Capital in the Twenty-First Century

by Thomas Piketty

  The Future of Retirement: Pay-As-You-Go and Low Growth

  Public pension systems are generally pay-as-you-go (PAYGO) systems: contributions deducted from the wages of active workers are directly paid out as benefits to retirees. In contrast to capitalized pension plans, in a PAYGO system nothing is invested, and incoming funds are immediately disbursed to current retirees. In PAYGO schemes, based on the principle of intergenerational solidarity (today’s workers pay benefits to today’s retirees in the hope that their children will pay their benefits tomorrow), the rate of return is by definition equal to the growth rate of the economy: the contributions available to pay tomorrow’s retirees will rise as average wages rise. In theory, this also implies that today’s active workers have an interest in ensuring that average wages rise as rapidly as possible. They should therefore invest in schools and universities for their children and promote a higher birth rate. In other words, there exists a bond among generations that in principle makes for a virtuous and harmonious society.43

  When PAYGO systems were introduced in the middle of the twentieth century, conditions were in fact ideal for such a virtuous series of events to occur. Demographic growth was high and productivity growth higher still. The growth rate was close to 5 percent in the countries of continental Europe, so this was the rate of return on the PAYGO system. Concretely, workers who contributed to state retirement funds between the end of World War II and 1980 were repaid (or are still being repaid) out of much larger wage pools than those from which their contributions were drawn. The situation today is different. The falling growth rate (now around 1.5 percent in the rich countries and perhaps ultimately in all countries) reduces the return on the pool of shared contributions. All signs are that the rate of return on capital in the twenty-first century will be significantly higher than the growth rate of the economy (4–5 percent for the former, barely 1.5 percent for the latter).44

  Under these conditions, it is tempting to conclude that the PAYGO system should be replaced as quickly as possible by a capitalized system, in which contributions by active workers are invested rather than paid out immediately to retirees. These investments can then grow at 4 percent a year in order to finance the pensions of today’s workers when they retire several decades from now. There are several major flaws in this argument, however. First, even if we assume that a capitalized system is indeed preferable to a PAYGO system, the transition from PAYGO to capitalized benefits raises a fundamental problem: an entire generation of retirees is left with nothing. The generation that is about to retire, who paid for the pensions of the previous generation with their contributions, would take a rather dim view of the fact that the contributions of today’s workers, which current retirees had expected to pay their rent and buy their food during the remaining years of their lives, would in fact be invested in assets around the world. There is no simple solution to this transition problem, and this alone makes such a reform totally unthinkable, at least in such an extreme form.

  Second, in comparing the merits of the two pension systems, one must bear in mind that the return on capital is in practice extremely volatile. It would be quite risky to invest all retirement contributions in global financial markets. The fact that r > g on average does not mean that it is true for each individual investment. For a person of sufficient means who can wait ten or twenty years before taking her profits, the return on capital is indeed quite attractive. But when it comes to paying for the basic necessities of an entire generation, it would be quite irrational to bet everything on a roll of the dice. The primary justification of the PAYGO system is that it is the best way to guarantee that pension benefits will be paid in a reliable and predictable manner: the rate of wage growth may be less than the rate of return on capital, but the former is 5–10 times less volatile than the latter.45 This will continue to be true in the twenty-first century, and PAYGO pensions will therefore continue to be part of the ideal social state of the future everywhere.

  That said, it remains true that the logic of r > g cannot be entirely ignored, and some things may have to change in the existing pension systems of the developed countries. One challenge is obviously the aging of the population. In a world where people die between eighty and ninety, it is difficult to maintain parameters that were chosen when the life expectancy was between sixty and seventy. Furthermore, increasing the retirement age is not just a way of increasing the resources available to both workers and retirees (which is a good thing in an era of low growth). It is also a response to the need that many people feel for fulfillment through work. For them, to be forced to retire at sixty and to spend more time in retirement in some cases than in a career, is not an appetizing prospect. The problem is that individual situations vary widely. Some people have primarily intellectual occupations, and they may wish to remain on the job until they are seventy (and it is possible that the number of such people as a share of total employment will increase over time). There are many others, however, who began work early and whose work is arduous or not very rewarding and who legitimately aspire to retire relatively early (especially since their life expectancy is often lower than that of more highly qualified workers). Unfortunately, recent reforms in many developed countries fail to distinguish adequately between these different types of individual, and in some cases more is demanded of the latter than of the former, which is why these reforms sometimes provoke strong opposition.

  One of the main difficulties of pension reform is that the systems one is trying to reform are extremely complex, with different rules for civil servants, private sector workers, and nonworkers. For a person who has worked in different types of jobs over the course of a lifetime, which is increasingly common in the younger generations, it is sometimes difficult to know which rules apply. That such complexity exists is not surprising: today’s pension systems were in many cases built in stages, as existing schemes were extended to new social groups and occupations from the nineteenth century on. But this makes it difficult to obtain everyone’s cooperation on reform efforts, because many people feel that they are being treated worse than others. The hodgepodge of existing rules and schemes frequently confuses the issue, and people underestimate the magnitude of the resources already devoted to public pensions and fail to realize that these amounts cannot be increased indefinitely. For example, the French system is so complex that many younger workers do not have a clear understanding of what they are entitled to. Some even think that they will get nothing even though they are paying a substantial amount into the system (something like 25 percent of gross pay). One of the most important reforms the twenty-first-century social state needs to make is to establish a unified retirement scheme based on individual accounts with equal rights for everyone, no matter how complex one’s career path.46 Such a system would allow each person to anticipate exactly what to expect from the PAYGO public plan, thus allowing for more intelligent decisions about private savings, which will inevitably play a more important supplementary role in a low-growth environment. One often hears that “a public pension is the patrimony of those without patrimony.” This is true, but it does not mean that it would not be wise to encourage people of more modest means to accumulate nest eggs of their own.47

  The Social State in Poor and Emerging Countries

  Does the kind of social state that emerged in the developed countries in the twentieth century have a universal vocation? Will we see a similar development in the poor and emerging countries? Nothing could be less certain. To begin with, there are important differences among the rich countries: the countries of Western Europe seem to have stabilized government revenues at about 45–50 percent of national income, whereas the United States and Japan seem to be stuck at around the 30–35 percent level. Clearly, different choices are possible at equivalent levels of development.

  If we look at the poorest countries around the world in 1970–1980, we find that governments generally took 10–15 percent of national income, both in Sub-Saharan Africa and in South Asia (especially
India). Turning to countries at an intermediate level of development in Latin America, North Africa, and China, we find governments taking 15–20 percent of national income, lower than in the rich countries at comparable levels of development. The most striking fact is that the gap between the rich and the not-so-rich countries has continued to widen in recent years. Tax levels in the rich countries rose (from 30–35 percent of national income in the 1970s to 35–40 percent in the 1980s) before stabilizing at today’s levels, whereas tax levels in the poor and intermediate countries decreased significantly. In Sub-Saharan Africa and South Asia, the average tax bite was slightly below 15 percent in the 1970s and early 1980s but fell to a little over 10 percent in the 1990s.

  This evolution is a concern in that, in all the developed countries in the world today, building a fiscal and social state has been an essential part of the process of modernization and economic development. The historical evidence suggests that with only 10–15 percent of national income in tax receipts, it is impossible for a state to fulfill much more than its traditional regalian responsibilities: after paying for a proper police force and judicial system, there is not much left to pay for education and health. Another possible choice is to pay everyone—police, judges, teachers, and nurses—poorly, in which case it is unlikely that any of these public services will work well. This can lead to a vicious circle: poorly functioning public services undermine confidence in government, which makes it more difficult to raise taxes significantly. The development of a fiscal and social state is intimately related to the process of state-building as such. Hence the history of economic development is also a matter of political and cultural development, and each country must find its own distinctive path and cope with its own internal divisions.

  In the present case, however, it seems that part of the blame lies with the rich countries and international organizations. The initial situation was not very promising. The process of decolonization was marked by a number of chaotic episodes in the period 1950–1970: wars of independence with the former colonial powers, somewhat arbitrary borders, military tensions linked to the Cold War, abortive experiments with socialism, and sometimes a little of all three. After 1980, moreover, the new ultraliberal wave emanating from the developed countries forced the poor countries to cut their public sectors and lower the priority of developing a tax system suitable to fostering economic development. Recent research has shown that the decline in government receipts in the poorest countries in 1980–1990 was due to a large extent to a decrease in customs duties, which had brought in revenues equivalent to about 5 percent of national income in the 1970s. Trade liberalization is not necessarily a bad thing, but only if it is not peremptorily imposed from without and only if the lost revenue can gradually be replaced by a strong tax authority capable of collecting new taxes and other substitute sources of revenue. Today’s developed countries reduced their tariffs over the course of the nineteenth and twentieth centuries at a pace they judged to be reasonable and with clear alternatives in mind. They were fortunate enough not to have anyone tell them what they ought to be doing instead.48 This illustrates a more general phenomenon: the tendency of the rich countries to use the less developed world as a field of experimentation, without really seeking to capitalize on the lessons of their own historical experience.49 What we see in the poor and emerging countries today is a wide range of different tendencies. Some countries, like China, are fairly advanced in the modernization of their tax system: for instance, China has an income tax that is applicable to a large portion of the population and brings in substantial revenues. It is possibly in the process of developing a social state similar to those found in the developed countries of Europe, America, and Asia (albeit with specific Chinese features and of course great uncertainty as to its political and democratic underpinnings). Other countries, such as India, have had greater difficulty moving beyond an equilibrium based on a low level of taxation.50 In any case, the question of what kind of fiscal and social state will emerge in the developing world is of the utmost importance for the future of the planet.

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  Rethinking the Progressive Income Tax

  In the previous chapter I examined the constitution and evolution of the social state, focusing on the nature of social needs and related social spending (education, health, retirement, etc.). I treated the overall level of taxes as a given and described its evolution. In this chapter and the next, I will examine more closely the structure of taxes and other government revenues, without which the social state could never have emerged, and attempt to draw lessons for the future. The major twentieth-century innovation in taxation was the creation and development of the progressive income tax. This institution, which played a key role in the reduction of inequality in the last century, is today seriously threatened by international tax competition. It may also be in jeopardy because its foundations were never clearly thought through, owing to the fact that it was instituted in an emergency that left little time for reflection. The same is true of the progressive tax on inheritances, which was the second major fiscal innovation of the twentieth century and has also been challenged in recent decades. Before I examine these two taxes more closely, however, I must first situate them in the context of progressive taxation in general and its role in modern redistribution.

  The Question of Progressive Taxation

  Taxation is not a technical matter. It is preeminently a political and philosophical issue, perhaps the most important of all political issues. Without taxes, society has no common destiny, and collective action is impossible. This has always been true. At the heart of every major political upheaval lies a fiscal revolution. The Ancien Régime was swept away when the revolutionary assemblies voted to abolish the fiscal privileges of the nobility and clergy and establish a modern system of universal taxation. The American Revolution was born when subjects of the British colonies decided to take their destiny in hand and set their own taxes. (“No taxation without representation”). Two centuries later the context is different, but the heart of the issue remains the same. How can sovereign citizens democratically decide how much of their resources they wish to devote to common goals such as education, health, retirement, inequality reduction, employment, sustainable development, and so on? Precisely what concrete form taxes take is therefore the crux of political conflict in any society. The goal is to reach agreement on who must pay what in the name of what principles—no mean feat, since people differ in many ways. In particular, they earn different incomes and own different amounts of capital. In every society there are some individuals who earn a lot from work but inherited little, and vice versa. Fortunately, the two sources of wealth are never perfectly correlated. Views about the ideal tax system are equally varied.

  One usually distinguishes among taxes on income, taxes on capital, and taxes on consumption. Taxes of each type can be found in varying proportions in nearly all periods. These categories are not exempt from ambiguity, however, and the dividing lines are not always clear. For example, the income tax applies in principle to capital income as well as earned income and is therefore a tax on capital as well. Taxes on capital generally include any levy on the flow of income from capital (such as the corporate income tax), as well as any tax on the value of the capital stock (such as a real estate tax, an estate tax, or a wealth tax). In the modern era, consumption taxes include value-added taxes as well as taxes on imported goods, drink, gasoline, tobacco, and services. Such taxes have always existed and are often the most hated of all, as well as the heaviest burden on the lower class (one thinks of the salt tax under the Ancien Régime). They are often called “indirect” taxes because they do not depend directly on the income or capital of the individual taxpayer: they are paid indirectly, as part of the selling price of a purchased good. In the abstract, one might imagine a direct tax on consumption, which would depend on each taxpayer’s total consumption, but no such tax has ever existed.1

  In the twentieth century, a fourth category of tax
appeared: contributions to government-sponsored social insurance programs. These are a special type of tax on income, usually only income from labor (wages and remuneration for nonwage labor). The proceeds go to social insurance funds intended to finance replacement income, whether pensions for retired workers or unemployment benefits for unemployed workers. This mode of collection ensures that the taxpayer will be aware of the purpose for which the tax is to be used. Some countries, such as France, also use social contributions to pay for other social spending such as health insurance and family allowances, so that total social contributions account for nearly half of all government revenue. Rather than clarify the purpose of tax collection, a system of such complexity can actually obscure matters. By contrast, other states, such as Denmark, finance all social spending with an enormous income tax, the revenues from which are allocated to pensions, unemployment and health insurance, and many other purposes. In fact, these distinctions among different legal categories of taxation are partly arbitrary.2