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.