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Editor’s blogMay 8 2014

It will take radical steps to undo rise in inequality

A new work by Thomas Piketty, chronicling the rise of income inequality, has become an unlikely best seller. But, while the French economist's observations about the uneven distribution of wealth certainly ring true, the solutions he offers to this growing problem are not nearly radical enough.
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The latest publishing sensation is French economist Thomas Piketty’s 'Capital in the Twenty-First Century'. Unusually for an economics book, this has become a top seller on Amazon. Clearly, in the aftermath of the financial crisis, with rising unemployment, slow economic growth, and continuing revelations of abuse and greed in high places, there is a demand for some new economic thinking.

Mr Piketty’s book provides evidence that the portions of wealth owned by the top 1% and top 10% of the population are climbing back to the highly skewed levels witnessed in the early part of the 19th century. His corresponding argument, that the way to counter this is through more redistribution, is therefore appealing. But appealing does not mean profound.

I have not read the book, but from the reports it seems that the policy prescriptions are conservative rather than radical. Mr Piketty wants to counter growing inequality in the most predictable way, by raising taxes and increasing redistribution – in other words, more of the same policies that have been central to post-war government policy in most Western countries, and have singularly failed to deliver inclusive growth.

There are a number of reasons why the Piketty approach fails. First of all there is the problem of taxing high-end wealth. Experience shows that a tax rate of more than 40% of income (Mr Piketty flirts with 80% for those on incomes about $500,000) delivers less total tax revenue overall. At rates of more than 40%, companies and individuals find it worthwhile to avoid tax where they legally can. They are encouraged by governments which – whatever they profess to the contrary – offer low tax incentives to attract both companies and individuals to their jurisdictions. The proposed acquisition of UK-Swedish pharmaceutical and biologics company AstraZeneca by US firm Pfizer is partly driven by favourable UK tax policy.

This means that the tax burden for redistribution falls on middle-income earners – the so-called 'squeezed middle' – who already feel that they are paying too much. More redistribution Piketty style is likely to push them into the arms of the far-right political groups, which are currently enjoying a resurgence in both the US and Europe.

Then there is the question of how the money is distributed. Mostly this is done in Western democracies the wrong way, via social security payments. Vast sums have been poured into social security with the result that huge numbers of people have fallen into a giant poverty trap. Wages of low-skilled jobs together with punitive tax rates make formal working less attractive than a combination of welfare and informal working. Means testing of benefits encourages people to stick where they are rather than progress.

The challenge in the Western democracies is to restructure the entire balance sheet of the state so that there is investment for the future rather than just the mopping up of past errors. That means welfare systems based on contribution rather than merely residence, pension schemes that are fully funded, tax systems which are not subject to fiscal drag at any point, government spending which is geared towards education, infrastructure, and research and development, rather than transfer payments. This would be a radical approach to the problem of inequality.

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