Most readers of Standpoint will by now be aware of Professor Thomas Piketty and his best-selling book, Capital in the Twenty-First Century.
His thesis is that the long run return on capital is always higher than the growth in output (r>g). The wealthy are able to save and accumulate wealth faster than others earn wages, in proportion to r-g, and the result is a spiral of inevitable inequality. The belief that free markets spread wealth more fairly is exposed as a myth inspired by misunderstanding the destruction of assets in the wars of the 20th century. Although inequality is not quite at pre-1914 levels, it soon will be thanks to high executive salaries that will found the next generation of mega-fortunes. The only way to save capitalism from itself, says Piketty, is to reintroduce punitive income tax and a new global wealth tax. This analysis is backed by 500 pages of charts, tables and relatively engaging prose.
Let us put Piketty’s proposals to the test. William is chief executive of Norton Corp. He is paid £350,000, which at present is taxed thus:
Headline salary: £350,000£32,000 @ 20 per cent tax: (£6,400)£118,000 @ 40 per cent tax: (£47,200)£200,000 @ 45 per cent tax: (£90,000)Take-home pay: £206,400Effective tax rate: 41.0 per cent
(Income bands have been rounded, and national insurance contributions ignored, for simplicity. As someone earning above £150,000 William is not entitled to a personal allowance.)
Norton Corp is discussing a salary increase for William to £500,000. If the UK tax system were unchanged that would leave him in the following position:
Headline salary: £500,000£32,000 @ 20 per cent tax: (£6,400)£118,000 @ 40 per cent tax: (£47,200)£350,000 @ 45 per cent tax: (£157,500)Take-home pay: £288,900Effective tax rate: 42.2 per cent
This doesn’t capture the full picture. Norton Corp, as his employer, can claim William’s salary as a deductible business expense, reducing the profits liable to corporation tax. So the extra £67,500 tax paid by William would be offset by a saving for the company of 20 per cent on the salary increase. But it still leaves the Exchequer better off by £37,500.
There, in a nutshell, is the justification for moderate income tax rates: it encourages value to move from being taxed in companies at 20 per cent to being taxed in the hands of individuals at 40 per cent/45 per cent. This is associated with the Laffer Curve, the thesis that there is an optimal tax rate which maximises revenue because a higher rate encourages avoidance and a lower rate raises less. According to taste this can be buttressed by arguments that people like William merit high pay as a reward, or need to be encouraged to work harder, but the foundation is all about cash-flow for the state.
Piketty rejects this. Government cash-flow is not a concern. There is a practical limit to the amount which a government can raise in tax, he agrees, and most European states have now reached that level (implicitly conceding Laffer’s argument without mentioning him — an interesting omission for a 577-page book about fiscal policy). But, says Piketty, it is equally impractical to cut that amount because it would become impossible to fund the welfare services of a modern state. For Piketty the main role of tax policy is to achieve social objectives, arranging how the burden is distributed. He advocates returning to a highly progressive income tax, levied at 60 per cent on the top 10 per cent of salaries and 80 per cent on the top 1 per cent.
On a rough-and-ready translation from figures in the book, William is already at the threshold where the new 80 per cent rate would bite, and the 60 per cent rate would probably come in where the existing UK additional 45 per cent rate starts. Under Piketty’s tax system William’s increased salary would be treated:
Headline salary: £500,000£32,000 @ 20 per cent tax: (£6,400)£118,000 @ 40 per cent tax: (£47,200)£200,000 @ 60 per cent tax: (£120,000)£150,000 @ 80 per cent tax: (£120,000)Take-home pay: £206,400Effective tax rate: 58.7 per cent
In other words, he would be exactly where he was before the pay increase under the old tax system. Presumably William would argue that he needs the increase just in order to stand still. On the other hand, we can also imagine the board of Norton Corp asking themselves if they couldn’t find a better use for their money than to hand 80p in every £1 of it straight to the Exchequer. This is what Piketty wants them to wonder. He contends that the principal impact of tax cuts since the 1980s has been to strengthen the bargaining power of senior executives in their negotiations with directors who have limited personal interest in resisting their demands. The result, he says, has been an explosion of executive pay unjustified by any explosion in talent or performance.
If Norton Corp froze William’s salary, and left him within the new 60 per cent tax band, his take-home pay would fall to £176,400. That will hurt him and his family, of course, but the board of Norton Corp might consider that if William cannot get by on over £170,000 then he probably hasn’t got the right sense of cost-control to be running their company in the first place. The new 80 per cent tax band will raise zero cash for the Exchequer-but, as Piketty cheerfully admits, he doesn’t intend it to raise any revenue anyway. It’s meant to discourage employers from paying salaries that large. In our example it has achieved its objective.
So William’s salary is frozen at the level of the new 80 per cent rate threshold. That gives the Exchequer a windfall gain of £30,000. For the foreseeable future the state will be partly financing the increases in William’s take-home pay, because even if his headline salary does not alter, for every £1 rise in the basic rate threshold he gains 40p and for every £1 rise in the 40 per cent band threshold he gains 20p. Over time the Exchequer’s gains from the new 60 per cent rate band will taper off.
Norton Corp is an ethical organisation, so of course it never occurs to the board to hire William’s wife as a consultant on £150,000. Had it done so, William’s household would be £13,900 better off than if the company had paid him the full salary increase under the pre-Piketty tax system. But, as I say, that would never happen in the real world.
What, then, does Norton Corp do with the £150,000? Suppose it does nothing. The company’s reported profit will be £150,000 higher. Of course, the company will then pay extra corporation tax of £30,000 (another windfall for the Exchequer) but to the outside world the directors have delivered better performance.
In aggregate terms nothing has happened to the economy. National income remains exactly the same. There has been no change in g, the growth in output. However, there has been a shift of £150,000 from Labour Income into Capital Income. That is significant, because net Capital Income is the value which Piketty uses to calculate the return on capital. There has been no alteration in the UK capital stock. Therefore, by not paying William a salary increase, the return on capital, r, has increased. Moreover, r-g has increased, too. According to Piketty these are Bad Things. Which is a little awkward.
Only a temporary embarrassment. Obviously, if a company’s reported pre-tax profits increase, we can expect its share price to increase, too — raising the market value of the capital stock to a point where r returns to its long run average. (Actually, that does open a can of worms. Piketty derives his figures on rates of return and inequality using the market value of assets. That creates a gigantic circular argument in his definition of “capital” and his calculation of r. Nobody should have the Cambridge Capital Controversy thrust upon them unless they are about to undergo root canal surgery so we shall pretend that this problem does not exist — as, indeed, does Piketty.)
A reasonable price/earnings ratio would be in the order of 10. Thus, the £150,000 saving on William’s salary will lead to a £1.5 million increase in the market capitalisation of Norton Corp. A nice little windfall for shareholders. I wonder what that does for the inequality of wealth.
Ah, the professor is ahead of us. His second weapon is a new annual tax on capital. It is not enough to prevent new fortunes accumulating by stopping high earners from saving. The state also has to rein in the growth of inherited wealth through an annual progressive levy. Although the details are sketchy, he suggests a charge of 1 per cent on estates of €1 million or more (£800,000) with a top rate of 2 per cent on estates in excess of €5 million (approximately £4 million). Piketty realises that this is a utopian scheme since it would require worldwide assets to be accounted for, and he devotes considerable space to explaining how governments would share banking information. That, he concedes, is a long way off. However he believes it would be feasible to implement the tax on an EU-wide basis — and he means with the UK included — and the revenues would helpfully solve the eurozone sovereign debt crisis.
Such a tax would dampen the uplift in share prices. In our example, Norton Corp’s capitalisation might only rise by £1.47 million. Nevertheless, Piketty is quite right to say that his new tax would raise considerable revenues and, all other things remaining equal, over a long period would have a significant impact on wealth distribution. The margin (r-g) would shrink and the forces of accumulation would be impaired. Unfortunately, all things never do remain equal. Shareholders are just as capable of working out the implications.
Anyone with access to sophisticated investment management tools — say, a pocket calculator — could deduce that every £1 cost saving in a company would deliver a gain in wealth of around £9.60 to shareholders even after paying Piketty’s new tax. What do you imagine the instructions of those shareholders will be to the directors they employ to manage the companies they own? Piketty is worried that income tax cuts since the 1980s inflated the bargaining power of senior managers. Well, if that process is reversed, it surely means that bargaining power passes back to the shareholders.
Where cost savings come from is irrelevant. So companies might slash their budgets for R&D, maintenance or new plant and equipment — you know, like we saw in the UK when we last had high income tax rates. The softest target will be the workforce. The volume saving from restraining wage increases would be considerable and far easier to justify when the bosses are having their salaries frozen or squeezed. The overall effect of this corporate austerity would be an even lower growth rate. We can expect r-g to remain the same, if not to expand.
To overcome income inequality at the high-earning end which carries the threat of a future increase in wealth inequality, Piketty wants to cause an immediate increase in wealth inequality which carries the threat of an increase in income inequality by squeezing low-earners. Hmm. Piketty is wasted at the Paris School of Economics. He should be running France — indeed, judging by that country’s current combination of ever-higher taxes and economic stagnation, perhaps he already is.