Capital Taxation in

The 21st Century?

By Mark J. Warshawsky
This article is a review and critique of the new
book by Thomas Piketty, Capital in the Twenty-First
Century. Piketty, a professor at the Paris School of
Economics, reviews data on income and wealth
inequality in developed countries over the past
hundred years or so. He makes bold projections that
apparent recent trends of increasing inequality will
continue and deepen. Based on his interpretation of
the data, Piketty gives strong prescriptions to sub-
stantially increase marginal tax rates on income and
to institute a global tax on capital.
The books political significance is high for Tax
Notes readers because the Obama administration
early on strongly endorsed Pikettys claim with
University of California, Berkeley professor Em-
manuel Saez that U.S. income and wage inequality
has grown significantly over the last 30 years. The
administration highlighted Pikettys findings in its
first proposed budget, presented in 2009, tying
major parts of President Obamas domestic policy
agenda to the research. More recently, Obama has
stated that inequality is the single most important
policy issue in the United States, the defining
challenge of our time. The book will also surely
resonate in Europe and among international eco-
nomic organizations. The books intellectual signifi-
cance is high for Tax Notes readers because the
statistics reported are based mainly on historical
and recent tax records for France, Great Britain, and
the United States (and to lesser extents, Germany,
Sweden, and other countries).
Economic Theory
Piketty organizes his analysis around two simple
equations that he calls fundamental laws of capital-
ism. The first is an accounting definition the
share of capital in national income equals the prod-
uct of the return on capital and the capital/income
ratio. While tautological, the equation is nonethe-
less informative because it expresses an important
relationship among key variables, each of which
can be measured and explained, sometimes inde-
pendently and often by various data sources. For
example, if the capital/income ratio is 600 percent
and the return is 5 percent, the share of capital in
national income is 30 percent. Capital is defined
and measured as all forms of real property (includ-
ing housing) and financial and professional capital
(plants, infrastructure, machinery, inventory, pat-
ents, and so on) used by companies and govern-
ment, all of which can be owned and exchanged, on
some market. Thus, capital is largely measured at
market prices.
The second equation, or fundamental law of
capitalism, is that the capital/income ratio is equal
in the long run to the savings rate divided by the
economic growth rate in inflation-adjusted terms.
For example, if the savings rate is 10 percent and the
growth rate is 2 percent, in the long run the capital/
income ratio must be 500 percent.
While these equations are elementary concepts in
the theories of economic growth and development,
their relevance to the study of inequality is that the
ownership of capital is often concentrated among a
relatively small group of the population. Hence, the
study of the path of capital is considered essential to
the study of inequality. Moreover, labor income can
be unequally distributed as well. Finally and
these are key points Piketty believes that the
return on capital has held fairly steady over time
and will continue to do so, while the rate of
economic growth declines as the population (that is,
labor force) stops increasing and even decreases in
many European and Asian countries. Piketty also
thinks that the savings rate is fairly steady, regard-
less of changes in economic conditions, because it is
mainly influenced by the desire of the rich to leave
bequests to their children. As we will see, these
beliefs lead to a strong prediction of an increasing
role for capital in the future, and therefore more
inequality arising from bequests, which Piketty
views negatively.
Capital Ratios and Income Factor Shares
Measuring the capital/income ratio over three
centuries, Piketty finds that through 1910, the ratio
in both Great Britain and France was steady at
Mark J. Warshawsky was formerly Treasury
assistant secretary of economic policy and is a
visiting scholar at the Mercatus Center at George
Mason University.
Thomas Piketty, Capital in the Twenty-First Cen-
tury (Harvard University Press, 2014), ASIN:
B00I2WNYJW (Hardback, $40).
tax notes

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about 700 percent and then plummeted in the
aftermath of World War I to about 300 percent. The
capital/income ratio remained at that low level,
even declining a bit, until 1950, when it began a
climb, reaching 500 percent in Britain and 600
percent in France by 2010. Looking at component
parts, one finds that at least part of the plunge in
1920 resulted from the expenditure of significant
net foreign capital to pay for the war, and at least
part of the recent rise is the result of substantial
increases in housing. In Germany, the trajectory is
largely the same except that the fall after World War
I continued through 1950 as physical capital was
destroyed in World War II, so that the capital/
income ratio was only about 200 percent then. The
later increase is significant but to a lower level, just
more than 400 percent in 2010, again largely be-
cause of housing assets.
By contrast, for the United States, the capital/
income ratio increased steadily from about 300
percent in 1770 to 500 percent in 1910, falling only
slightly after World War I and increasing again
through 1930 with the stock market boom. The ratio
fell to below 400 percent by 1950 and, thereafter,
increased only slightly through 2010 to about 430
percent. Interestingly, the run-up in housing prices,
although present in the United States, is much less
pronounced than in France, Piketty found, using
decade average statistics, although the short-term
drop for the United States from 550 percent in 2007
to 430 percent in 2010 surely reflects the volatility of
both the housing and stock markets. Income
growth, partly the result of rapid population
growth from immigration, is also higher in the
United States than in Europe, which increases the
denominator and therefore lowers the long-run
capital/income ratio.
Piketty collects similar data for other countries
Canada, Japan, Australia, and Italy although
generally for shorter periods. He finds a massive
run-up of Japans capital/income ratio, from about
360 percent in 1970 to 800 percent in 1990, followed
by a rapid decline to 700 percent after the asset
bubble popped in the country, and a further de-
crease to about 600 percent in 2010. For Italy, he sees
a steady and rapid increase from just about 250
percent to 600 percent over that same period.
Piketty explains the overall increases in those coun-
tries ratios by the second fundamental law of
capitalism: low economic growth and high savings
rates.
From this and other scattered data, Piketty makes
some truly bold assumptions and takes two gigan-
tic leaps. He creates a world capital/income ratio
from 1870 to 2010 and then projects that ratio
through 2100. While some would view that exercise
as almost a work of fiction, Piketty is serious about
the results. He says that the world ratio was 500
percent in 1910, dropped to 260 percent in 1950, and
then increased to about 440 percent by 2010. There-
after, it is projected to continue to increase to 600
percent by 2060 and to 670 percent by 2100. One
must credit Piketty for taking a global view because
capital markets have indeed become open and
linked in most countries. The simplicity of using the
second equation and assuming in the long run an
average world savings rate of 10 percent and an
economic growth rate of 1.5 percent to project the
global capital/income ratio is breathtaking, how-
ever.
Piketty next moves from the capital/income ratio
to the share of capital income in total national
income, using the first fundamental law of capital-
ism. He shows that there has been an overall
downward trend for Britain and France, from about
40 percent in the 19th century to about 20 to 25
percent or even less in most of the 20th century,
increasing recently to about 25 percent or a bit
higher. Piketty attributes most of this trend to the
changes in the capital/income ratio over time, but
he allows for some changes in the rate of return as
well, with return increases in the mid-20th century
and declines most recently. Looking over a shorter,
more recent period, Piketty finds that the capital
share in the United States increased from 21 percent
in 1975 to 29 percent in 2010, with considerable
volatility in between, apparently related to the stock
market. With the exception of Canada, the other
developed countries saw similar share increases for
capital over that period.
Despite recent lows in interest rates, Piketty says
that the total rate of return on capital, averaging
across risk types, is still and generally will be about
4 to 5 percent in inflation-adjusted terms. These
rates have changed little from the rates of return on
agricultural land and government bonds implicit in
Jane Austens depiction of Mr. Darcys estate in-
come or in Honor de Balzacs description of the
dowries of Pre Goriots daughters in the 1810s. So,
according to Piketty, while rates of return may fall
somewhat as capital increases, most of the projected
increase in the capital/income ratio will flow
through to the capital share of income. In more
technical terms, this indicates that the elasticity of
substitution between capital and labor exceeds 1, a
controversial claim.
Piketty concludes this section of the book by
projecting that with a capital/income ratio of 700 to
800 percent and a rate of return of 4 to 5 percent,
capitals share in national income will increase to 30
to 40 percent levels close to those of the in-
egalitarian inheritance-influenced days of Austen
and Balzac. Again, these projection calculations are
extremely rough and, indeed, seem exaggerated,
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but Piketty uses them to advance his central argu-
ment that income inequality arising from the in-
creasing role of capital in an environment of
economic stagnation is growing and will continue
to do so, with little in the way of natural checks
except for government intervention.
Inequality
The main way Piketty measures inequality,
whether of income, labor earnings, or capital own-
ership, is to calculate the share of various top
percentiles of the population in the quantity in
question (income, etc.) for various countries and
periods. For example, he reports that the top per-
centile in Scandinavia in the 1970s and 1980s got 5
percent of total labor income, while the next 9
percent got 15 percent. For the same region and
period, capital ownership was more concentrated,
with the top percentile owning 20 percent and the
next 9 percent owning 30 percent. These data are
based mostly on annual observations, either from
tax records or surveys, and there is no assurance
that they represent the same people or families over
long periods (even generations), particularly if
there is a lot of mobility and volatility in the society
and economy. Nonetheless, Piketty calls the top 1
percent the dominant class, the next 9 percent the
well-to-do class, the middle 40 percent the middle
class, and the bottom 50 percent the lower class.
These clearly are arbitrary categories that may or
may not correspond to recognizable social and
political groupings, such as British nobility in the
1820s.
As is usual in Capital, Piketty starts with and
concentrates his review of data in France. The upper
deciles share of national income decreased from 40
to 50 percent in the 1910s to mid-1930s to 30 to 35
percent today. Almost the entire drop occurred just
before and during World War II. By contrast, the
wage share has been fairly flat over the entire
century, at about 25 percent of total labor income.
The collapse in income for the top percentile started
earlier, after World War I, and was more dramatic
from 20 percent in 1910 to 8 percent by 1945 and
increasing slightly to 9 percent by 2010 while top
wage shares are remarkably stable, at 6 percent over
100 years. Piketty also shows that the share of
income of the top 0.5 percent coming from capital
and labor inverted between 1932 and 2005. He calls
these trends the fall of the rentier and the rise of a
society of managers. Note, however, that those data
exclude capital gains.
Piketty then presents comparable data for the
United States. The share of the top decile in total
income was about 40 percent in the 1910s, it in-
creased to 45 percent in the 1920s-1930s, plummeted
to just above 30 percent during the years of World
War II, remained at that level through 1980, and
climbed back to 45 percent by 2010. If capital gains
are included, the levels are somewhat higher on
average and far more volatile. Piketty attributes
much of the plunge in income inequality during
World War II to the activity of the federal govern-
ment in restricting wage increases. Given his ulti-
mate focus on tax policy, it is surprising that he
ignores the potentially more significant changes in
tax law and administration during the war.
Piketty provides data showing that most of the
increase in income inequality in the United States
from the mid-1980s forward is attributable to the
top percentile, some of it to the top 1 to 5 percent
and almost nothing to the top 5 to 10 percent.
Indeed, in 1986 the share of the top percentile in
total income was 9 percent. It jumped to 13 percent
in 1988 after passage of the Tax Reform Act of 1986,
followed the path of asset markets up and down
thereafter, and by 2010 increased to 17 percent.
Further, Piketty finds that regarding labor income
data, about two-thirds of the increase in income
inequality is attributable to the rise of wage inequal-
ity, which he attributes to the advent of superman-
agers. Note that wages include all bonuses and
stock options.
Looking at other countries, Piketty finds that
increases in income inequality are generally similar
to those in the United States but smaller. In the
United Kingdom, the top percentile share increased
from 7 percent in 1981 to 15 percent in 2010. Over
the same period, the share increased from 5 percent
to 9 percent in Australia, 8 percent to 12 percent in
Canada, 4 percent to 7 percent in Sweden, 7 percent
to 10 percent in Japan, and 9 percent to 11 percent in
Germany.
Note that despite a large increase in the capital/
income ratio in France, the increase in income
inequality there was the smallest among the devel-
oped countries surveyed. By contrast, the increases
in reported income inequality were large in the
United States and the United Kingdom, while the
capital/income ratio remained flat in the United
States and increased in the United Kingdom, but to
a lesser extent than in France. Those observations
are inconsistent with Pikettys central point that we
should be concerned about the growth of capital
and tax it heavily because of the dire implications of
income inequality.
Piketty then turns to the inequality of capital
ownership. He finds that in France the top decile
owned 90 percent of capital in 1910 but that that
share dropped steadily to 60 percent in 1970 and
thereafter remained constant. According to Piketty,
a similar pattern and levels may be found for the
United Kingdom and Sweden, although there were
small increases after 1980. For the United States, the
height in the ownership of capital by the top decile
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was reached at only 80 percent in 1910, fell to 65
percent by 1970, and increased slightly to 70 percent
by 2010. At face value, these statistics connection to
Pikettys central hypothesis is unclear the con-
centration of capital ownership has remained flat or
increased slightly, while changes in capital/income
ratios and income inequality have diverged across
countries. Piketty cites progressive capital taxation
in explaining why the concentration of capital own-
ership has not increased more, but he does not
analyze this view deeply, for example, by examin-
ing inter-county differences in tax policy.
Chris Giles, an editor at the Financial Times,
recently found some errors and questionable judg-
ments in Pikettys calculations of the concentration
of capital ownership. Giles makes a case that the
concentration of capital in the United Kingdom has
actually declined in the last three decades and that
it has remained flat (at a lower level than Piketty
reports) in the United States. Piketty has given a
response. In my opinion, Giless view is a more
reasonable read of the available data. The difference
of opinion about these key results further under-
mines the support for Pikettys central hypothesis
of a positive and causal relationship between capi-
tals prominence and income inequality recently
and into the future.
Finally, relying mainly on French data, Piketty
looks at the role of inheritance versus savings in the
accumulation of private wealth. For France, he finds
that the annual inheritance flow was about 20 to 25
percent of national income during the 19th century
and until 1914; it then fell to less than 5 percent in
the 1950s and returned to about 15 percent in 2010.
(A similar trend is apparent in German data.) As-
suming that the rate of return on capital exceeds the
rate of economic growth, which is asserted repeat-
edly in the book, Piketty projects that inheritance
flows will continue to increase, to perhaps as high
as 23 percent of income in 2100. This would imply
that more than 90 percent of wealth in France will
be inherited, up from 70 percent currently. Because,
according to Piketty, rentiers are the enemies of
democracy, this would a bad outcome for society.
It may seem strange to American eyes and ears
that bequests and not retirement savings, which are
generally used up in a workers lifetime, are cred-
ited with the creation of most wealth. Historically,
of course, retirement from work is a fairly recent
social creation, coincident with the increase in life
expectancies and income in the years before and
following World War II. Still, it is surprising that
Piketty does not give retirement saving a greater
role in explaining recent trends and projecting the
future. Recall though that in France and Germany,
pay as you go public retirement income and
health programs are generous and provide the
resources for most workers to have long and com-
fortable retirements. So retirement asset savings
will be crowded out in those countries and account
for much less than in the United States, the United
Kingdom, Canada, and other countries where pri-
vately (and sometimes publicly) funded retirement
plans and accounts are widespread.
Figure 1 shows retirement-related assets (such as
employer-provided pension entitlements, annuities,
and IRAs) as a share of household net worth in the
United States over the 1981-2013 period.
Retirement-related assets are about a third of house-
hold net worth. Clearly, retirement saving is signifi-
cant even by this narrow measure.
Moreover, even housing functions as a type of
retirement saving in these Anglo-Saxon countries
without complete social insurance programs for
care needs at the end of life. Many households in
the middle class and above use housing equity to
pay for home healthcare and nursing home care,
which are expensive, particularly for those with
Alzheimers and other chronic diseases that can
incapacitate an individual for many years. More
broadly, households use other types of nonspecial-
ized assets mutual funds, deposits, and so on
to finance retirement spending. A rough estimate
would point to the retirement savings motivation as
explaining at least half of capital accumulated in the
United States, much more weight than Piketty gives
to the life cycle hypothesis of saving, which detracts
from the bequest motive.
To an American audience, Piketty also severely
understates the role of entrepreneurs and overstates
that of inheritance in the creation of wealth. For
example, in the United States, megabillionaires like
Bill Gates and Warren Buffett did not inherit their
assets and are setting up charitable foundations to
receive them for the benefit of future generations.
Piketty may include the entrepreneurial effect in a
high general return on capital, but that approach
ignores the truly unique and personal catalyzing
and organizing contribution of the individuals in-
volved in establishing new businesses, raising capi-
tal, hiring workers, and creating and marketing
new technologies.
Pikettys Prescriptions for Tax Policy
Without taxes, society has no common destiny,
and collective action is impossible (Capital, at 493).
With these stirring, but somewhat debatable,
words, Piketty gives his recommendations for tax
policy. He begins with a historical review of the
ratio of tax revenues to national income. For the
countries examined (France, Sweden, Britain, and
the United States), the tax ratio was flat at about 10
percent from 1870 through 1910 and was used to
fund regalian functions that is, the police,
courts, roads, army, and so on. From 1910 through
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1950, the tax ratio increased to 25 to 35 percent as
social spending rose rapidly, for example, on public
pensions and education. It continued to increase
through 1980 from 30 to 55 percent as healthcare
was added to social insurance but flattened out
thereafter to 30 percent in the United States, 40
percent in Britain, 50 percent in France, and 55
percent in Sweden. In Pikettys view, European
levels of revenue probably represent close to the
upper limit because of a public reluctance to pay
higher taxes when income growth is slowing and
attributable to the productive inefficiency of the
public sector. Still, to counteract the increase in
inequality of income and capital ownership that
Piketty sees and foresees, he recommends an in-
crease in the progressivity of taxation on income, on
inheritances, and on capital directly.
Piketty reminds us that the income tax generally
applies to both labor income and at least some
capital income (dividends, interest, rents, and so
on). Taxes on capital also include any levy on the
flow of income from capital, such as the corporate
income tax, as well as any tax on the capital stock
itself such as property, inheritance, and direct
wealth taxes. In most countries, social insurance
taxes are placed just on labor income and are often
dedicated only to the social insurance purpose,
sometimes through an earned benefit formula for
the individual. Taxes can be proportional, regres-
sive, or progressive.
Piketty claims that the progressivity of income
and estate taxation has a direct positive effect,
reducing the inequality of income and capital own-
ership. He says that the spectacular decrease in the
progressivity of the income tax in the U.S. and
Britain since 1980 . . . probably explains much of the
increase in the very highest earned incomes (Capi-
tal, at 495).
1
Piketty is also concerned that tax
1
Piketty has to be arguing loosely here because the top
inheritance tax rate in France has been consistently and signifi-
cantly below that in the United States from 1980 through 2010,
even as the concentration of capital ownership increased in the
United States and remained flat in France, according to his
calculations. Also, the U.S. top income tax rate increased from 28
percent in 1988 to nearly 40 percent through 2000, even as the
share of reported income (including capital gains) of the top
percentile rose from 16 percent to 22 percent over that period.
Figure 1. Employer-Provided Retirement Resources, Annuities, and IRAs
As a Share of Household Net Worth, United States, 1982-2013
Source: http://www.federalreserve.gov/datadownload/Choose.aspx?rel=z1.
Years
1982
2013
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
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competition between countries in Europe has led to
cuts in corporate tax rates and to the exemption of
capital income from the progressive income tax.
Piketty reviews the history of top income and
inheritance tax rates. He shows that there were
substantial increases for all countries during and
following World War I and that in the United States
and Britain in particular, top rates were again
increased dramatically during the Depression and
World War II, remaining at high rates through 1980
when they were cut. Piketty says that Germany and
France used means other than tax policy to control
capitalism after World War II, including public
ownership of companies and the direct setting of
executive salaries. For the United States and Britain
since 1980, he is critical of the practice of corporate
governance that has led to an explosion of executive
salaries, which he attributes to the cutting of the top
income tax rate. Piketty says that lower marginal
tax rates encourage executives to negotiate harder
for higher pay. He does not explain, however, why
the owners of corporate capital, who are also facing
lower marginal tax rates, would not also put up a
tougher fight against executive demands in re-
sponse.
Based on these interpretations, arguments, and
considerations, Piketty recommends the following
tax policy, in particular for the United States. The
top income tax rate should be 80 percent, levied on
incomes exceeding $500,000 or $1 million. Also, to
develop the meager U.S. social state and invest
more in health and education (Capital, at 513), tax
rates of 50 percent or 60 percent should be imposed
on incomes above $200,000.
2
Piketty acknowledges
the difficulty of making these changes, which he
attributes to the political process being captured by
the 1 percent and to a drift to oligarchy. He says
there is little reason for optimism about where the
U.S. is headed (Capital, at 514).
Pikettys boldest recommendation is a progres-
sive global tax on capital coupled with a high level
of international financial transparency to enable
collection of the tax. This annual tax would be in
addition to current income tax, social insurance tax,
inheritance tax, and other capital taxes. As men-
tioned above, Piketty is motivated by what he sees
as harmful tax competition among European coun-
tries in what he views as an endless inegalitarian
spiral and a lack of transparency, leading to the
widespread use of illegal tax shelters. He also
believes that for the wealthy, capital rather than
measured income is the best way to assess contribu-
tive capacity.
His proposal would establish a tax schedule
applicable to all wealth around the world. The
resulting revenues would somehow be apportioned
among and within countries. Piketty suggests the
following annual rate schedule: 0.1 percent for net
assets below 200,000; 0.5 percent for between
200,000 and 1 million; 1 percent for between 1
million and 5 million; 2 percent for between 5
million and 1 billion; and 5 to 10 percent for above
1 billion. All types of assets would be included, at
market value. Part of the motivation for the higher
tax rate on the wealthy is his view that the wealthy
get a much higher real return on capital: 6 to 7
percent. That estimate is rough, based on data from
the Forbes survey of the worlds billionaires, and
does not control for exposure to risk.
Piketty places a high premium on transparency
to increase our knowledge of capital ownership
inequality; to improve financial regulation, espe-
cially in handling banking crises; and to force
governments to broaden international agreements
on the automatic sharing of financial data. With
broader agreements, the national tax authorities
would receive all the information needed to accu-
rately compute the net worth of every citizen
including information from countries like the Cay-
man Islands and Switzerland. In this regard, Piketty
is complimentary of the Foreign Account Tax Com-
pliance Act and critical of various weaker EU
directives. Public transparency would be required
of corporations and individuals in situations
where there is no other way to establish trust
(Capital, at 570). How that approach would be
consistent with privacy and even the safety of the
individuals and their families is unclear.
To reduce public debt, Piketty suggests a pro-
gressive, one-time tax on private capital or inflation.
Economic Critiques
In summarizing and reviewing Capital above, I
have already begun to critique some aspects of the
book. There are, however, two major areas that
warrant further critical comment: the rate of return
on capital (and the claimed inference of a rapid
growth of capital) and U.S. income (wage) inequal-
ity.
Piketty underplays the fact that in the United
States, short-term interest rates have been zero for
several years, long-term interest rates on nominal
government bonds are less than 3 percent, and rates
on inflation-indexed securities have been negative.
These are the rates available to all income and
wealth groups, not just the lower ones. According to
universally accepted finance theory, rates on those
low-risk securities serve as the base for the expected
2
It is hard to imagine why the United States would want to
spend more on health, when it already devotes a far larger share
of its income to it than all other developed countries do.
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rates of return on other, riskier types of capital so
that as the rates decline, so do all other rates of
return.
As further evidence of current low rates of re-
turn, see the data on yields on long-term British
government bonds in figures 2 and 3. Figure 2
shows yields on consols and inflation rates over a
long historical period. We indeed see the 5 percent
yield in the 1810s experienced by Mr. Darcy, al-
though contrary to Pikettys assertion, inflation was
relevant even then, at least during war times. But in
any event, the yield is almost always lower than 5
percent historically and certainly is lower in real
terms, and especially in 2013, when due consider-
ation is given to trends in inflation. Figure 3 is a
direct measure of the real (that is, inflation-
adjusted) low-risk rate because it shows the yield
on inflation-indexed, long-maturity U.K. govern-
ment bonds. In recent periods, the yield is negative
and has generally been around 1 percent. Therefore,
Pikettys assertion of a fairly constant 4 to 5 percent
real rate of return on capital flies in the face of past,
recent, and current experience and would certainly
be unlikely to hold true if the capital/income ratio
increased further.
As a related matter, most scholarly evidence
shows that the elasticity of substitution between
capital and labor is less than 1, particularly if
housing is included in the measure of capital. In the
United States, the savings rate has declined in
recent decades at the same time stock and housing
prices have increased, leading to greater household
wealth. So there are indeed automatic mechanisms
in market systems applying to the two fundamental
laws of capitalism to prevent the continual expan-
sion in the capital/income ratio and any income
inequality that would arise therefrom.
Much has been written questioning the data
produced by Piketty and his colleague Saez on
increasing U.S. income and wage inequality. Har-
vard economist Martin Feldstein made the follow-
ing three points in a May 15, 2014, editorial in The
Wall Street Journal:
Figure 2. U.K. Consol Yields and Inflation Rates From 1728 to 2013
Long-TermGovernment BondYields
10-Year MovingAverageforAnnual InflationRate
20
15
10
5
0
-5
-10
D
o
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n
Years
Sources: http://www.dmo.gov.uk/ceLogon.aspx?page=about&rptCode=D41and
http://www.measuringworth.com/calculators/inflation/result.php.
1
7
3
3
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1. TRA1986 lowered the top rate on all income
from 50 percent to 28 percent and considerably
expanded the tax base by reducing the use of
deductions and exclusions, importantly limit-
ing the use of top-hat pension plans and other
forms of deferred compensation. Because the
top income earners and the corporations that
pay them are sensitive and quick to react to
changes in tax rules, more income was paid as
taxable salaries but did not increase the total
resources available to those earners.
2. The income tax data used by Piketty does
not include the corporate income of profes-
sionals and small businesses before TRA
1986s repeal of the General Utilities doctrine
and the decline of the top personal rate to less
than the corporate rate. Those changes
prompted high-income taxpayers to shift their
business income out of taxable corporations
and onto their individual returns. That was
achieved in part by having the companies pay
the individuals interest, rent, or salaries, or by
converting the businesses to subchapter S cor-
porations. These changes in taxpayer behav-
ior substantially increased the amount of
income included on the returns of high-
income individuals. This creates the false im-
pression of a sharp rise in the incomes of
high-income taxpayers even though there was
only a change in the legal form of that in-
come. (Feldstein claims that this change hap-
pened gradually, but again, because of the
rapidity by which the well-to-do react to the
advice of their tax advisers and the long lead
time of TRA 1986, I think it is more likely to
have occurred quickly. Indeed, the data used
by Piketty show a particularly rapid rise in
inequality in the immediate years after the
passage of TRA 1986.)
3. Social Security, other retirement benefits,
and health benefits (both from the government
and from employers) are a large and growing
part of the personal incomes of low- and
middle-income households but, while consid-
ered earned, are largely not taxed. When com-
paring the incomes of the top 10 percent of the
population with the total personal incomes of
the rest of the population, including these
benefits would show a much smaller rise in
the relative size of incomes at the top.
Regarding the point about employer-provided
health benefits, my own empirical research for a
recent period has shown that the rapidly increasing
cost of healthcare largely explains the increase in
Figure 3. Yields (Percentage) on U.K. Inflation Linked Treasury Bonds (2035 Treasury Stock),
November 25, 2002, to June 3, 2014
Close of Business Day
Source: http://www.dmo.gov.uk/ceLogon.aspx?page=about&rptCode=D3B.
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reported wage inequality in the United States.
3
Over the seven-year period for which I obtained
compensation data from the Bureau of Labor Statis-
tics (BLS), health cost increases fully accounted for
changes in the distribution of income. In other
words, without rising health costs, there would
have been virtually no change in income inequality
over the period of 1999-2006.
As background, most employers pay workers a
combination of both wages and fringe benefits,
which include paid time off, retirement plans,
health coverage, and other benefits. The role of
fringe benefits has grown significantly over time: In
1950 benefits made up only 7 percent of total
compensation, according to the Bureau of Economic
Analysis; today, benefits make up 20 percent of
compensation. Most of these benefits are not in-
cluded in taxable income. Also note that these
fringe benefits have become more widely distrib-
uted across income groups over time, owing in part
to the tightening of nondiscrimination rules in the
tax code that applies to employers providing ben-
efits to their full-time workers. In particular, when
pension plans were first widely established to get
around the effect of wage controls and higher tax
rates in World War II, they primarily benefited
higher-paid workers, what we now measure as the
top decile. This is now untrue a significant
provision of benefit plans extends much lower
down in the earnings categories.
Both economic theory and empirical findings
indicate a trade-off between salaries and benefits: If
benefits become more expensive, wage growth will
suffer. Indeed, the fact that employer costs for
family health coverage, according to the Kaiser
Family Foundation, rose from around $4,200 in 1999
to nearly $11,800 in 2013 helps explain why average
wages have stagnated in recent years. Total com-
pensation continued to increase, but rapidly grow-
ing health costs ate away at wages and non-health
benefits.
But not every employee is affected in the same
way by rising health costs. The dollar cost of health
coverage is similar for high- and low-income work-
ers, which means that healthcare makes up a far
larger share of total compensation for low-income
earners than for the top 1 percent. I obtained
unpublished data from the BLSs National Compen-
sation Survey that show that for the lowest-paid
full-time workers in 1999, health coverage made up
around 6.2 percent of total compensation. Those
workers were in the 30th percentile of the overall
wage distribution. For middle-income workers, em-
ployer health contributions made up 7.2 percent of
compensation. This was not because their health
coverage was more generous in dollar terms so
much as because health coverage is more predomi-
nant in middle-income jobs. But for the top 1
percent of earners, health coverage made up just 4
percent of compensation.
Now, consider what happens when health costs
increase rapidly. Although rising healthcare costs
eat away at wage growth for everyone, the effects
will be largest for the working and middle classes
because their health costs are so large relative to the
rest of their compensation package.
The BLS data show that from 1999 through 2006,
health coverage rose from 6.2 percent to 12.2 per-
cent of compensation for a lower-wage worker, a
massive increase for a seven-year period. As a
result, while total compensation for this group rose
by 41 percent from 1999 through 2006, wages grew
by only 28 percent. For a middle-income worker,
health coverage increased from 7.2 percent to 10.4
percent of compensation. And while compensation
grew by 34 percent from 1999 through 2006, wages
3
See Mark J. Warshawsky, Can the Rapid Growth in the Cost
of Employer-Provided Health Benefits Explain the Observed
Increase in Earnings Inequality? Pension & Benefits Daily (Feb.
3, 2012).
Growth of Earnings and Total Compensation, 1999-2006
Health Coverage as Percent of
Compensation Growth, 1999-2006
Earnings Percentile 1999 2006 Earnings Compensation
30th 6.2% 12.2% 28% 41%
40th 8.0% 9.9% 26% 28%
50th 7.2% 10.4% 27% 34%
60th 6.8% 11.1% 27% 36%
70th 7.3% 9.6% 28% 34%
80th 6.8% 8.5% 30% 36%
90th 6.5% 7.3% 31% 33%
95th 5.5% 7.1% 34% 38%
99th 4.0% 4.3% 35% 36%
Source: Mark J. Warshawsky, BNA Pensions & Benefits Daily, Feb. 3, 2012. Unpublished BLS National Compensation Survey data.
Bottom 30 percent of workers omitted to exclude part-time employees.
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grew by only 27 percent. For the top 1 percent of
earners, health costs increased from 4 percent to 4.3
percent of total compensation. Because of the
smaller role healthcare plays for top earners, their
earnings grew nearly as quickly as their compensa-
tion 35 percent for earnings and 36 percent for
total compensation.
Total compensation that is, the total wages and
benefits paid to employees did not grow more
unequal from 1999 through 2006. In fact, total
compensation for the lowest-paid full-time workers
increased more quickly than for the top 1 percent.
But rising health costs suppressed wage growth
much more for lower- and middle-income workers
than high-income earners, with the result that re-
ported wage and income inequality rose signifi-
cantly. These data show that in the absence of
rapidly rising health costs, income inequality
wouldnt have budged from 1999 through 2006.
4
If healthcare were producing additional value
commensurate with its rising costs, these changes in
the makeup of workers compensation wouldnt
matter, just as we wouldnt care much if employers
paid workers somewhat lower salaries but contrib-
uted more to their retirement plans. But many
studies suggest that the extra spending in the U.S.
healthcare system is often of marginal benefit to
patients. We pay more, but we often dont get more.
Workers would have been better off paying less for
healthcare and seeing higher wages on their pay
stubs. And policy to reduce inequality would be
better directed at reducing the rapid growth in the
cost of healthcare than at increasing tax rates in the
higher brackets.
Another criticism of Pikettys interpretation of
his findings has been made by Scott Winship in the
May 19, 2014, issue of the National Review. Because
tax returns count all gains when they are realized
and members of the top 1 percent strategically time
the sale of their assets after holding them for years,
all of the gains accruing over time are counted on a
single tax return in years close to asset-market
peaks. This increases the share of capital income
accrued by the top of the income strata, since its
concentrated in one year. Indeed, there is a strong
element of stock market performance in both the
income (including capital gains) and wage (includ-
ing stock options) data reported by Piketty, spiking
with the booms and falling with the busts. Winship
also attributes some of the trend of the reported
increase in income inequality to a declining house-
hold size over recent decades as marriage rates
dropped, divorce rates rose, and elderly widow-
hood increased and to a conflation of tax returns
with households and persons.
Finally, getting into the methodological weeds,
one finds there may be another artificiality intro-
duced into Pikettys results by swings in the per-
centage of the adult population (tax units) filing
income tax returns. Since the full-scale implemen-
tation of income tax withholding during World War
II, the percentage of units filing income tax returns
has averaged about 90 percent. But that percentage
fluctuates significantly. For example, from 2000 to
2012, it declined from 96 percent to 90 percent. Still,
Piketty and Saez assume that all nonfilers get a
constant 20 percent of average income, which is
somewhat arbitrary, whereas one might have ex-
pected the income of nonfilers to increase some-
what as the percentage of filing declines,
particularly if the decline is attributable to changes
in tax administration and law intended to remove
low-income taxpayers from filing status. Hence, the
rise in inequality is probably overstated. Note that
this criticism holds true in the opposite direction as
well: When the percentage of filers exploded during
World War II from 14 percent in 1939 to 85
percent in 1945 it is likely that the average
income represented by new filers declined, so the
sharp decline in inequality during the war reported
by Piketty is probably overstated.
Capitals Style and Tone
Now, allow me to make some personal com-
ments about the books style, approach, and tone.
Although the book is jammed with extensive data,
written by a professor of economics and published
by Harvard University Press, Capital is not a work
of science. The discussion of empirical method in
the text is exceedingly brief, and although the
summary of theory is in parts quite good and
intuitive, it is neither nuanced nor complete. Most
importantly, we are given no information or think-
ing by which to judge what levels and types of
inequality are bad immoral or harmful. Nor is
there any inclusion of the empirical effects of cur-
rent policies and practices tax, social insurance,
welfare, charity, and so on that effectively reduce
inequality in all countries in modern times. Those
are notable omissions for the discussion of policy,
given that there is significant relevant philosophical
and economic literature to use.
By Pikettys admission, the data reported are
sometimes smoothed, interpolated, combined, or
adjusted. There seems to be no logical consistency
4
A Congressional Budget Office study also incorporated
healthcare costs into its analysis of income inequality. The CBO
found a smaller role for health costs in driving income inequal-
ity. But that study indirectly estimates health benefits for
employees using household survey data, which are subject to
error, and healthcare data sets from the 1970s. By contrast, the
BLSs National Compensation Survey is more current, and that
data is collected directly from employers, providing more
timely and reliable data.
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in the picking and choosing among methods and
different types of data sets. This broad approach
makes the data look more convincing than they
really are; other scholars would instead show series
breaks and several alternatives and list caveats.
Pikettys straight use of informal journalistic data
sources with an inadequately disclosed method,
such as Fortune magazines tracking of the worlds
billionaires, would never appear in a top profes-
sional economics journal (I think/hope).
Although generally well written and well orga-
nized, the book would have benefited from tighter
editing, since it is sometimes repetitive. The re-
peated invocations of Balzacs Pre Goriot, while at
first clever and truly illustrative of the dynamics of
inheritance and income in historical France, get
annoying and tiring by the fourth and fifth and
sixth mentions. And despite the books global am-
bitions and American popularity, it is mainly and
consistently about France and Britain in terms of
formal data and depth of historical explanations,
and indeed for many of its projections and conclu-
sions.
The new work in the book, and its main contri-
bution the models of future capital/income
ratios and capital shares is informal and impres-
sionistic, almost no better than back-of-the-
envelope calculations and armchair philosophy.
The discussions throughout the book are not bal-
anced or comprehensive, failing to consider past
criticisms, additional data, or alternative explana-
tions or points of view. For example, Piketty does
not consider that reported developments might
come as narrow behavioral reactions to changes in
tax law and administration, and indeed might arise
from the inherent nature of the reporting and
collection of the data. And while he initially allows
for good (that is, justified) as well as bad inequality,
Piketty abandons that pretense by the middle of the
book and, as his ideal, suggests capital ownership
shares substantially more evenly distributed than
observed even in Scandinavia of the 1970s-1980s.
And then there is the lack of respect for past
work by the pioneers and leaders of the economics
profession. For example, Piketty dismisses and mis-
represents the views of the 1971 Nobel Prize winner
and early pioneer in the empirical study of income
inequality, professor Simon Kuznets, on the evolu-
tion of income inequality across time and countries
as magic, a fairy tale, motivated by professional
hubris, and a product of the Cold War. Are
economics and economists really that small?
Concluding Observations
Lets not end this review on a critical note.
Piketty is to be credited with the hard work of
collecting the massive data sets and writing a long
but accessible book with a sustained argument
based on strong and generally openly stated opin-
ions. Moreover, income inequality is a universal
and timeless issue for those concerned with a fair
and free society, as we should all be.
Fairness is also a major consideration in tax
policy. That is particularly true today as policymak-
ers for the federal and state governments recognize
that their structural levels of spending, now and
especially for the future, are severely underfunded
and overpromised. Either spending must be cut
(but how to do so fairly?), or taxes must be in-
creased (again, how to do so?). It is no surprise that
those who support raising taxes and revenues have
championed Pikettys work because it justifies
advocates a more progressive approach to tax
policy, generally thought to be more popular with
the electorate than across-the-board tax increases.
On the other side of the debate, Pikettys focus on
raising the taxation of capital and entrepreneurial
effort is criticized by those who believe it will harm
the engine of economic growth, the revving of
which is the best remedy for revenue shortfalls.
Moreover, they believe his approach will impinge
on the individuals freedom to pursue economic
opportunity.
Although Pikettys strong conclusions about
capital, inequality, and the implications for tax
policy are not supported by his data and projec-
tions, other insights are possible. For example, the
clear increase in capital in France and Britain attrib-
utable to a rise in housing prices and assets, likely
concentrated in increasingly expensive and finite
Paris and London, argues for more enlightened
policy to spread infrastructure, housing develop-
ment, and cultural activities across all parts of those
countries. In the United States, the reported increase
in wage inequality clearly provides support for new
strategies and policies to address one of the key
underlying causes the rapid rate of growth in the
cost of healthcare. Also, for the United States and
Britain, some of the reported perhaps some
actual increase in income inequality is attribut-
able to stock market performance. While this is
mostly a reflection of the greater risk taken by the
higher-income groups, it makes sense to more ag-
gressively offer these higher expected returns to
lower-income groups on an opt-out, low-cost basis,
say through add-on personal accounts centrally
managed as part of Social Security reform.
COMMENTARY / POLICY AND PRACTICE
TAX NOTES, June 30, 2014 1557
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