Thomas Piketty’s unlikely bestseller Capital in the Twenty-First Century has pushed income inequality into public consciousness once again, both because there are stagnant wages in the US and Europe despite other signs of recovery and because of his radical policy prescription: a global wealth tax as high as 80% for people making $1 million per year. Most critics have focused on how such a high tax rate could affect productivity and the enormous logistical problems that would arise.
But Gavekal Dragonomics chairman Charles Gave sees a more fundamental error in Piketty’s analysis.
When Baupost, the $30 billion Boston-based hedge fund now managed by Seth Klarman, was founded in 1982, it was launched with a core set of aims. Q4 2021 hedge fund letters, conferences and more Established by Harvard professor William Poorvu and a group of four other founding families, including Klarman, the group aimed to compound Read More
“Piketty confuses the return on invested capital, or ROIC, with the growth rate of corporate profits, a mistake so basic it is scarcely believable,” he writes.
Piketty: ROIC versus corporate profit growth rate
A central part of Piketty’s argument is that the rate of return of invested capital grows faster than the overall economy, what he calls r and g, then the rich will inevitably get richer and the poor poorer.
“The inequality r > g implies that wealth accumulated in the past grows more rapidly than output and wages,” writes Piketty. “Once constituted capital reproduces itself faster than output increases. The past devours the future.”
Gave’s objection is that corporate profits can’t simply be re-invested and compounded in the way that Piketty’s argument implies. He gives the example of an industrial bakery that he is invested in as a mature, profitable business that is a fine source of income for its shareholders, but not something that will benefit much from re-investment.
Gave: Mature businesses have high ROIC and low profit growth
“Instead of reinvesting in the bakery, we distribute the profits among the shareholders and they invest them elsewhere as they see fit. In short, our bakery has a high ROIC but no profit growth,” he writes. Businesses can also have low ROIC and high profit growth, or anything in between. Assuming that corporate profits grow at a steady rate ignores the marginal return on additional capital, which Gave sees as an irreparable mistake.
According to Gave, the last 150 years in now developed economies proves that capitalism lifts people out of poverty, and the last twenty years in emerging economies have proven it once again. He doesn’t address the role that public policy has on building a middle class (tax rates are one factor that has historically affected income inequality, as one example).