In Thomas Piketty’s masterpiece, Capital in the 21st century, he showed the strong association between the rate of return on capital (capital here means assets like companies and land) and the levels of inequality in a society. The key mechanism at play here is that capital is much much more concentrated than labour. Finally, using data from American universities, he showed that larger those with larger endowments were able to earn much higher returns on their endowments. He argued that this was because they’re able to spend more money on professionals who are able to get above market returns. 

It’s an open question whether or not a rate of return on capital greater than the growth rate of the economy actually causes higher levels of inequality; Acemoglu and Robinson have a nice paper showing that when you control for various measures of how extractive institutions are, the effect mostly goes away. Despite this somewhat weak empirical grounding, I’m going to spend this blog post giving my musings on why high relative returns on capital might be causing high inequality. 

I can’t think of a good heading but this is a natural break

There’s no fundamental reason why inequality should be higher in a society where capital is more valuable than labour, or where there’s a very large amount of capital. Indeed, income inequality was low in the Soviet Union despite the Soviet Union having a vast stock of capital relative to labour, as did Germany and Japan which also have relatively low levels of inequality. In theory merely having a large stock of capital could decrease the share of national income going to capital if the return on capital is elastic enough. If increasing the stock of capital dramatically reduced how productive the marginal unit of capital was, the countries with large amounts of capital could have lower shares of national income going to capital than in countries with limited amounts of capital. However, Piketty found that empirically that doesn’t seem to be the case. The return on capital doesn’t fall fast enough for capital rich economies also to have a smaller proportion of their national incomes going to capital. 

There are two reasons why I think capital income from capital could be inherently less equal than income from labour. Firstly, the return to capital is intrinsically higher for richer people, no ability to purchase investing skills required. Secondly, Capital is much much easier to accumulate than human capital. 

Where does the return on capital come from?

It’s important to distinguish between returns on capital and profits from businesses. The return capital is what people earn from lending money to a business, or from owning the machines that a business might rent out. In practice, businesses often own the physical machines or patents or whatever that they use (but not, for instance, the premises they operate out of) meaning that business owners often earn both profit and returns from their capital. But conceptually the two are distinct. Importantly for our purposes, in a competitive market the return on capital is non-zero but profit is zero. In a competitive market the return on capital is given by its marginal product, as it is for labour. 

Capital and labour will get their return of their marginal product net of costs, but they will also be paid back their costs. The most important and simplest case to think about for capital is the interest that is charged by a lender. In this case the main costs are risk, time and loss of liquidity. 

There is some risk that a borrower won’t pay back the loan, which increases the cost of the loan to the lender, so they increase the interest rate. There are lots of reasons to prefer to have money now to that same amount of money later. You might die in the intervening period, or there might be massive inflation that reduces the value of your money to effectively 0 and empirically it just seems that humans like to have things now rather than later. Therefore the time period between lending out the money and getting the money back is itself a cost, increasing the interest rate charged again. Finally, it's really useful to be able to pay for unexpected expenses and for this you need an  asset which can be turned into money. You can sell the right to collect interest on the loan you made but this will take time and is messy. If you had the money you loaned out on the other hand you’d have the ultimate liquid asset. 

All of these costs are much smaller for rich people. They are much much smaller for rich companies like banks. If you’re making lots of loans it’s not very likely that lots of them will fail at the same time, so the cost of risk is lower. Liquidity also matters a lot less. If you’re a big company it’s much much easier for you to get lines of credit than it is for a random individual, so having access to cash is much less important. This is why I currently have most of my assets in money rather than in an index fund - I’m a poor student and I quite often have (relatively) large, unexpected expenses. In rich countries currently, time discount rates aren’t that different for rich people and poor people. In poor and middle income countries this certainly isn’t true. In countries with weak property rights, high crime and high chance of illness it’s much more likely that the value of your investment will go to zero for some reason - it’s expropriated, or stolen or you suffer a terrible illness - if you are poor than if you are rich. When you’re rich you can afford very large losses. If you’re poor you cannot. A venture capitalist who was poor would be able to survive - well before they found the next google they would have gone bankrupt from all of the companies that died too young for us to know their names. For a very rich person halving your income means you’re merely quite rich, for a middle income person it consigns you to penury.  

So the costs of investing are much smaller the richer you get. This means that rich people can do two things. Either they can rent out their capital at a lower price than their poorer competitors, or they seek out riskier or longer term investments that their poorer competitors can’t seek out. Either way, richer people get market share and market power, allowing them to earn higher returns on their investments and the rich get richer.

You can accumulate capital but not labour 

If I become a rich man and for some reason have decided I don’t want to donate the money to some worthy cause, I will not be able to invest in my human capital in a productive way. I can get all of the training I want, host all the cocktail parties filled with hedge fund managers and software engineers that I like, and still I have my hypothetical fortune almost fully intact. It’s just very hard to find ways to spend money that reliably improves your wage earning power past a certain point. This is not the case for the capital. For any individual, their personal investment in the stock market will have no effect on the rate of return, whereas their investments in themselves diminish extremely quickly. The principle at work here is that while I personally might have invested everything I profitably can in myself or my business, there are many millions of others who haven’t for which I can provide the capital they need. 
 

In this framing, the reason that high returns on capital drives inequality is that rich people will have much more of their income coming from their capital returns than the returns on their labour, even if initially all of their income came from their labour. 

Wow, policy
 

In Capital in the 21st century Piketty advocates for a wealth tax to contain capital driven inequality. An alternative remedy suggested by the explanation of differences in the costs of lending is for the state to take on the role of a vanilla lender. Lots of lending involves real work. The work of identifying which firms are likely to most probably deploy capital is useful and important work that should be incentivised with monetary reward. Much of finance does not work like that however. Mortgage lending, bonds issued by safe lenders are prime examples of capital earning returns just from capital rather than labour. The state could step in to provide this vanilla financing. One of the disadvantages of taxation of capital is that it would disincentives innovation and returns from labour, like the work of efficiently allocating capital, that hide as returns to capital. State ownership would get around this problem because it would just target the returns to capital that come from the advantages of low costs of a lack of liquidity, time and risk. This is of course not a worked out policy - that will come in a later post - but it’s an idea.