To apportion mixed incomes between capital and labor, I have used the same average capital-labor split as for the rest of the economy. This is the least arbitrary choice, and it appears to yield results close to those obtained with the other two commonly used methods.2 It remains an approximation, however, since the very notion of a clear boundary between income from capital and income from labor is not clearly defined for mixed incomes. For the current period, this makes virtually no difference: because the share of mixed income in national income is small, the uncertainty about capital’s share of mixed income affects no more than 1–2 percent of national income. In earlier periods, and especially for the eighteenth and nineteenth centuries when mixed incomes may have accounted for more than half of national income, the uncertainties are potentially much greater.3 That is why available estimates of the capital share for the eighteenth and nineteenth centuries can only be counted as approximations.4
Despite these caveats, my estimates for capital’s share of national income in this period (at least 40 percent) appear to be valid: in both Britain and France, the rents paid to landlords alone accounted for 20 percent of national income in the eighteenth and early nineteenth centuries, and all signs are that the return on farmland (which accounted for about half of national capital) was slightly less than the average return on capital and significantly less than the return on industrial capital, to judge by the very high level of industrial profits, especially during the first half of the nineteenth century. Because of imperfections in the available data, however, it is better to give an interval—between 35 and 40 percent—than a single estimate.
For the eighteenth and nineteenth centuries, estimates of the value of the capital stock are probably more accurate than estimates of the flows of income from labor and capital. This remains largely true today. That is why I chose to emphasize the evolution of the capital/income ratio rather than the capital-labor split, as most economic researchers have done in the past.
The Notion of the Pure Return on Capital
The other important source of uncertainties, which leads me to think that the average rates of return indicated in Figures 6.3 and 6.4 are somewhat overestimated, so that I also indicate what might be called the “pure” rate of return on capital, is the fact that national accounts do not allow for the labor, or at any rate attention, that is required of anyone who wishes to invest. To be sure, the cost of managing capital and of “formal” financial intermediation (that is, the investment advice and portfolio management services provided by a bank or official financial institution or real estate agency or managing partner) is obviously taken into account and deducted from the income on capital in calculating the average rate of return (as presented here). But this is not the case with “informal” financial intermediation: every investor spends time—in some cases a lot of time—managing his own portfolio and affairs and determining which investments are likely to be the most profitable. This effort can in certain cases be compared to genuine entrepreneurial labor or to a form of business activity.
It is of course quite difficult—and to some extent arbitrary—to calculate the value of this informal labor in any precise way, which explains why it is omitted from national accounts. In theory, one would have to measure the time spent on investment-related activities and ascribe an hourly value to that time, based perhaps on the remuneration of equivalent labor in the formal financial or real estate sector. One might also imagine that these informal costs are greater in periods of very rapid economic growth (or high inflation), for such times are likely to require more frequent reallocation of investments and more time researching the best investment opportunities than in a quasi-stagnant economy. For example, it is difficult to believe that the average returns on capital of close to 10 percent that we observe in France (and to a lesser degree in Britain) during periods of postwar reconstruction are simply pure returns on capital. It is likely that such high returns also include a nonnegligible portion of remuneration for informal entrepreneurial labor. (Similar returns are also observed in emerging economies such as China today, where growth rates are also very rapid.)
For illustrative purposes, I have indicated in Figures 6.3 and 6.4 my estimates of the pure return on capital in Britain and France at various times. I obtained these estimates by deducting from the observed average return a plausible (although perhaps too high) estimate of the informal costs of portfolio management (that is, the value of the time spent managing one’s wealth). The pure rates of return obtained in this way are generally on the order of one or two percentage points lower than the observed returns and should probably be regarded as minimum values.5 In particular, the available data on the rates of return earned by fortunes of different sizes suggest that there are important economies of scale in the management of wealth, and that the pure returns earned by the largest fortunes are significantly higher than the levels indicated here.6
The Return on Capital in Historical Perspective
The principal conclusion that emerges from my estimates is the following. In both France and Britain, from the eighteenth century to the twenty-first, the pure return on capital has oscillated around a central value of 4–5 percent a year, or more generally in an interval from 3–6 percent a year. There has been no pronounced long-term trend either upward or downward. The pure return rose significantly above 6 percent following the massive destruction of property and numerous shocks to capital in the two world wars but subsequently returned fairly rapidly to the lower levels observed in the past. It is possible, however, that the pure return on capital has decreased slightly over the very long run: it often exceeded 4–5 percent in the eighteenth and nineteenth centuries, whereas in the early twenty-first century it seems to be approaching 3–4 percent as the capital/income ratio returns to the high levels observed in the past.
We nevertheless lack the distance needed to be certain about this last point. We cannot rule out the possibility that the pure return on capital will rise to higher levels over the next few decades, especially in view of the growing international competition for capital and the equally increasing sophistication of financial markets and institutions in generating high yields from complex, diversified portfolios.
In any case, this virtual stability of the pure return on capital over the very long run (or more likely this slight decrease of about one-quarter to one-fifth, from 4–5 percent in the eighteenth and nineteenth centuries to 3–4 percent today) is a fact of major importance for this study.
In order to put these figures in perspective, recall first of all that the traditional rate of conversion from capital to rent in the eighteenth and nineteenth centuries, for the most common and least risky forms of capital (typically land and public debt) was generally on the order of 5 percent a year: the value of a capital asset was estimated to be equal to twenty years of the annual income yielded by that asset. Sometimes this was increased to twenty-five years (corresponding to a return of 4 percent a year).7
In classic novels of the early nineteenth century, such as those of Balzac and Jane Austen, the equivalence between capital and rent at a rate of 5 percent (or more rarely 4 percent) is taken for granted. Novelists frequently failed to mention the nature of the capital and generally treated land and public debt as almost perfect substitutes, mentioning only the yield in rent. We are told, for example, that a major character has 50,000 francs or 2,000 pounds sterling of rent but not whether it comes from land or from government bonds. It made no difference, since in both cases the income was certain and steady and sufficient to finance a very definite lifestyle and to reproduce across generations a familiar and well-understood social status.
Similarly, neither Austen nor Balzac felt it necessary to specify the rate of return needed to transform a specific amount of capital into an annual rent: every reader knew full well that it took a capital on the order of 1 million francs to produce an annual rent of 50,000 francs (or a capital of 40,000 pounds to produce an income of 2,000 pounds a year), no matter whether the i
nvestment was in government bonds or land or something else entirely. For nineteenth-century novelists and their readers, the equivalence between wealth and annual rent was obvious, and there was no difficulty in moving from one measuring scale to the other, as if the two were perfectly synonymous.
It was also obvious to novelists and their readers that some kinds of investment required greater personal involvement, whether it was Père Goriot’s pasta factories or Sir Thomas’s plantations in the West Indies in Mansfield Park. What is more, the return on such investments was naturally higher, typically on the order of 7–8 percent or even more if one struck an especially good bargain, as César Birotteau hoped to do by investing in real estate in the Madeleine district of Paris after earlier successes in the perfume business. But it was also perfectly clear to everyone that when the time and energy devoted to organizing such affairs was deducted from the profits (think of the long months that Sir Thomas is forced to spend in the West Indies), the pure return obtained in the end was not always much more than the 4–5 percent earned by investments in land and government bonds. In other words, the additional yield was largely remuneration for the labor devoted to the business, and the pure return on capital, including the risk premium, was generally not much above 4–5 percent (which was not in any case a bad rate of return).
The Return on Capital in the Early Twenty-First Century
How is the pure return on capital determined (that is, what is the annual return on capital after deducting all management costs, including the value of the time spent in portfolio management)? Why did it decrease over the long run from roughly 4–5 percent in the age of Balzac and Austen to roughly 3–4 percent today?
Before attempting to answer these questions, another important issue needs to be clarified. Some readers may find the assertion that the average return on capital today is 3–4 percent quite optimistic in view of the paltry return that they obtain on their meager savings. A number of points need to be made.
First, the returns indicated in Figures 6.3 and 6.4 are pretax returns. In other words, they are the returns that capital would earn if there were no taxes on capital or income. In Part Four I will consider the role such taxes have played in the past and may play in the future as fiscal competition between states increases. At this stage, let me say simply that fiscal pressure was virtually nonexistent in the eighteenth and nineteenth centuries. It was sharply higher in the twentieth century and remains higher today, so that the average after-tax return on capital has decreased much more over the long run than the average pretax return. Today, the level of taxation of capital and its income may be fairly low if one adopts the correct strategy of fiscal optimization (and some particularly persuasive investors even manage to obtain subsidies), but in most cases the tax is substantial. In particular, it is important to remember that there are many taxes other than income tax to consider: for instance, real estate taxes cut into the return on investments in real estate, and corporate taxes do the same for the income on financial capital invested in firms. Only if all these taxes were eliminated (as may happen someday, but we are still a long way from that) that the returns on capital actually accruing to its owners would reach the levels indicated in Figures 6.3 and 6.4. When all taxes are taken into account, the average tax rate on income from capital is currently around 30 percent in most of the rich countries. This is the primary reason for the large gap between the pure economic return on capital and the return actually accruing to individual owners.
The second important point to keep in mind is that a pure return of around 3–4 percent is an average that hides enormous disparities. For individuals whose only capital is a small balance in a checking account, the return is negative, because such balances yield no interest and are eaten away by inflation. Savings accounts often yield little more than the inflation rate.8 But the important point is that even if there are many such individuals, their total wealth is relatively small. Recall that wealth in the rich countries is currently divided into two approximately equal (or comparable) parts: real estate and financial assets. Nearly all financial assets are accounted for by stocks, bonds, mutual funds, and long-term financial contracts such as annuities or pension funds. Non-interest-bearing checking accounts currently represent only about 10–20 percent of national income, or at most 3–4 percent of total wealth (which, as readers will recall, is 500–600 percent of national income). If we add savings accounts, we increase the total to just above 30 percent of national income, or barely more than 5 percent of total wealth.9 The fact that checking and savings accounts yield only very meager interest is obviously of some concern to depositors, but in terms of the average return on capital, this fact is not very important.
In regard to average return, it is far more important to observe that the annual rental value of housing, which accounts for half of total national wealth, is generally 3–4 percent of the value of the property. For example, an apartment worth 500,000 euros will yield rent of 15,000–20,000 euros per year (or about 1,500 euros per month). Those who prefer to own their property can save that amount in rent. This is also true for more modest housing: an apartment worth 100,000 euros yields 3,000–4,000 euros of rent a year (or allows the owner to avoid paying that amount). And, as noted, the rental yield on small apartments is as high as 5 percent. The returns on financial investments, which are the predominant asset in larger fortunes, are higher still. Taken together, it is these kinds of investments, in real estate and financial instruments, that account for the bulk of private wealth, and this raises the average rate of return.
Real and Nominal Assets
The third point that needs to be clarified is that the rates of return indicated in Figures 6.3 and 6.4 are real rates of return. In other words, it would be a serious mistake to try to deduce the rate of inflation (typically 1–2 percent in the rich countries today) from these yields.
The reason is simple and was touched on earlier: the lion’s share of household wealth consists of “real assets” (that is, assets directly related to a real economic activity, such as a house or shares in a corporation, the price of which therefore evolves as the related activity evolves) rather than “nominal assets” (that is, assets whose value is fixed at a nominal initial value, such as a sum of money deposited in a checking or savings account or invested in a government bond that is not indexed to inflation).
Nominal assets are subject to a substantial inflation risk: if you invest 10,000 euros in a checking or savings account or a nonindexed government or corporate bond, that investment is still worth 10,000 euros ten years later, even if consumer prices have doubled in the meantime. In that case, we say that the real value of the investment has fallen by half: you can buy only half as much in goods and services as you could have bought with the initial investment, so that your return after ten years is −50 percent, which may or may not have been compensated by the interest you earned in the interim. In periods during which prices are rising sharply, the “nominal” rate of interest, that is, the rate of interest prior to deduction of the inflation rate, will rise to a high level, usually greater than the inflation rate. But the investor’s results depend on when the investment was made, how the parties to the transaction anticipated future inflation at that point in time, and so on: the “real” interest rate, that is, the return actually obtained after inflation has been deducted, may be significantly negative or significantly positive, depending on the case.10 In any case, the inflation rate must be deducted from the interest rate if one wants to know the real return on a nominal asset.
With real assets, everything is different. The price of real estate, like the price of shares of stock or parts of a company or investments in a mutual fund, generally rises at least as rapidly as the consumer price index. In other words, not only must we not subtract inflation from the annual rents or dividends received on such assets, but we often need to add to the annual return the capital gains earned when the asset is sold (or subtract the capital loss, as the case may be). The crucial poi
nt is that real assets are far more representative than nominal assets: they generally account for more than three-quarters of total household assets and in some cases as much as nine-tenths.11
When I examined the accumulation of capital in Chapter 5, I concluded that these various effects tend to balance out over the long run. Concretely, if we look at all assets over the period 1910–2010, we find that their average price seems to have increased at about the same rate as the consumer price index, at least to a first approximation. To be sure, there may have been large capital gains or losses for a given category of assets (and nominal assets, in particular, generate capital losses, which are compensated by capital gains on real assets), which vary greatly from period to period: the relative price of capital decreased sharply in the period 1910–1950 before trending upward between 1950 and 2010. Under these conditions, the most reasonable approach is to take the view that the average returns on capital indicated in Figures 6.3 and 6.4, which I obtained by dividing the annual flow of income on capital (from rents, dividends, interest, profits, etc.) by the stock of capital, thus neglecting both capital gains and capital losses, is a good estimate of the average return on capital over the long run.12 Of course, this does not mean that when we study the yield of a particular asset we need not add any capital gain or subtract any capital loss (and, in particular, deduct inflation in the case of a nominal asset). But it would not make much sense to deduct inflation from the return on all forms of capital without adding capital gains, which on average amply make up for the effects of inflation.
Capital in the Twenty-First Century Page 24