Few people illustrate the reach and influence of online discussion better than Matthew Rognlie. In April 2014, the 26-year-old MIT student had just read Thomas Piketty’s Capital in the Twenty-First Century, and among the numerous reviews of the book, he felt that a nagging problem was not being addressed or even noticed.
Rognlie questioned the assumptions of Piketty’s work, and in the early hours of a Thursday morning, Rognlie shared his thoughts in a comment on a Marginal Revolution article. His six paragraphs were enough to get the attention of the site’s owner, Professor Tyler Cowen of George Mason University. Cowen featured Rognlie’s comment, and other economists took notice.
Piketty’s central argument is that wealth grows faster than economic output, and that as the ratio of wealth to output increases, the share of output going to wealth increases. This is the cause of inequality. He further states that slow growth will exacerbate this concentration at the top, and only a high rate of economic growth can counter it. Consider how a slowing economy does not affect a rich person’s ability to invest and build wealth, while the majority of people are more constrained by higher prices or lower wages.
He presents this by arguing that if the rate of return on capital (r) is greater than the rate of economic growth (g), then, in the long run, the ratio of capital income to output will rise continually, leading to inequality. If r = g, then capital and national income increase at the same rate, and inequality does not get any worse.
When we talk about capital, we can think about something as simple as an automated kiosk at Burger King. If a business owner decides to add a kiosk and lay off a cashier, she has replaced labor with capital. A business owner’s return on capital, then, is the value the new kiosk creates for her relative to its initial cost.
To argue that return on capital is greater than economic growth (r > g), Piketty focuses on the elasticity of substitution between capital and labor. In our example, elasticity of substitution is the degree to which automated kiosks can replace cashiers when relative prices or productivity change.
Critically, Rognlie noticed that while Piketty uses net production concepts that account for capital depreciation, he draws conclusions about the elasticity of substitution based on a gross production function. Gross production functions don’t consider depreciation.
Think of it like this: Burger King is on the cusp of replacing thousands of its cashiers with self-order kiosks for customers. It’s less expensive in the long-run to get rid of workers and replace them with machines, but upfront costs are high and, critically, the machines will rapidly lose value and need replacing after a few short years.
It’s a tough decision. But imagine that somehow this depreciation didn’t occur and the machines kept their value forever. Suddenly the business decision seems an obvious one, and the workers will be replaced. This is Piketty’s conclusion, which is why he concludes that labor will be substituted for capital and inequality with continue to worsen.
Rognlie essentially pointed out that Piketty’s central ‘r > g’ argument fails to account for depreciation and exaggerates the tendency for capital to return a larger share of national income as capital investment increases.
Rognlie’s short comment made a stir among economists, and by spring 2015 he had expanded his arguments into a 70-page paper entitled “Deciphering the Fall and Rise in the Net Capital Share”. Unlike Piketty, Rognlie recognizes the importance of distinguishing among structures, equipment and land.
Further, Piketty did not explore the possibility that income shares of different types of assets were changing in different ways. Rognlie found that, in fact, the unabated growth in returns was confined to the housing sector. Excluding housing, the return on wealth has moved neither up nor down since 1970. Bloomberg’s Noah Smith suggests that this is Rognlie’s most salient point:
Economists combine a lot of different things into “capital,” such as machines, buildings, and land. Rognlie points out that almost all of the increase in the value of capital over Piketty’s timeline comes from land, instead of from other forms of capital. In other words, it’s landlords, not corporate overlords, who are sucking up the wealth in the economy. It’s a dramatic, startling insight that was somehow overlooked before Rognlie came along.
In the meantime, growth in the productive capacity of cities will only mean greater returns for the owners of the high-value urban land. Consider San Francisco, where much of the wealth generated by the boom in new tech jobs has been absorbed by landlords. Restrictive zoning policy with respect to housing construction has only made this worse.
Piketty uses historical evidence to argue for a global tax on individual wealth. Rognlie’s results, on the other hand, suggest that workers benefit from increases in investments in equipment and structures, and that the best way to fight wealth inequality is to tax the rental value of land instead of labor and capital.
Rognlie suggests that the explanation for the recent trend in the share of income going to capital is that “residential investment has become more expensive and land scarcer.” (p. 2) Increased scarcity of housing has been accompanied by an increase in net rents per unit of housing that has pushed up the contribution of housing to capital’s net share of income. Therefore, the net capital share is increasing because residential land is rising in value faster than output is increasing, not because capital is becoming more abundant. As Rognlie explains in his paper:
It is increasingly commonplace to believe that labor is ceding ground to capital. But a closer look at postwar experience reveals a murkier story, in which steady increase is limited to the gross capital share. The net share, by contrast, has fallen and then recovered; it consists of a large long-term increase in net capital income from housing, and a more volatile contribution from the rest of the economy, with little cumulative movement in either direction. (p.50)
Outside of housing, however, this paper raises more questions than it answers about the evolution of the net capital share: once the accumulation view has been discarded, there is no master narrative at hand that can explain the postwar fall and rise.If anything, these results suggest that concern about inequality should be shifted away from the overall split between capital and labor and toward other aspects of distribution, such as the within-labor distribution of income. (p. 51)
If anything, these results suggest that concern about inequality should be shifted away from the overall split between capital and labor and toward other aspects of distribution, such as the within-labor distribution of income. (p. 51)
French economists Guillaume Allegre and Xavier Timbeau have shown that an increase in real estate prices is accompanied by an increase in wealth inequality. This, along with Rognlie’s findings, calls into question much of the hysteria around the future of work and the threat of growing automation.
The problem is not in automated technology but in the disproportionate private appropriation of land. As U.S. economics blogger Matthew Yglesias says, “nobody thinks that there have been huge recent technological advances in the realm of landlording.”
If labor’s falling share of national income is entirely accounted for by the increased returns to housing capital, then it seems we should be looking at housing-specific trends to explain the problem. Rather than robots, the problem is almost certainly snob zoning rules that prevent the construction of new affordable housing in expensive areas.
Zoning policies are currently set up to allow wealthy residents to keep their neighborhoods exclusive at no cost to themselves. A Land Value Tax would be an ideal mechanism to build that cost of excluding others into land ownership.
This problem is represented by Rognlie as wealth from ‘housing’, but in fact, we can apply the same principle to all centrally-located real estate. Retail and office buildings in central business districts are just as critical as housing, if not more so. Former McDonald’s CFO Harry Sonneborn famously said the company was “not in the food business; we are in the real estate business”. Discussions of ‘housing’ should be broadened to include all high-value land, that which is tied up in corporations and among homeowners alike.
Implementing a Land Value Tax would be a hugely beneficial step toward a fairer economy. Further, it would reduce or eliminate otherwise harmful taxes on trade — income tax, VAT, corporate tax.