The Inequality Puzzle | Lawrence H. Summers

Larry Summers exposes the flaw in Thomas Piketty’s Capital in the Twenty-First Century. Piketty argues that inequality is rising because the rate of return on capital is higher than the economy’s growth rate.

Does not the rising share of profits in national income in most industrial countries over the last several decades prove out Piketty’s argument? Only if one assumes that the only factors at work are the ones he emphasizes. Rather than attributing the rising share of profits to the inexorable process of wealth accumulation, most economists would attribute both it and rising inequality to the working out of various forces associated with globalization and technological change. For example, mechanization of what was previously manual work quite obviously will raise the share of income that comes in the form of profits. So does the greater ability to draw on low-cost foreign labor.

Correlation does not imply causation. The fact that two events occur together does not prove that one has caused the other.

Summers also addresses whether returns on capital are largely reinvested:

A brief look at the Forbes 400 list also provides only limited support for Piketty’s ideas that fortunes are patiently accumulated through reinvestment. When Forbes compared its list of the wealthiest Americans in 1982 and 2012, it found that less than one tenth of the 1982 list was still on the list in 2012, despite the fact that a significant majority of members of the 1982 list would have qualified for the 2012 list if they had accumulated wealth at a real rate of even 4 percent a year. They did not, given pressures to spend, donate, or misinvest their wealth. In a similar vein, the data also indicate, contra Piketty, that the share of the Forbes 400 who inherited their wealth is in sharp decline.

That income inequality is rising is undisputed, but the causes are not as simple as Piketty assumes. His proposal of a progressive tax on wealth is unlikely to see the light of day: the history of inheritance taxes is an indication of their ineffectiveness. But a shift away from income taxes towards land taxes and other flat rate, indirect taxes would provide a significant boost to the economy as illustrated by the following chart from the Henry Review.

Marginal welfare loss from a small increase in selected Australian taxes

Marginal welfare loss is the loss in consumer welfare per dollar of revenue raised for a small increase in each tax (the extent of compensation required to restore consumer satisfaction reflects the distorting effect of the tax on the economy). A decrease in the level of tax, on the other hand, would be likely to produce a similar-sized benefit. So a trade off between taxes at the top of the scale and those at the bottom would be expected to deliver a substantial net benefit.

Read more at Lawrence H. Summers for Democracy Journal: The Inequality Puzzle.

7 thoughts on “The Inequality Puzzle | Lawrence H. Summers

  1. […] what also dawned on me after reading The Inequality Puzzle by Larry Summers is that there may be a common thread. The impact of new technologies over the last two decades and […]

  2. Craig says:

    In addition, Summers is right in pointing out mechanization and foreign labor (shall we call it slave labor?) in this process. Is it a surprise that capital growing faster than inflation and taxed at 15%, quickly outpaces wages from labor held in check or reduced by inflation and taxed at 25 – 35%? The surprise would be if wealth from labor grew at all.
    Is Piketty doing anything more than substantiating what the man at or very near the top of the Forbes list, Warren Buffett, has been telling us for years? That his secretary is taxed at a rate much higher than he is? I seem to remember Mr. Buffett getting the same type of response Piketty is seeing.

    Finally, judging by the fact that Larry Summers responded at all, no matter how feebly, it is a sign that Piketty must have gotten very close to the target in this game of horse shoes and hand grenades.

    • ColinTwiggs says:

      Warren Buffett was able to accumulate his vast fortune without paying much income tax. That is because of the way capital gains are taxed. Raising income tax rates would not correct this. Replacing income/capital gains taxes with a tax on assets would minimize this distortion.

      A land tax is the most obvious, but there are other asset classes that derive rent and should be taxed at similar rates in the interest of fairness. This is an area that requires further investigation.

      • Craig says:

        If we taxed capital gains and carried interest as income it would help correct this, but perhaps not completely. It also might motive a flight of capital which could be counter productive unless the same measures were taken internationally. I completely agree with your second point, but taxes on assets would need to include a host of assets regardless of where they are held, a point brought up by others critiquing Piketty.

      • ColinTwiggs says:

        A fair argument against taxing capital gains as they are made is that the gains are not realized until the asset is sold. Taxing assets is not as easy as it sounds: how do you assess the value of a railway or a chemical factory? And how can the owner afford to pay taxes if the asset — whether land, a railway or an art collection — does not generate an income? Should they be forced to sell?

        Taxpayers would be taxed based on their country of residence if the assets are located offshore.

  3. Craig says:

    Perhaps the Forbes 400 and the way it is formulated makes it a poor example? Here is a bit of that from Forbes: “We have not included dispersed family fortunes (as those of the Du Ponts) when individual net worths are below our minimum –this year the minimum was $1.05 billion. But we do include wealth belonging to a member’s immediate relatives if the wealth can be traced to one living individual; in that case, you’ll see “& family” on our list as an indication.”

    1. The list is an assumption in large part. I’m sure Forbes is as comprehensive as possible, but they admit that some are less forthcoming than others and that the list is the result of estimates.
    2. With a cut off of $1.05 billion, it would seem to me (and I would guess a large percentage of those who can only dream of such wealth) that the Forbes list (from 1982 to 2012) is a inaccurate measure of whether capital is reinvested or if it grows faster than labor. There is a lot unaccounted for in such an assumption as Forbes points out in the above quote. There are other holes in such a list. How many on the 1982 list are dead? It would be hard to make the list if you’re dead. What was the cut off in 1982? What about wealth not attributed or traceable to one individual? What about wealth distributed to larger families resulting in estates under the rather substantial cut off of $1.05B ? What about other means of distribution such as life insurance that isn’t accounted for? What about the obvious issue of hidden assets? Is Forbes sending investigators to the Caymans and Switzerland? How many on the list have family to pass wealth on to? As someone old enough to be involved in both receiving wealth from my heirs and in finding ways to pass even a small amount of wealth to my family (certainly by Forbes standards) I know enough to question the Forbes list as any indicator. The list provides more questions than answers.
    3. I agree that the effect of the changing various tax schemes would help if it resulted in the reduction or elimination of income taxes on labor (earned income).

    • ColinTwiggs says:

      Piketty’s explanation of growing inequality requires that most returns on wealth are reinvested. The number of first-generation billionaires on the Forbes 400 list (at least 10 of the top 20) points to other factors at work besides slow, steady reinvestment. Dispersion of wealth amongst a number of heirs will break up the concentration of wealth as effectively as a single profligate heir.

      I believe that taxes on income act as a disincentive on earning additional income — a handbrake on the economy — whereas taxes on consumption encourage savings and new investment and taxes on assets such as land discourage accumulation of large holdings of those assets. A shift to indirect taxes (and away from income taxes) would provide a substantial boost to the economy.

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