“Wealth inequality is considered one of the most troubling economic problems of the 21st century. “
By Jeremy Ron Teboul
Wealth inequality is considered one of the most troubling economic problems of the 21st century. While recovering from wars, economic crises and recession, our economy has split households into two categories: the ones that are well-off and the ones that are not. In the past five years, many economists with conflicting views and solutions have tried to solve the issue of inequality in both income and wealth. The most intriguing one remains Professor Thomas Piketty in his chef d’oeuvre “Capital in the 21st century.”
Capital, which first appeared in France in 2013 and became later on a best-seller in the United States and many other countries, has left optimistic economists quite unsettled. Thomas Piketty is a Professor at the Paris School of Economics and EHESS, a French Grande École. He worked on his book for more than a decade, gathering data from the past 250 years in order to advance an argument on the issue of inequality. His vision, supported by strong statistical evidence from 20+ countries, is clear: Output generated by the economy grows slower than wealth – the rate of return of wealth r is greater than the economic growth rate g – thus, he suggests that governments cooperate and intervene in the economy by creating “a global tax on capital” to strictly inverse the rate of inequalities, which has been growing for centuries.
On an economic standpoint, Piketty makes valuable observations on what actually causes inequality today. He derives appropriate conclusions on the structure of inequalities, as far as income and capital are concerned. However, almost four years after the publication of his book, many economists have successfully challenged his empirical statements about the world economy, claiming that his framework towards equality lacks theoretical support and is not feasible.
What makes Thomas Piketty’s thesis reasonable?
There are many ways to look at inequality. The first question we ask is ‘inequality of what?’ For Piketty, the problem is everywhere: There exists considerable inequality of wealth and income. A common misconception is to think that wealth and income are similar while they actually have little in common:
Wealth, and especially inherited wealth, is rare and precious to middle-class households in the United States . NYU Economist Edward Wolff explains that a fifth of the population of the United States holds close to 90% of the whole wealth of the country (Pew Research Center).
Income, the other source of revenue for households in our economy is not only formed of labor income, but can also be represented quantitatively by interest rates, profits, capital gains and rents. Labor income relates to the exchange economy model, where households provide labor in exchange for wages.
Income and wealth form a basis for Piketty’s argument on how to solve inequalities in the 21st century.
Without loss of generality, Piketty uses many statistical tools to describe these inequalities, such as 20:20 ratios, gini indexes and of course public data. These statistical indicators are commonly used by economists to show inequality within different geographic regions or within different economic backgrounds. Piketty looks at the richest 10%, 1% and 0,01% of society, considers various geographic regions and looks at a large timeframe, from 1900 to 2010.
In the above graph from Capital, we can see that the gap between levels of inequality in the United States versus Europe has been increasing dramatically since the 1970’s, reaching a global maximum in 2010. Piketty’s main observation in Capital is on the annual returns to capital r compared to the annual growth rate g of the economy: He stands firm on the relationship: r is greater than g . Piketty explains that “when the rate of return on capital significantly exceeds the growth rate of the economy, then it logically follows that inherited wealth grows faster than output and income.”
r > g
However, he makes an interesting exception to his claims: For Piketty, Twentieth Century’s data has to be excluded from the model since the Great Depression and the Great Wars destroyed high amounts of wealth. Apart from the twentieth century exception, r remains greater than g and inequality increases.
Piketty’s observation of such facts may be explained by what he refers to as the “hyper meritocratic society” of “winners take all markets”. He explains that it is relatively easier for someone born with considerable wealth (say in the top (0%;10%] richest part of society) to stay wealthy or become even wealthier. This advantage, while present in most capitalist regimes, is present critically in the United States.
Piketty encourages two pure strategies which are best responses to the problem of inequality:
- The first one is about raising the minimum wage. It is fundamental to not only complement low incomes but also to ensure low income households generate wealth. Entrepreneurship, participation in the workforce, affording health care, education and leisure: these all depend on the accumulation and management of wealth – non-inherited as far as low income households are concerned. This is key to Piketty’s argument: In the United States, a low income person has very few chances of accumulating wealth. The graph above shows the minimum wages per hour in U.S. dollar and Euro in the United States and France. European Welfare States not only have higher minimum wages than the United States but the governments also subsidize education, healthcare and other social services
- The second best response to the problem of inequality is taxation. Taxing wealth, labor income and income from wealth dramatically lowers inequalities and ensures a more equitable and equal society. All socialist and welfare state countries use progressive tax systems based on total income and wealth. Piketty thus suggests a progressive global tax on capital to fight inequality around the world.
From the courtesy of Economics online:
The effect of a negative externality on a macroeconomic market
However, is it fair, feasible, and will it end inequality?
Vilfredo Pareto, Italian economist, which gave his name to the field of Pareto Economics, helps understand the First Fundamental Theorem of Welfare Economics: ‘Under specific restrictions of Equilibrium Theory in Economics, a competitive free market tends towards Pareto Efficiency.’ An allocation of resources, such as wealth in our case between some individuals, is Pareto efficient if and only if such allocation makes at least one individual better off without making anyone else worse off. Market Performance theory suggests that any allocation of resources which is not Pareto efficient leads to market failure. Piketty’s argument, while reasonable, is not necessarily a pareto efficient situation: Shifting that much wealth from the top richest 0,01% to the bottom 50% of society would surely make the bottom 50% of society better off, but will end up making the top 0,01% worse off. Since resources are shifted away from this small percentage of the upper class towards a large portion of the lower class, the principle of non-satiation, commonly referred to as ‘the more the better’, proves this allocation is not pareto efficient. Therefore, we wonder if Piketty’s global tax on capital could lead to market failure.
Another important point of tax-sceptics and critics of Professor Piketty’s book uses the idea of externalities. Externalities of a transaction in economics refer to effects that can increase or, in our case, decrease the welfare of third-parties, not necessarily involved in the transaction. Elinor Ostrom, Nobel Prize winner too, “reflects on the [tragedy of the] Commons” in the first chapter of her best-seller “Governing the Commons.” She uses game theory and quotes many famous intellectuals such as Aristotle’s Politics to prove that a resource allocation that works in practice can also work in theory. She uses the example of environmental externalities to show that we do not care enough about our ecosystem, which she considers as our greatest resource.
We can then question whether Piketty’s argument works in practice to justify the theory. On the one hand, there exists enough resources in the world which, if shared equally, would make everyone live a very normal and decent life. Shifting resources from people in the top 5% of society would complement any lack of such present in the bottom 50% part of society. However, the absolute amount of wealth we have in the world does not directly imply how wealth should be divided: It is very unlikely that governments, which not only have different political ideologies but also differ in their economic positions, will ever agree on a certain tax structure and tax base to equalize wealth. Therefore, it is unlikely that Piketty’s strategies to fight inequality hold in practice.
Since Professor Piketty’s empirical argument lacks feasibility to properly function in practice, the theory might also not stand correctly.
Piketty’s argument, though contested, still stands today.
Thomas Piketty is and will be remembered for his incredible observations on inequality. Where most economists saw inequality as a result of secondary factors like education or social background only, he successfully proved there exists a clear correlation between capital and inequalities today. This Marxist method – primarily focusing on capital – for ending inequalities is also properly synthesized which explains why Piketty’s ‘Capital in the 21st century’ was such a success. However, economists have managed to transform Piketty’s roadmap for governments into a manifesto for socialism. It is very likely that we will hear more about Piketty in the next few years, especially with the rise of Bernie Sander’s democratic socialist movement in the United States.
While countries have borders, inequalities have no limit.
Jeremy Ron Teboul
The Economics Review
Image source: Pexels photo library
Piketty, T., & Goldhammer, A. (2014). Capital in the twenty-first century. Cambridge, MA: Belknap Press of Harvard University Press.
Ostrom, T. L. (2015). Governing the commons. Place of publication not identified: Cambridge Univ Press.
Thomas Piketty’s. (2014, May 04). Retrieved February 23, 2017, from http://www.economist.com/blogs/economist-explains/2014/05/economist-explains
Economics Online. (n.d.). Retrieved February 27, 2017, from http://www.economicsonline.co.uk/Market_failures/Externalities.html