June 30, 2014

Capital Taxation in The 21st Century?

Mark J. Warshawsky

Former Senior Research Fellow
Summary

This article is a review and critique of the new book by Thomas Piketty, Capital in the Twenty-First Century. Piketty, a professor at the Paris School of Economics, reviews data on income and wealth inequality in developed countries over the past hundred years or so.

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This article is a review and critique of the new book by Thomas Piketty, Capital in the Twenty-First Century. Piketty, a professor at the Paris School of Economics, reviews data on income and wealth inequality in developed countries over the past hundred years or so. He makes bold projections that apparent recent trends of increasing inequality will continue and deepen. Based on his interpretation of the data, Piketty gives strong prescriptions to substantially increase marginal tax rates on income and to institute a global tax on capital.

The book’s political significance is high for Tax Notes readers because the Obama administration early on strongly endorsed Piketty’s claim with University of California, Berkeley professor Emmanuel Saez that U.S. income and wage inequalityhas grown significantly over the last 30 years. The administration highlighted Piketty’s findings in its first proposed budget, presented in 2009, tying major parts of President Obama’s domestic policy agenda to the research. More recently, Obama has stated that inequality is the single most important policy issue in the United States, ‘‘the defining challenge of our time.’’ The book will also surely resonate in Europe and among international economic organizations. The book’s intellectual significance is high for Tax Notes readers because the statistics reported are based mainly on historical and recent tax records for France, Great Britain, and the United States (and to lesser extents, Germany, Sweden, and other countries).

Economic Theory

Piketty organizes his analysis around two simple equations that he calls fundamental laws of capitalism. The first is an accounting definition — the share of capital in national income equals the product of the return on capital and the capital/income ratio. While tautological, the equation is nonetheless informative because it expresses an important relationship among key variables, each of which can be measured and explained, sometimes independently and often by various data sources. For example, if the capital/income ratio is 600 percent and the return is 5 percent, the share of capital in national income is 30 percent. Capital is defined and measured as all forms of real property (including housing) and financial and professional capital (plants, infrastructure, machinery, inventory, patents, and so on) used by companies and government, all of which can be owned and exchanged, on some market. Thus, capital is largely measured at market prices.

The second equation, or fundamental law of capitalism, is that the capital/income ratio is equal in the long run to the savings rate divided by the economic growth rate in inflation-adjusted terms. For example, if the savings rate is 10 percent and the growth rate is 2 percent, in the long run the capital/income ratio must be 500 percent.

While these equations are elementary concepts in the theories of economic growth and development, their relevance to the study of inequality is that the ownership of capital is often concentrated among a relatively small group of the population. Hence, the study of the path of capital is considered essential to the study of inequality. Moreover, labor income can be unequally distributed as well. Finally — and these are key points — Piketty believes that the return on capital has held fairly steady over time and will continue to do so, while the rate of economic growth declines as the population (that is, labor force) stops increasing and even decreases in many European and Asian countries. Piketty also thinks that the savings rate is fairly steady, regardless of changes in economic conditions, because it is mainly influenced by the desire of the rich to leave bequests to their children. As we will see, these beliefs lead to a strong prediction of an increasing role for capital in the future, and therefore more inequality arising from bequests, which Piketty views negatively.

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