Entrepreneurs thus tend to turn into rentiers, not only with the passing of generations but even within a single lifetime, especially as life expectancy increases: a person who has had good ideas at the age of forty will not necessarily still be having them at ninety, nor are his children sure to have any. Yet the wealth remains, in some cases multiplied more than tenfold in twenty years, as in the case of Bill Gates or Liliane Bettencourt.
This is the main justification for a progressive annual tax on the largest fortunes worldwide. Such a tax is the only way of democratically controlling this potentially explosive process while preserving entrepreneurial dynamism and international economic openness. In Part Four we will examine this idea further, as well as its limitations.
The fiscal approach is also a way to move beyond the futile debate about the moral hierarchy of wealth. Every fortune is partially justified yet potentially excessive. Outright theft is rare, as is absolute merit. The advantage of a progressive tax on capital is that it provides a way to treat different situations in a supple, consistent, and predictable manner while exposing large fortunes to democratic control—which is already quite a lot.
All too often, the global debate about great wealth comes down to a few peremptory—and largely arbitrary—assertions about the relative merits of this or that individual. For example, it is rather common to contrast the man who is currently the world’s wealthiest, Carlos Slim, a Mexican real estate and telecom tycoon who is of Lebanese extraction and is often described in the Western press as one who owes his great wealth to monopoly rents obtained through (implicitly corrupt) government favors, and Bill Gates, the former number one, who is seen as a model of the meritorious entrepreneur. At times one almost has the impression that Bill Gates himself invented computer science and the microprocessor and that he would be 10 times richer still if he had been paid his full marginal productivity and compensated for his personal contribution to global well-being (and fortunately the good people of the planet have been the beneficiaries of his “positive externalities” since he retired). No doubt the veritable cult of Bill Gates is an outgrowth of the apparently irrepressible need of modern democratic societies to make sense of inequality. To be frank, I know virtually nothing about exactly how Carlos Slim or Bill Gates became rich, and I am quite incapable of assessing their relative merits. Nevertheless, it seems to me that Bill Gates also profited from a virtual monopoly on operating systems (as have many other high-tech entrepreneurs in industries ranging from telecommunications to Facebook, whose fortunes were also built on monopoly rents). Furthermore, I believe that Gates’s contributions depended on the work of thousands of engineers and scientists doing basic research in electronics and computer science, without whom none of his innovations would have been possible. These people did not patent their scientific papers. In short, it seems unreasonable to draw such an extreme contrast between Gates and Slim without so much as a glance at the facts.20
As for the Japanese billionaires (Yoshiaka Tsutsumi and Taikichiro Mori) who from 1987 to 1994 preceded Bill Gates at the top of the Forbes ranking, people in the Western world have all but forgotten their names. Perhaps there is a feeling that these men owe their fortunes entirely to the real estate and stock market bubbles that existed at the time in the Land of the Rising Sun, or else to some not very savory Asian wheeling and dealing. Yet Japanese growth from 1950 to 1990 was the greatest history had ever seen to that point, much greater than US growth in 1990–2010, and there is reason to believe that entrepreneurs played some role in this.
Rather than indulge in constructing a moral hierarchy of wealth, which in practice often amounts to an exercise in Western ethnocentrism, I think it is more useful to try to understand the general laws that govern the dynamics of wealth—leaving individuals aside and thinking instead about modes of regulation, and in particular taxation, that apply equally to everyone, regardless of nationality. In France, when Arcelor (then the second largest steel company worldwide) was bought by the steel magnate Lakshmi Mittal in 2006, the French media found the actions of the Indian billionaire particularly outrageous. They renewed their outrage in the fall of 2012, when Mittal was accused of failing to invest enough in the firm’s factory in Florange. In India, everyone believes that the hostility to Mittal is due, at least in part, to the color of his skin. And who can be sure that this did not play a role? To be sure, Mittal’s methods are brutal, and his sumptuous lifestyle is seen as scandalous. The entire French press took umbrage at his luxurious London residences, “worth three times as much as his investment in Florange.”21 Somehow, though, the outrage is soft-pedaled when it comes to a certain residence in Neuilly-sur-Seine, a posh suburb of Paris, or a homegrown billionaire like Arnaud Lagardère, a young heir not particularly well known for his merit, virtue, or social utility yet on whom the French government decided at about the same time to bestow the sum of a billion euros in exchange for his share of the European Aeronautic, Defense, and Space Co. (EADS), a world leader in aeronautics.
One final example, even more extreme: in February 2012, a French court ordered the seizure of more than 200 cubic meters of property (luxury cars, old master paintings, etc.) from the Avenue Foch home of Teodorin Obiang, the son of the dictator of Equatorial Guinea. It is an established fact that his share of the company, which was authorized to exploit Guinea’s forests (from which he derives most of his income), was acquired in a dubious way and that these forest resources were to a large extent stolen from the people of Equatorial Guinea. The case is instructive in that it shows that private property is not quite as sacred as people sometimes think, and that it was technically possible, when someone really wanted to, to find a way through the maze of dummy corporations by means of which Teodorin Obiang administered his capital. There is little doubt, however, that it would not be very difficult to find in Paris or London other individuals—Russian oligarchs or Quatari billionaires, say—with fortunes ultimately derived from the private appropriation of natural resources. It may be that these appropriations of oil, gas, and aluminum deposits are not as clear-cut cases of theft as Obiang’s forests. And perhaps judicial action is more justified when the theft is committed at the expense of a very poor country, as opposed to a less poor one.22 At the very least, the reader will grant that these various cases are not fundamentally different but belong to a continuum, and that a fortune is often deemed more suspect if its owner is black. In any case, the courts cannot resolve every case of ill-gotten gains or unjustified wealth. A tax on capital would be a less blunt and more systematic instrument for dealing with the question.
Broadly speaking, the central fact is that the return on capital often inextricably combines elements of true entrepreneurial labor (an absolutely indispensable force for economic development), pure luck (one happens at the right moment to buy a promising asset at a good price), and outright theft. The arbitrariness of wealth accumulation is a much broader phenomenon than the arbitrariness of inheritance. The return on capital is by nature volatile and unpredictable and can easily generate capital gains (or losses) equivalent to dozens of years of earned income. At the top of the wealth hierarchy, these effects are even more extreme. It has always been this way. In the novel Ibiscus (1926), Alexei Tolstoy depicted the horrors of capitalism. In 1917, in St. Petersburg, the accountant Simon Novzorov bashes in the skull of an antique dealer who has offered him a job and steals a small fortune. The antique dealer had become rich by purchasing, at rock-bottom prices, the possessions of aristocrats fleeing the Revolution. Novzorov manages to multiply his initial capital by 10 in six months, thanks to the gambling den he sets up in Moscow with his new friend Ritechev. Novzorov is a nasty, petty parasite who embodies the idea that wealth and merit are totally unrelated: property sometimes begins with theft, and the arbitrary return on capital can easily perpetuate the initial crime.
The Pure Return on University Endowments
In order to gain a better understanding of unequal returns on capital without being distracted by issue
s of individual character, it is useful to look at what has happened with the endowments of American universities over the past few decades. Indeed, this is one of the few cases where we have very complete data about investments made and returns received over a relatively long period of time, as a function of initial capital.
There are currently more than eight hundred public and private universities in the United States that manage their own endowments. These endowments range from some tens of millions of dollars (for example, North Iowa Community College, ranked 785th in 2012 with an endowment of $11.5 million) to tens of billions. The top-ranked universities are invariably Harvard (with an endowment of some $30 billion in the early 2010s), Yale ($20 billion), and Princeton and Stanford (more than $15 billion). Then come MIT and Columbia, with a little less than $10 billion, then Chicago and Pennsylvania, at around $7 billion, and so on. All told, these eight hundred US universities owned nearly $400 billion worth of assets in 2010 (or a little under $500 million per university on average, with a median slightly less than $100 million). To be sure, this is less than 1 percent of the total private wealth of US households, but it is still a large sum, which annually yields significant income for US universities—or at any rate some of them.23 Above all—and this is the point that is of interest here—US universities publish regular, reliable, and detailed reports on their endowments, which can be used to study the annual returns each institution obtains. This is not possible with most private fortunes. In particular, these data have been collected since the late 1970s by the National Association of College and University Business Officers, which has published voluminous statistical surveys every year since 1979.
The main results I have been able to derive from these data are shown in Table 12.2.24 The first conclusion is that the return on US university endowments has been extremely high in recent decades, averaging 8.2 percent a year between 1980 and 2010 (and 7.2 percent for the period 1990–2010).25 To be sure, there have been ups and downs in each decade, with years of low or even negative returns, such as 2008–2009, and good years in which the average endowment grew by more than 10 percent. But the important point is that if we average over ten, twenty, or thirty years, we find extremely high returns, of the same sort I examined for the billionaires in the Forbes rankings.
To be clear, the returns indicated in Table 12.2 are net real returns allowing for capital gains and inflation, prevailing taxes (virtually nonexistent for nonprofit institutions), and management fees. (The latter include the salaries of everyone inside or outside the university who is involved in planning and executing the institution’s investment strategy.) Hence these figures reflect the pure return on capital as defined in this book, that is, the return that comes simply from owning capital, apart from any remuneration of the labor required to manage it.
The second conclusion that emerges clearly from Table 12.2 is that the return increases rapidly with size of endowment. For the 500 of 850 universities whose endowment was less than $100 million, the average return was 6.2 percent in 1980–2010 (and 5.1 percent in 1990–2010), which is already fairly high and significantly above the average return on all private wealth in these periods.26 The greater the endowment, the greater the return. For the 60 universities with endowments of more than $1 billion, the average return was 8.8 percent in 1980–2010 (and 7.8 percent in 1990–2010). For the top trio (Harvard, Yale, and Princeton), which has not changed since 1980, the yield was 10.2 percent in 1980–2010 (and 10.0 percent in 1990–2010), twice as much as the less well-endowed institutions.27
If we look at the investment strategies of different universities, we find highly diversified portfolios at all levels, with a clear preference for US and foreign stocks and private sector bonds (government bonds, especially US Treasuries, which do not pay well, account for less than 10 percent of all these portfolios and are almost totally absent from the largest endowments). The higher we go in the endowment hierarchy, the more often we find “alternative investment strategies,” that is, very high yield investments such as shares in private equity funds and unlisted foreign stocks (which require great expertise), hedge funds, derivatives, real estate, and raw materials, including energy, natural resources, and related products (these, too, require specialized expertise and offer very high potential yields).28 If we consider the importance in these various portfolios of “alternative investments,” whose only common feature is that they abandon the usual strategies of investing in stocks and bonds accessible to all, we find that they represent only 10 percent of the portfolios of institutions with endowments of less than 50 million euros, 25 percent of those with endowments between 50 and 100 million euros, 35 percent of those between 100 and 500 million euros, 45 percent of those between 500 million and 1 billion euros, and ultimately more than 60 percent of those above 1 billion euros. The available data, which are both public and extremely detailed, show unambiguously that it is these alternative investment strategies that enable the very largest endowments to obtain real returns of close to 10 percent a year, while smaller endowments must make do with 5 percent.
It is interesting to note that the year-to-year volatility of these returns does not seem to be any greater for the largest endowments than for the smaller ones: the returns obtained by Harvard and Yale vary around their mean but not much more so than the returns of smaller institutions, and if one averages over several years, the mean returns of the largest institutions are systematically higher than those of the smaller ones, with a gap that remains fairly constant over time. In other words, the higher returns of the largest endowments are not due primarily to greater risk taking but to a more sophisticated investment strategy that consistently produces better results.29
How can these facts be explained? By economies of scale in portfolio management. Concretely, Harvard currently spends nearly $100 million a year to manage its endowment. This munificent sum goes to pay a team of top-notch portfolio managers capable of identifying the best investment opportunities around the world. But given the size of Harvard’s endowment (around $30 billion), $100 million in management costs is just over 0.3 percent a year. If paying that amount makes it possible to obtain an annual return of 10 percent rather than 5, it is obviously a very good deal. On the other hand, a university with an endowment of only $1 billion (which is nevertheless substantial) could not afford to pay $100 million a year—10 percent of its portfolio—in management costs. In practice, no university pays more than 1 percent for portfolio management, and most pay less than 0.5 percent, so to manage assets worth $1 billion, one would pay $5 million, which is not enough to pay the kind of specialists in alternative investments that one can hire with $100 million. As for North Iowa Community College, with an endowment of $11.5 million, even 1 percent a year would amount to only $115,000, which is just enough to pay a half-time or even quarter-time financial advisor at going market rates. Of course a US citizen at the median of the wealth distribution has only $100,000 to invest, so he must be his own money manager and probably has to rely on the advice of his brother-in-law. To be sure, financial advisors and money managers are not infallible (to say the least), but their ability to identify more profitable investments is the main reason why the largest endowments obtain the highest returns.
These results are striking, because they illustrate in a particularly clear and concrete way how large initial endowments can give rise to better returns and thus to substantial inequalities in returns on capital. These high returns largely account for the prosperity of the most prestigious US universities. It is not alumni gifts, which constitute a much smaller flow: just one-tenth to one-fifth of the annual return on endowment.30
These findings should be interpreted cautiously, however. In particular, it would be too much to try to use them to predict how global wealth inequality will evolve over the next few decades. For one thing, the very high returns that we see in the period 1980–2010 in part reflect the long-term rebound of global asset prices (stocks and real estate), which may not continue (in which case
the long-term returns discussed above would have to be reduced somewhat in the future).31 For another, it is possible that economies of scale affect mainly the largest portfolios and are greatly reduced for more “modest” fortunes of 10–50 million euros, which, as noted, account for a much larger share of total global wealth than do the Forbes billionaires. Finally, leaving management fees aside, these returns still depend on the institution’s ability to choose the right managers. But a family is not an institution: there always comes a time when a prodigal child squanders the family fortune, which the Harvard Corporation is unlikely to do, simply because any number of people would come forward to stand in the way. Because family fortunes are subject to this kind of random “shock,” it is unlikely that inequality of wealth will grow indefinitely at the individual level; rather, the wealth distribution will converge toward a certain equilibrium.
These arguments are not altogether reassuring, however. It would in any case be rather imprudent to rely solely on the eternal but arbitrary force of family degeneration to limit the future proliferation of billionaires. As noted, a gap r − g of fairly modest size is all that it takes to arrive at an extremely inegalitarian distribution of wealth. The return on capital does not need to rise as high as 10 percent for all large fortunes: a smaller gap would be enough to deliver a major inegalitarian shock.
Another important point is that wealthy people are constantly coming up with new and ever more sophisticated legal structures to house their fortunes. Trust funds, foundations, and the like often serve to avoid taxes, but they also constrain the freedom of future generations to do as they please with the associated assets. In other words, the boundary between fallible individuals and eternal foundations is not as clear-cut as is sometimes thought. Restrictions on the rights of future generations were in theory drastically reduced when entails were abolished more than two centuries ago (see Chapter 10). In practice, however, the rules can be circumvented when the stakes require. In particular, it is often difficult to distinguish purely private family foundations from true charitable foundations. In fact, families often use foundations for both private and charitable purposes and are generally careful to maintain control of their assets even when housed in a primarily charitable foundation.32 It is often not easy to know what exact rights children and relatives have in these complex structures, because important details are often hidden in legal documents that are not public. In some cases, a family trust whose purpose is primarily to serve as an inheritance vehicle exists alongside a foundation with a more charitable purpose.33 It is also interesting to note that the amount of gifts declared to the tax authorities always falls drastically when oversight is tightened (for example, when donors are required to submit accurate receipts, or when foundations are required to submit more detailed financial statements to certify that their official purpose is in fact respected and private use of foundation funds does not exceed certain limits), confirming the idea that there is a certain porosity between public and private uses of these legal entities.34 Ultimately, it is very difficult to say precisely what proportion of foundations fulfill purposes that can truly be characterized as being in the public interest.35
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