Thomas Piketty’s “Capital in the Twenty-First Century” became the most talked-about and most critiqued economics book of 2014 before academic readers had a chance to finish the book. When they did, many responded with rebuttals that cut directly to the core of Piketty’s argument.
In “Capital,” Piketty makes six main claims. Here, we compare the evidence Piketty offers in favor of those claims with critics’ rebuttals and counter-evidence.
Claim 1: Wealth-to-income ratios and wealth inequality were much higher in Europe circa 1900 than they are today.
Critics have raised a few qualms with Piketty’s historical work. His data shows that until the outbreak of World War I, the wealth-to-income ratio remained steady at a very high level in Europe and wealth ownership was concentrated. In 1870, the top 10 percent of owners possessed 70 percent to 90 percent of national wealth, depending on the country. Most displeasing to Piketty is that inherited wealth was particularly important, so birth and marriage were the surest paths to riches.
From World War I through the Great Depression and World War II, the wealth-to-income ratio and income inequality shrank, and not only where the bombs fell. Piketty points to economic crisis and consequent regulatory policies as a greater culprit in wealth’s decline:
[The] budgetary and political shocks of two world wars proved far more destructive of capital than combat itself. In addition to physical destruction, the main factors that explain the dizzying fall in the capital/income ratio between 1913 and 1950 were on the one hand the collapse of foreign portfolios and the very low savings rate characteristic of the time… and on the other the low asset prices that obtained in the new postwar political context of mixed ownership and regulation.
Old money was destroyed by “bombardment, expropriation, or bankruptcy…. The war reset all counters to zero…and inevitably resulted in a rejuvenation of wealth.” The immediate postwar decades were characterized by low inequality, rapid growth, high employment, and a burst of fertility. Piketty rebukes nostalgia for the midcentury moment—an “enchanted world” that will not recur, but he wants to prevent a full adjustment back to the bad old days of inherited wealth and high wealth-to-income ratios.
Claim 2: A simple model can account for how wealth and income co-evolved over 200 years.
Many economists have documented that capital’s share of income has risen in the past few decades in most advanced economies. Usually, this is interpreted as a result of globalization (which made available a huge pool of labor in China, India, and elsewhere) or technological advancement. Piketty has a unique interpretation: The growth of the share of income going to wealth is a fundamental feature of capitalism.
Piketty employs a slightly modified version of the neoclassical Solow Growth Model to tie the broad global changes together. The Solow model’s key feature is that capital and labor combine to create output. All the income in the economy goes to either capital or labor. Piketty argues that labor and wealth are highly interchangeable in production, and calibrates his model accordingly.
In Piketty’s telling, the rise since 1970 of the wealth-to-income ratio (mainly in Europe) is the cause of the fall in labor’s share of income. But critics have shown that the rise of housing to about half of all wealth better explains why wealth-to-income ratios have risen since 1970. Most of the new wealth is homes owned by middle-class families. Matthew Rognlie, in a thorough and technical critique of Piketty’s model, concludes that Piketty’s “justification…vanishes once we remove housing.”
According to Piketty’s explanation, the rise of wealth should take the form of reinvested profits earned by the very rich. Instead, the increase in capital is largely taking place in real estate and depends on using a particular method of accounting for price and rent changes. Thus, his model fails to match the data on which it was based.
Claim 3: The model predicts that capital-to-income ratios will rise in the twenty-first century, and capital’s share of income will rise.
To make predictions with his model, Piketty takes an extreme view of the substitutability of capital and labor. As our chart shows, his choice is far outside the mainstream. And unlike the rigorous estimates of earlier researchers, Piketty’s choice is basically a rough guess.
Intuitively, this makes sense when one remembers that half of all wealth is residential structures, and commercial and industrial buildings account for a significant share, as well. Stefan Homburg uses publically-available data for France to show that machinery and equipment constitute a small and shrinking share of wealth. While ATMs and robots might displace human labor, a house would be a worthless substitute.
Once this error is corrected, Piketty’s model fails to predict rising wealth inequality or a rising capital-to-income ratio.
Economists Per Krusell and Tony Smith take a different approach, rebuking Piketty for using a model that assumes extremely static saving behavior. Their critique shows how fragile Piketty’s model is: a little bit of added complexity deflates its scary predictions.
Claim 4: The richest earn the highest returns and save most of their earnings, so rising capital will also increase wealth inequality.
A necessary link in Piketty’s argument is conspicuously absent from his model. Specifically, how do the rich get richer? If everyone’s wealth grows at the same rate, the distribution will not change, although wealth might become larger relative to income, as has occurred in France. The rich could get richer in two ways: either by saving a larger fraction of their income or by earning a higher return on their investments. Piketty emphasizes the latter, but hints at the former.
However, Piketty lacks supporting data. He shows that the largest fortunes of Forbes’ 2013 list are much larger than the largest fortunes of 1987, but neglects to note that the fortunes are not the same year to year. In fact, he presents an openly dishonest table of growth rates, calculating from the Forbes list of billionaires what he calls the “[average] real growth rate per year” of the “top 1/(100 million) highest wealth holders.” What the table actually presents is the average annual percentage difference in the size of the largest fortunes—regardless of who owned them.
Those who have worked with the Forbes lists (usually focusing on the U.S. data) instead document that fortunes tend to soar and plummet quickly. There is high turnover. The new arrivals made the list by growing fantastic fortunes with unbelievable rates of return, but existing fortunes tend to grow modestly and often shrink.
William McBride found that most of those on the Forbes list of the 400 richest Americans in 1987 had dropped off the list by 2013. The upper bound on the growth of their fortunes was 2.4 percent per year, with 0.2 percent a more likely estimate. Even the best performing fortunes—the 73 individuals who were on the list in both 1987 and 2013—had a growth rate lower than Piketty ascribes to the entire group.
Piketty also uses data on unequal returns from U.S. university endowments. The largest endowments take the most risks, hire the best investors, and earn the highest returns. Yet education is much more static in the U.S. than either private wealth or corporate power. The fact that Piketty had to use data on universities speaks volumes about the unavailability of data on private fortunes that could actually prove his point.
Claim 5: Capitalism has a fundamental tendency toward high and centralized wealth.
Accepted uncritically, Piketty’s argument is an elegant explanation of how the rich stay rich under capitalism. The mechanism is clear: Wealth usually grows faster than wages, and capital can effectively replace labor, so the rich grow perpetually richer unless some outside force—a world war or a confiscatory tax—intervenes.
Academic critics, however, have thoroughly rejected the idea that rising inequality and wealth are native to capitalism. As Krusell and Smith point out, the only reason Piketty’s model tends toward perpetually increasing wealth is that he assumed net savings rates are constant. Another critic, Debraj Ray, wrote that “Piketty’s [equation r > g] is a red herring. [It] has been known to economic theorists for at least 50 years, and no economic theorist has ever suggested that it ‘explains’ rising inequality.”
Empirically, Larry Summers cites research finding that the rich spend enough to offset their investment earnings. Piketty should have learned this from his own data. He records that the wealthy “in the interwar years did not reduce expenses sufficiently rapidly to compensate for the shocks to their fortunes…so they eventually had to eat into their capital to finance current expenditures.” If the wealthy of the twentieth century did not save slavishly to increase the value of their estates, why expect the wealthy of the twenty-first to do so?
Furthermore, the role of inheritance, which is central to Piketty’s fear of wealth concentration, is fading at the very top. Wojciech Kopczuk and Allison Schrager note:
[The] number of people on the Forbes 400 list of the wealthiest Americans whose wealth had come from inheritances halved between 1980s and 2000s. Moreover, since the 1970s, fewer women rank among the very richest estate taxpayers—another reason to conclude that inheritances are no longer the main path to membership in the super-wealthy club…self-made wealth is skewed toward men, whereas inherited wealth is more or less equal between genders.
Claim 6: High wealth inequality breaks down democracy.
Piketty’s main reason for worrying about inequality appears to be a desire to preserve democracy by protecting it from the rich. (He is oddly vague about his reasons for disliking inequality.)
A cursory look at history shows that most Western countries extended their franchise during the nineteenth century, when Piketty’s theory says democracy should have been under siege. The fascist and communist regimes arose not during the era of concentrated wealth but during the interwar years, when wealth was collapsing. The era of wealth concentration was not broken by socialist revolutionaries or captains of industry. It was undone by arrogant Kaisers and Marshals who believed their nation’s blood and wealth was theirs to dispose of in war.
Piketty’s Disastrous Solution
Piketty’s solution to preventing this dystopian future is to tax the rich fiercely. He favors progressive income and inheritance taxes with rates as high as 80 percent and a progressive annual tax on wealth levied globally to prevent the owners from fleeing the confiscation.
Piketty is under no illusion that his high taxes will raise huge amounts of revenue:
When a government taxes a certain level of income or inheritance at a rate of 70 or 80 percent, the primary goal is obviously not to raise additional revenue (because these very high brackets never yield much). It is rather to put an end to such incomes and large estates.
Even Piketty sees taxes at this level as confiscatory and punitive. Unlike taxes designed to fund the operation of government, these taxes are expressly intended to curtail economic activity and punish activities that Piketty considers antisocial.
We estimate that adding Piketty’s wealth tax to the existing U.S. tax system would yield a 104 percent tax on investment income. Taxing away more than the total returns to capital would grind investment to halt and would cause the value of existing capital to drop precipitously. Working capital would become very scarce—scarce enough that the total return on investment would be as large as it had been before. That would mean drastically lower incomes for everyone in the economy, not just the previously wealthy. Anyone concerned with people as real individuals with material circumstances, and not merely as percentiles in a distribution, should abhor Piketty’s luddite tax proposals.
The best critiques of “Capital” have shown that most of the links in Piketty’s argument are broken. His model does not match his data as well as he claims. His prediction of permanently rising wealth inequality rests on two implausible modeling assumptions. And his recommendation of punitive taxes is based on the glib assumption that capital accumulation is unimportant for wage growth, an assumption at odds with the data and even with his own model. As a result, almost nothing in “Capital in the Twenty-First Century” can be applied usefully to policymaking.
This article is excerpted from the authors’ Heritage Foundation Backgrounder. For citations, see the original.