As a way of organizing an economy, capitalism has many desirable attributes. But its distinguishing feature is, well, capital.
Capital can be defined many ways, but a simple definition is “anything that can be used to generate future income.” This captures the key difference between capital and virtually everything else in economic life: it isn’t consumed. Think factories, equipment, and intellectual property. Unlike raw materials or hours of labor, capital isn’t absorbed by the production process; unlike t-shirts or iPads, it isn’t devoured by consumers.
The central innovation of capitalism is that everyone (in theory) gets to be a capital owner, reaping the rewards that come with saving and investment (for most people, this means things like stocks and homeownership).
Harnessed by effective laws, such private property institutions provide individuals with incentives to work hard and innovate. In pursuing self-interest, they improve the fortunes of their societies.
Accumulating wealth becomes a way of generating even more income. The historically unprecedented growth of the global economy since the Industrial Revolution is evidence of just how powerful the capitalist force can be.
But capitalism doesn’t always work out how the textbooks say it will. That, at least, is the central theme of French economist Thomas Piketty’s new tome, Capital in the Twenty-First Century.
A Capital Classic
Released in the U.S. on March 10, it’s one of those books destined to be an instant classic. Paul Krugman says it may be the most important economics book of the decade. According to The Economist, it could “revolutionize the way people think about the economic history of the past two centuries.” And it’s already achieved a feat virtually impossible among economics’ texts: selling out on Amazon.
Needless to say, Capital has been getting a ton of attention lately, among both academics and the popular press. Rather than add to that heap of praise, what I want to do is recall one of Piketty’s earlier works, a 2003 paper with Emmanuel Saez in The Quarterly Journal of Economics, titled “Income Inequality in the United States, 1913-1998.”
For those who care about inequality, this paper started it all. Indeed, without it, it’s hard to imagine the current discussion about inequality could have proceeded with anything near the clarity and consensus it achieved.
Piketty and Saez trace the evolution of U.S. income distribution during the 20th century, focusing on the share of income held by the upper deciles. The result is their now-famous U-curve.
The Birth of the One Percent
In the early 1900’s, the top one percent of earners took home something like a fifth of the national income. However, the events of the 20th century (Great Depression, World War II), together with truly progressive taxation (with top marginal rates above 80 percent), the strengthening of labor market institutions (unions and the minimum wage), and the rise of social norms militating against inequality, conspired to flatten things out. By the 1970s, the share of income going to the top fell to about 9 percent. Economic growth had taken off, prosperity was shared, the American dream was alive and well.
The story since then is more well-known. Globalization and technological change cut into middle-class wages. Regressive tax cuts under Ronald Reagan and George W. Bush allowed the wealthy to keep more of their bounty.
At the same time, the social safety net eroded and public spending on infrastructure dwindled. The economy became increasingly financialized and outsized CEO paychecks became pervasive, even as unions disappeared. Not surprisingly, top income shares today have returned to their highest levels since the Great Depression.
Below, I’ve reproduced the U-curve for 1913 to 2012, using data from The World Top Incomes Database, an outgrowth of Piketty’s seminal work.
The picture is striking.
Quite literally, it turned conventional wisdom on its head. Prior to Piketty and Saez, most economists subscribed to the view articulated by Simon Kuznets of Harvard, who argued that while inequality may rise during development, capitalist societies tend to become more equal over time.
As it turns out, the hill shape Kuznets predicted was exactly upside down. Far from being inevitable, the relationship between capitalism, economic growth, and inequality is largely a function of social preferences and politics.
A decade later, Piketty and Saez ‘s paper still holds two important lessons.
The first lesson concerns the composition of the upper income shares. For most of America’s history—actually for much of the world’s history—the upper income echelon was dominated by an endowed aristocracy—the rentiers, as Piketty calls them. Think families like the Rockefellers, the Vanderbilts, or, more recently, the Waltons. Wealth was something you were born into, not something you earned.
What Piketty and Saez found, however, was that the historic confluence of forces in the 20th century—the stock market crash, progressive taxation, and two world wars—largely destroyed dynastic wealth. Even as the upper income shares reasserted their dominance over economic life after the 1970s, their composition changed.
Today’s superrich—Bill Gates, Warren Buffet, Mike Bloomberg, Jeff Bezos—are the working rich. The source of their wealth stems from outsized returns to superstardom now acceptable in America. Entertainers, athletes, or, more mundanely (but much more regularly), CEOs dominate the income distribution. Partly, this is a good thing. After all, it has brought us Microsoft, Google, and Amazon.com, among other things.
But—and herein lies the problem—the longer this goes on, the more likely things are to revert to their dynastic priors. In the decade since Piketty and Saez published their work, the economic outlook has changed considerably. In 2003, it was possible to read their paper with a sense of optimism, or at least neutrality. Sure the rich were getting richer, but this time, at least, they did something to earn it.
That changes when you consider to whom today’s working rich will bequeath their fortunes. Their heirs could well become the beginnings of a new rentier class. If, as Piketty fears, concentrated wealth is accompanied by a continuation of low taxation, lack of labor market protections, low economic mobility, and returns on capital in excess of economic growth, inequality will only get worse.
Not only does this imply life might get a whole lot harder for the poor and middle class (definitely in relative terms, but perhaps also absolutely)—but it also suggests political remedies may become more limited, as the rich consolidate their control of American democracy.
The Capital Diagnosis
The second lesson is more general and speaks to solutions. Treating a problem requires diagnosing it correctly. And diagnosis depends crucially on data.
The central contribution of Piketty and Saez’s 2003 paper was not its assessment of inequality, but its measurement of it. Before this paper, we knew America was unequal, but we didn’t really know by how much. That’s because the typical instruments used to measure income and its distribution—household surveys by the Census Bureau—largely exclude the top one percent. The rich are often not sampled (there’s not many of them); even when they are, topcoding (to protect anonymity), can understate their incomes.
Piketty and Saez’s innovation was to use tax data from the IRS to get a fuller picture of top incomes. And when they did so, they realized we had been drastically underestimating the degree of inequality in the U.S.
In the graph below, I show the U.S. Gini coefficient for 1979 to 2007, both before and after fully accounting for the top one percent. The Gini measures inequality on a 0-1 scale, where 0 represents perfect equality and 1 represents complete inequality. As you can see, in 2007, it jumps from 0.46 (black solid line) to 0.59 (red dotted line), solely by accurately accounting for top income shares. We’re 27 percent more unequal than we thought! It’s been this way for a while–and the reason is huge gains at the top. This realization has shaped subsequent policy discussions in powerful ways.
Do yourself a favor and read Piketty’s book. Better still, go back and take a look at his 2003 paper first. You don’t have to agree with his conclusions, but you should appreciate his methods—ways of collecting and analyzing data that yield new insights about our economic environment.
Policy progress depends upon building on what came before. Piketty has laid us an elegant foundation. Now is the time for us to capitalize.