The intergenerational aspect of Piketty’s theory fundamentally misses the mark

See Thomas Piketty Is Wrong: America Will Never Look Like a Jane Austen Novel.  From The New Republic by Eric Posner and Glen Weyl. Eric Posner is a professor at the University of Chicago Law School and Glen Weyl is an economist at the University of Chicago. Excerpts:

"commentators have overlooked a central mechanism of this theory: that rich people try to create multi-generational dynasties of the sort that existed in aristocratic countries in nineteenth-century Europe. Piketty supports a global wealth tax in order to counter the accumulation of capital over generations. But this intergenerational aspect of Piketty’s theory fundamentally misses the mark."

The extreme inequality plaguing the United States today is not an outgrowth of the accumulation of capital in dynasties. Piketty’s own data show that it arises primarily from enormous salaries earned by a small business and financial elite. Nor is the real problem with these salaries their size, a problem that could be tackled by the taxes Piketty advocates. Instead the real danger is the way they reflect and stimulate a dramatic shift in the sorts of careers pursued by talented individuals in the United States—away from modestly-paying, public-spirited research, education, and engineering jobs, and toward lucrative careers in business and finance. The right solution, therefore, is not to shackle capitalism with a blunt wealth tax but to channel its energies into more productive, diverse activities."

"If all of this return on capital is captured by the person who owns the capital and if that person saves it all, then the capital owned by that person will grow, relative to the broader economy, at around 3 percent per year. This means that a single person’s fortune could grow by about 20 times in 100 years, relative to the economy."

"But is such an explosive inequality dynamic plausible? Barring a miraculous life-extending technology, Buffet will not be alive in the year 2100. A $1 trillion fortune derived from Buffet’s wealth will exist only if a single (great-)grandchild owns it all and Buffet and heirs did not consume or give away much of this money between now and then."

Let’s therefore consider a more realistic example. A person inherits a fortune of a billion dollars at the age of 50, and lives until 80. Let us assume (optimistically) that she can earn a 6 percent real return on her capital (say, 8 percent minus 2 percent inflation) and that the economy grows at a 1 percent rate. Her (real) return is then $60 million per year.

Suppose she spends $10 million per year on houses, cars, and yachts for herself and her family. She must also pay taxes on her 8 percent return; those taxes will cost her another $20 million or so. If she is like most wealthy Americans, she’ll want to influence politics, and give money to charity. Say that would cost her another $10 million. She is thus left with a mere $20 million dollars in savings, or a 1 percent return relative to the economy, each year. (If the economy grows 1 percent per year, then her fortune must increase by $10 million annually to maintain a constant share of the economy.)

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"In such a scenario, her fortune would increase only by 35 percent relative to the economy over the 30 years of her accumulation. The government would then take 40 percent of her fortune in inheritance taxes, leaving her heirs with only 80 percent of what their mother inherited relative to the economy. If she divides her fortune between two children, each would end up with only 40 percent."

Even if we take the extreme case in which the person in question saves her entire disposable income, existing taxes alone will ensure that each of her children will inherit only 73 percent of their mother’s wealth, relative to the economy. Only very extreme scenarios, where every wealthy individual does all of the following at the same time can lead to the sort of explosive inequality dynamics Piketty fears:

1. Marries someone at least as wealthy or bequeaths all wealth to one child.
2. Consumes very little.
3. Avoids paying most taxes.
4. Contributes little to charity or politics.
5. Invests optimally while avoiding Bernie Madoff and his ilk.

But in Balzac’s France and Austen’s Britain, strong cultural norms and strict legal rules helped keep fortunes in a single family. There are dynasties in the U.S. today—the Rockefellers, the Pritzkers, the Waltons—but dynasties like these have existed for a long time. They do not seem more numerous or influential than in the past. The old world of people scheming to marry wealthy heirs isn't prevalent in our world."

"Piketty acknowledges, at least half of fortunes are self-made rather than inherited. "

"as the capital stock grows (likely in the form of robots), more and more people will be able to live comfortable lives without doing any work, or very little. It will become easier for people to work part-time, to take low-paying jobs in the nonprofit sector, to stay home with young children for extended periods of time, to volunteer."

"What, then, is the source of the vast and growing inequality of income we see in the United States today, and should we worry about it?

As Piketty not only concedes, but documents himself, most of this inequality arises from labor income, not capital income—from compensation earned by executives at big firms, entrepreneurs, and financial wizards."

"Thus, the fundamental problem facing American capitalism is not the high rate of return on capital relative to economic growth that Piketty highlights, but the radical deviation from the just rewards of the marketplace that have crept into our society and increasingly drives talented students out of innovation and into finance.

If that perspective is correct, Piketty’s prescriptions are not oriented toward the right problems."

"We agree that a higher income tax would be desirable. But broad taxes, while useful absent better policy in other areas, are poorly targeted, because they do not distinguish clearly between people who are undercompensated for their social contributions (researchers, teachers, engineers) and those who receive excessive pay (financiers, lawyers).

While reforms are needed in many areas of the economy, the most important goal is to reward people for developing and spreading new ideas that benefit society. Unfortunately, the law does a poor job of rewarding innovators and teachers. New, fundamental ideas do not receive intellectual property protection. Funding for basic research is constantly being axed. Prizes for outstanding scientific contributions are paltry and rare. Reform should focus on these problems—above all, on rewarding scientific research and taxing lucrative but socially useless endeavors like high-frequency trading—not on long-term inequality."

"Piketty’s conjecture that we will reach the same or worse levels of wealth inequality than in the nineteenth century is implausible."