Capital in the Twenty-First Century

by Thomas Piketty

  Reducing Public Debt: Tax on Capital, Inflation, and Austerity

  How can a public debt as large as today’s European debt be significantly reduced? There are three main methods, which can be combined in various proportions: taxes on capital, inflation, and austerity. An exceptional tax on private capital is the most just and efficient solution. Failing that, inflation can play a useful role: historically, that is how most large public debts have been dealt with. The worst solution in terms of both justice and efficiency is a prolonged dose of austerity—yet that is the course Europe is currently following.

  I begin by recalling the structure of national wealth in Europe today. As I showed in Part Two, national wealth in most European countries is close to six years of national income, and most of it is owned by private agents (households). The total value of public assets is approximately equal to the total public debt (about one year of national income), so net public wealth is close to zero.1 Private wealth (net of debt) can be divided into two roughly equal halves: real estate and financial assets. Europe’s average net asset position vis-à-vis the rest of the world is close to equilibrium, which means that European firms and sovereign debt are owned by European households (or, more precisely, what the rest of the world owns of Europe is compensated by what Europeans own of the rest of the world). This reality is obscured by the complexity of the system of financial intermediation: people deposit their savings in a bank or invest in a financial product, and the bank then invests the money elsewhere. There is also considerable cross-ownership between countries, which makes things even more opaque. Yet the fact remains that European households (or at any rate those that own anything at all: bear in mind that wealth is still very concentrated, with 60 percent of the total owned by the wealthiest 10 percent) own the equivalent of all that there is to own in Europe, including its public debt.2

  Under such conditions, how can public debt be reduced to zero? One solution would be to privatize all public assets. According to the national accounts of the various European countries, the proceeds from selling all public buildings, schools, universities, hospitals, police stations, infrastructure, and so on would be roughly sufficient to pay off all outstanding public debt.3 Instead of holding public debt via their financial investments, the wealthiest European households would become the direct owners of schools, hospitals, police stations, and so on. Everyone else would then have to pay rent to use these assets and continue to produce the associated public services. This solution, which some very serious people actually advocate, should to my mind be dismissed out of hand. If the European social state is to fulfill its mission adequately and durably, especially in the areas of education, health, and security, it must continue to own the related public assets. It is nevertheless important to understand that as things now stand, governments must pay heavy interest (rather than rent) on their outstanding public debt, so the situation is not all that different from paying rent to use the same assets, since these interest payments weigh just as heavily on the public exchequer.

  A much more satisfactory way of reducing the public debt is to levy an exceptional tax on private capital. For example, a flat tax of 15 percent on private wealth would yield nearly a year’s worth of national income and thus allow for immediate reimbursement of all outstanding public debt. The state would continue to own its public assets, but its debt would be reduced to zero after five years and it would therefore have no interest to pay.4 This solution is equivalent to a total repudiation of the public debt, except for two essential differences.5

  First, it is always very difficult to predict the ultimate incidence of a debt repudiation, even a partial one—that is, it is difficult to know who will actually bear the cost. Complete or partial default on the public debt is sometimes tried in situations of extreme overindebtedness, as in Greece in 2011–2012. Bondholders are forced to accept a “haircut” (as the jargon has it): the value of government bonds held by banks and other creditors is reduced by 10–20 percent or perhaps even more. The problem is that if one applies a measure of this sort on a large scale—for example, all of Europe and not just Greece (which accounts for just 2 percent of European GDP)—it is likely to trigger a banking panic and a wave of bankruptcies. Depending on which banks are holding various types of bonds, as well as on the structure of their balance sheets, the identity of their creditors, the households that have invested their savings in these various institutions, the nature of those investments, and so on, one can end up with quite different final incidences, which cannot be accurately predicted in advance. Furthermore, it is quite possible that the people with the largest portfolios will be able to restructure their investments in time to avoid the haircut almost entirely. People sometimes think that imposing a haircut is a way of penalizing those investors who have taken the largest risks. Nothing could be further from the truth: financial assets are constantly being traded, and there is no guarantee that the people who would be penalized in the end are the ones who ought to be. The advantage of an exceptional tax on capital, which is similar to a haircut, is precisely that it would arrange things in a more civilized manner. Everyone would be required to contribute, and, equally important, bank failures would be avoided, since it is the ultimate owners of wealth (physical individuals) who would have to pay, not financial institutions. If such a tax were to be levied, however, the tax authorities would of course need to be permanently and automatically apprised of any bank accounts, stocks, bonds, and other financial assets held by the citizens under their jurisdiction. Without such a financial cadaster, every policy choice would be risky.

  But the main advantage of a fiscal solution is that the contribution demanded of each individual can be adjusted to the size of his fortune. It would not make much sense to levy an exceptional tax of 15 percent on all private wealth in Europe. It would be better to apply a progressive tax designed to spare the more modest fortunes and require more of the largest ones. In some respects, this is what European banking law already does, since it generally guarantees deposits up to 100,000 euros in case of bank failure. The progressive capital tax is a generalization of this logic, since it allows much finer gradations of required levies. One can imagine a number of different brackets: full deposit guarantee up to 100,000 euros, partial guarantee between 100,000 and 500,000 euros, and so on, with as many brackets as seem useful. The progressive tax would also apply to all assets (including listed and unlisted shares), not just bank deposits. This is essential if one really wants to reach the wealthiest individuals, who rarely keep their money in checking accounts.

  In any event, it would no doubt be too much to try to reduce public debt to zero in one fell swoop. To take a more realistic example, assume that we want to reduce European government debt by around 20 percent of GDP, which would bring debt levels down from the current 90 percent of GDP to 70 percent, not far from the maximum of 60 percent set by current European treaties.6 As noted in the previous chapter, a progressive tax on capital at a rate of 0 percent on fortunes up to 1 million euros, 1 percent on fortunes between 1 and 5 million euros, and 2 percent on fortunes larger than 5 million euros would bring in the equivalent of about 2 percent of European GDP. To obtain one-time receipts of 20 percent of GDP, it would therefore suffice to apply a special levy with rates 10 times as high: 0 percent up to 1 million, 10 percent between 1 and 5 million, and 20 percent above 5 million.7 It is interesting to note that the exceptional tax on capital that France applied in 1945 in order to substantially reduce its public debt had progressive rates that ranged from 0 to 25 percent.8

  One could obtain the same result by applying a progressive tax with rates of 0, 1, and 2 percent for a period of ten years and earmarking the receipts for debt reduction. For example, one could set up a “redemption fund” similar to the one proposed in 2011 by a council of economists appointed by the German government. This proposal, which was intended to mutualize all Eurozone public debt above 60 percent of GDP (and especially the debt of Germany, France, Italy, and Spain) and then to
reduce the fund gradually to zero, is far from perfect. In particular, it lacks the democratic governance without which the mutualization of European debt is not feasible. But it is a concrete plan that could easily be combined with an exceptional one-time or special ten-year tax on capital.9

  Does Inflation Redistribute Wealth?

  To recapitulate the argument thus far: I observed that an exceptional tax on capital is the best way to reduce a large public debt. This is by far the most transparent, just, and efficient method. Inflation is another possible option, however. Concretely, since a government bond is a nominal asset (that is, an asset whose price is set in advance and does not depend on inflation) rather than a real asset (whose price evolves in response to the economic situation, generally increasing at least as fast as inflation, as in the case of real estate and shares of stock), a small increase in the inflation rate is enough to significantly reduce the real value of the public debt. With an inflation rate of 5 percent a year rather than 2 percent, the real value of the public debt, expressed as a percentage of GDP, would be reduced by more than 15 percent (all other things equal)—a considerable amount.

  Such a solution is extremely tempting. Historically, this is how most large public debts were reduced, particularly in Europe in the twentieth century. For example, inflation in France and Germany averaged 13 and 17 percent a year, respectively, from 1913 to 1950. It was inflation that allowed both countries to embark on reconstruction efforts in the 1950s with a very small burden of public debt. Germany, in particular, is by far the country that has used inflation most freely (along with outright debt repudiation) to eliminate public debt throughout its history.10 Apart from the ECB, which is by far the most averse to this solution, it is no accident that all the other major central banks—the US Federal Reserve, the Bank of Japan, and the Bank of England—are currently trying to raise their inflation targets more or less explicitly and are also experimenting with various so-called unconventional monetary policies. If they succeed—say, by increasing inflation from 2 to 5 percent a year (which is by no means assured)—these countries will emerge from the debt crisis much more rapidly than the countries of the Eurozone, whose economic prospects are clouded by the absence of any obvious way out, as well as by their lack of clarity concerning the long-term future of budgetary and fiscal union in Europe.

  Indeed, it is important to understand that without an exceptional tax on capital and without additional inflation, it may take several decades to get out from under a burden of public debt as large as that which currently exists in Europe. To take an extreme case: suppose that inflation is zero and GDP grows at 2 percent a year (which is by no means assured in Europe today because of the obvious contractionary effect of budgetary rigor, at least in the short term), with a budget deficit limited to 1 percent of GDP (which in practice implies a substantial primary surplus, given the interest on the debt). Then by definition it would take 20 years to reduce the debt-to-GDP ratio by twenty points.11 If growth were to fall below 2 percent in some years and debt were to rise above 1 percent, it could easily take thirty or forty years. It takes decades to accumulate capital; it can also take a very long time to reduce a debt.

  The most interesting historical example of a prolonged austerity cure can be found in nineteenth-century Britain. As noted in Chapter 3, it would have taken a century of primary surpluses (of 2–3 points of GDP from 1815 to 1914) to rid the country of the enormous public debt left over from the Napoleonic wars. Over the course of this period, British taxpayers spent more on interest on the debt than on education. The choice to do so was no doubt in the interest of government bondholders but unlikely to have been in the general interest of the British people. It may be that the setback to British education was responsible for the country’s decline in the decades that followed. To be sure, the debt was then above 200 percent of GDP (and not barely 100 percent, as is the case today), and inflation in the nineteenth century was close to zero (whereas an inflation target of 2 percent is generally accepted nowadays). Hence there is hope that European austerity might last only ten or twenty years (at a minimum) rather than a century. Still, that would be quite a long time. It is reasonable to think that Europe might find better ways to prepare for the economic challenges of the twenty-first century than to spend several points of GDP a year servicing its debt, at a time when most European countries spend less than one point of GDP a year on their universities.12

  That said, I want to insist on the fact that inflation is at best a very imperfect substitute for a progressive tax on capital and can have some undesirable secondary effects. The first problem is that inflation is hard to control: once it gets started, there is no guarantee that it can be stopped at 5 percent a year. In an inflationary spiral, everyone wants to make sure that the wages he receives and the prices he must pay evolve in a way that suits him. Such a spiral can be hard to stop. In France, the inflation rate exceeded 50 percent for four consecutive years, from 1945 to 1948. This reduced the public debt to virtually nothing in a far more radical way than the exceptional tax on capital that was collected in 1945. But millions of small savers were wiped out, and this aggravated the persistent problem of poverty among the elderly in the 1950s.13 In Germany, prices were multiplied by a factor of 100 million between the beginning of 1923 and the end. Germany’s society and economy were permanently traumatized by this episode, which undoubtedly continues to influence German perceptions of inflation. The second difficulty with inflation is that much of the desired effect disappears once it becomes permanent and embedded in expectations (in particular, anyone willing to lend to the government will demand a higher rate of interest).

  To be sure, one argument in favor of inflation remains: compared with a capital tax, which, like any other tax, inevitably deprives people of resources they would have spent usefully (for consumption or investment), inflation (at least in its idealized form) primarily penalizes people who do not know what to do with their money, namely, those who have kept too much cash in their bank account or stuffed into their mattress. It spares those who have already spent everything or invested everything in real economic assets (real estate or business capital), and, better still, it spares those who are in debt (inflation reduces nominal debt, which enables the indebted to get back on their feet more quickly and make new investments). In this idealized version, inflation is in a way a tax on idle capital and an encouragement to dynamic capital. There is some truth to this view, and it should not be dismissed out of hand.14 But as I showed in examining unequal returns on capital as a function of the initial stake, inflation in no way prevents large and well-diversified portfolios from earning a good return simply by virtue of their size (and without any personal effort by the owner).15

  In the end, the truth is that inflation is a relatively crude and imprecise tool. Sometimes it redistributes wealth in the right direction, sometimes not. To be sure, if the choice is between a little more inflation and a little more austerity, inflation is no doubt preferable. But in France one sometimes hears the view that inflation is a nearly ideal tool for redistributing wealth (a way of taking money from “German rentiers” and forcing the aging population on the other side of the Rhine to show more solidarity with the rest of Europe). This is naïve and preposterous. In practice, a great wave of inflation in Europe would have all sorts of unintended consequences for the redistribution of wealth and would be particularly harmful to people of modest means in France, Germany, and elsewhere. Conversely, those with fortunes in real estate and the stock market would largely be spared on both sides of the Rhine and everywhere else as well.16 When it comes to decreasing inequalities of wealth for good or reducing unusually high levels of public debt, a progressive tax on capital is generally a better tool than inflation.

  What Do Central Banks Do?

  In order to gain a better understanding of the role of inflation and, more generally, of central banks in the regulation and redistribution of capital, it is useful to take a step back from the current crisis and t
o examine these issues in broader historical perspective. Back when the gold standard was the norm everywhere, before World War I, central banks played a much smaller role than they do today. In particular, their power to create money was severely limited by the existing stock of gold and silver. One obvious problem with the gold standard was that the evolution of the overall price level depended primarily on the hazards of gold and silver discoveries. If the global stock of gold was static but global output increased, the price level had to fall (since the same money stock now had to support a larger volume of commercial exchange). In practice this was a source of considerable difficulty.17 If large deposits of gold or silver were suddenly discovered, as in Spanish America in the sixteenth and seventeenth centuries or California in the mid-nineteenth century, prices could skyrocket, which created other kinds of problems and brought undeserved windfalls to some.18 These drawbacks make it highly unlikely that the world will ever return to the gold standard. (Keynes referred to gold as a “barbarous relic.”)

  Once currency ceases to be convertible into precious metals, however, the power of central banks to create money is potentially unlimited and must therefore be strictly regulated. This is the crux of the debate about central bank independence as well as the source of numerous misunderstandings. Let me quickly retrace the stages of this debate. At the beginning of the Great Depression, the central banks of the industrialized countries adopted an extremely conservative policy: having only recently abandoned the gold standard, they refused to create the liquidity necessary to save troubled banks, which led to a wave of bankruptcies that seriously aggravated the crisis and pushed the world to the brink of the abyss. It is important to understand the trauma occasioned by this tragic historical experience. Since then, everyone agrees that the primary function of central banking is to ensure the stability of the financial system, which requires central banks to assume the role of “lenders of last resort”: in case of absolute panic, they must create the liquidity necessary to avoid a broad collapse of the financial system. It is essential to realize that this view has been shared by all observers of the system since the 1930s, regardless of their position on the New Deal or the various forms of social state created in the United States and Europe at the end of World War II. Indeed, faith in the stabilizing role of central banking at times seems inversely proportional to faith in the social and fiscal policies that grew out of the same period.