The following article explains why Piketty's theory of wealth accumulation
is wrong and why his estimate of increased income inequality is based on a
flawed interpretation of US income tax data
Marty Feldstein
(Available at www.nber.org/feldstein/wsj05152014.pdf)
Originally published in The Wall Street Journal May 15, 2014
Piketty's Numbers Don't Add Up
By MARTIN FELDSTEIN
Thomas Piketty has recently attracted widespread attention for his claim
that capitalism will now lead inexorably to an increasing inequality of
income and wealth unless there are radical changes in taxation. Although
his book, "Capital in the Twenty-First Century," has been praised by those
who advocate income redistribution, his thesis rests on a false theory of
how wealth evolves in a market economy, a flawed interpretation of U.S.
income-tax data, and a misunderstanding of the current nature of household
wealth.
Mr. Piketty's theoretical analysis starts with the correct fact that the
rate of return on capital—the extra income that results from investing an
additional dollar in plant and equipment—exceeds the rate of growth of the
economy. He then jumps to the false conclusion that this difference between
the rate of return and the rate of growth leads through time to an
ever-increasing inequality of wealth and of income unless the process is
interrupted by depression, war or confiscatory taxation. He advocates a top
tax rate above 80% on very high salaries, combined with a global tax that
increases with the amount of wealth to 2% or more.
His conclusion about ever-increasing inequality could be correct if people
lived forever. But they don't. Individuals save during their working years
and spend most of their accumulated assets during retirement. They pass on
some of their wealth to the next generation. But the cumulative effect of
such bequests is diluted by the combination of existing estate taxes and
the number of children and grandchildren who share the bequests.
The result is that total wealth grows over time roughly in proportion to
total income. Since 1960, the Federal Reserve flow-of-funds data report
that real total household wealth in the U.S. has grown at 3.2% a year while
the real total personal income calculated by the Department of Commerce
grew at 3.3%.
The second problem with Mr. Piketty's conclusions about increasing
inequality is his use of income-tax returns without recognizing the
importance of the changes that have occurred in tax rules. Internal Revenue
Service data, he notes, show that the income reported on tax returns by the
top 10% of taxpayers was relatively constant as a share of national income
from the end of World War II to 1980, but the ratio has risen significantly
since then. Yet the income reported on tax returns is not the same as
individuals' real total income. The changes in tax rules since 1980 create
a false impression of rising inequality.
In 1981 the top tax rate on interest, dividends and other investment income
was reduced to 50% from 70%, nearly doubling the after-tax share that
owners of taxable capital income could keep. That rate reduction thus
provided a strong incentive to shift assets from low-yielding, tax-exempt
investments like municipal bonds to higher yielding taxable investments.
The tax data therefore signaled an increase in measured income inequality
even though there was no change in real inequality.
The Tax Reform Act of 1986 lowered the top rate on all income to 28% from
50%. That reinforced the incentive to raise the taxable yield on portfolio
investments. It also increased other forms of taxable income by encouraging
more work, by causing more income to be paid as taxable salaries rather
than as fringe benefits and deferred compensation, and by reducing the use
of deductions and exclusions.
The 1986 tax reform also repealed the General Utilities doctrine, a
provision that had encouraged high- income individuals to run their
business and professional activities as Subchapter C corporations, which
were taxed at a lower rate than their personal income. This corporate
income of professionals and small businesses did not appear in the
income-tax data that Mr. Piketty studied.
The repeal of the General Utilities doctrine and the decline in the top
personal tax rate to less than the corporate rate caused high-income
taxpayers to shift their business income out of taxable corporations and
onto their personal tax returns. Some of this transformation was achieved
by paying themselves interest, rent or salaries from their corporations.
Alternatively, their entire corporation could be converted to a Subchapter
S corporation whose profits are included with other personal taxable income.
These changes in taxpayer behavior substantially increased the amount of
income included on the returns of high-income individuals. This creates the
false impression of a sharp rise in the incomes of high-income taxpayers
even though there was only a change in the legal form of that income. This
transformation occurred gradually over many years as taxpayers changed
their behavior and their accounting practices to reflect the new rules. The
business income of Subchapter S corporations alone rose from $500 billion
in 1986 to $1.8 trillion by 1992.
Mr. Piketty's practice of comparing the incomes of top earners with total
national income has another flaw. National income excludes the value of
government transfer payments including Social Security, health benefits and
food stamps that are a large and growing part of the personal incomes of
low- and middle-income households. Comparing the incomes of the top 10% of
the population with the total personal incomes of the rest of the
population would show a much smaller rise in the relative size of incomes
at the top.
Finally, Mr. Piketty's use of estate-tax data to explore what he sees as
the increasing inequality of wealth is problematic. In part, this is
because of changes in estate and gift-tax rules, but more fundamentally
because bequeathable assets are only a small part of the wealth that most
individuals have for their retirement years. That wealth includes the
present actuarial value of Social Security and retiree health benefits, and
the income that will flow from employer-provided pensions. If this wealth
were taken into account, the measured concentration of wealth would be much
less than Mr. Piketty's numbers imply.
The problem with the distribution of income in this country is not that
some people earn high incomes because of skill, training or luck. The
problem is the persistence of poverty. To reduce that persistent poverty we
need stronger economic growth and a different approach to education and
training, not the confiscatory taxes on income and wealth that Mr. Piketty
recommends.
Mr. Feldstein, chairman of the Council of Economic Advisers under President
Reagan, is a professor at Harvard and a member of The Wall Street Journal's
board of contributors.
Received on Thu May 15 2014 - 10:36:10 EDT
