For a long time in economics it was believed that issues of distribution could be considered separately from issues of economic growth. As far as welfare was concerned, the consensus was that growth was of first order importance and the inequality in the distribution of the benefits of this growth was a relatively minor second order concern. Indeed, following Kuznets (1955) it was believed that while the process of development might initially lead to an increase in inequality, as societies developed it appeared that the forces for convergence in the distribution, such as the diffusion of knowledge and skills, became stronger. It looked as if equality was a normal good which societies would increasingly choose as they became wealthier. This belief was underpinned by the observation of high levels of inequality prior to World War I, and lower levels of inequality in the period from 1950 – 1980.
However, since 1980 inequality has been rising again in advanced economies, and this issue exploded from a relatively minor issue in the economic literature to the top of the best sellers lists with the publication of Piketty (2014) “Capital in the Twenty-First Century”. This work, with its comprehensive summary of the data and trends in inequality of both income and wealth, as well as a theory proposing that these trends would continue, provided the intellectual support for growing feelings in the advanced economies of the world that the distribution of income and wealth was now becoming problematic. The response of many governments in the advanced world to the structural deficits revealed by the financial crisis of 2007-09 was to cut spending rather than raise taxes. This fuelled the political narrative in which the wealthy, who were heavily invested in the financial sector, had both been the proximate cause of the crisis and had benefited from financial sector bail-outs, while the poorer sections of society, who disproportionately used public services, were paying the costs. Inequality was back as a political issue.
The economic study of inequality has typically focussed on income inequality. Even prior to Piketty (2014) the rising trends in inequality had been noticed, and were typically explained by job polarisation, globalisation, and skill-biased technological change. This focus on income rather than wealth inequality may be simply due to data availability, but it also likely reflects a belief that income inequality is what matters. This would clearly be true if returns on wealth holdings were lower than the general rate at which earnings were rising, since any dispersion in initial endowments would eventually be reduced to a rounding error by compounding. However, if returns on wealth exceed the growth rate of wages, “r > g” in the now famous notation from Piketty (2014), then it may be (under various assumptions) that the distribution of wealth is as important as the distribution of earned income in determining the overall level of inequality.
Piketty argues that, whilst a market economy also contains forces that narrow inequalities, the forces that widen these inequalities are related to the difference between the private return on capital and the growth rate of the economy i.e. the forces promoting inequality are positively related to “r – g“. To the extent that private returns on capital are insensitive to changes in the growth rate, low growth can be expected to widen inequalities. Piketty presents evidence that the rate of return on capital has indeed been fairly stable, and that both inequality and the value of assets compared to annual income was high (low) in the low (high) growth period prior to World War I (after World War II). The mechanisms for these dynamics are more speculative, but include either a story about technology making capital and labour more substitutable over time, so that the rate of return on capital does not fall very much as wealth accumulates; or a story about institutions, norms and expectations such that the rate of profit is determined in a some political manner which ensures a minimum rate of interest acceptable to the wealth-owning class.
Since publication, various critiques of the theory and mechanisms of Piketty (2014) have been made, but no one has qualitatively disputed the main thrust of the data presented, that asset values are rising relative to GDP, and that inequality is rising. As summarised by Rognlie (2015) “Among large developed economies, the remarkably consistent trend toward rising capital values and income is undeniable. This trend is a story of rising capital prices and the ever greater cost of housing – not the secular accumulation emphasized [in Piketty (2014)] – but it has distributional consequences all the same.”
There are a number of strands to the criticism of Piketty’s theory. Firstly, the popularising of Piketty (2014) in terms of r > g leads to the obvious criticism that all optimal growth models exhibit r > g, such a condition being the simple consequence of savers not throwing away the free lunch of being able to reduce saving rates (increasing today’s consumption) without compromising future levels of consumption. However, even if we reframe the popular “r > g => inequality” as a more careful “the forces that promote inequality are increasing in r – g“, the mechanisms behind this still run into theoretical obstacles.
For capital to accumulate with falling growth rates in the manner proposed in Piketty (2014), it must be that agents save at ever higher rates as growth falls. Krusell and Smith (2014) show that this implies implausible savings behaviour. Further, the assumption that the return to capital is insensitive to how much capital is accumulated apparently relies on a high elasticity of substitution between labour and capital. Rognlie (2014) shows that the estimated elasticity of substitution between labour and capital is not particularly high, and rather any significant accumulations of capital will be accompanied by diminishing returns.
These facts can be reconciled with the data by noting that the more recent rise in the capital to income ratio is not explained by the accumulation of capital. Rognlie (2014) and Homburg (2014) both show that the rising value of land or housing explains most of the change in the capital to income ratio i.e. what we are seeing is the revaluation of land rather than the accumulation of capital. In fact we should not be surprised at this conclusion as it is obvious from the charts included in Piketty (2014) itself:
Figure 1: Data from Piketty (2014) formatted to show contribution of changing land values. Figure taken from http://www.slate.com/blogs/moneybox/2014/02/03/piketty_and_land_ricardo_s_return.html
The rise of land or housing not only explains the change in the capital values to GDP ratio, but as shown by Rognlie (2015) (see Figure 2), also explains the change in the capital share of income, which if housing is excluded has actually been declining.
Figure 2: Time series of capital share from blog accompanying Rognlie (2015): www.brookings.edu/about/projects/bpea/papers/2015/land-prices-evolution-capitals-share
Whatever the mechanisms, if Piketty is correct then we can expect lower economic growth to mean the continuation of these trends. We are now 6 years on from the financial crisis and economic growth remains well below the post WWII trend that existed prior to 2008. Should we expect low growth in future? Piketty (2014) himself proposes that we should expect growth to slow from its post WWII rate because that rate was abnormal, and was derived from the need to catch-up lost growth over the period including both world wars and the great depression. In future we should expect something much more like the rate which pertained over the whole of the 19th century and up to the outbreak of WWI.
Other authors have also proposed a growth slowdown. Gordon (2012) notes a slowdown in innovation since the mid-20th century which is estimated to lower current growth prospects, and Cowen (2011) claims that the low hanging fruit of easy ways to boost output has already been picked so that, at least for a while, we face a future of lower growth due to a lack of monetisable investment opportunities. Fertility has fallen and Aksoy, Basso, Grasl, and Smith (2015) describe how this affects the macroeconomic outlook – it lowers projections of future growth.
If we suppose that economic growth continues to decline, and that this boosts the value of assets relative to GDP, especially via the channel of increased land values, how important is this for inequality? This is an empirical question relating to the concentration of ownership of these assets, and how this concentration will evolve over time as the ownership of these assets is transferred to future generations. At ScotFES we are developing a microsimulation model that accurately describes the income and wealth distribution of households, and that we can project forward in time to examine the evolution of these distributions over time. The ownership of assets is distributed more unevenly than labour income and these distributions are positively correlated. Rising land values impacts inequality through its intergenerational effects: the children of today’s property owners will be wealthy through inheritance. To the extent that human capital is also heritable, these bequests will be correlated with future income and will exacerbate future inequality. The microsimulation model can also look at different policy responses to combat the falling growth induced rises in inequality.
The policy implications of this exercise may be different to those suggested in Piketty (2014), which advocates a globally coordinated wealth tax. If the main cause of the slow growth induced rise in inequality is related to land values rather than capital accumulation, then a land tax may be a better instrument. With land reform and local tax reform fairly high on the Scottish political agenda, it is a good time to be studying these questions. Shifting the burden of taxation towards land, given the existing (and proposed) framework of the devolution for Scotland, is a fiscally attractive proposition since this is not a mobile tax base. The case for taxing land and ensuring a wide distribution of land ownership would be further enhanced if it could be shown that these policies were also particularly effective in mitigating any expected rises in inequality as we face the headwinds of slow growth in the 21st century.
Aksoy, Y., H. Basso, T. Grasl, and R. Smith (2015): “Demographic Structure and Macroeconomic Trends,” Birkbeck Working Papers in Economics and Finance.
Cowen, T. (2011) “The Great Stagnation: How America Ate All The Low-Hanging Fruit of Modern History, Got Sick, and Will (Eventually) Feel Better,” http://digamo.free.fr/cowen11.pdf
Gordon, R. (2012): “Is U.S. Economic Growth Over? Faltering Innovation Confronts the Six Headwinds,” NBER Working Paper.
Homburg, S. (2014): “Critical Remarks on Piketty’s `Capital in the Twenty-First Century’,” Working Paper
Krusell, P., and A. Smith (2014): “Is Piketty’s \Second Law of Capitalism” Fundamental?,” Working Paper
Kuznets, S. (1955): “Economic Growth and Income Inequality,” American Economic Review.
Piketty, T. (2014): “Capital in the Twenty-First Century.” The Belknap Press of Harvard University Press, Cambridge, Massachusetts.
Rognlie, M. (2014): “A note on Piketty and diminishing returns to capital,” Working Paper.
Rognlie, M. (2015): “Deciphering the fall and rise in the net capital share,” Brookings Papers on Economic Activity.