Capital in the Twenty-First Century

  It is striking, moreover, how frequently opponents of progressive taxation, who were clearly in the majority among the economic and financial elite of Belle Époque France, rather hypocritically relied on the argument that France, being a naturally egalitarian country, had no need of progressive taxes. A typical and particularly instructive example is that of Paul Leroy-Beaulieu, one of the most influential economists of the day, who in 1881 published his famous Essai sur la répartition des richesses et sur la tendance à une moindre inégalité des conditions (Essay on the Distribution of Wealth and the Tendency toward Reduced Inequality of Conditions), a work that went through numerous editions up to the eve of World War I.20 Leroy-Beaulieu actually had no data of any kind to justify his belief in a “tendency toward a reduced inequality of conditions.” But never mind that: he managed to come up with dubious and not very convincing arguments based on totally irrelevant statistics to show that income inequality was decreasing.21 At times he seemed to notice that his argument was flawed, and he then simply stated that reduced inequality was just around the corner and that in any case nothing of any kind must be done to interfere with the miraculous process of commercial and financial globalization, which allowed French savers to invest in the Panama and Suez canals and would soon extend to czarist Russia. Clearly, Leroy-Beaulieu was fascinated by the globalization of his day and scared stiff by the thought that a sudden revolution might put it all in jeopardy.22 There is of course nothing inherently reprehensible about such a fascination as long as it does not stand in the way of sober analysis. The great issue in France in 1900–1910 was not the imminence of a Bolshevik revolution (which was no more likely than a revolution is today) but the advent of progressive taxation. For Leroy-Beaulieu and his colleagues of the “center right” (in contrast to the monarchist right), there was one unanswerable argument to progressivity, which right-thinking people should oppose tooth and nail: France, he maintained, became an egalitarian country thanks to the French Revolution, which redistributed the land (up to a point) and above all established equality before the law with the Civil Code, which instituted equal property rights and the right of free contract. Hence there was no need for a progressive and confiscatory tax. Of course, he added, such a tax might well be useful in a class-ridden aristocratic society like that of Britain, across the English Channel, but not in France.23

  FIGURE 14.2. Top inheritance tax rates, 1900–2013

  The top marginal tax rate of the inheritance tax (applying to the highest inheritances) in the United States dropped from 70 percent in 1980 to 35 percent in 2013.

  Sources and series: see piketty.pse.ens.fr/capital21c.

  As it happens, if Leroy-Beaulieu had bothered to consult the probate records published by the tax authorities shortly after the reform of 1901, he would have discovered that wealth was nearly as concentrated in republican France during the Belle Époque as it was in monarchical Britain. In parliamentary debate in 1907 and 1908, proponents of the income tax frequently referred to these statistics.24 This interesting example shows that even a tax with low rates can be a source of knowledge and a force for democratic transparency.

  In other countries the estate tax was also transformed after World War I. In Germany, the idea of imposing a small tax on the very largest estates was extensively discussed in parliamentary debate at the end of the nineteenth century and beginning of the twentieth. Leaders of the Social Democratic Party, starting with August Bebel and Eduard Bernstein, pointed out that an estate tax would make it possible to decrease the heavy burden of indirect taxes on workers, who would then be able to improve their lot. But the Reichstag could not agree on a new tax: the reforms of 1906 and 1909 did institute a very small estate tax, but bequests to a spouse or children (that is, the vast majority of estates) were entirely exempt, no matter how large. It was not until 1919 that the German estate tax was extend to family bequests, and the top rate (on the largest estates) was abruptly increased from 0 to 35 percent.25 The role of the war and of the political changes it induced seems to have been absolutely crucial: it is hard to see how the stalemate of 1906–1909 would have been overcome otherwise.26

  Figure 14.2 shows a slight upward tick in Britain around the turn of the century, somewhat greater for the estate tax than for the income tax. The rate on the largest estates, which had been 8 percent since the reform of 1896, rose to 15 percent in 1908—a fairly substantial amount. In the United States, a federal tax on estates and gifts was not instituted until 1916, but its rate very quickly rose to levels higher than those found in France and Germany.

  Confiscatory Taxation of Excessive Incomes: An American Invention

  When we look at the history of progressive taxation in the twentieth century, it is striking to see how far out in front Britain and the United States were, especially the latter, which invented the confiscatory tax on “excessive” incomes and fortunes. Figures 14.1 and 14.2 are particularly clear in this regard. This finding stands in such stark contrast to the way most people both inside and outside the United States and Britain have seen those two countries since 1980 that it is worth pausing a moment to consider the point further.

  Between the two world wars, all the developed countries began to experiment with very high top rates, frequently in a rather erratic fashion. But it was the United States that was the first country to try rates above 70 percent, first on income in 1919–1922 and then on estates in 1937–1939. When a government taxes a certain level of income or inheritance at a rate of 70 or 80 percent, the primary goal is obviously not to raise additional revenue (because these very high brackets never yield much). It is rather to put an end to such incomes and large estates, which lawmakers have for one reason or another come to regard as socially unacceptable and economically unproductive—or if not to end them, then at least to make it extremely costly to sustain them and strongly discourage their perpetuation. Yet there is no absolute prohibition or expropriation. The progressive tax is thus a relatively liberal method for reducing inequality, in the sense that free competition and private property are respected while private incentives are modified in potentially radical ways, but always according to rules thrashed out in democratic debate. The progressive tax thus represents an ideal compromise between social justice and individual freedom. It is no accident that the United States and Britain, which throughout their histories have shown themselves to value individual liberty highly, adopted more progressive tax systems than many other countries. Note, however, that the countries of continental Europe, especially France and Germany, explored other avenues after World War II, such as taking public ownership of firms and directly setting executive salaries. These measures, which also emerged from democratic deliberation, in some ways served as substitutes for progressive taxes.27

  Other, more specific factors also mattered. During the Gilded Age, many observers in the United States worried that the country was becoming increasingly inegalitarian and moving farther and farther away from its original pioneering ideal. In Willford King’s 1915 book on the distribution of wealth in the United States, he worried that the nation was becoming more like what he saw as the hyperinegalitarian societies of Europe.28 In 1919, Irving Fisher, then president of the American Economic Association, went even further. He chose to devote his presidential address to the question of US inequality and in no uncertain terms told his colleagues that the increasing concentration of wealth was the nation’s foremost economic problem. Fisher found King’s estimates alarming. The fact that “2 percent of the population owns more than 50 percent of the wealth” and that “two-thirds of the population owns almost nothing” struck him as “an undemocratic distribution of wealth,” which threatened the very foundations of US society. Rather than restrict the share of profits or the return on capital arbitrarily—possibilities Fisher mentioned only to reject them—he argued that the best solution was to impose a heavy tax on the largest estates (he mentioned a tax rate of two-thirds the size of the estate, rising to 100 percent if the estate was more than t
hree generations old).29 It is striking to see how much more Fisher worried about inequality than Leroy-Beaulieu did, even though Leroy-Beaulieu lived in a far more inegalitarian society. The fear of coming to resemble Old Europe was no doubt part of the reason for the American interest in progressive taxes.

  Furthermore, the Great Depression of the 1930s struck the United States with extreme force, and many people blamed the economic and financial elites for having enriched themselves while leading the country to ruin. (Bear in mind that the share of top incomes in US national income peaked in the late 1920s, largely due to enormous capital gains on stocks.) Roosevelt came to power in 1933, when the crisis was already three years old and one-quarter of the country was unemployed. He immediately decided on a sharp increase in the top income tax rate, which had been decreased to 25 percent in the late 1920s and again under Hoover’s disastrous presidency. The top rate rose to 63 percent in 1933 and then to 79 percent in 1937, surpassing the previous record of 1919. In 1942 the Victory Tax Act raised the top rate to 88 percent, and in 1944 it went up again to 94 percent, due to various surtaxes. The top rate then stabilized at around 90 percent until the mid-1960s, but then it fell to 70 percent in the early 1980s. All told, over the period 1932–1980, nearly half a century, the top federal income tax rate in the United States averaged 81 percent.30

  It is important to emphasize that no continental European country has ever imposed such high rates (except in exceptional circumstances, for a few years at most, and never for as long as half a century). In particular, France and Germany had top rates between 50 and 70 percent from the late 1940s until the 1980s, but never as high as 80–90 percent. The only exception was Germany in 1947–1949, when the rate was 90 percent. But this was a time when the tax schedule was fixed by the occupying powers (in practice, the US authorities). As soon as Germany regained fiscal sovereignty in 1950, the country quickly returned to rates more in keeping with its traditions, and the top rate fell within a few years to just over 50 percent (see Figure 14.1). We see exactly the same phenomenon in Japan.31

  The Anglo-Saxon attraction to progressive taxation becomes even clearer when we look at the estate tax. In the United States, the top estate tax rate remained between 70 and 80 percent from the 1930s to the 1980s, while in France and Germany the top rate never exceeded 30–40 percent except for the years 1946–1949 in Germany (see Figure 14.2).32

  The only country to match or surpass peak US estate tax rates was Britain. The rates applicable to the highest British incomes as well as estates in the 1940s was 98 percent, a peak attained again in the 1970s—an absolute historical record.33 Note, too, that both countries distinguished between “earned income,” that is, income from labor (including both wages and nonwage compensation) and “unearned income,” meaning capital income (rent, interests, dividends, etc.). The top rates indicated in Figure 14.1 for the United States and Britain applied to unearned income. At times, the top rate on earned income was slightly lower, especially in the 1970s.34 This distinction is interesting, because it is a translation into fiscal terms of the suspicion that surrounded very high incomes: all excessively high incomes were suspect, but unearned incomes were more suspect than earned incomes. The contrast between attitudes then and now, with capital income treated more favorably today than labor income in many countries, especially in Europe, is striking. Note, too, that although the threshold for application of the top rates has varied over time, it has always been extremely high: expressed in terms of average income in the decade 2000–2010, the threshold has generally ranged between 500,000 and 1 million euros. In terms of today’s income distribution, the top rate would therefore apply to less than 1 percent of the population (generally somewhere between 0.1 and 0.5 percent).

  The urge to tax unearned income more heavily than earned income reflects an attitude that is also consistent with a steeply progressive inheritance tax. The British case is particularly interesting in a long-run perspective. Britain was the country with the highest concentration of wealth in the nineteenth and early twentieth centuries. The shocks (destruction, expropriation) endured by large fortunes fell less heavily there than on the continent, yet Britain chose to impose its own fiscal shock—less violent than war but nonetheless significant: the top rate ranged from 70 to 80 percent or more throughout the period 1940–1980. No other country devoted more thought to the taxation of inheritances in the twentieth century, especially between the two world wars.35 In November 1938, Josiah Wedgwood, in the preface to a new edition of his classic 1929 book on inheritance, agreed with his compatriot Bertrand Russell that the “plutodemocracies” and their hereditary elites had failed to stem the rise of fascism. He was convinced that “political democracies that do not democratize their economic systems are inherently unstable.” In his eyes, a steeply progressive inheritance tax was the main tool for achieving the economic democratization that he believed to be necessary.36

  The Explosion of Executive Salaries: The Role of Taxation

  After experiencing a great passion for equality from the 1930s through the 1970s, the United States and Britain veered off with equal enthusiasm in the opposite direction. Over the past three decades, their top marginal income tax rates, which had been significantly higher than the top rates in France and Germany, fell well below French and German levels. While the latter remained stable at 50–60 percent from 1930 to 2010 (with a slight decrease toward the end of the period), British and US rates fell from 80–90 percent in 1930–1980 to 30–40 percent in 1980–2010 (with a low point of 28 percent after the Reagan tax reform of 1986) (see Figure 14.1).37 The Anglo-Saxon countries have played yo-yo with the wealthy since the 1930s. By contrast, attitudes toward top incomes in both continental Europe (of which Germany and France are fairly typical) and Japan have held steady. I showed in Part One that part of the explanation for this difference might be that the United States and Britain came to feel that they were being overtaken by other countries in the 1970s. This sense that other countries were catching up contributed to the rise of Thatcherism and Reaganism. To be sure, the catch-up that occurred between 1950 and 1980 was largely a mechanical consequence of the shocks endured by continental Europe and Japan between 1914 and 1945. The people of Britain and the United States nevertheless found it hard to accept: for countries as well as individuals, the wealth hierarchy is not just about money; it is also a matter of honor and moral values. What were the consequences of this great shift in attitudes in the United States and Britain?

  If we look at all the developed countries, we find that the size of the decrease in the top marginal income tax rate between 1980 and the present is closely related to the size of the increase in the top centile’s share of national income over the same period. Concretely, the two phenomena are perfectly correlated: the countries with the largest decreases in their top tax rates are also the countries where the top earners’ share of national income has increased the most (especially when it comes to the remuneration of executives of large firms). Conversely, the countries that did not reduce their top tax rates very much saw much more moderate increases in the top earners’ share of national income.38 If one believes the classic economic models based on the theory of marginal productivity and the labor supply, one might try to explain this by arguing that the decrease in top tax rates spurred top executive talent to increase their labor supply and productivity. Since their marginal productivity increased, their salaries increased commensurately and therefore rose well above executive salaries in other countries. This explanation is not very plausible, however. As I showed in Chapter 9, the theory of marginal productivity runs into serious conceptual and economic difficulties (in addition to suffering from a certain naïveté) when it comes to explaining how pay is determined at the top of the income hierarchy.

  A more realistic explanation is that lower top income tax rates, especially in the United States and Britain, where top rates fell dramatically, totally transformed the way executive salaries are determined. It is always difficult for a
n executive to convince other parties involved in the firm (direct subordinates, workers lower down in the hierarchy, stockholders, and members of the compensation committee) that a large pay raise—say of a million dollars—is truly justified. In the 1950s and 1960s, executives in British and US firms had little reason to fight for such raises, and other interested parties were less inclined to accept them, because 80–90 percent of the increase would in any case go directly to the government. After 1980, the game was utterly transformed, however, and the evidence suggests that executives went to considerable lengths to persuade other interested parties to grant them substantial raises. Because it is objectively difficult to measure individual contributions to a firm’s output, top managers found it relatively easy to persuade boards and stockholders that they were worth the money, especially since the members of compensation committees were often chosen in a rather incestuous manner.

  Furthermore, this “bargaining power” explanation is consistent with the fact that there is no statistically significant relationship between the decrease in top marginal tax rates and the rate of productivity growth in the developed countries since 1980. Concretely, the crucial fact is that the rate of per capita GDP growth has been almost exactly the same in all the rich countries since 1980. In contrast to what many people in Britain and the United States believe, the true figures on growth (as best one can judge from official national accounts data) show that Britain and the United States have not grown any more rapidly since 1980 than Germany, France, Japan, Denmark, or Sweden.39 In other words, the reduction of top marginal income tax rates and the rise of top incomes do not seem to have stimulated productivity (contrary to the predictions of supply-side theory) or at any rate did not stimulate productivity enough to be statistically detectable at the macro level.40