Picketty’s Theory on Income and Wealth Inequality

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31 October 2018

It was presumed for a long time by many researchers that inequality had been driven more by earnings from work (i.e. wages) and that income from capital stock (wealth) is neither important nor interesting. The publication of Capital in the 21st Century by French professor Thomas Picketty, however, fundamentally invalidates that presupposition.

 

Using multi-country data dating back 260 years, Picketty shows that even in the past — during Europe’s Belle Époque and America’s Gilded Age unequal ownership of assets (i.e. wealth), not unequal pay (i.e. wages), was the prime driver of income disparities. He further warns that societies today are showing signs of similar social divide. Picketty’s ground-breaking study on income from capital led to a resurgence in research interests on the roles of wealth in driving social disparities. 

[About Belle Époque] The Belle Époque was a period of Western European history between the end of the Franco-Prussian War in 1871 and the outbreak of World War I in 1914. The period was characterized by optimism, regional peace, economic prosperity and technological, scientific and cultural innovations. It was considered by some as a golden age for Europe preceding World War I. In the Great Britain, for example, the period of Belle Époque coincided with late Victorian era and early Edwardian era, both of which stand out as a time of peace and plenty especially for the aristocrats, the gentry and a bourgeoning middle class comprising of entrepreneurial business owners. However, under that veil of prosperity, the advent of Industrial Revolution and the rapid increase in population and urbanization also resulted in rising incidence of poverty. Workers were paid subsistence level wages to work long hours in workhouses with appalling working conditions and child labour was prevalent. Shortage in housing also contributed to overcrowding and the emergence of slums. In contrast to the hardship of the working class, the aristocrats and the gentry were able to live a life of opulence from inherited assets. The Belle Époque was therefore also a period of drastic class divide.

[About Gilded Age] The Gilded Age (1870s – 1900), on the other hand, is the American parallel of Europe’s Belle Époque. It was a period when big wigs like John Rockefeller, JP Morgan and Andrew Carnegie dominated the American industries and political parties served the interests of the big businesses instead of the electorates’. Often referred to as “robber barons”, these corporate bosses were able to pursue unethical and unfair business practices aimed at eliminating competition and increasing profits. As social disparity widened and problems of unsafe working conditions, child labour, and political and corporate corruption became increasingly widespread and entrenched, many Americans began to question the fairness of free-market capitalism. By the 1890s, efforts by reformist politicians to rein in these negative effects of industrialization led to the onset of Progressive Era lasting till 1920. During this period, the progressives sought to regulate private industry, strengthen protections for workers and consumers, expose corruption in both government and big business, and generally improve society. In the end, common sense ideas such as antitrust legislation, progressive income tax, minimum/living wage and collective bargaining/unionization laws were passed.

 

Why is Income Inequality Always Higher than Wage Inequality?

 

According to Thomas Picketty, income inequality is always a lot higher than wage inequality.  

 

To explain the higher income inequality, Picketty invokes a simple, intuitive and yet dynamic model that takes into consideration rates of economic growth, g, and rates of return to capital, r.  In effect, g proxies the rate of wage growth, which is positively link to rate of economic growth. The faster the economy grows, the more likely wage growth will also increase. Similarly, the higher the return from capital investments, r, the faster wealth will accumulate.

 

In general, Picketty posits that income inequality, and hence also wealth inequality, is a steeply increasing function of (rg).

When r (i.e. earnings from capital investments) is higher than g (i.e. wage or earnings from work), then initial wealth inequalities attributable to intergenerational inheritance get amplified at a faster pace than earnings from work can be accumulated in current generation. This results in widening wealth inequality over time. Conversely, when g is higher than r, than earnings from work in current generation grows faster than new wealth can be generated from existing wealth and wealth gap may not widen as quickly or may even begin to narrow depending on how equitable the wage distribution is.

Picketty’s research shows that r was indeed greater than g in most part of the history of mankind. During the times of agrarian society, for example, growth was close to 0% while returns to capital, mostly in the form of rental income, were 5%. Economic growth rose to 1% – 2% with the onset of Industrial Revolution but returns to capital rose in tandem with economic growth too. Wealth gap in Europe and the US therefore continued to widen through the 19th century and reached its peak in 1910 when top 10% wealth share hit 90% and 80% respectively. It began its declining trend though after that firstly as a result of the lower return to capital, r, between 1914 – 1945 attributable to the two world wars and the Great Depression, the higher tax rates and then because of the higher g of 3% - 4% in the vibrant post-war global economy. 

 

After 1970s, however, wealth inequality resumed its climbing trend because of wide-scale neoliberal policy initiatives driving privatization, deregulation, and changes in tax structure and of technological changes and globalization, all of which contributed to higher r leading to higher income inequality.

 

On a global level, the real average return on private capital, all classes of assets included – stocks, bonds, real estate, bank deposits, and so on – was about 6% between 1980 – 1990  but declined slightly to about 5% per year between 2000 – 2015. For those who invest more in international stocks, on the other hand, the return they enjoy was 8%. As for hedge funds, reserved for the ultra -rich, their average performance at one time even exceeded 10%.[1]

 

Today, the level of wealth concentration in the top rung has recovered from the 1914 – 1945 shocks although the inequality is less extreme than a century ago. Top 10% wealth share in Europe and the US hovers around 60% and 70% respectively. The moderation from its 1910 peak of 90% and 80% can be explained by the emergence of the new middle class, which was non-existence a century ago, owning 20% to 30% of the total wealth.

 

Looking ahead, with g slowing down to 1% – 2% (and henceforth also the shrinking of middle class) in the long run and with r rising as a result of tax competition between countries to attract capital, wealth concentration may well rise again in the coming decades to reach or surpass the peak recorded in the early 20th century.

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REFERENCES

[1] See Gabriel Zucman (2015). “The hidden wealth of nations: the scourge of tax havens.” Translated by Teresa Lavender Fagan. The University of Chicago. Pg 49.