Inequality in the Long Run

Thomas Piketty and Emmanuel Saez (2014)

 Outline

• Basic facts regarding the LR evolution of income

and wealth inequality in Europe and the US
• Income and wealth inequality high a century ago
in Europe, but dropped dramatically in the first
half of the 20th century
• Income inequality has surged back in the US since
the 1970s so that the US is more unequal than
Europe today
• Possible interpretations and lessons for the future
• Do the dynamics of private capital
accumulation inevitably lead to the
concentration of income and wealth in
fewer hands: Marx?

• Do the balancing forces of growth,

competition and technological progress lead
in later stages of development to reduced
inequality and greater harmony among the
classes: Simon Kuznets?
 Data and methods
• Simon Kuznets used tabulated income data coming
from income tax returns (available since the creation
of the US Federal income tax, 1913 + interpolation
techniques for top deciles and percentiles of the US
population.

• After dividing by national income, he obtained US top

income shares for 1913-1948.
• 1960s and 70s: similar methods using inheritance tax
records were developed to construct top wealth shares
• Survey data: not appropriate to infer top percentile
incomes – small sample size
• World Top Incomes Database (WTID)
• http://topincomes.parisschoolofeconomics.
eu/

• Historical top income and wealth series:

more than 25 countries
Aside: Kuznets inverted U curve
 3 Facts about inequality in the LR
Country specific institutions and historical circumstances can lead to very
different inequality outcomes

1. Income
inequality
Europe* > US:
1900
US> Europe: 2010

*European average series

constructed from UK, France,
Germany and Sweden
Technological innovation?
 2. Wealth Inequality
• Concentration of capital ownership
extreme, not income concentration
• Wealth concentration>> income
concentration
• Top decile wealth share: 60-90%
• Bottom 50% wealth share < 5%
• Top decile income share: 30-50%
• Bottom 50% income share: 20-
30%
• Wealth inequality in US still not as
high as 1870s Europe
• Top decile wealth share: 70-80%
• Bottom 50% wealth share
negligible
• 20-30% belongs to the middle
class
• A wealth middle class in US
• Europe: No wealth middle class earlier
• Top decile wealth share: 90%
• Middle 40% wealth holders as poor as
bottom 50% wealth holders
• Wealth middle class NOW has higher share
of total wealth in Europe than in US
→Emergence of a wealth middle class in
Europe
 Questions
Wealth inequality in US today<1913 Europe. Why is US
income inequality> 1913 Europe?

• Modern US inequality based on very large increase in

top labour incomes than on extreme wealth
concentration
• 1913 Europe: top incomes were predominantly top
capital incomes – large concentration of capital
ownership
• Top US incomes today composed equally of labour
incomes and capital incomes
• This generates same level of total income inequality but
not the same form of inequality
 3. Wealth-to-income ratios

• U-shaped

• Europe: Land of
booming wealth
• US: Land of
booming top
labour incomes
Fall in European W/Y ratios following the 1914-1945 capital
shocks can be accounted for by 3 factors:

1. War related physical destruction of domestic capital assets

(real estate, factories, machinery, equipment)

2. Lack of investment ( a large fraction of 1914-1945 private saving

flows was absorbed by the enormous public deficits induced by
war financing

3. Fall in relative asset prices (real estate and stock market prices
were at a historical low in the immediate post war period) because
of nationalization, capital controls etc.

France and Germany: these factors accounted for 1/3rd of the total
decline in wealth-income ratios
UK: (1) was limited; other two factors accounted for almost 50% of
the decline in W/Y ratios.
• Why did post-war recovery of W/Y ratios
take so long?
• Why is capital accumulation a slow process?
• How is the long run equilibrium W/Y ratio
determined?
• Why does it vary across countries and over
time?
Back to the Harrod-Domar Solow formula

g=s/β where β = K/Y is our old θ

It can be shown that the wealth to income ratio,

𝛽𝑡 = 𝐾𝑡 /𝑌𝑡 converges to β=s/g
s: LR annual savings rate
g: LR annual total growth rate
g = population growth rate + productivity growth
(real income growth rate per person)
 “Capital is back because low
growth is back.”
β=s/g
• With a savings rate s=10% and a growth rate
g=3%, β≈300%
• If g drops to 1.5%, we have β≈600%
• In a low growth society, s>0 the quantity of
accumulated capital approaches infinity, β will
rise indefinitely.
• With positive but small growth, the process is
not as extreme: the rise of β stops at some
finite level. However, this finite level can be
very high.
Using this, one can explain why the US
accumulates structurally less capital relative
to its annual income than Europe and Japan
Population Productivity g=pop+prody Savings rate
growth growth
US >1% 1.5% 2.5% 𝑠𝑈𝑆 < 𝑠𝐸𝑢𝑟𝑜𝑝𝑒,𝐽𝑎𝑝𝑎𝑛
(immigrations
etc)
Europe; ≈0 1.5% 1.5% 𝑠𝑈𝑆 < 𝑠𝐸𝑢𝑟𝑜𝑝𝑒,𝐽𝑎𝑝𝑎𝑛
Japan
Share of capital income in national income,
α=rK/Y=rβ
r: average annual real rate of return on wealth
If r=5% and β=K/Y=600%, then α=30%

Does a rise in β→ a rise in α?

Perfectly competitive markets: 𝑟 = 𝑀𝑃𝐾
As the volume of capital β↑, 𝑀𝑃𝐾 and therefore, r↓

Does r fall more or less rapidly than the rise

in β?
 How does r↓ relative to β↑?
Depends on the elasticity of substitution 𝜎 between
capital and labour in the production function Y=F(L,K)

• Unitary elastic: r↓ exactly offsets β↑

• →capital share α=rβ is a technological constant

• Historical variations in capital shares large

• α typically varies in the 20-40% range
• Labour share (1-α) varies in the 60-80% range
• In recent decades, rich countries have experienced
both a rise in β and a rise in α
→ 𝜎 >1
• Intuitively, 𝜎 tends to rise over the
development process, as there are more
diverse uses and forms for K and more
possibilities to substitute K for L
• Will capital share α keep rising in the future?
• Depends both on technological forces and on
the bargaining power of K and L and the
collective institutions regulating the K-L
relationship
• A possibility if the population and productivity
growth slowdown pushes the global capital
income ratio β towards higher levels.
 LR Dynamics of wealth inequality

• The patrimonial societies of Europe a

century ago were characterized by very high
α, β; as well as extreme capital
concentration, with top decile wealth share
of 90%
• Modelling (empirical)structural changes in
wealth inequality
• Dynamic model with multiplicative random
shocks
Assume that individual level wealth process
has the form:
𝑧𝑖𝑡+1 = 𝑤𝑖𝑡 𝑧𝑖𝑡 + 𝜀𝑖𝑡
𝑧𝑖𝑡 : position of individual i in wealth
distribution at t ; 𝑧𝑖𝑡 = 𝑘𝑖𝑡 /𝑘𝑡
𝑘𝑖𝑡 : net wealth owned by individual i, at t
𝑘𝑡 : average net wealth of the entire population
𝑤𝑖𝑡 : multiplicative random shock
𝜀𝑖𝑡 : additive random shock
 Interpretation of shocks 𝒘𝒊𝒕 ; 𝜺𝒊𝒕

• 𝑤𝑖𝑡 ; 𝜀𝑖𝑡 can be interpreted as reflecting

different types of events in individual
wealth histories
• Shocks to rates of return
• Shocks to demographic parameters
• Shocks to preference parameters
• Shocks to productivity parameters
• For a given structure of shocks, the variance
of the multiplicative term 𝑤𝑖𝑡 is an
increasing function of (r-g)
𝑣𝑎𝑟(𝑤𝑖𝑡 )=f(r-g)
f’>0
• Higher (r-g) tends to amplify initial wealth
inequalities
• (r-g) large in earlier times: see graph 4 –- r
high and g low
• 20th century: g high; r low
 Dynamics of income inequality

• Combines inequality of capital ownership and

capital income; and inequality of labour
income
• Kuznets inverted U: income inequality first
rises with economic development when new,
higher productivity sectors emerge (e.g.
manufacturing industry during Industrial
Revolution) and falls when more workers join
high paying sectors of the economy
• Piketty: data doesn’t support this
 Piketty…

• Decline in inequality observed because top

capital incomes fell due to
– World wars and the Great Depression
– Regulatory fiscal policies in response to these
shocks

• There was no structural decline in the

inequality of labour income
What forces determine labour income inequality
in the LR?

• Race between education and technology

• Expansion of education→↑in supply of skills
• Technological change→↑in demand for skills
• What outpaces the other decides the income
inequality
• Globalization, rise of IT, skill biased technological
change→↑in global competition for skills
 Labour income inequality uneven across
countries
• Rise of labour income inequality relatively
limited in Europe, Japan compared to US
• The supply and demand for skills have kept
pace with each other
• US: Insufficient educational investment for
large segments of the US labour force
– Policy to curb income inequality: investment in
education?
• However, this race fails to explain the ↑in very
top labour incomes in US
• A very large part of the rise of top 10%
income share comes from the top 1%
income share (or even the top 0.1%)
– Tax policy…Laffer?
– Social norms regarding pay equality
• Inequality does not follow a deterministic
process.