A clarification on my ideological standpoint first. I am not a free-market fan, neither am I a socialist. One deals with “economic efficiency”, the other with “economic equality”. Both, in their own ways, are reprehensible. My thought can best be described as in support of “economic equity“.

Mark Thoma wrote that inequality is not a forgone conclusion in capitalist systems. He is partly correct in stating that inequality is not a forgone conclusion in capitalist systems.

On mentioning “inequality”, most people think of “income inequality” and stop there. However, income inequality is only the beginning of the story.

First, a look at why Thoma’s assertion was “partly correct”. A capitalist system is defined by allowing a market to operate freely, with none of the participants allowed to exert undue influence on the price of that product and also free of government interference (there are exceptions).

In capitalism, the system is defined by certain rules that are derived from the societal norms that are prevailing at the time. In America, the economic system came to be defined with a strong emphasis on individual rights. This led to many modifications to the economic analysis later on (think Prisoner’s Dilemma for starters, the old thinking that “greed is good” is the assumption that got further modified).

This strong focus on individual rights, in economics, led to capitalism being designed as it is. An economic agent gets to keep their earning, after deductions for government programs. There is nothing wrong there really. At least on the face of it.

Better clarity can be achieved if actual data is referred to in the explanation. Data was sourced from the US Census Bureau for this. The following graph shows US GINI from the post-WW II period till the end of the first decade of the 2000s. It shows the evolution of GINI through the years. The blue line was by the software package used, the red line was added in by me to show the general trend over time.

Initially, GINI, that is income disparity, was on a slow downward trend. Sometime after 1970, the trend reversed and rose in a direction roughly perpendicular to the downward trend.

Some hints of what led to this turn of events can be found when one goes through Robert Reich’s “Supercapitalism”. He identified the same period as when inequality began to show itself. Several changes that exacerbated inequality are pointed to – fall of unions, change of the economic structure (oligopolies to competitive industries), changing nature of finance capital (go wherever greater profit looks more likely and assured). In the book, Reich says that it was not that people got more greedy but the opportunities to express that greed that had changed with the economy and finance.

The structure of the economy changed in that period, but what built up the pressure for that change? Hints of the answer may again be found in Supercapitalism, finance had begun to move about with greater frequency in search of greater profits. Which is perfectly reasonable, what use is money lying around doing nothing? The wealth, that sought ever larger returns, came from being the biggest economy in the world for several decades at a stretch.

The wealth build up came at an age when the government was actively involved in large portions of the economy. There was an extensive set of intensive regulations, directed mostly at regulating the market actor behavior. There was also heavy government involvement in many sectors of the economy, particularly in various R&D projects that spilled over into industry and greatly advanced civilian life. (Note: The wealth build-up is independent of the government’s involvement in the economy. The spread of the income and wealth distribution depended on how the economy was designed to operate and not on the government’s involvement.)

During the early 1970s, free-market capitalism had won the argument and the government began to pull out of markets and lessened their diktats to various market participants.

Theoretical approaches explaining inequality reducing as an economy matures further made the case for free-market capitalism stronger [see Kuznets curve].

This same argument is also advanced by Eduardo Porter in an NYTimes article. The relevant portion is quoted below:

Mr. Kuznets’s conclusion provided a huge moral lift to capitalism as the United States faced off with the Soviet Union. It suggested that the market economy could distribute its fruits equitably, without any heavy-handed intervention of the state.

And it more or less put an end to economists’ interest in the topic. Economic theorists assumed that in a balanced economy, wages and profits rose at the same pace and turned their attention to the ups and downs of the business cycle.

The government still regulated certain markets (finance for example), but, overall, the trend was clear with free-market theories winning the ideological battle. Deregulation of every industry and market present then. The labour market was also deregulated, lower tax rates, fewer tax brackets, removing government support for union activity, scaling back social supports, to name a few. The lower rates and fewer brackets drove up income inequality, shown in the graph. A closer inspection of the graph reveals that the rate of the rise of income inequality sped up after around 1990 (not shown). More than policy changes, it was the wealth accumulated in the period since deregulation took hold that played the bigger factor (a strong gut feeling at the moment and also from the fact that Piketty found that the wealth inequality was decreasing up to when deregulation took hold).

Economists do not focus on wealth inequality much, turning almost all attention to “income inequality”. There is a real danger here, in the (paraphrased) words of Michael Sandel, when access to a market is determined by the access to credit, inequality matters a great deal. At the end of the day, what determines access to credit is not income itself, but income and wealth. A simple example will help to clear up the confusion. Imagine two people, both earning a salary of $20,000 a month. One of them lives on personally owned property and therefore pays no rent. The other has to pay $6,000 a month as rent. Their disposable income then is $20,000 and $14,000 respectively. If you calculate a GINI, it will show perfect equality, a modified GINI that takes expenditures into account will show a different picture though.

Consider the following two trends:

• Increasing wealth in the hands of (some) people.
• The move to make every facet of life market-based (old age home, child rearing, even traffic control, and so many others).

A few short examples will lead to the point that I hope to make.

• Schools that offer the best education to students and the best salaries to the teachers. They are widely known as private schools. Only the families who can afford these schools send their children there. A very normal sight for almost everyone.
• Hospitals, also private, that charge prohibitive sums for treatment. It seems normal to most people as they grew up watching this model in practice. (Wasn’t so about 40-50 years back.)
• Enabling toll collection from vehicles traveling on the freer lanes of a road (or collecting tolls to free a packed road). A newer idea, it has been in limited practice on highways and toll bridges, with gradual movement into inner-city roads, London introduced a “congestion charge” on 17th February, 2003.

As wealth is increasing for people, many will find all the above examples very mundane, a part of everyday life. To the vast majority who are not so lucky, they get left behind by the market unable to afford the required product. Lacking the product, they find themselves in a disadvantage over the long run – socially, economically, educationally, health wise, and now, politically.

Increasing wealth and income (together, not singularly) are driving inequality in many spheres of life. Here is where I can make clear the distinction between “equality” and “equity”. Take the case of food (that I mentioned in a previous post referred to at the beginning), when going out to eat, you can get the same level of nutrition at different prices. That is unequal but equitable. Consider something like politics. You cannot set different price points for the same political PoV. In other words, every person gets to cast ONE vote according to his/her beliefs. That’s equality and equity; what if someone were able to leverage their beliefs so that it were to be more widely advertised? What if they were able to make arrangements such that their beliefs were to be heard louder and sounded more true than all the others? That is political inequity, when one vote is more influential than another because that person is able to spread their opinion to influence the remaining population. So even though you have political equality, you are having political inequity. How can someone carry out such a program? They have access to wealth backed-up by an income to make this possible (I ordered it this way deliberately).

Wealth plays a huge role in the market. For the two people earning the same amount, with one living in his/her own house and the other in rented property, the disposable income changes, and that can be by a large amount. The disposable income determines what economists refer to as “willingness to pay”, how much someone is willing to pay for a certain product. A trade occurs when the seller finds a buyer who is willing and able to buy at the market price. Obviously, when the various aspects of life are controlled or distributed in a market, only those who meet both the criteria will be able to demand the product. So in the long run, it is wealth inequality that will negatively impact total consumption in the economy. The product can be anything – food, health, education, political representation.

What does accumulated wealth do? It increases a person’s risk appetite over time as their wealth increases and they move their wealth in search of increased income. This argument is presented in the following article and the relevant portion is quoted here:

Although r > g is an elegant and compelling explanation for the persistence and growth of inequality, Piketty is not completely clear on what he means by the rate of return on capital. As Piketty readily admits, there is no single rate of return that everyone enjoys. Sitting on short-term U.S. Treasury bills does not yield much: a bit over one percent historically in inflation-adjusted terms and, at the moment, negative real returns. Equity investments such as stocks, on the other hand, have a historical rate of return of about seven percent. In other words, it is risk taking — a concept mostly missing from this book — that pays off. [underline added]

In the following New Yorker article reviewing Piketty’s “Capital in the 21st Century”, Piketty suggests a radical solution as the policy prescription for the skewed wealth distribution in his book, a global wealth tax combined with income taxes of 80%+ on the top earners worldwide. It will work on two levels –

1. Governments will have enough money to redistribute from winners to losers (which controls income inequality). [80%+ income taxes; personally, I have a strong suspicion it should be 90%+, something that I came across when toying around with taxation for my master’s thesis, which is not very well done as I am not any theoretical economist, also see the following charts].
2. The risk appetites of the very rich will be greatly diminished when they realize their wealth will be taxed. (A wealth tax will ensure people do not move their money into risky ventures, think derivatives and their ilk, and will not drag down the economy when they go bust.)

The most interesting point that I encountered when going through reams of text that were for/against a wealth tax was the fact that it seemed to be a taboo subject that was not to be discussed, like harvesting human embryos for stem cells. Many discussions ended at “this is not for discussion”. The attitude adopted by most people (not just economists) with regards to a wealth tax reminded me of Robert Nelson’s book.

Apparently, Piketty’s suggested solution runs foul of the US constitution. If I understand correctly, the constitution is meant to reflect the beliefs held by the population (at that time with safeguards in place). That would suggest that holding on to one’s income (converting income to wealth) is seen as the right of an economic agent.

There is a huge storm about why Piketty’s suggestion of a wealth tax is poor policy, most articles I had encountered were most interesting. They say more by what they do not say than what they do say. I have yet to encounter an argument against the wealth tax that is based on mathematical logic and arguments based on more than just the “hand waving” denials, “This is a bad idea and people will be scared to hold on to any wealth or save any money.” [There have been a deluge of articles, many in favour of the wealth tax idea, since Piketty’s book came out.]

To start off, let’s first debunk some popular wealth tax fictions and in the process also understand what a wealth tax will cover.

1. Imposing a wealth tax on a large part of the developed world will lead to capital flight. For starters, a country ranked as a member of the first world generally has strong institutions and laws to protect property rights, whereas the same does not apply to developing or underdeveloped countries. Would people be willing to move their wealth to a country where they face a higher risk of losing their wealth? Unlikely, unless the person has a huge stash and an income that will turn your eyes up. Therefore, large-scale capital flight seems unlikely.

2. A wealth tax will be a disincentive to save money. That will happen if the person has a rather small saving rate to begin with, if that is the case, then perhaps the rates of return to capital and to labour need to be investigated and the capitalistic system needs to be reformed.

3. Taxing the retired who live in a house for owning that house is crazy. Yes it is, that would be a flawed policy design, the proper one would take into account whether the source of wealth is a currently a consumption good (a house that is being lived in) or a store of value (an empty house that creates owner equity) or a revenue stream (a property that is being rented out).

4. What is the worth of a, for example, “rare painting”? For such items, I would take the purchase price and hit it with a year-on-year inflation adjustment. “What if they fall in value?” Didn’t this thought cross the buyer’s mind at the time the item was being purchased? The wealth tax will make people think twice about being extravagant. These things belong in the public exhibitions and not private collections anyways.

5. Intangible capital goods like, for example, a patent? Is the patent itself producing some good or have an alternative use as a consumption good? No? Then they simply are not to be counted. If the next argument is, “They are worth millions on the market,” no, they are not. They are simply permits to use physical capital and labour in a particular manner. The wealth will be in the physical capital and not a document itself. On its own, the permit to use the knowledge contained in the patent is worth far less than what capitalists make of them. With the production process (machinery and all) to use that knowledge, it is worth much more. What if they have the wealth to buy the patent and the production method? The wealth tax will be covering all that wealth anyways. Knowledge, in and of itself, is worth little. On being put to action, it can be worth the world. [Patent wars? They fall outside the purview of anything to do with wealth, read how damages from patent infringements are calculated.]

6. The assets held by a business will get taxed and this means lower capital will be held by a business. Businesses take all costs into consideration, this will  be another one. It could lead to a slightly slower growth overall for the business and the economy, but who says “faster growth is definitely good”? The experience from the growth after the 2008 recession should be proof enough that it is not merely growth but also how the growth is distributed that determines whether it is “good” or “bad” growth. If anything, it will make the business (owners) more careful when making investments.

Moving on to why there should be a wealth tax (as opposed to what should a wealth tax be applied to), it is often argued that a progressive income tax is akin to taxing good fortune but not a wealth tax. An incorrect (IMO) approach to the question of good luck. Two simple thought exercises will be needed here to understand why a/an (progressive) income tax will be, when factoring in luck, regressive.

1. Two people, Jack and John, both earn $100 a month. Jack lives with his parents in the family owned house and his bills for food and entertainment amount to $30 a month. John lives in a rental paying $20 a month as rent and his remaining expenses come to $20 a month. Income tax on both come to 35%, or $35. So total expenses for Jack is $65 and for John is $75 with savings for Jack being $35 and $25 for John. Consider the short run scenario of a year, $420 saved by Jack and $300 saved by John. Jack is almost 50% wealthier than John (more if you consider the houses).
   In this situation, what would be the appropriate policy response to “taxing good fortune”? [One was born or came to own wealth, the other did not.]

2. Enter Mary and Jane, earning $100 per month, taxed at 35%, expenses at $30 a month, both living with their parents. Mary’s mother suffers from cancer and that eats away another $20 a month of Mary’s income. Mary’s expenditure – $85, Jane’s – $65. Mary’s savings after a year – $180, Jane’s – $420. Jane is wealthy by more than a factor of two. What needs to be taxed to tax “luck”? Income or savings?

The above examples should clear up why making an income and good fortune are not equivalent but retaining income and good fortune that are equivalent. Therefore, taxing good fortune means that it is wealth and not income that should get taxed.

Finally, how is it that “inequity” will be addressed with a wealth tax? It is how the policy should be designed, the proceeds of a wealth tax can be directed into specific causes and needs to ensure that there is greater equality (not just equity) in the economy, or at minimum, there is equity.

Even further reading:

A Modern Marx

Change.org petition

Problem with Piketty’s book : Problem answered (sign in required for both)