June 2014

Arts & Letters

An Australian take on Thomas Piketty’s ‘Capital in the Twenty-first Century’

By Andrew Leigh

Thomas Piketty. © Ed Alcock / MYOP

Is the growth of inequality inevitable?

Penned 120 years ago, Henry Lawson’s poem ‘For’ard’ describes class distinctions on a steamship. The “for’ard” section houses the “second-classers”, who are “stowed away like sheep”, while in the aft section the gentry travel in “cushioned cabins”. Women in the forward section are fed separately from the men, “just as if they couldn’t trust ’em for to eat along with us!”, but the gentlemen and ladies “always dine together, aft”.

The two groups are separated by a sign in the middle of the ship that says “second-classers ain’t allowed abaft o’ this”. Lawson yearns for a time when “the curse o’ class distinctions from our shoulders shall be hurled … When the people work together, and there ain’t no fore-’n’-aft.”

Australia’s history is one of a constant belief in the value of egalitarianism, amid changing levels of inequality. Lawson’s desire for egalitarianism reflected the views of, among others, the gold-diggers of the 1850s who arrived in a land where “Jack was as good as his master, and in many cases better”.

Since the late 1700s, the level of inequality in Australia has risen, fallen and risen again: a graph of it would look like a tilde (~). At the time of British settlement, both communities – indigenous Australians and the colonial arrivals – were quite equal. But as settlement proceeded, the distribution of land became increasingly unequal. By 1844, a mere 0.1% of Australians owned 17% of all land, while those at the bottom were landless wanderers. When the English novelist Anthony Trollope visited Australia in the late 19th century, he was struck by the fact that “the bulk of the labour is performed by a nomad tribe, who wander in quest of their work, and are hired only for a time”.

By World War One, Australian inequality was close to its first peak. One per cent of Australians owned a third of all wealth and earnt an eighth of all income. By contrast, many of those who went off to fight possessed so little that they could carry it all on their backs.

And then inequality began to fall. By World War Two, unionisation rates had risen from a fifth to half of the workforce. Income taxes were federalised, and the top tax rate set at a whopping 93%.

In the postwar decades, incomes rose faster on the factory floor than in the corner office. Home ownership increased and car ownership came within reach of everyday families. As the economist William Rubinstein put it, “so markedly different were trends among the very rich compared with those for society as a whole that the postwar period seemed to constitute, as it were, an age of affluence for everyone except the very affluent”. By the 1970s, we had reached the bottom curve of the tilde.

Then came the second rise in inequality, which has yet to peak. Since the mid 1970s, real earnings for the top tenth have risen by 59%, while for the bottom tenth they have risen by just 15%. Today, the three richest Australians have more wealth than the million poorest. They are likely to pass their privileged position on to their heirs; three of the five richest people on the 2013 BRW Rich List themselves received multi-million-dollar inheritances. 

The past decade has seen Porsche sales almost double, and the private jet fleet almost triple in size. Where the rich want to buy items that are scarce, the prices of those items have risen markedly. There are now at least 20 streets in Australia where the typical house sells for more than $7 million. Or take the sought-after 1959 Penfolds Grange. In the late 1980s, it sold for around $300. Now, as any former premier can tell you, such a bottle retails for more than ten times as much.

My interest in studying long-run inequality was piqued by a knight. I first met Oxford University’s Sir Tony Atkinson more than a decade ago when he gave a seminar at Harvard, where I was a student, and he generously invited me to collaborate with him on a research paper looking at Australia and New Zealand.

Where others had analysed inequality over a generation, Atkinson wanted to look back a century. He had been inspired by a young French researcher, Thomas Piketty, who had carried out a study of long-run inequality in his home country. Piketty’s idea was that taxation and population statistics could be combined with national accounts to examine the top end of the wealth distribution, such as the top 1%. Piketty and Emmanuel Saez of the University of California, Berkeley, went on to apply the methodology to the United States, where they showed that the income share of the top 1% had doubled since 1980. Without Piketty and Saez, the Occupy movement’s slogan “We are the 99%” might never have been born.

Like much of modern economics, Piketty’s approach to estimating inequality requires a modicum of maths and a large dose of data. Over the past decade, researchers have dug out taxation statistics to produce top incomes estimates for most developed nations, and some developing ones.

With collaborators, Piketty has now set up the World Top Incomes Database, which makes it possible to see patterns and compare trends. It shows that the Australian story is far from unique. In other English-speaking nations – Britain, Canada, New Zealand and the US – inequality fell in the decades after World War Two, and has risen sharply since the 1980s. By contrast, continental European nations saw a dramatic fall in inequality during the early 20th century, but a more modest rise over recent decades.

What explains trends in Australian inequality? In my book Battlers and Billionaires, I argued that three main factors accounted for the rise in inequality since the 1980s. First, technology and globalisation have boosted the earnings of those at the top of their fields, such as superstar CEOs, lawyers and entertainers. Second, the unionisation rate has fallen from half the workforce to less than a fifth. And third, income-tax rates have become less progressive, with the top marginal rate falling from 60% to 45%. I argued that each of these factors deserved approximately equal responsibility for the rise in inequality, though this has been mitigated by increases in school attendance, vocational training and university education.

In general terms, my explanations focus on earnings. While tax rates affect workers and rentiers alike, the importance of superstar labour markets, unionisation and education implies that the chief drivers of inequality are labour earnings rather than capital accumulation.

In his new book, ambitiously titled Capital in the Twenty-first Century (trans. Arthur Goldhammer; Harvard University Press; $59.99), Piketty argues that many studies of inequality have missed a key part of the puzzle: the relationship between capital and income. Capital is the net stock of assets in a society: the combined value of all our land, houses, vehicles, jewellery and so on. Income is the annual flow of money received by everyone in a society: how much we make from wages, rents, dividends and everything else.

Many studies of inequality have missed a key part of the puzzle: the relationship between capital and income

In principle, these two amounts could be the same, which would mean that it took precisely one year for a nation to earn as much in income as the net value of its assets. But to see how odd this would be, imagine a society where one year’s pay bought you a typical home. In just about any nation, it takes at least a few years’ income to earn the value of the private capital stock.

Analysing long-run data for Britain and France, Piketty shows that the value of private wealth – relative to national income – has followed a U-shaped pattern over the past one and a half centuries. From 1700 to 1900, private wealth was worth six to seven years of national income. By 1950, it was worth just two to three years of national income. Today, private wealth in Britain and France is worth five to six years of national income.

From this, Piketty posits a “fundamental inequality”: if the rate of return on capital is higher than the rate of economic growth, then the gap between rich and poor will increase. His chief concern is that if wealth accumulates faster than output and wages, then the “entrepreneur inevitably tends to become a rentier, more and more dominant over those who own nothing but their labor”.

Historically, Piketty notes, the rate of return on capital has been a stable 5%. Thus it was “taken for granted” by 19th-century novelists such as Jane Austen and Honoré de Balzac that rental yields and bonds would pay 5% of their value each year. Because this was well above the growth rate (1%), inequality rose through the 19th century.

Things changed in the first half of the 20th century, when two world wars and rapid inflation drove down the return on capital in Europe. Meanwhile, economic growth picked up. In the three decades after World War Two (the period the French refer to as “les trente glorieuses”), European growth per person was nearly 4% a year.

In Europe, over the past generation, the rate of return on capital has settled back to around 5%, while economic growth per capita has been below 2% (the French refer to the past three decades as “les trente piteuses”). With capital returns outpacing economic growth, the natural tendency of the economy is towards greater inequality. Most economic models predict that as growth declines, so too will the rate of return on capital. But Piketty points to the 18th and 19th centuries as evidence that healthy capital returns and sluggish growth can co-exist.

Piketty posits a “fundamental inequality”: if the rate of return on capital is higher than the rate of economic growth, then the gap between rich and poor will increase

Piketty’s “fundamental inequality” theory is primarily grounded in European data, so it’s worth exploring its application in other settings. In particular, Australians will want to know how well his theory explains fluctuations in inequality here. Because 19th-century Australian wealth data isn’t very good, I tested the theory by focusing on the past century (from the first inequality peak onwards). To do this, I looked at the ratio of Australian private wealth to national income over the past century, then compared this to long-run measures of inequality: the income share and wealth share of the top 1%.

From 1910 to 1950, there is little relationship between inequality and the wealth–income ratio. While the amount of income needed to buy the stock of private wealth rose (from three years’ worth to four), inequality trended downwards. Similarly, the period 1950 to 1980 saw wealth stay stable while inequality fell. It is only in the period from 1980 to 2010 that the data match Piketty’s theory, with the value of capital rising from three years of national income to four and a half years, while the income share of the top 1% almost doubled.

Australia is not the only country for which Piketty’s capital theory doesn’t quite match the data. In the US, the wealth–income ratio does not track inequality particularly well over the past century. If you must sum up 20th-century American inequality in a single theory, the idea that best fits the facts is that of Harvard economists Claudia Goldin and Lawrence Katz, who characterise inequality as a race between education and technology. When education advances faster than technology, inequality falls. When education stagnates amid technological breakthroughs, inequality rises.

Why doesn’t the capital theory apply as well for the US and Australia? Part of the answer is that immigration in both countries has been a source of fluidity, preventing the ossifying effect of old money. As Piketty points out, France’s population has approximately doubled since the revolution of 1789. By contrast, the US population has increased 100-fold since the 1776 Declaration of Independence, and Australia’s has grown perhaps 25-fold or more since 1788. When a nation grows as much as the US and Australia have, it is more difficult for privilege to be perpetuated down the generations.

Another reason why earnings matter more in English-speaking countries is the internationalisation of the labour markets for top talent. A generation ago, a top Australian firm seeking a CEO would typically do an Australia-wide search. Today, the company does a worldwide search, which means it pays the going global rate. But to be a player in the global talent market, it helps to speak English. One fascinating study showed that top incomes in Canada closely tracked those in the US. Yet top incomes in Francophone Canada had risen more slowly than in the English-speaking part. Why? Because if you only speak French, it’s hard to threaten to move south for a pay rise. What goes for Quebec also applies to top executives in continental Europe, where pay gaps between managers and workers generally remain smaller than in the English-speaking countries.

The Oxford philosopher Isaiah Berlin once suggested that thinkers could be divided into two categories: hedgehogs (who know one big thing) and foxes (who know many things). To date, Capital in the Twenty-first Century seems to have been marketed as a hedgehog book, which will encapsulate inequality in a few simple equations. On this score, Australian readers may find it unsatisfying. Indeed, as Piketty notes about halfway through the book, the rise in inequality in English-speaking countries in the past generation has more to do with superstar incomes than capital returns.

Thankfully, much of the nearly 700-page tome is written not by Piketty the hedgehog but by Piketty the fox. He may be a literature-loving French intellectual, but he is also one of the greatest data-crunchers economics has ever known. So we are treated to a plethora of insightful observations, including the fact that the US pioneered an inheritance tax in the 1910s precisely because it took pride in being more equal than Europe. Indeed, over the period 1932–1980, the top income tax rate in the US averaged 81%, which was considerably above the rate anywhere in Europe.

On the subject of supermanagers, Piketty discusses how modern-day companies can end up paying their CEOs for being lucky rather than skilful, and argues that lower tax rates have led managers to bargain for higher pay packets (since they can keep more of whatever they are paid). He mines data on global billionaires to show that they have tripled their share of world wealth since 1987. And he observes how family structure matters, noting that as families have fewer children, inherited privilege becomes acute (since there are fewer siblings among whom to divide the estate).

The foxlike nature of Piketty’s book extends to some fascinating discursions. We are treated to a five-page tangent on the economics and ethics of slaves as “capital” in antebellum America, and to the observation that the Catholic Church owned a similar share of pre-revolutionary France as private foundations own of modern-day America. He chides macroeconomists for using “representative agent” models that ignore inequality, and takes a gentle swipe at statistical agencies whose inequality figures tend to underrate the top 1% (and to my friends at the Australian Bureau of Statistics, yes, he’s talking about you too). Along the way, references to The Aristocats, Titanic, Dirty Sexy Money and Mad Men are a reminder that economics should never drift too far from the society it is trying to explain.

The reaction to Piketty has marked inequality as a vital issue of our age

Do changes in capital returns explain Australian inequality? Probably more than I acknowledged in Battlers and Billionaires, but less than a simplistic reading of Capital in the Twenty-first Century might suggest. And yet Piketty’s capital theory might be more important for Australia’s future than our past. Australian households currently save around a tenth of their income, the highest the rate has been in decades. Moreover, while the wealthiest fifth have a savings rate around 15%, the poorest fifth have one of just 4%. If growth slumps and savings remain high, this will likely push up Australian inequality.

If policymakers are concerned that the gap between fore and aft is growing, what might we do about it? Whatever might be said about the economics of Piketty’s preferred solution – a progressive global wealth tax – it is a political chimera. But while there is little appetite in English-speaking nations for taxing people’s stock of assets, some countries are reconsidering the way they tax the flow of income from capital. For example, President Barack Obama has advocated the “Buffett rule” in the US: that individuals who earn more than $1 million per year should pay tax on capital gains at a rate of 30%, rather than 15%. The rule gets its name from the billionaire Warren Buffett, who noted that it didn’t seem fair that he paid a lower marginal tax rate than his secretary.

But tax is not the only way of redressing inequality, particularly if you believe that the rise in Australian inequality was at least partly driven by changes in the labour market. Boosting teacher quality in disadvantaged schools would pay a double dividend: increasing productivity and reducing earnings gaps. Better evaluation of social policies – through randomised trials, for example – would help make programs more effective. Recognising the egalitarian role of unions might act as a check against attempts to curb the role of collective bargaining. Growing inequality makes it harder to reduce the gender pay gap, and tougher to close the gap between indigenous and non-indigenous Australians.

Perhaps the most significant thing about this book isn’t the extent to which it explains why inequality rose. Instead, it’s that the reaction to Piketty has marked inequality as a vital issue of our age. In the era of Twitter and shouting-heads television, it is delightful that a nearly 700-page book by an economist has received such a rapturous reception. As a friend of mine asked after the cartoonist First Dog on the Moon devoted a strip to Piketty’s book: “Have we reached peak Piketty yet?”

Three-quarters of Australians tell survey researchers that “differences in income are too large”. About the same proportion believe that government has a role in redistributing income “towards ordinary working people”. When I speak with audiences about inequality, I sense that Australian values like egalitarianism, mateship and the fair go are still strongly held.

If Australia continues to become more unequal – as Piketty’s capital theory suggests it might – then it will become increasingly difficult to hang on to these values. A veneer of fairness might persist, but a shallow equality of manners would be a poor substitute for the deeper egalitarianism that has traditionally characterised our nation. How much should we let inequality grow? There is no right answer to this question, but we should not shrink from asking it.

Andrew Leigh

Andrew Leigh is a former economics professor and a member of the Australian Parliament. His books include Reconnected (with Nick Terrell), Randomistas, and The Luck of Politics.


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