Capital in the 21st Century

 The Quid on

 Capital In The 21st Century 

Book Author: Thomas Piketty 

 

Preview 

The rich are getting richer while the poor are slipping further into poverty. Thomas Piketty, in his book Capital in the 21st Century, which focuses on the inequality in the developed world, tries to provide an integrated explanation for this phenomenon, through a unified theory of inequality. It contains empirical data to prove that inequality has been steadily rising, and will continue to do so. 

 

About the Author 

Thomas Piketty is a French economist who teaches at the Paris School of Economics. His work focuses on wealth and income inequality. In a recent research paper that he co-authored with a colleague at the Paris School of Economics, he indicated that the inequality in India, too, is at the highest level ever with the top 1% population pocketing 22% of national income. 

What to expect? The growing evil of inequality 

While income (here referring to aggregate income) is equal to the total output of goods and services in a given period, capital refers to the total stock of wealth at a given point in time. Dividing total capital stock by the annual flow of income will give the Capital-Income ratio.  

Now comes the first fundamental law of Capitalism. It states that multiplying the Capital-Income ratio with the rate of return on capital gives us the share of income from capital in national income.  

Upon studying the distribution of income between various regions in the world, we find glaring inequalities. Some regions like Sub-Saharan Africa have per capita incomes of less than 250 euros a month, while some regions like Western Europe have per capita incomes of over 2500 euros a month, a difference of 10 times. 

Though regions like Asia and Africa are witnessing high economic growth rates, a high rate of population growth nullifies the effect. At the same time, low, and even negative rates of population growth in European and North American countries, have resulted in per capita incomes remaining very high, despite relatively low growth in GDP. 

This quid will help you to: 

• Understand how and why inequality has been rising 
• Know about capital-labor relations and how that affects inequality 
• Know specific remedies to help mitigate the increase in inequality 

 

 

The nature of Capital has changed over time 

The capital-income ratio has been relatively stable through the 19th and 20th century, before plummeting after the First World War, dropping steadily through the period of the Great Depression and the Second World War, before again rising after the 1950s, and reaching the pre-World-War 1 levels by 1980. However, the nature of capital has changed a lot. In the 17th and 18th centuries, the total stock of capital mostly consisted of farmland. In modern times, the importance of farmlands has decreased, and its place has been taken by industrial and financial capital.  

Capital is of two types: domestic capital and foreign capital. Foreign capital is an essential aspect in today's times due to increased globalization, and its key metric is net foreign assets. This is the difference between total assets held in foreign countries and debt owed to foreign countries. During the period of colonialism, European countries like Britain and France had huge net foreign assets. From the period of the First World War to the Second World War, it dropped steadily, reaching almost zero by 1950. This has remained so ever since, with net foreign assets of Britain and France hovering quite close to zero for most of the period between 1950 and 2000. 

The distribution of capital between Private and Government is highly skewed. In countries like Britain and France, most of the wealth has been in the form of private wealth, with public wealth being almost insignificant. Although the government holds substantial assets, this is largely nullified by public debt. 

Why did the capital-income ratio decline steadily after World War II in the first place? The primary reasons are the physical destruction of capital due to the two world wars, decolonisation (which wiped out the net foreign assets of Western European countries), low savings rate, and reduction in the prices of shares and real estate. 

The study of capital in the New World requires special attention. The capital income ratio in the US has been far more stable than in Europe, and the shock of the two World Wars was felt on a much smaller scale in the US than in Europe. The US, not having any major colonies (except the Philippines), never had any substantial amount of foreign assets. Thus, its net foreign assets always remained slightly negative.  

Higher savings and a lower rate of growth lead to the accumulation of capital 

In the long run, the Capital to Income ratio will be equal to the savings rate divided by the growth rate. This is the second fundamental law of capitalism. This implies that if a country has a high savings rate and a low rate of growth, it will have a huge stock of wealth (in relation to income). On the other hand, a country with a low savings rate and a high rate of growth will have a low capital-income ratio, thus, a lower stock of wealth in comparison to income. 

If we see the period after the Second World War, the capital-income ratio has been rising steadily. This is especially true of the period 1970-2010 when the savings rate was high (around 10-12% at an average) and the rate of growth was low (between 2—2.5%), leading to a high capital income ratio (between 5 and 6). 

Another reason for the rising capital income ratio was privatization of public firms, which led to the transfer of public wealth to the private sector. This includes the sale of several British public corporations at low prices in the 1980s and 90s. Another reason is the increase in asset prices, which were depressed due to the two World Wars and the Great Depression. After 1950, these asset prices gradually recovered and accelerated in 1980. 

The share of income going to capital is increasing 

Given the capital-income ratio and the rate of return on capital, we can determine the share of capital income in the total income. Since the capital income ratio has already been discussed at length, let us focus on the rate of return on capital. 

Historically speaking, capital’s share of income was about 35-40 % in the late eighteenth century and throughout the nineteenth, before falling to 20-25 % in the middle of the twentieth century and then rising again to 25-30 % in the late twentieth and early twenty-first centuries. The rate of return on capital has been around 5-6 % in the eighteenth and nineteenth centuries, rising to 7-8 % in the mid-twentieth century, and then falling to 4-5 % in the late twentieth and early twenty-first centuries. 

The marginal productivity of capital, which is the additional production due to one more unit of capital employed, determines the rate of return on capital. When the stock of capital increases, the marginal productivity of capital decreases, since if there is already a considerable amount of machinery or land, then an additional piece of machinery or an additional hectare would increase production only by a little. A decrease in marginal productivity would signify a fall in the rate of return on capital. 

In the recent period, the capital income ratio has been on the rise. However, the rate of return of capital has been more or less stable at around 4 to 5 percent. What this means is that the share of income going to capital is increasing, and may reach around 30-40% in the near future. Whether this could be the prime reason behind modern-day inequality deserves further discussion. 

Inequality in wealth is more pronounced than inequality in income 

To have a useful measure of inequality, we need to look at the distribution of income based on centiles, deciles, and quartiles. What this means is that we need to know how much the top and bottom 1%, 10%, and 25% earn. If the top 10% happen to earn much more than the bottom 10%, it implies high inequality; if the income of the top 10% is not significantly higher than the bottom 10%, it implies that inequality is very low. 

It should be clear that the distribution of wealth and income needs to be studied separately; the top 10% in terms of income, may not be the same as the top 10% in terms of wealth. However, in modern times, there is a strong (but not perfect) correlation between the two. 

Inequalities in capital (or wealth) are much more pronounced than inequalities in incomes. In terms of income, inequality is very low in Scandinavian countries like Norway and Sweden, moderate in countries like Britain and France, and very high in the US. The same holds for wealth distribution, although inequality is much more extreme. For example, in Scandinavian countries, the top 10% of the populace earns 35% of the income but owns over 50% of the wealth. Things are worse in countries like Britain, France, and the US. The most striking factor is that large chunks of the population own almost nothing; the bottom 50% in these countries own less than 10% of the wealth. 

Inequality of Labour Income can be reduced by increased investment in education 

To explain an increase in inequality of labor income in the 1980s in the US, two factors should be weighed in. Firstly, the difference between the wages of those having a high school diploma and those having a college degree has increased greatly. Secondly, there has been a rise in a new kind of workers called “supermanagers”, who enjoy much higher wages than the average workers. 

Several theories have been suggested to explain the inequality in labour income. The prime theory talks about the race between education and technology. Simply put, the theory states that a worker’s wage depends on his output, which in turn depends on his skill. Thus, well-educated and highly skilled workers are likely to get more wages in a technology-intensive workspace than one without such skills. The inequality thus derives from differences among people in getting access to such useful skills. 

Thus, the surest way to reduce inequality (at least labour income inequality) would be to equip people with suitable skills to increase their productivity and wages and make sure that a broader base of the population has access to learning these skills. This can be done through increased investment in education. 

 

The rate of return on capital is higher than the rate of growth of the economy, leading to the rich getting richer automatically 

Now we turn to the inequality of capital ownership. As discussed earlier, capital ownership is much more concentrated than labour income. In the period between the two World Wars, inequality in wealth had dropped sharply. After 1950, it started rising again, with limited growth and a rising capital income ratio. 

One of the reasons for the increased inequality of wealth is that the rate of return on capital is higher than the rate of growth of the economy. What this means is that the income derived from capital, if reinvested (added to the stock of existing capital), grows the capital faster than the economy. Therefore, if someone owns a huge amount of capital, he can afford to reinvest most of the income derived from it and his wealth would grow faster than the economy (he would keep getting richer faster than the average person). A society of rentiers thus develops who only make a living from their existing wealth, and through no merit or labour of their own. Hence, the importance of inheritance is more than the importance of merit. 

However, this importance placed on earnings from existing capital is not due to a lack of free-market or competition, it is instead a result of competition in the capital market. Capital fetches return because it is a scarce resource, and in times of low growth rate the return on capital is usually higher. Additional competition will not solve this problem, instead, redistribution of wealth through inheritance and wealth tax is a more suitable remedy. 

A progressive system of taxation along with a global tax on capital will reduce inequality 

The involvement of the state in the economic life of the country is more now than ever. This is evidenced by the fact that taxes constitute almost 60% of national income in developed countries like Norway, Britain, France, and the US. The government spends a lot on the basic education of children, and also on healthcare for the poor. This is a case of redistribution of income through public services, made available to the poor but financed (largely) by the rich. 

In the case of higher education though, the public sector falls short, at least in the US. Students belonging to poorer households are not able to afford admission into institutions of higher education and are forced to find a job with just a high school diploma or a community college associate degree. This limits their earning potential severely. The public sector must expand to allow access to higher education for all, irrespective of economic background. 

Taxes should ideally be progressive. The rate of taxation should increase as one's income rises. This is because a person earning more can afford to let go of a larger part of his income, while still retaining a sufficient amount, whereas for a poor person even letting go of a small portion of his income, seems a lot. 

However, progressive income taxation has been under threat in recent times. There have been calls by political groups for a reduction in taxes, especially for the people in the top tax brackets. Moreover, there have been calls for an entire category of incomes (such as capital gains) to be exempted from taxes. What is instead needed is higher taxes on the super-rich (the millionaires and the billionaires). Evidence suggests that a high tax bracket for those earning over $500,000 or $1 million a year would not only not lead to a reduction in growth, but rather would lead to a more even distribution of the fruits of economic growth. 

Although this may sound like a utopian idea, requiring seemingly impossible cooperation between countries and institutions, a global tax on capital may be desirable to implement.  

Public debt should be reduced to arrest the transfer of wealth from the poor to the rich 

Governments finance their expenditure in two ways, either by taxation or by borrowing. Although taxation is preferable to borrowing (because debt has to be repaid, often with interest), due to various reasons, governments of most countries resort to borrowing to finance a big part of their expenditures. This is more so in the case of developed nations than developing. Governments of countries like France, Japan, the US, and Greece are steeped in debt. Governments in developing countries are also in debt but to a much lesser extent. 

Public debt is usually a tool through which wealth moves from the poor to the rich; only the rich have the means to lend substantial funds to the government, but taxes have to be paid by everybody. Public debt should thus be reduced, this can be through income taxes, taxes on capital, or through austerity measures (reduced government spending). A tax on capital is most desirable since it ensures the redistribution of wealth. Progressive income tax is another good measure. Austerity measures usually hit the poor harder than the rich, and thus are undesirable. 

Conclusion and key message 

We hope you enjoyed this quid on Capital in the 21st Century. Wealth inequality is set to rise. The fundamental reason for this is that the rate of return on capital is higher than the rate of economic and income growth. People can live off existing wealth, and yet their wealth would grow on its own, without any labour from the owner of capital. Once constituted, capital grows on its own. This is surely a problem since it gives an unfair advantage to those who inherit a huge fortune and place those who are born poor at a disadvantage. 

This is not an aberration of capitalism, but rather a very feature or consequence of capitalism. It doesn’t stem from lack of competition, rather the competition over capital causes interest rates (rate of return on capital) to rise. 

 The only remedy is through redistribution of wealth by the government, i.e., through higher taxes on the rich and capital taxes, and by spending it on welfare services for the poor.