ranging from 0.32 to 0.54 for panel data of various countries. For the Cobb-Douglas production function a is constant at 1.0. In different industries, a significantly exceeds 1.0.

⁷ Piketty provides the example of s = 12% and g = 2% resulting in a h of 600%.

⁸ This argument refers to the dependency theory in which underdeveloped countries are owned by rich countries enriching wealthier countries at expanse of the underdeveloped (So, 1990). For Africa as a contemporary example of dependency theory, cf. Palma (1978).

⁹ Mirrlees (1971) describes the incentive problem arising from taxation. He describes a thought experiment with only low and high skilled workers. Since the government is only able to tax observable attributes, the income of the two groups is taxed, not their individual skill. Therefore, he proposes a taxation on commodities.