What’s causing capital income to grow?
Ever since Thomas Piketty’s Capital in the Twenty First Century came out last year, economists have been discussing the role of capital income in the economy. The debate centered on Piketty’s simple but profound formula, r > g. That is, the rate of return on capital—r—is greater than the growth of the economy: g.
Intuitively, this seems correct. The economy grows at about 3% (in a good year), while the stock market routinely returns 4-6% above inflation. So equity returns are greater than economic growth. And capital’s share of income in the economy has been growing. Since the ‘70s capital income has grown from 31% to almost 40% of the US economy.
Source: Economic Policy Institute
Since income from labor is subject to payroll taxes while capital income is not, many people are calling for higher capital gains taxes and taxes on investment income in order to even the playing field. After all, if you tax something more you tend to get less of it, and we seem to be taxing labor more and getting less labor income. And hedge-fund billionaires are convenient targets for tax policy.
But these studies treat all capital income alike—as if it all came from sweat-shop factories and stock dividends. A lot of capital these days is in the form of intellectual property, like computers and the software, which depreciates quickly. After depreciation, capital income isn’t nearly so important. And the only long-term rise in capital income comes from housing.
Source: Brookings Institute
By this measure, rental payments—not bond coupons—are displacing labor income as a share of the economy. And this makes sense. The stock market has been rising for over 400 years. If r > g, why hasn’t capital taken over the whole economy by now? The magic of compound interest should dictate that all of us should be working as wage-slaves for some mega-rich robber-baron in some tax-haven. But that’s not the case.
Housing plays a pivotal role in the economy. As societies have urbanized, more and more people live in rental units. This rental income has become an increasing share of GDP. But housing ownership is broadly distributed, and doesn’t fit into the traditional left-right, capital-labor debate, or discussions on the role of technology.
Tax policy has encouraged building more housing, and we’ve gotten more housing. Everyone needs a roof over his head. But if policy makers are really concerned about income inequality, they should look at housing costs. The rent is just too high.
Douglas R. Tengdin, CFA
Chief Investment Officer
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