Business Today

Demolishing the 'Trickle-Down' Theory

A much lauded new take on the age old conflict about how to split output between wages and profit.
Ajit Ranade | Print Edition: June 8, 2014
Capital in the Twenty-First Century
Capital in the Twenty-First Century

Capital in the Twenty-First Century
Thomas Piketty
Pages: 684; Price: $39.95

The book opens with an illustrative story of a conflict between labour and capital. Striking mine workers are demanding a doubling of their wages. It ends tragically with police firing and the killing of 34 workers. The owners settle the negotiations with a meagre 15 per cent hike. This is not the 1850's Europe of Karl Marx. It is 2012 in South Africa.

The age old conflict about how to split output between wages and profits is one of the key questions tackled in Thomas (pronounced "Thomah") Piketty's magnum opus. It is a scholarly tome of 684 pages, with the last one fifth of the book devoted to detailed footnotes, tables, index and bibliography. But unlike many other authors of tracts from the "dismal science", this distinguished French economist has rendered an eminently readable account of the history and dynamics of capitalism and inequality. The original French edition was published in 2013, and his work has been well known in academic circles. It is based on more than two decades of painstaking analysis of data, mainly from developed countries.

Already in Europe and the US the buzz around the book has reached "Beatlemania" proportions. An early October review described the book as one of the watershed books in economic thinking, and possibly the most important book to be published in decades. Paul Krugman says that this book is "serious, discourse-changing scholarship". Piketty's academic credentials are solid. He won the prize for the best young economist in France back in 2002.

He is also not shy of active engagement with policy makers, and was economic adviser to presidential aspirant Segolene Royal. Capital distils his own and his co-authors' longstanding research and findings into a lucid tale of why inequality in the world is increasing, and what we should be doing about it. The right leaning crowd may be dismayed with his prescriptions of stiff global wealth taxes, but neither leftists nor rightists can dispute the data that he presents.

He is among the pioneer economists who looked at data from the tax authorities rather than rely only on income and expenditure surveys, to assess trends in inequality. Tax data is more authentic. It also allows researchers to trace the source of income. Generally speaking, aggregate national income accrues to two categories, which are labour and capital. It has been fashionable to include "human capital" too as part of the nation's capital stock. This term was popularised by Nobel laureate Gary Becker. Becker's work implies that richer nations have a much higher share of human capital in their nation's stock. Becker during his maiden trip to India a few years ago, highlighted the big difference in measured human capital stock as a share of GDP between India and the US.

Human capital is the monetary value of an individual's lifetime income attributed to his abilities, skills and training. But Piketty (and others) have pointed to a fallacy in this computation, which uses the same discount factor for labour and capital income flows. In any case Piketty excludes human capital since its ownership is not transferable nor can it be traded in the market, except in slave owning societies. So Piketty's "capital" is defined as the sum of all non-human assets that can be owned and exchanged in some market. The ownership of such capital is quite skewed. Inheritance and bequests worsen the skew over time. If in addition, the growth rate of national income is less than the rate of return to capital, then income growth worsens inequality.

This is one of the central insights of Piketty's book . It seems like a faint echo of Marx's analysis of the principle of infinite capital accumulation, and concentration in fewer hands. This is what led Marx to predict the end of capitalism in his 1848 Communist Manifesto. But his theory was published only in 1867, and that too was incomplete. As such his apocalyptic pronouncement was too hasty - as subsequent history showed. Piketty is much more careful about his statistical sources, the historical depth of his analysis, and much less ambitious with his pronouncement. But Marx's insight of capital accumulation pervades Piketty's book, and hence remains relevant.

Piketty's other big insight is in demolishing the Kuznets curve. Simon Kuznets postulated an inverse relationship between inequality and growth of national income. In the early high growth phase inequality of income becomes worse, as high income earners (mostly capitalists) benefit disproportionately. But as growth slows down, and there's more of the trickle-down effect, inequality is reduced. Piketty, armed with solid data says that this empirical finding was clouded due to the two world wars, which saw massive destruction of capital, and hence increase in the share of labour income. Were it not for the wars, capital concentration would have remained unabated.

According to Piketty, the only real corrective to capital's concentration is a global capital tax (because it is freely globally mobile), and a stiff inheritance tax. This is controversial, but what is not disputed is that inequality in income and wealth within each country has gotten much worse in the past three decades. The question is what do we do about it. For starters, we should read this excellent book.

Thomas Piketty
Thomas Piketty

It is important, I think, to insist that one of the most important issues in coming years will be the development of new forms of property and democratic control of capital. The dividing line between public capital and private capital is by no means as clear as some have believed since the fall of the Berlin Wall. As noted, there are already many areas, such as education, health, culture and the media in which the dominant forms of organisation and ownership have little to do with the polar paradigms of purely private capital (modelled on the joint stock company entirely owned by its shareholders) and purely public capital (based on a similar top-down logic in which the sovereign government decides all investments. There are obviously many intermediate forms of organisation capable of mobilising the talent of different individuals and the information at their disposal.

The author is Chief Economist, Aditya Birla Group

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