Capitalists shouldn’t be frightened of Piketty’s growth-retarding manifesto

Graeme Leach
There are better ways to redistribute income than Piketty's tax hikes

WHEN a book called Capital in the Twenty-First Century, written by a French economist, hits the top of the best-seller list, you have to ask why. It’s not exactly familiar territory, after all.

The answer lies in a clash of worldviews. The conflict is between those, like the book’s author Thomas Piketty, who want to see a larger state, a more progressive tax system and a more equal state-imposed distribution of income and wealth; versus those (like me) who want to see the opposite, with a much smaller state, a low flat rate tax system, and a far greater role for individual altruism as a means of enhancing social capital. The twenty-first century battle lines between these two worldviews are clearly marked by Piketty. For that we should be genuinely grateful.

Yet one of the most interesting aspects of the book is what it omits: a discussion of why rising income inequality is a problem – it’s assumed but not justified. This might seem a ridiculous question. After all, isn’t a more compassionate society one with a narrow distribution of income? Well it might not be, if the more equal share is of a much smaller cake, due to the disincentive effects of a global wealth tax and 80 per cent marginal rates on high incomes. Throw in the effect on asset prices of the sales to pay those higher taxes, and Piketty’s assumption that the return on capital will exceed national income growth in the future looks somewhat flaky. And there’s a debate to be had about how important the distribution of income and wealth is in an advanced economy, where per capita incomes are so much higher than historically. Do you set an absolute base and ignore relativity?

But in Piketty’s world, the good times are when the ratio of wealth to national income is falling. That gives us the First World War, the Second World War and the Great Depression. Fun guy.

There’s also a right and a wrong way to flatten the distribution of income and wealth – you either lift the bottom up or push the top down. Surely the best way forward is to lift the bottom up with a broadening of capital ownership? In short, we need more capitalism, not less. And if Piketty is correct in projecting a rate of return on capital in excess of the growth in national income – with rising inequality – surely the most obvious policy measure is to boost growth through radical supply-side reform? Instead of growth enhancing, Piketty proposes a growth retarding response through higher taxation.

There’s also a fundamental philosophical issue at the heart of this debate. Redistribution Piketty-style is like all direct taxation, a denial of the property rights of the individual. In other words, it uses immoral tools (denial of property rights) to achieve supposedly moral aims (a fairer society). Behind this, of course, is the deeper combination of immoral aims (envy) and immoral tools. Dan Hannan has written: “We shouldn’t be surprised when people who suffer from envy elevate it to a political concept called fairness”. And this in no way denies the need for a re-distribution of income. Rather, the issue is one of private sector and voluntary altruism versus public sector and involuntary taxation.

Further, Piketty’s data sources on the distribution of income are not the full picture. Taking the US as an example, Cornell economist Richard Burkhauser points out that US pre-tax, pre-transfer median real income (1979-2007) increased by a paltry 3.2 per cent using the tax unit data (two married people are one tax unit) employed by Piketty.

However, using household units, which allow for rising cohabitation, the increase jumps to 12.5 per cent. If we then add in government transfer payments the rise is 15.2 per cent. Add in tax cuts and the rise is 20.2 per cent. Other adjustments for household size, together with the inclusion of employer-provided health insurance, mean that the final increase is 36.7 per cent. Household data produces a totally different interpretation of the change in the US distribution of income over recent decades. Houston, we might not have a problem!

The issue doesn’t stop there either. Looking beyond income to data on the US distribution of wealth, similar problems arise. Piketty excludes the impact of welfare programmes, and the capitalised value of Social Security and Medicare, on the effective distribution of capital – quite an omission when these unfunded liabilities are around $10 trillion. The US Gini coefficient post tax, post transfers has been remarkably stable over the past four decades, as has the Gini coefficient on consumption inequality. Comparing the household share of total expenditure, between the top and bottom quintile, also shows remarkable stability.

Capital in the Twenty-First Century is an immense quantitative achievement, but it should not be seen as the last word on the distribution of income and wealth. Both the data and worldview must be challenged. Should it frighten those with free market views? Not really. Every generation has to make the case for capitalism. This is the test for ours.

Graeme Leach is director of economics & prosperity studies at the Legatum Institute.