Sunday, November 23, 2014

The Great Income Divide

WASHINGTON, DC – Thomas Piketty’s book Capital in the Twenty-First Century has captured the world’s attention, putting the relationship between capital accumulation and inequality at the center of economic debate. What makes Piketty’s argument so special is his insistence on a fundamental trend stemming from the very nature of capitalist growth. It is an argument much in the tradition of the great economists of the nineteenth and early twentieth centuries. In an age of tweets, his bestseller falls just short of a thousand pages.

The book’s release follows more than a decade of painstaking research by Piketty and others, including Oxford University’s Tony Atkinson. There were minor problems with the treatment of the massive data set, particularly the measurement of capital incomes in the United Kingdom. But the long-term trends identified – a rise in capital owners’ share of income and the concentration of “primary income” (before taxes and transfers) at the very top of the distribution in the United States and other major economies – remain unchallenged.

The law of diminishing returns leads one to expect the return on each additional unit of capital to decline. A key to Piketty’s results is that in recent decades the return to capital has diminished, if at all, proportionately much less than the rate at which capital has been growing, thereby leading to an increasing share of capital income.

Within the framework of textbook microeconomic theory, this happens when the “elasticity of substitution” in the production function is greater than one: capital can be substituted for labor, imperfectly, but with a small enough decline in the rate of return so that the share of capital increases with greater capital intensity. Larry Summers recently argued that in a dynamic context, the evidence for elasticity of substitution greater than one is weak if one measures the return net of depreciation, because depreciation increases proportionately with the growth of the capital stock.

But traditional elasticity of substitution measures the ease of substitution with a given state of technical knowledge. If there is technical change that saves on labor, the result over time looks similar to what high elasticity of substitution would produce. In fact, just a few months ago, Summers himself proposed a reformulation of the production function that distinguished between traditional capital (K1), which remains, to some degree, a complement to labor (L), and a new kind of capital (K2), which would be a perfect substitute for L.

An increase in K2 would lead to increases in output, the rate of return to K1, and capital’s share of total income. At the same time, increasing the amount of “effective labor” – that is, K2 + L – would push wages down. This would be true even if the elasticity of substitution between K1 and aggregate effective labor were less than one.

Until recently not much capital could be classified as K2, with machines that could substitute for labor doing so far from perfectly. But, with the rise of “intelligent” machines and software, K2’s share of total capital is growing. Oxford University’s Carl Benedikt Frey and Michael Osborne estimate that such machines eventually could perform roughly 47% of existing jobs in the US.

If that is true, the aggregate share of capital is bound to increase. Given that capital ownership remains concentrated among those with high incomes, the share of income going to the very top of the distribution also will rise. The tendency of these capital owners to save a large proportion of their income – and, in many cases, not to have a large number of children – would augment wealth concentration further.

Other factors could help to augment inequality further. One that has been largely neglected in the debate about Piketty’s book is the tendency of the superrich to marry one another – an increasingly common phenomenon as more women join the group of high earners. This, too, causes income concentration to occur faster than it did two or three decades ago, when wealthy men married women less likely to have comparably large incomes. Add to that the modern scale effects on professional and “superstar” incomes – a result of winner-take-all global markets – and a picture emerges of fundamental forces tending to concentrate primary income at the top.

Without potent policies aimed at counteracting these trends, inequality will almost certainly continue to rise in the coming years. Restoring some balance to the income distribution and encouraging social mobility, while strengthening incentives for innovation and growth, will be among the most important – and formidable – challenges of the twenty-first century.

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    1. CommentedKir Komrik

      What a refreshing observation, thank you.

      "Without potent policies aimed at counteracting these trends, inequality will almost certainly continue to rise in the coming years. Restoring some balance to the income distribution and encouraging social mobility, while strengthening incentives for innovation and growth, will be among the most important – and formidable – challenges of the twenty-first century."

      This reads like the craftily coded paragraph of a truth denier :)

      Let's break it down, call a duck a duck and get a real for second.

      What is the end game here? If inequality rises too much it is destabilizing, a result the wealthy seek no more than the poor. So, we agree a solution must be found? At the risk of sounding like a dreamer or idealist, let's continue to translate this paragraph into blunt words.

      "Restoring some balance to the income distribution" means we need to stop paying people more simply because they are better educated or more skilled. Sounds bizarre, but that is what the data is telling us. Maybe we should view everyone's role in society as equally valued instead, and pay accordingly. Bizarre, but that is the duck before us. And this is because you can't "encourage social mobility" if the number of persons at the destination is finite, overcrowded and does not admit of newcomers. Someone will always be at the bottom of the "social mobility" hierarchy, by definition.

      Paying everyone the same rate based on the time committed, and upon no other factor, seems antithetical to “strengthening incentives for innovation and growth”. Or is it? Do people seek money or power in this life? Or is money just the path to power? Maybe if we created “potent policy” to enable people to truly choose what their role in society is, rather than having to take the one economics demands, might strengthen incentives for innovation and growth? So perhaps we should rethink how we connect employers and employees (at least in the States, which is all I can speak to here). Maybe we need to make that system more robust with better matching of person to role? Just saying.

      What I’m trying to say is that the answer is right in front of us, the elephant in the living room, but as soon as you say “systemic” or “novel” people run out of the room like a bunch of scared chickens. Maybe we should stick around and listen.

      The idea that people are motivated by money is a myth. Human beings are motivated by power and control over their lives, and the related contentment of choosing your role in life. Money just happens to be one way to get that.

      Maybe we should create policies to better match people to roles and maybe we should make policy to just pay everyone the same thing, or to at least devise a formula of some kind to constrain by law the extent to which income can deviate in civilized society? We don’t need to be a Marxist to do that, we can just adjust it a little to limit the excesses Pinketty correctly identified. This is really just a smarter form of minimum wage, imo.

      I don’t see any economic fundamental that _requires_ this degree of inequality of income and wealth, so I don’t see how legislation such as this would hurt the economy as long as the “equalization” is moderate.

      - kk

    2. CommentedJonathan Lam

      Gamesmith94134: The Great Income Divide

      The question on restoring some balance to the income distribution and encouraging social mobility may not be easy as can be; if the present capital and labor environment are restrained to the present system that is being institutionalized and man-handled to meet its economical growth with lesser compromise on depreciation of assets and marginalized income. Perhaps, I would explain it in the margin of affordability that expanded the gaps among the groups earned and consumed in the same habitat as a society or community. We demand the equality in the consuming power but to accept the variables in earning. There is no income divide in real socialistic community or slum or Silicon Valley; since they are marginalized as a group in common, poor and wealthy. It became a conflict that we also defy K1 inversion as in devaluation of asset; and institutionalized community also create a ceiling on K2 that labor must qualify to apply or fail under the statute of cost-of-living. Thus is how we are getting the income divide by enforcing the institutionalized community and jobs that many failed to qualify.

      The present joke is all Londoner and San Franciscans are considered to be millionaires, since single house in London is 450,000 pound and 1 million in San Francisco. It is how the capitalist elites think how we must raise the low income supplement or wages to fit in the community. Perhaps, I would like to compare the boom and bust period on the Dot Com years in the 90’s in San Francisco, or the common industrial cities like Detroit. In a word, corporations are more mobile than the communal citizens and easier to raise the price of their products when choices of products are limited. In some cases, when the corporation were forced to accommodate the raise or price heist in office rental; they left after higher cost defy their profit after earnings. Then cities are busted by it tax cut for corporation or after they left while low income supplements are set in. These booming cities were murdered by the city worker’s pensions and its $25/hr janitors and $35/hr bus drivers.

      It is why I would warn Ms. Yellon on the changing on PPI CPI and trade deficit; and my utility bill had gone up 15%, and housing jumped to 40% of their total earning. It is hideous danger to equity buying and dollar’s valuation. Some may sneer at depreciation and affordability; but it is the nature’s way to set its majority ruling. There is no politics to abstain expansion, but often majority rules that a haircut is a natural thing. It is why I would object the 15 dollar/hour wages demanded and residential housing market that corporation or hedge funds purchased. These are the present financial risks many developed nations, even the FED, must reckon with how their policies are changing the habitat or community and its value system by diversification.

      In order to modify the financial risks we diversify, and we must have policies on commercial and private industries by setting regional developments with mom-and pop stores for lower standard of qualification and wages. Perhaps, there are arguments on the part-time jobs many corporations offer; but there are high tech qualified and not quantified. Besides, No matter how the news or financial report telling you how much you worth; and you may do the appropriate thing to own an Apple or BMW to survive in the big city; and its statement in labeling you as a millionaire is much over-stated; and I prefer the happy days in my college years. Working two full days to pay my rent and the rest days are part-time job anywhere that paid all expenses including McDonald---my pay was 60 cents an hour, and my 25cents burger. I survived. Now, lunch is $8, and dinner is $14. These are millionaire’s expenses and not a plan of survival.

      Do the youngsters really understand how much they must work to pay all expenses? What is a $15 job anyway? It is not more money, but how adaptive you can be or what can you qualify? That needs fresh new financial policies.

      May the Buddha bless you?

    3. CommentedNathan Weatherdon

      Probably many businesses can treat money and people as perfectly substitutable.

      But that presupposes an existence of many firms which specialize in that conversion, and that takes brains.

      Interesting for micro, but I would hesitate to put too much weight in the directions that could be taken from macro perspectives.

      At the end of the day, most citizens of most countries want jobs, and will expect governments to account for this in the process of arbitrating between diverse interests in unfolding development processes.

      I.e., this may be an apparent benefit for firms in a more flexible economy, but this does not mean that the economy itself can achieve identical objectives with identically expensive human and capital costs.

    4. CommentedNathan Weatherdon

      Eventually, we will find a political solution to improve returns to capital by allowing labour to more easily shift to where the capital needs it.

      Or wait, is it the other way around.

      What effect could that possibly have on wages, and therefore the incentive for individuals and nations to cultivate their human capacities?

    5. Commentedwilliam Mattingly

      income distribution? how quaint. what happened to earnings, work product.

        CommentedTim Chambers

        Work product no longer pays when commodities are in surplus and prices are falling due to scarce demand. There is a way to address that problem but it takes a different midset from what comes out of our business schools and departments of economics. You keep production at home, but you go upmarket and pay people more to produce higher value added goods. That is what the Europeans and Japanese do so well, and we do so poorly. Paying people more, not less, creates more demand.

    6. Commentedwilliam Mattingly

      language is so important. When did poverty become income inequality? They probably are not the same thing. Poverty should be the item addressed.

        CommentedTim Chambers

        Most people living in poverty today actually do have jobs, at places like Walmart or MacDonalds, that don't pay a living wage, and are in fact subsidized by government benefits and taxpayers. The biggest beneficiary of food stamps and Medicaid is Walmart and the Walton family. They are even offered property tax relief to come into town and provide those lousy jobs, and scarf up the wealth that used to remain local, and support schools, libraries, and Little League. It's the poor beggared homeowners who subsidize their property taxes.

    7. CommentedProcyon Mukherjee

      Kermal Davis strikes a chord in his observation on society's penchant to pick winners, mostly individuals and then providing highly skewed incentives for their wins, which is summarized in the syndrome called 'Winner take all'.

      In a world where billions are spent on selling products, ideas, services and assets to Billions of people, it is rather sad that the process is entirely tilted towards focusing on individuals as 'saleable' commodities and making them appear as 'above human' characters, while what they may have achieved could be a handiwork of groups and individuals coming together that coalesced cooperative virtues in humans rather than the competitive traits. In designing incentives, this aspect is sadly missed, which is also one of the drivers of inequality.