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Thursday, August 28, 2014

Understanding Piketty, part 4

We now come to the exciting conclusion of Thomas Piketty's monumental work, Capital in the Twenty-First Century. This is not an exaggeration: the final part of the book contains findings that I consider to be simply bombshells in their significance.

In Part 4, "Regulating Capital in the Twenty-First Century," Piketty calls for a new "social state" for the new century, as well as a new way of taxing, a progressive tax on capital. Highlighting the United States, France, the United Kingdom, and Sweden as representative, he shows that all followed similar trends in taxation. Until World War I, all four collected less than 10% of gross national income in taxes. By 1980, the figures had increased to levels ranging from about 30% in the United States to 55% in Sweden. Since 1980, those levels are essentially unchanged.

As discussed by Alan Krueger, countries with high inequality tend to have lower inter-generational income mobility. This holds true in particular for the United States. In fact, Piketty says "the most firmly established result" of research on this question is that the U.S. has the highest correlation of income from one generation to the next (lowest mobility), and the Nordic countries the lowest correlation (highest mobility). The fable often told by conservatives that "we may have inequality, but that changes over generations" is not true today and, more surprisingly, was not true in the twentieth century when the U.S. had lower inequality than Europe.

One reason for this lack of mobility could be the high cost of college, especially among top schools. According to the Harvard financial aid website, tuition and fees come to $43,938 per year. Piketty estimates that the average (mean) income of Harvard students' parents is $450,000 per year, which is enough to put you in the top 2% of U.S. incomes. Harvard notes that ">70% of our students receive some form of aid," which isn't surprising when you run the cost calculator. A family of three with just the one child going to Harvard can receive financial aid even with an annual income of $240,000.

While I have written before about the coming retirement crisis, Piketty points out that it's not just the United States where Social Security is the only thing standing between seniors and poverty. He writes (p. 478), "in all the rich countries, public pensions are the main source of income for at least two-thirds of retirees (and generally three-quarters)." Ending senior poverty which, as he says, was "endemic as recently as the 1950s," is the third main outcome of the expansion of the social state (after education and health expenditures). As I've said before, we need to keep senior poverty from reappearing.

Piketty considers the future of pensions in a low-growth environment. He notes that in pay-as-you-go (PAYGO) systems, such as Social Security was before the creation of the Trust Fund in the 1980s, "the rate of return is by definition equal to the growth rate of the economy." Thus, he says, it would be wise to promote rising wages, for example through increased education funding and even policies to increase the birth rate (pp. 487-88). When r>g, however, it seems logical that money for future pensions should be invested to take advantage of the higher return on investment. That was one of the arguments for privatizing Social Security. However, transitioning to a PAYGO system runs into the huge problem that "an entire generation of retirees is left with nothing." Of course, this is exactly what has happened in the United States and why we are looking at a looming middle class retirement crisis. However, it has not taken place in the Social Security system, but in the area of private pensions. That is, while public pensions in continental Europe equal 12-13% of national income (p. 478), they are only 7-8% in the United States so, traditionally, private pensions picked up the slack. But we now face a situation where 49% of private-sector workers have no pension at all, 31% have been stuck with a defined-contribution plan (401-k, 403-b, etc.), and only 20% have a true pension. Since the 1980s, workers have been transitioned off of defined-benefit pensions and on to -- nothing! Well, almost nothing, as we can see from the $6.6 trillion shortfall between what people need to maintain their current standard of living and what they've actually saved for retirement.

Moreover, investment-based systems suffer from having much higher variance in their returns, a problem that is magnified when investment accounts are individual rather than collective, i.e. as with the Trust Fund. Indeed, as Piketty says, "the rate of wage growth may be less than the rate of return on capital, but the former is 5-10 times less volatile than the latter." This is especially a problem, I would argue, when the level of retirement benefits is low relative to pre-retirement income, as it is in the United Kingdom and the United States. Piketty's preferred solution is to keep PAYGO pensions, but supplement them with guaranteed rates of return for small savers that are closer to r than to g. However, this may have problems of its own. First, where will lower-income people get the money to save in the first place, with falling real wages and all? Second, how will government finance the guarantee in a way that is cheaper than just expanding Social Security? Expanding Social Security has the advantage of shielding individuals from the volatility of the market (and the fact that small investors earn lower rates of return than large investors) while offering a risk-free return (the Trust Fund is invested in Treasury bonds).

Piketty next turns to the progressive income tax, which he calls "the major twentieth-century innovation in taxation" (p. 493). However, in the twenty-first century, it faces two related challenges. First, it is being undermined by international tax competition, including from tax havens. Second, at the very top of the income hierarchy, the income tax is turning regressive, i.e., having lower rates than for those further down the income scale. This is the point Warren Buffett refers to when decrying the fact that he pays taxes at a lower rate than his secretary.

Piketty argues that one reason the progressive income tax is coming under intellectual attack today is that it was adopted chaotically, without time for all its implications to be debated. The tax, he says, "was as much a product of the two world wars as it was of democracy" (p. 498). That is, while many countries had adopted income taxes before World War I, it is only in the aftermath of the war that the top tax rate in major countries exploded. For example, the U.S. top marginal rate went from 7% in 1915 to 77% in 1918. In the United Kingdom, it went from 8% to 60%; in Germany from 4% to 40%, and in France, from 2% to 50%, all in the space of a few years.

Indeed, in both income and estate taxation, the United States was a leader with high rates. Piketty points out that the top marginal rate in the U.S. averaged 81% for the 48-year period from 1932 to 1980. While Britain had similar rates over a long period of time, no other European country did.

Okay, now for the bombshells. As you probably know, top marginal tax rates fell after 1980 everywhere among developed OECD (Organization for Economic Cooperation and Development) member countries. This seems to have increased the incentive for high earners to increase their compensation. In fact, in all 18 countries in the World Top Incomes Database, "the two phenomena are perfectly correlated: the countries with the largest decreases in their top tax rates are also the countries where the top earners' share of national income has increased the most (especially when it comes to the remuneration of executives of large firms)" (p. 509).

Having the incentive to try for bigger pay raises, managers took advantage of the fact that "it is objectively difficult to measure individual contributions to a firm's output" and persuaded their employers to give them big raises, often helped by the fact that their compensation committees were composed of people like themselves. So, Piketty says, it is really a question of bargaining power at the top (and don't forget that he already told us that there is no correlation between executive compensation and firm performance).

Not only did the countries with the biggest cuts in their top marginal tax rate see the greatest increases in top income shares, but at the same time they did not show any greater increase in productivity growth. So top managers were not creating some generalized increase in productivity that they had some kind of moral claim to. In fact, as Piketty points out, productivity growth was 2.3% annually from 1950-1970 but only 1.4% per year in 1990-2010. Yet it is the latter period in which executive pay mushroomed, not the former.

You can probably see where this is going. The entire idea that people's pay level is based on their marginal productivity, such that they "merit" the incomes they earn, is bunk. It is innately hard to measure marginal productivity, and some people have more bargaining power than others (not to mention greater incentives to bargain hard) for reasons that have nothing to do with productivity. In fact, Piketty, Saez, and Stantcheva found that executive could achieve big raises without great performance most easily in countries with the lowest top marginal tax rate. Thus, the theoretical edifice for the claim that inequality is "fair" collapses.

What can counter the massive increase in incomes at the very top of the distribution? If we stick with income tax, Piketty says that the optimal top marginal rate in the United States is 82% (p. 512). This would apply to the top 0.5% or top 1% of incomes only. This would not affect productivity because it would largely wipe out some economically useless activities. Because those activities would disappear, a tax that high would not raise much revenue. If the United States wanted to raise revenue, Piketty suggests a marginal tax rate of 50-60% on incomes in the top 5%. It's important to note that while the United States could do this because it is the world's largest national economy, it is not possible for European countries unless they achieve fiscal coordination. This is extremely difficult due to EU rules requiring unanimity on votes affecting direct taxation (personal and corporate income tax).

The ideal solution, he argues, would be a global tax on capital plus "a very high level of international financial transparency" (p. 515). Piketty recognizes that this is infeasible right now, although he says it might be possible "incrementally," at the European level, for example (which would still run up against EU voting rules). He argues, though, that the alternative could well be worse: If people view inequality to have reached unacceptable levels, the response might be a breakdown of the global economy via widespread protectionism. (I offer a similar argument at the end of Competing for Capital.) A tax on capital allows high levels of trade to continue while directly addressing the problem of inequality.

One important element of achieving international financial transparency is shutting down bank secrecy. For Piketty, without solid information on inequality (and hence on individuals' ownership of capital), it is impossible to have a democratic debate about the type of taxation and government services that individuals want. Tax havens and their defenders will whine about this being an intrusion on people's privacy, but Piketty's response is compelling (p. 522):
No one has the right to set his own tax rates. It is not right for individuals to grow wealthy from free trade and economic integration only to rake off the profits at the expense of their neighbors. That is outright theft.
For this reason, he advocates the automatic exchange of bank information to ensure transparency.

Piketty argues that we should not rely solely on an income tax. The fact of the matter is that capital ownership generates much economic income (such as capital gains) that doesn't have to be declared year-to-year. As a result, income tax filings grossly understate rich people's true income. This means that the problem of tax regressivity at the top is even worse than he discussed under the income tax. He goes back to the example of L'Oréal heiress Liliane Bettencourt. Her wealth exceeds €30 billion, and her rate of return is somewhere between 6% and 7% a year (1.8-2.1 billion in economic income). Yet she herself has said that she has never declared more than €5 million per year in income. Even if she's paying 50% of this figure in income taxes (France's top bracket is currently 53%), that €2.5 million is barely 0.1% of her economic income. It is hard to get taxation more regressive than that.

Not only would a tax on capital create financial transparency while raising a modest amount of revenue (Piketty envisions 2% of European GDP), but Piketty argues that an extraordinary tax on capital on the order of 15% could wipe out Europe's current debt problems. As he says (p. 540), "From the standpoint of the general interest, it is normally preferable to tax the wealthy rather than borrow from them." The alternatives are inflation, which governments have frequently used, and austerity, which Europe is currently using with predictably bad results. Moreover, he says, it is possible to get more precise targeting of the distributional consequences you want with a wealth tax than with debt repudiation or inflation.

I mentioned before that Piketty believes that the United States is large enough by itself to levy an 82% top income tax rate, whereas Europe isn't. The same is true, in his view, on a capital tax (he also thinks China might be able to effectively tax capital). Europe's problem is that tax competition is particularly intense, a problem he lays at the feet of the smaller economies, particularly Ireland (no surprise there). Piketty sees the creation of fiscal union (with EU-wide corporate income taxes apportioned to each country by formula) as no more utopian than the idea of creating the euro. Indeed, he seems to think that political union is ultimately necessary to end destructive tax competition, though he is pleasantly surprised at the traction gained for instituting a European financial transaction tax. He proposes a "budgetary parliament" for the Eurozone that could make democratic decisions on fiscal matters, and argues that it should not be bound by any fixed rules limiting deficits or debt -- which will be nearly impossible to get Germany to agree to.

He concludes by reminding us that we cannot escape the possibly infinite concentration of capital that follows from r>g unless governments take proactive policies, most importantly an annual progressive tax on capital. The inequality r>g does not follow from market imperfections, so it cannot be solved simply by making markets more competitive. While he acknowledges that there is a real risk that increased European integration could lead to the shriveling of the social states constructed in each nation, the problem is that this is inevitable in the absence of creating a political entity large enough to regulate capitalism. "If we are to regain control over capitalism, we must bet everything on democracy -- and in Europe, democracy on a European scale."

For those of us in the United States, we already have a political entity big enough to battle the pressures for greater inequality. But of course we have numerous obstacles in our way as great wealth buys high levels of political influence, especially in the Citizens United era.

My next post will provide a summary and critique of the book. 

Cross-posted at Angry Bear.

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