Harry Geels: Enthusiasm for Piketty is misplaced
This column was originally written in Dutch. This is an English translation.
By Harry Geels
Thomas Piketty is back in the news, this time with a plea for a British wealth tax. But his analysis of inequality is far from convincing. He makes two errors in reasoning and fails to identify the real causes of inequality.
Last week, a group of more than thirty 'leading' economists from the UK and abroad, including Thomas Piketty, called on the British government to lay the foundations for a new wealth tax in the UK in its autumn budget. They argue that extreme inequality has arisen in the country. In a column in newspaper Trouw, economist Paul Schenderling also argued that inequality in the Netherlands is the highest after the US and – again referring to Piketty – that we should tax wealth more heavily.
Why Piketty is constantly being referred to is a mystery to me. Admittedly, he has written an impressive book, Capital in the Twenty-First Century, in which he uses a wealth of data and graphs to show that wealth inequality has increased significantly, especially in recent decades. But his arguments for taxing wealth more heavily (and progressively) are not convincing. Moreover, his analysis of the causes of increasing inequality is downright flawed. It is worrying that Piketty is gaining more and more influence on policy.
Flaw 1
The basis of his argument for heavy taxation of wealth is that the average annual growth of wealth, 'r', is greater than the growth rate of income, ‘g’. This is correct, at least when looking at averages.
After all, over the long term, wealth grows by around 6% per year and labour income by 3%. However, he fails to take into account that growth or returns must be adjusted for risk. If we do so, income growth yields more than wealth growth. After all, the volatility of wealth growth is much greater than that of income.
This may seem like a trick on my part, but it is absolutely not. In general, we only invest our wealth if there is a reward for the risk. The higher the risk, the higher the expected or required return. If we intervene (too much) in this mechanism – by taxing wealth (gains) – this principle works less well, leading to distortions. Investors will then take fewer or, conversely, much greater risks. Wealth taxes therefore have a distorting effect and thus undermine prosperity.
Flaw in reasoning 2
The second flaw in reasoning is that the value of r>g would be the same for everyone. We talked about averages earlier, but there is something else at play here. The extent to which 'r' is greater than 'g' depends heavily on the size of the capital. We also refer to this as the heterogeneity of capital growth. Only for really large investors is 'r' greater than 'g', because they can keep investment costs low, hire the best investment experts and gain access to private markets, where returns are generally higher.
In fact, for around 70% of wealthy individuals, r is smaller than g. If Piketty has a point with his r>g, it is therefore only for the very wealthiest. The 'problem' for Piketty, however, is that higher taxes on the wealthiest immediately lead to 'anxiety and capital flight planning', as was recently demonstrated when the UK introduced a capital gains tax on real estate and the revenue from this has so far been disappointing. Wealthy individuals are postponing tax payments or optimising their tax arrangements.
Reasons for inequality
What is remarkable is that Piketty continues to cling to his 'r>g dogma'. It would be much better to make a proper analysis of why there is such great wealth inequality today. Otherwise, taxes are nothing more than a symptom treatment, which is never a good basis for action. Piketty falls short when it comes to a proper analysis of inequality. He does mention tax avoidance by the wealthy, through tax-optimised structures or tax exemptions (such as institutional investors).
But there is more. First, monetary policy. Since the 1980s – when inequality really started to increase sharply – monetary policy has become increasingly loose (quantitative easing and ever lower interest rates, financial repression), which has led to asset inflation. In addition, inadequate anti-competition rules have led to a 'wealth transfer' from consumers and smaller companies to powerful, oligopolistic corporations (especially their shareholders and top executives).
Solutions other than wealth (capital gains) taxes
Piketty's failure to mention the last two causes of inequality is probably due to his centralist-leftist background. He is a staunch advocate of more government intervention and supranational coordination. Expanding central banks and powerful corporations working hand in hand with the government fit perfectly into his worldview. However, the real solution lies in strengthening fair competition and curbing monetary and fiscal privilege, not in even more market-distorting, symptom-treating tax burdens.
This article contains the personal opinion of Harry Geels