Capital in the Twenty-First Century

by Thomas Piketty

  This does not mean that senior executives and compensation committees can set whatever salaries they please and always choose the highest possible figure. “Corporate governance” is subject to certain institutions and rules specific to each country. The rules are generally ambiguous and flawed, but there are certain checks and balances. Each society also imposes certain social norms, which affect the views of senior managers and stockholders (or their proxies, who are often institutional investors such as financial corporations and pension funds) as well as of the larger society. These social norms reflect beliefs about the contributions that different individuals make to the firm’s output and to economic growth in general. Since uncertainty about these issues is great, it is hardly surprising that perceptions vary from country to country and period to period and are influenced by each country’s specific history. The important point is that it is very difficult for any individual firm to go against the prevailing social norms of the country in which it operates.

  Without a theory of this kind, it seems to me quite difficult to explain the very large differences of executive pay that we observe between on the one hand the United States (and to a lesser extent in other English-speaking countries) and on the other continental Europe and Japan. Simply put, wage inequalities increased rapidly in the United States and Britain because US and British corporations became much more tolerant of extremely generous pay packages after 1970. Social norms evolved in a similar direction in European and Japanese firms, but the change came later (in the 1980s or 1990s) and has thus far not gone as far as in the United States. Executive compensation of several million euros a year is still more shocking today in Sweden, Germany, France, Japan, and Italy than in the United States or Britain. It has not always been this way—far from it: recall that in the 1950s and 1960s the United States was more egalitarian than France, especially in regard to the wage hierarchy. But it has been this way since 1980, and all signs are that this change in senior management compensation has played a key role in the evolution of wage inequalities around the world.

  The Takeoff of the Supermanagers: A Powerful Force for Divergence

  This approach to executive compensation in terms of social norms and acceptability seems rather plausible a priori, but in fact it only shifts the difficulty to another level. The problem is now to explain where these social norms come from and how they evolve, which is obviously a question for sociology, psychology, cultural and political history, and the study of beliefs and perceptions at least as much as for economics per se. The problem of inequality is a problem for the social sciences in general, not for just one of its disciplines. In the case in point, I noted earlier that the “conservative revolution” that gripped the United States and Great Britain in the 1970s and 1980s, and that led to, among other things, greater tolerance of very high executive pay, was probably due in part to a feeling that these countries were being overtaken by others (even though the postwar period of high growth in Europe and Japan was in reality an almost mechanical consequence of the shocks of the period 1914–1945). Obviously, however, other factors also played an important role.

  To be clear, I am not claiming that all wage inequality is determined by social norms of fair remuneration. As noted, the theory of marginal productivity and of the race between technology and education offers a plausible explanation of the long-run evolution of the wage distribution, at least up to a certain level of pay and within a certain degree of precision. Technology and skills set limits within which most wages must be fixed. But to the extent that certain job functions, especially in the upper management of large firms, become more difficult to replicate, the margin of error in estimating the productivity of any given job becomes larger. The explanatory power of the skills-technology logic then diminishes, and that of social norms increases. Only a small minority of employees are affected, a few percent at most and probably less than 1 percent, depending on the country and period.

  But the key fact, which was by no means evident a priori, is that the top centile’s share of total wages can vary considerably by country and period, as the disparate evolutions in the wealthy countries after 1980 demonstrate. The explosion of supermanager salaries should of course be seen in relation to firm size and to the growing diversity of functions within the firm. But the objectively complex problem of governance of large organizations is not the only issue. It is also possible that the explosion of top incomes can be explained as a form of “meritocratic extremism,” by which I mean the apparent need of modern societies, and especially US society, to designate certain individuals as “winners” and to reward them all the more generously if they seem to have been selected on the basis of their intrinsic merits rather than birth or background. (I will come back to this point.)

  In any case, the extremely generous rewards meted out to top managers can be a powerful force for divergence of the wealth distribution: if the best paid individuals set their own salaries, (at least to some extent), the result may be greater and greater inequality. It is very difficult to say in advance where such a process might end. Consider again the case of the CFO of a large firm with gross revenue of 10 billion euros a year. It is hard to imagine that the corporate compensation committee would suddenly decide that the CFO’s marginal productivity is 1 billion or even 100 million euros (if only because it would then be difficult to find enough money to pay the rest of the management team). By contrast, some people might think that a pay package of 1 million, 10 million, or even 50 million euros a year would be justified (uncertainty about individual marginal productivity being so large that no obvious limit is apparent). It is perfectly possible to imagine that the top centile’s share of total wages could reach 15–20 percent in the United States, or 25–30 percent, or even higher.

  The most convincing proof of the failure of corporate governance and of the absence of a rational productivity justification for extremely high executive pay is that when we collect data about individual firms (which we can do for publicly owned corporations in all the rich countries), it is very difficult to explain the observed variations in terms of firm performance. If we look at various performance indicators, such as sales growth, profits, and so on, we can break down the observed variance as a sum of other variances: variance due to causes external to the firm (such as the general state of the economy, raw material price shocks, variations in the exchange rate, average performance of other firms in the same sector, etc.) plus other “nonexternal” variances. Only the latter can be significantly affected by the decisions of the firm’s managers. If executive pay were determined by marginal productivity, one would expect its variance to have little to do with external variances and to depend solely or primarily on nonexternal variances. In fact, we observe just the opposite: it is when sales and profits increase for external reasons that executive pay rises most rapidly. This is particularly clear in the case of US corporations: Bertrand and Mullainhatan refer to this phenomenon as “pay for luck.”35

  I return to this question and generalize this approach in Part Four (see Chapter 14). The propensity to “pay for luck” varies widely with country and period, and notably as a function of changes in tax laws, especially the top marginal income tax rate, which seems to serve either as a protective barrier (when it is high) or an incentive to mischief (when it is low)—at least up to a certain point. Of course changes in tax laws are themselves linked to changes in social norms pertaining to inequality, but once set in motion they proceed according to a logic of their own. Specifically, the very large decrease in the top marginal income tax rate in the English-speaking countries after 1980 (despite the fact that Britain and the United States had pioneered nearly confiscatory taxes on incomes deemed to be indecent in earlier decades) seems to have totally transformed the way top executive pay is set, since top executives now had much stronger incentives than in the past to seek large raises. I also analyze the way this amplifying mechanism can give rise to another force for divergence that is more political in nature: the decrease
in the top marginal income tax rate led to an explosion of very high incomes, which then increased the political influence of the beneficiaries of the change in the tax laws, who had an interest in keeping top tax rates low or even decreasing them further and who could use their windfall to finance political parties, pressure groups, and think tanks.

  {TEN}

  Inequality of Capital Ownership

  Let me turn now to the question of inequality of wealth and its historical evolution. The question is important, all the more so because the reduction of this type of inequality, and of the income derived from it, was the only reason why total income inequality diminished during the first half of the twentieth century. As noted, inequality of income from labor did not decrease in a structural sense between 1900–1910 and 1950–1960 in either France or the United States (contrary to the optimistic predictions of Kuznets’s theory, which was based on the idea of a gradual and mechanical shift of labor from worse paid to better paid types of work), and the sharp drop in total income inequality was due essentially to the collapse of high incomes from capital. All the information at our disposal indicates that the same is true for all the other developed countries.1 It is therefore essential to understand how and why this historic compression of inequality of wealth came about.

  The question is all the more important because capital ownership is apparently becoming increasingly concentrated once again today, as the capital/income ratio rises and growth slows. The possibility of a widening wealth gap raises many questions as to its long-term consequences. In some respects it is even more worrisome than the widening income gap between supermanagers and others, which to date remains a geographically limited phenomenon.

  Hyperconcentrated Wealth: Europe and America

  As noted in Chapter 7, the distribution of wealth—and therefore of income from capital—is always much more concentrated than the distribution of income from labor. In all known societies, at all times, the least wealthy half of the population own virtually nothing (generally little more than 5 percent of total wealth); the top decile of the wealth hierarchy own a clear majority of what there is to own (generally more than 60 percent of total wealth and sometimes as much as 90 percent); and the remainder of the population (by construction, the 40 percent in the middle) own from 5 to 35 percent of all wealth.2 I also noted the emergence of a “patrimonial middle class,” that is, an intermediate group who are distinctly wealthier than the poorer half of the population and own between a quarter and a third of national wealth. The emergence of this middle class is no doubt the most important structural transformation to affect the wealth distribution over the long run.

  Why did this transformation occur? To answer this question, one must first take a closer look at the chronology. When and how did inequality of wealth begin to decline? To be candid, because the necessary sources (mainly probate records) are unfortunately not always available, I have thus far not been able to study the historical evolution of wealth inequality in as many countries as I examined in the case of income inequality. We have fairly complete historical estimates for four countries: France, Britain, the United States, and Sweden. The lessons of these four histories are fairly clear and consistent, however, so that we can say something about the similarities and differences between the European and US trajectories.3 Furthermore, the wealth data have one enormous advantage over the income data: they allow us in some cases to go much farther back in time. Let me now examine one by one the four countries I have studied in detail.

  France: An Observatory of Private Wealth

  France is a particularly interesting case, because it is the only country for which we have a truly homogeneous historical source that allows us to study the distribution of wealth continuously from the late eighteenth century to the present. In 1791, shortly after the fiscal privileges of the nobility were abolished, a tax on estates and gifts was established, together with a wealth registry. These were astonishing innovations at the time, notable for their universal scope. The new estate tax was universal in three ways: first, it applied to all types of property: farmland, other urban and rural real estate, cash, public and private bonds, other kinds of financial assets such as shares of stock or partnerships, furniture, valuables, and so on; second, it applied to all owners of wealth, whether noble or common; and third, it applied to fortunes of all sizes, large or small. Moreover, the purpose of this fundamental reform was not only to fill the coffers of the new regime but also to enable the government to record all transfers of wealth, whether by bequest (at the owner’s death) or gift (during the owner’s lifetime), in order to guarantee to all the full exercise of their property rights. In official language, the estate and gift tax has always—from 1791 until now—been classified as one of a number of droits d’enregistrement (recording fees), and more specifically droits de mutation (transfer fees), which included both charges assessed on “free-will transfers,” or transfers of title to property made without financial consideration, by bequest or gift, and “transfers for consideration” (that is, transfers made in exchange for cash or other valuable tokens). The purpose of the law was thus to allow every property owner, large or small, to record his title and thus to enjoy his property rights in full security, including the right to appeal to the public authorities in case of difficulty. Thus a fairly complete system of property records was established in the late 1790s and early 1800s, including a cadastre for real estate that still exists today.

  In Part Four I say more about the history of estate taxes in different countries. At this stage, taxes are of interest primarily as a historical source. In most other countries, it was not until the end of the nineteenth century or beginning of the twentieth that estate and gift taxes comparable to France’s were established. In Britain, the reform of 1894 unified previous taxes on the conveyance of real estate, financial assets, and personal estate, but homogeneous probate statistics covering all types of property go back only to 1919–1920. In the United States, the federal tax on estates and gifts was not created until 1916 and covered only a tiny minority of the population. (Although taxes covering broader segments of the population do exist in some states, these are highly heterogeneous.) Hence it is very difficult to study the evolution of wealth inequalities in these two countries before World War I. To be sure, there are many probate documents and estate inventories, mostly of private origin, dealing with particular subsets of the population and types of property, but there is no obvious way to use these records to draw general conclusions.

  This is unfortunate, because World War I was a major shock to wealth and its distribution. One of the primary reasons for studying the French case is precisely that it will allow us to place this crucial turning point in a longer historical perspective. From 1791 to 1901, the estate and gift tax was strictly proportional: it varied with degree of kinship but was the same regardless of the amount transferred and was usually quite low (generally 1–2 percent). The tax was made slightly progressive in 1901 after a lengthy parliamentary battle. The government, which had begun publishing detailed statistics on the annual flow of bequests and donations as far back as the 1820s, began compiling a variety of statistics by size of estate in 1901, and from then until the 1950s, these became increasingly sophisticated (with cross-tabulations by age, size of estate, type of property, etc.). After 1970, digital files containing representative samples from estate and gift tax filings in a specific year became available, so that the data set can be extended to 2000–2010. In addition to the rich sources produced directly by the tax authorities over the past two centuries, I have also collected, together with Postel-Vinay and Rosenthal, tens of thousands of individual declarations (which have been very carefully preserved in national and departmental archives since the early nineteenth century) for the purpose of constructing large samples covering each decade from 1800–1810 to 2000–2010. All in all, French probate records offer an exceptionally rich and detailed view of two centuries of wealth accumulation and distribution.4

  The Met
amorphoses of a Patrimonial Society

  Figure 10.1 presents the main results I obtained for the evolution of the wealth distribution from 1810 to 2010.5 The first conclusion is that prior to the shocks of 1914–1945, there was no visible trend toward reduced inequality of capital ownership. Indeed, there was a slight tendency for capital concentration to rise throughout the nineteenth century (starting from an already very high level) and even an acceleration of the inegalitarian spiral in the period 1880–1913. The top decile of the wealth hierarchy already owned between 80 and 85 percent of all wealth at the beginning of the nineteenth century; by the turn of the twentieth, it owned nearly 90 percent. The top centile alone owned 45–50 percent of the nation’s wealth in 1800–1810; its share surpassed 50 percent in 1850–1860 and reached 60 percent in 1900–1910.6

  Looking at these data with the historical distance we enjoy today, we cannot help being struck by the impressive concentration of wealth in France during the Belle Époque, notwithstanding the reassuring rhetoric of the Third Republic’s economic and political elites. In Paris, which was home to little more than one-twentieth of the population in 1900–1910 but claimed one-quarter of the wealth, the concentration of wealth was greater still and seems to have increased without limit during the decades leading up to World War I. In the capital, where in the nineteenth century two-thirds of the population died without any wealth to leave to the next generation (compared with half of the population in the rest of the country) but where the largest fortunes were also concentrated, the top centile’s share was about 55 percent at the beginning of the century, rose to 60 percent in 1880–1890, and then to 70 percent on the eve of World War I (see Figure 10.2). Looking at this curve, it is natural to ask how high the concentration of wealth might have gone had there been no war.