Quarterly essays (in English and French) on the theme "Querying economic orthodoxy"

No. 52 - June 2011

Thomas Piketty, expert on inequality


What ideological folly has persuaded the public authorities to allow whole financial sectors to develop unsupervised, without prudential regulation, without having to render accounts worthy of the name? How have we been so blind as to let directors and traders pay themselves tens of millions of dollars without reacting, and even glorifying them?
Thomas Piketty, Le Monde (Paris), 23 April 2009.

A French economist battles against excessive inequalities

Financial inequalities are one of the hottest topics of the day, with good reason. Since the last quarter of the last century, they have expanded hugely throughout much of the world. 

Free-market (libertarian) ideologues, sure enough, see no problem here. They insist that the judgements of the market cannot be unjust, so there is no reason to find fault with them. Did not the famous American philosopher Robert Nozick dictate that the individual has an absolute right to whatever he can acquire legally? So, we must accept the grotesque distribution of revenues that has accompanied market liberation. For extreme libertarians, taxing the very rich at higher than normal rates, or even taxing personal fortunes at all, amounts to theft. But the general public, with perhaps rather more common sense than the economic theorists, has trouble following this argument.

It has long been claimed that overall economic growth automatically means growing prosperity for everyone. This argument no longer holds water. Following the rise to power of more and more free-market regimes in developed countries, there has indeed been economic growth (despite phases of recession), but this growth has mainly benefited the people at the top; the average citizen has seen little of it. Indeed, for most people, life has in many ways grown worse: jobs are harder to find and to keep, work is more stressful, public services have deteriorated.

Let us look therefore at the ideas of an economist who has made this problem his speciality. Professor at the Paris School of Economics, Thomas Piketty (born 1971) won in 2002 a prize for the best young French economist. He is known for his studies of inequalities in their historic and international context.

Inequalities in pay

To explain pay inequalities, Piketty begins with the theory of human capital, that is: individuals have differing capacities to contribute to the production of the goods and services that consumers demand.1 Those who acquire qualifications and practical experience become more valuable to employers, who can therefore pay them more. However, the pay differentials between the various groups of workers, with their differing qualifications and experience, can vary over time because of fluctuations in supply and demand. The rise of inequalities since 1970 seems to have its origins in the technological revolution; demand for qualified staff has increased, while demand for low-productivity work has shrunk.

Piketty provides a fascinating study of the various methods of reducing inequalities: redistribution via the tax system, regulation of pay levels and trade union solidarity.

Fiscal redistribution has the merit of preserving the role of 'price' in allocating pay to different jobs, while at the same time redistributing the revenues obtained by the various workers.2  High incomes are taxed more heavily, while tax on lower incomes is reduced; the lowest-paid may even be awarded a 'negative tax'. This method has the advantage of making it possible to improve the position of the poorest workers, or of those with children to support, without increasing the cost to businesses of unskilled work, and thus without reducing the quantity of unskilled employment.3

However, there are circumstances where fiscal redistribution does not work, such as monopsony [from the Greek opsōnein = 'to do one's shopping'], where a market is dominated by a single buyer. Thus, a dominant employer may be able to cut low wages even below the miserable market level. In this case, even after fiscal redistribution, the worker's income may still be inadequate. In effect, the employer gets the benefit of the tax reduction or credit. This can happen when there is just one predominant employer, or where several employers collude to keep wages low.

The minimum wage

So we consider another method, pay regulation. One can impose minimum wage levels. Today, in most developed countries, including the USA, minima are imposed by law. In some countries, such as Germany, national wage levels are fixed by negotiation between unions and federations of employers. It is normal among free-marketeers to condemn this method on the argument that, if it costs more to employ workers, then fewer of them will be employed, so there will be more unemployment.

However, in reality, the opposite can be true. Piketty quotes studies by American researchers Card and Krueger, which have shown convincingly that the effect of raising the minimum wage on the level of employment has generally been positive.4 It seems that higher wage rates may encourage more people to take jobs, thus raising the level of employment. Piketty concludes that certain situations of monopsony justify the introduction of a legal minimum wage.

This opinion is, as you might expect, disputed. But the neo-Keynesian economist Paul Kruger makes the following comment: the work of Card and Krueger has been attacked because...it was ideologically disturbing to many. Yet it has stood up very well to repeated challenges, and new cases confirming its results keep coming in.5 Free-market ideologues take a dim view of any research that might discredit their beloved theory.

We may note also a study of around twenty developing countries by the International Labour Office, which shows that other things being equal, the level of the minimum wage has an insignificant effect on the level of unemployment.6

The role of unions

We turn to the third means of reducing inequalities: trade union solidarity. According to Piketty, unions generally strive not only for an increase in the general level of wages, but also for some narrowing of pay differentials within firms.7 To this end, they call for the introduction of obligatory scales of pay for employees of different qualifiactions and experience. This means that each employee who reaches a given level of competence must be paid at a rate fixed in advance by negotiation.

Piketty thinks that union activity is, in principle, less efficient than fiscal redistribution; but he is far from decrying the usefulness of unions. He quotes studies showing that the countries whose pay inequalities have grown most sharply since the 1970s are the United Kingdom and the United States, the same countries in which union power has been most reduced. These countries have failed to replace the inefficient redistribution obtained by unions with more efficient fiscal redistribution.8 On the contrary, they have cut back on that too. Workers have suffered two simultaneous bombardments by the libertarian artillery. Under a regime that declines to practice fiscal redistribution, in principle unions should fill the gap.

Piketty explains an interesting advantage of fixed pay scales: they can encourage employers to invest in training their workers, and the workers themselves to acquire skills. In other words, they can foster the formation of human capital. Why? Imagine a business where there is no fixed scale, where pay is totally flexible, as libertarians would wish. In the case of an employee who has acquired a valuable skill, but who cannot readily move to another firm where it will be useful, his employer may persist in paying him less than he is worth. But that will discourage other employees from acquiring valuable skills. The existence of an obligatory scale can avoid this problem, since people will then be more willing to develop skills in the knowledge that they will be properly rewarded.

German horse-sense astonishes foreigners

On the other hand, in the case where the well-qualified employee can easily move to a competing firm, the employer may be unwilling to train apprentices. It may be feared that this will be a waste of time and money since, once trained, they will disappear. Piketty notes that the famous German system of apprenticeship  often puzzles foreigner observers:

The fact that many German firms finance very costly centres of training and apprenticeship has always astonished foreigners, inasmuch as there is generally no commitment on the part of the apprentices to stay with the firm where they were trained...The most convincing explanation is the existence of obligatory, standard pay rates for new employees and for those at various stages of training, which apply to all firms in a given industrial sector. This ensures that apprentices will not be lured away by competing firms once they have been trained.9

That is a system which rejects a whole slice of free-market doctrine by suppressing competition between firms in the matter of employment. Non-Germans may consider this heretical, but how many of them come from countries whose economies are more successful than Germany's? And remember: there was once a similar, though more informal, arrangement in the City of London; it was "not done" for merchant banks to poach each other's staff. This prevented the bidding up of the rewards of top bankers to ridiculous levels.

I am sorry to have to say that our thinking has been so polluted in recent decades by the nonsense of economic theorists, that when we see an all too rare example of economic common sense, we are astonished!

The subject of apprenticeship brings me to another fundamental question. Redistribution can mitigate the inequalities of income that flow from inequalities of human capital; but how do we tackle the latter? Piketty is clear about what needs to be done in under-developed countries, where inequalities are often serious. Compulsory elementary education is without doubt the most effective possible means of redistribution.10 This principle holds also for more advanced countries whose education and training systems are defective. 

The exorbitant incomes of top management

According to Piketty, this phenomenon is not really a case of market failure, since the laws of the market...have nothing to say about the appropriate level of pay above a certain level.11 At the top of the pyramid, matters are in fact very simple. In the absence of any clear pay level set by the market, top managers take advantage of this uncertainty by putting their hands in the till.

So, what is to be done? There is a well-known remedy, regarded today as obsolete: put a huge tax on huge incomes. Let's follow the good old German economists by taking a look at history, rather than theory. Piketty examines the period of F. D. Roosevelt and his successors. In the USA, the maximum marginal rate of Federal income tax was 70% or more between 1936 and 1981, even over 90% between 1944 and 1963.12 Piketty comments: The method works: during the whole period when tax rates were high, the top executives of large groups enjoyed very comfortable incomes, but their demands were to a certain extent restrained. In fact, hardly anyone was taxed at the top rate.

And he adds: the lesson of this piece of history is that high tax rates did not kill capitalism, nor did they interfere with human rights...[we lived through] a half-century in which capitalism and democracy fared no worse than at other times. Quite the opposite.

Will Americans, and others who have unwisely followed their recent bad example, come back one day to Roosevelt's good sense?

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1 Piketty, L’économie des inégalités (1997) (6th edition, La Découverte, Paris, 2008), ch. 3, p. 64.

2 Ibid., p 71.

3 Ibid., p 70.

4 Ibid., p. 89; D. Card and A. Krueger, Myth and Measurement (Princeton Univ. Press, 1995).

5 Paul Krugman, The Conscience of a Liberal (Norton, New York, 2007), p. 261.

6 Catherine Saget, Is the Minimum Wage an Effective Tool? (ILO Employment Paper 2001/13), p. 21.

7 Piketty, loc. cit., p. 83.

8 Ibid., p. 86.

9 Ibid., p.  87.

10 Ibid., p. 75.

11 Piketty, Il faut taxer fortement les très hauts revenus in Alternatives Economiques (Paris, January 2009). Subsequent quotations come from the same article.

12 In 1944 and 1945, the top rate was 94% on any income in excess of $200,000 (equivalent to roughly $2 million at today's prices).