A brief exposition of the ideas in Thomas Piketty’s book, “Capital in the 21st Century”
Many people I’ve met have concluded that it is getting harder to “make it” in America. When I was a kid in the 1970’s our neighbor worked as a butcher at a chain grocery store and was able to own a nice house, support his wife and two kids, and live a comfortable life, purely on the basis of wages he received. This was typical in my neighborhood; regular working people without advanced degrees could live well in America. Now, people who work 40 hours/week at a grocery store have no chance of buying a house on their own, and can barely afford rent. What happened?
Surprisingly, it is fairly well established what happened, and also pretty well understood what needs to be done to bring things back to the state of affairs that existed in the 1970’s and 1980’s. This article explains it.
Another way of saying, “it is harder to make it”, is that wealth of the middle class in America has shrunk. The cost of houses, cars, college, etc. has risen much more than the wages and wealth of the regular people who make up the middle class. So we need to discuss what determines the wealth of the middle class. It is important to note that throughout almost all of human history there was essentially no middle class. Under monarchy, the basic government system in place for all except the last couple hundred years, the richest 1% to 10% of the people owned basically everything and the bottom 90% of people owned basically nothing. This makes sense in monarchy where, before democracy, the nobility (top 1%-2%) were in complete control of everything and almost everyone else were peasants and serfs. Even during most of the 1800’s and up to eve of World War I, it was a fact that the bottom 90% of people owned almost nothing, and that there was essentially no middle class.
However, between the two world wars (1914 through 1945) shocks to the system caused the creation of a middle class for the first time in human history. There were many reasons for this, among the most important of which were that many large fortunes were destroyed by the wars and by the stock market crash of 1929, European nations lost their colonies, rebuilding from the wars and the introduction of new technology caused very high economic growth rates, and finally, for one of the few times in human history, extremely high taxes on the wealthy were imposed. Taken together these shocks to the system caused the fraction of wealth owned by the top 1% to drop by a large amount, meaning that the share of wealth owned by people in the middle class became significant for the first time in human history. After WWII, due to high economic growth and high taxes on the wealthy, the middle class wealth continued to increase in size until the 1980’s, when it began to shrink again.
Figure 1: The Rise and Fall of the Middle Class
This is shown in Figure 1 for the United States from 1962 until today (using data from the WID). If you want to understand the decline in the middle class, it is important to understand this figure. The blue region shows the share of wealth owned by the middle class (defined as American individuals who own more than the 50% poorest Americans, but less than the top 10%, i.e., the middle 40% of America by wealth). In 1962 the middle class owned 28% of the total American wealth, where wealth is defined as the value of financial assets (stocks, etc.) plus non-financial assets (e.g. house and car), minus debts (e.g. mortgage, credit cards, student loans). The middle class share increased yearly, until 1985 when they owned 37% of the total wealth, the largest middle class in American history. Since 1985 the middle class has steadily shrunk, reaching again 28% by 2014 (the last year the WID data set describes).
This figure shows that our intuitive impression that it is getting harder to make it in America is backed up by hard data. Note, from this same plot, that total wealth of the top 1% (the rich), shown as the magenta region, was decreasing from 1962 until the 1980’s and then started to grow again in exactly the opposite behavior of the middle class. The total wealth of the top 10% excluding the top 1% (the well-off) shown in yellow, shrunk a little during this whole time, but stayed mostly the same. And, the bottom 50% of Americans (poor and/or lower middle class) shown by the red region owned very little in 1964, increasing their share up to 2% in 1985, but then losing even that, today owning less than nothing (meaning the poor/lower middle class have more debts than assets).
The change from an increasing middle class wealth to a shrinking middle class wealth happened between 1982 and 1988, and is marked by two vertical dashed lines. What happened during these years to make this change happen? Basically, under Reagan, the taxes on the wealthy were radically reduced. Lower taxes are a good thing, right? Nope, it depends on whose taxes are reduced.
There is an economic law that determines whether the middle class wealth is growing or shrinking. It is just the comparison of two numbers: g, the percentage yearly growth of the economy (very roughly the Gross Domestic Product (GDP) increase), and r, the yearly return on investment of capital (for example, think average yearly percentage yield of a stock market portfolio).
The law says that if r<g, then the middle class will grow, and if r>g, the middle class will shrink. This law is discussed extensively and shown to be true in Piketty’s book. What happened during and after the world wars caused r<g, so the middle class grew (and the wealth of the rich shrunk). In the 1980’s changes in g and r meant that r>g, so that since then the top 1% own an ever larger share of the wealth, meaning the middle class share of wealth is dropping.
Thomas Piketty wrote a 600 page book showing this economic law to be true, but it is fairly intuitive. Suppose the economy grows by 3% per year. For simplicity ignore the growth of population (this is covered in detail in Piketty’s book). In general then the total wealth of the country will grow by 3%, meaning on average everyone gets 3% richer; this is related to the famous Libertarian/Republican saying, “A rising tide lifts all boats”, an idea due to the economist Kuznets in the 1950s. This is half the story. But just because people are getting richer on average doesn’t mean that all or even most people are getting richer.
Next, consider r, and suppose that the after tax yearly return on investment is 7%. Almost all investments are owned by the richest Americans, so the top 1%(and some of the top 10%) get roughly 7% richer each year. If the average is increasing by 3%, but the wealthy get 7%, then each year the top 1% pull ahead of the average by more than 7%-3%=4%. So the SHARE of the total wealth owned by the top 1% will increase, and the share owned by the others will decrease. A relative gain of 4% may not seem like a lot, but if this continues for 28 years, the share owned by the rich will increase by a factor of 3, meaning everyone else’s share shrink by factor of 3. This intuitive argument is over simplified; Piketty’s book contains myriad caveats, uncertainties, other issues, and details, but the basic idea holds even after considering everything in detail.
From this perspective, it is easy to understand what is happening in Figure 1. The USA started income tax in 1914, and at various times had very large taxes on the wealthy. For example, in the 1940’s and 1950’s, under FDR and Eisenhower, the highest marginal tax rate was over 90% on income over $3 million. This tax rate was often changed but never dropped below 70% until Reagan’s tax cuts in the 1980s. If r was 7% before taxes, but the very wealthy paid 90% tax, that would reduce the real return on investment to less than 1%. Then we would have r<g and the middle class would grow (at the expense of the rich). There are many things that happened between the 1950s and 1985, but this is the most important ingredient to explain why, in Figure 1, the middle class grew until 1985. In the 1980’s, under Reagan, the top tax brackets were removed, so the highest marginal tax rate dropped in 1982, 1987, and 1988, ending up at 28% on income over $62,000. The dates of the Reagan tax reductions are shown by dashed vertical lines and the effect of these changes are easy to see in Figure 1. I mark the changes in highest marginal tax rate in the figure, but other changes in tax law were also very important, e.g. changes in capital gains tax, inheritance tax, etc. all of which went into increasing r. In addition, the US total growth rate, g, which in America was quite high after WWII, dropped during the 1980’s. Without meaningful taxes on the richest Americans, this meant we switched from r<g to r>g, and the middle class started shrinking again back towards 0 (as it was in the 1800's).
Figure 1 has the major changes in highest marginal tax rate marked with arrows showing when the changes occurred, along with the president at the time. Note that decreases in top tax rate were made while Republicans were in power, and that the few attempts at increasing these tax rates were made by Democrats. Anyone who cares about preserving and/or increasing the middle class should take note of this fact. The persistent political drive to lower taxes on the wealthy is the main cause shrinking the middle class.
This economic analysis makes the future of the American middle class very clear. Unless tax rates on the wealthy are increased substantially, r will remain greater than g in the forseeable future. Thus the middle class will continue to shrink and it will be ever harder to “make it” in America.
Next we ask: “What is the future of the middle class?” History does show us several possibilities. Look at Figures 2 and 3, where five different possibilities are shown.
First, some people, when presented with the idea of describing the share of total wealth owned by different classes of society, think I am advocating a “true equality”, where everyone has same amount of wealth. This is not true. The left hand pie chart in Figure 2 shows what this would look like. If everybody owned the same amount, the top 1% would own only 1% of the total wealth, shown as the tiny blue portion of the left hand pie chart, and the bottom 50% would own half of everything (shown in purple). This kind of true wealth equality has never existed in human history and would mean that a normal economic market is not operating. It would not be a good idea. I know of no one who advocates true wealth equality, since it doesn’t make economic sense.
FIGURE 2: Share of Wealth: What should the goal be?
However, history does show us cases where people are happy, society works well, and capitalism is used in a way more equal than America today. Figure 2 also shows the wealth shares of Scandinavia in the 1970s and 1980s, perhaps the most egalitarian society in history. Here the top 1% and bottom 50% own roughly the same amount, 20% of the total. The middle class (middle 40%) owns roughly the average amount of the entire society (35%), and the top 10% to 1% own 28%. I believe this would be a reasonable goal. If we set up a tax system to make r<g until this goal was met, it would be a large step forward for America. Next consider the USA’s actual past, present, and future as shown in Figure 3.
FIGURE 3: Percentage Share of Total Weath: Past, Present, and Likely Future of US inequality.
The top left pie chart in Figure 3 shows America in 1985, when we had the largest middle class in US history. The size of the middle class then was about the same as the ideal of Figure 2. The biggest difference between the USA in 1985 and the ideal case is that in USA, even in 1985, the bottom 50% owned basically nothing, and the top 10% owned 61%, perhaps a little high.
The top right pie chart in Figure 3 shows the USA in 2014. We see how the middle class has shrunk and the top 1% have increased their share due to current economic policies (mainly low taxes on the wealthy). Finally the bottom pie chart in Figure 3 shows the USA future if we continue with the current economic policies and don’t raise taxes on the wealthy in order to get r<g. If we continue on our current path, the USA will return to the inequality that existed in 1910, in the 1800’s, and in a typical monarchy, where the bottom 90% of people have nothing, and society is completely owned (and therefore controlled) by the top 10%, with the top 1% owning more than half of everything. The middle class will be gone, as can be seen as the tiny green and purple areas in the bottom pie chart. Continuing out the current trends seen in Figure 1 we could have arrive at this situation in only 20 to 40 years.
Note that in order to keep this article short and simple, I have left out many details and greatly oversimplified things. Piketty’s book, “Capital in the 21st Century” should be read if you are interested in these things. For example, I used the wage income tax brackets in the figures and discussion, but when considering r (the rate of return on capital), the tax on unearned income, is more important. The extremely wealthy have more unearned income (capital gains, dividends, rents, inheritances, etc.) than earned income (wages), and some of these incomes (e.g. capital gains and dividends) are currently taxed at the extremely low rate of 15% in the USA. Obviously to get r<g, we will need to tax unearned income above a high threshold at the same high rates as wage income. Note that from the 1940’s until the 1970’s the tax rate on large inheritances was nearly 80%, explaining, in part, why the middle class grew, and also showing that large “death taxes” have been an important part of a strong capitalism in America in the past. These certainly should be reinstated.
Also, I didn’t include the effects of savings rate, spending rates, transfers such as welfare, social security, and unemployment insurance, as well as many, many other effects. There are also very large uncertainties in the data, especially for wealth, since the rich hide huge amounts of money in offshore tax haven accounts which are not included in data coming from public tax records. Again, see Piketty’s book for the size of these effects and much more careful discussion.
Piketty’s book also offers solutions other than making r<g for the addressing the inequality problem. For instance, a annual progressive wealth tax, of say 1% on assets over $2 million, 2% on assets over $10 million and 3% on assets over $1 billion directly works to decrease the share of wealth owned by the 1%. Such a tax is completely consistent with market capitalism and could be used to reduce taxes for the bottom 99%, as well as pay for health care/education/environment/etc.
Finally, it should be clear why the information and discussion in this article is not well known. The people in the top 1% have a keen interest in making sure ordinary people in the bottom 99% do not understand that their policies are enriching themselves and shrinking the middle class. Many members of the top 1%, from the time of FDR, have strongly tried to reduce the top tax rates and roll back the New Deal (social security, unemployment insurance, Medicare, public schools, labor unions, etc.). Figure 1 shows why this makes sense: the growth of the middle class came directly from the wealth of the 1%. Since the wealthiest 1% own and control most large corporations, we see that “business friendly” really means policies that help the 1% at the expense of the middle class. Also, since almost all mass media are owned and controlled by the 1%, we almost never see meaningful discussion of these ideas in the mainstream press. So-called liberal media such as the New York Times, Washington Post, CNN, NBC in fact almost always ridicule these ideas as impractical, socialist or even communism, even though they were part of main stream American economic policy from the 1940s through the 1970s, and are a big part of what made America great after WWII. The supposedly liberal media are owned and controlled, of course, by large corporations and the extremely wealthy, so it is not surprising that, like all privately owned entities, they serve the needs of their owners. In my opinion the US mainstream media do a “good cop/bad cop” routine on the American public, with Fox and AM radio playing the bad cop and the “liberal media” playing the good cop, but both conspiring to not let these ideas out. As proof of this, note that in 2016, when Bernie Sanders started outlining some of these ideas, ALL the “liberal” main stream media ignored the ideas, instead focusing on personalities, etc. Fox and the right wing media did focus on the ideas, but only to distort and lie about them, knowing their audience was not very demanding of factual information.
So it will be a struggle to get these ideas out, and a further struggle to implement them. But, the existence of the middle class depends upon us winning this struggle.
Frequently Asked Questions
1. What about people who say high taxes on the wealthy is unfair?
There are some rather well educated and well paid people whose job seems to be to stop the ideas above from settling into public consciousness. They often use statistics to “prove” that these ideas are not true and/or unfair. One deceptive way of defending the destruction of the middle class is to use “fairness”, and to claim that the wealthy are already paying more than their share of taxes. They use (true) statistics, such as that the top 1% of American earners pay almost 40% of all federal income taxes, which is more than the entire bottom 90% pay. They then ask, “How can raising taxes on the wealthy be fair?” This is a deceptive trick to fool those who otherwise might be receptive to the arguments I made above. First, there are other taxes besides the federal income tax, and these should be included, and second the wealthy pay a large percentage of the taxes simply because they make a large percentage of the income. For example, including taxes besides federal income taxes, the top 1% pay 24% of total taxes, but get 21% of the total income. That doesn’t seem so unfair. It is even better to use wealth instead of income, in which case the top 1% pay 24% of taxes while owning 37% of the total wealth. This is certainly not unfavorable to the wealthy, especially if one considers disposable income and savings. The average person in the top 1% makes about $2 million dollars per year and has plenty of money to spare after subtracting food, shelter, taxes, and basic living expenses. Thus the wealthy can (and do) save a large fraction of their income, meaning that next year they are even richer. The poor and middle class spend a much larger fraction of their income just surviving and save much less, basically remaining in the same state of wealth. Taken together these facts means that each year the middle class owns a smaller percentage of the total wealth, while the rich get richer, i.e. the middle class wealth, as I defined it above, shrinks. As above, the obvious solution is to increase the tax rate on the wealthy until their share of the total wealth does not increase, or better yet, goes down to what it was in the 1980's.
2. I’ve heard that the middle class is not shrinking, but actually growing and that middle class people are doing better than in the past.
A second common deception seen in business pages are “official” reports that say that the middle class is not shrinking, or that if it is, it is actually a good thing. For example, in the Guardian newspaper (April 13, 2019, Richard Reeves) there was an article on an OECD report saying that, yes the middle class is shrinking, but it is because more people are moving into the wealthy class, therefore everyone should stop worrying about the shrinking middle class. The article uses lots of statistics, all of which, while true, have the purpose of fooling people into not seeing or understanding the shrinking of the middle class wealth. The main trick used in this article (and many other business analyses) is to use a seemingly reasonable but deceptive definition of the “middle class”. They define the “size” of the middle class as the fraction of people whose income is between 75% and 200% of the median income. This fraction of people says nothing about how much money these people have relative to the top 1%, so says almost nothing about the growth or shrinking of the wealth of the middle class. Note also that this definition pegs the middle class size to the median income, so even if the median income drops by a large factor, it may have little impact on the “size” of this middle class. For example, the article above states that in the 1980’s the “size” of the middle class was 64% of the total US population, while currently it is 61%, not a very big change. Then, to increase the deception, the article analyzes that small change and says that the 61% is smaller than the 64% because more people are above the 200% threshold than they were in the 1980’s, and thus are “richer”.
Note that for Piketty’s and our definition of the middle class, the fraction of people in the middle class doesn’t change; it is always the 40% of people who make more than the poorest 50%, but less than the richest 10%. Under our definition, the “size” of the middle class is meaningless. However, the wealth of the middle class dropped from 37% of the total wealth in 1980 to 27% in 2014, clearly shrinking in a bad way. The fraction of income earned by our middle class dropped from 50% in 1982 to 42% in 2014, also representing an important shrinking in middle class earnings. As an example of how bad the OECD definition of middle class is, consider an extreme case of a feudal system where the top 1% (the nobility) earn 95% of the total and the bottom 99% (serfs) earn 5%. One might also suppose in such a society that for the bottom 99%, debts outweigh assets, implying a total wealth of less than zero. In this (artificial) example there is clearly no middle class, since everyone except the top 1% earns and owns almost nothing. However, the size of the middle class by the deceptive definition above, could still be 61%, the same as it actually is today in the US. [Proof: Suppose a total population of 10 million people with a total income of 1 trillion dollars per year, so the top 1% consist of 100,000 people who earn a total of $950 billion per year and the bottom 99% are 9.9 million who earn a total of $50 billion. Thus the top 1% earn $9.5M each on average and the bottom 99% earn $5050 each on average. The OECD definition above uses median income, not average income, so suppose the incomes of the poorest 99% are distributed evenly between $100 and $10000, giving the correct average of $5050, and implying a median income of $5000. Thus members of this “middle class” have incomes between 0.75*5000=$3750 up to 2*5000= $10000. Thus we find the fraction of people in this “middle class” is 0.99(10000–3750)/(10000–100) = 62% of the total, basically the same as today. Thus, this definition says that the size of middle class does not change even if they go from earning roughly 42% of total income as they do today, to earning and owning almost nothing.]
In conclusion, this deceptive definition of the middle class should not be used. Anyone using it is probably trying to HIDE the actual shrinking of the middle class wealth.
3. I thought union busting and shifting jobs to China is what weakened the middle class?
Both destruction of unions in the US and transferring of manufacturing jobs overseas are included in the r>g formula. When unions are destroyed workers make less money than when unions are in force. That money lost by workers goes into company profits which are returned to the company’s owners and management in the form of dividends, stock options, and increased stock prices, etc. Thus the return on capital investment, r, increases, meaning r>g is more likely.
When manufacturing jobs are moved overseas, say to China, this also increases company profits, increasing r. In addition, the money that was going into the US economy now flows to the Chinese economy. Thus the growth that would have gone to the USA goes to China. Thus the American g goes down and the Chinese g goes up. Due to the huge number of jobs transferred to China, China has had g>9% for decades, which has been very good for the Chinese middle class. Lowering g and increasing r, makes r>g more likely and shrinks the US middle class.
It is possible to address the union busting and job transferring problems directly. In Germany, a law says that 50% of board of director members of large companies must be elected from the employees. The German electronics company, Siemens, could increase its profits by moving manufacturing to China, but when that proposal is brought to the board of directors, the employee members just vote no. So Germany has not lost as many manufacturing jobs as the USA. In addition laws that help destroy unions, such as the so-called “right to work” laws, common throughout the US South and Midwest, could be removed and stronger laws supporting unionization enacted. Alternatively, we could let the wealthy make more money and just tax that money more highly, returning it to ordinary people via socialized health care, expanded free public education including College, etc.
4. Suppose the tax changes suggested are not made and middle class wealth continues to shrink. What will that look like?
We have a long history of times with no middle class and there are many countries in the world today that have essentially no middle class. So we can see what it was like in those times and what it is like in these places and expect the US in the future to look like those times and places. Actually, finding historically accurate description of average (aka poor) people’s life in the past is difficult; only the wealthy were literate, and the stories were almost entirely written by and for the wealthy. So it is easier to look at third world countries today. In a typical third world country today there are gated areas where the wealthy live protected by guards. The streets are usually dirty and many people live in ramshackle “tiny houses” usually called slums. Most people do not own cars, attend school, have access to health care, clean water, good food, or even have regular jobs. Begging and menial labor are common. The best jobs available to regular (aka non-wealthy) people are as servants to the wealthy. The police are typically corrupt, protect only the wealthy (who buy them off) and prey upon the poor. The government may be a dictatorship or democracy, but corruption means that even in democracies the poor have little to no impact on the government, which serves only the wealthy.
This is what we should expect the US to be like in the future unless the middle class wealth is protected. Since the middle class shrinks only a few percent per year, we expect the US transition to 3rd world conditions to happen fairly slowly. In fact, this transition started in the 1980’s and is fairly obvious today to anyone paying attention.
To a middle class person living during the transition it just looks like everything becoming extremely expensive and therefore unaffordable. Technically it happens through inflation, where prices of everything go up faster than wages, and it gets harder and harder to find a good job. So, the current difficulty of affording rent, health care, a new car, paying for college, etc. is just evidence of the shrinking of middle class wealth since the 1980’s caused by r>g. Today many people have to work overtime or several jobs to survive and still can’t afford rent. Expect more of this, more homelessness, more poverty, etc., until most people live in slums and can’t find good work.
Note: the data from the figures come from the WID, Wealth Inequality Database [https://wid.world] and [http://piketty.pse.ens.fr/capital21c]. The Figure starts in 1962 since that is the earliest data on the middle class listed in the WID, but the increase in wealth owned by the middle class was increasing through the 1940s and 1950s.