Friday, January 3, 2020

Wealth and Taxes, part II

(This is a continuation of Wealth and Taxes, part IPart III follows.  See the overview for a summary. The punchline comes in Part V.)

A second asset pricing perspective helps us to digest "wealth," its distribution, and whether we should care.   

Here is another Smith, Zidar and  Zwick  graph showing the top 0.1% share of wealth (as they define and measure wealth). (Reminder. The game here is to start with selected income streams, then divide them by a rate of return to produce large wealth numbers. $100 income / 0.01 interest rate = $10,000 of wealth.) The "baseline" case capitalizes realized capital gains, which I argued last time was a pretty crazy thing to do. The bottom line treats only dividends. If dividends are properly measured, the value of the firm is the value of dividends only and repurchases are irrelevant.

The graph makes the obvious point that "capitalizing" capital gain "income" is an important assumption to driving up the appearance of wealth inequality.

But it makes a deeper point, my focus today. The top graph is pretty much the graph of the S&P index. This illustrates visually a deeper point:  
  • A lot of the rise in "wealth," and "wealth inequality," even properly defined and measured as the market value of net assets, consists of higher market prices for the same underlying physical assets. In turn, higher asset prices stem almost entirely from lower real interest rates and lower risk premiums, not from higher expectations of economic growth. 
This raises a deep "why do we care" question. Suppose Bob owns a company, giving him $100,000 a year income. Bob also spends $100,000 a year. The discount rate is 10%, so his company is worth $1,000,000. The interest rate goes down to 1%, and the stock market booms. Bob's company is now worth $10,000,000. Hooray for Bob!

But wait a minute. Bob still gets $100,000 a year income, and he still spends $100,000 a year. Absolutely nothing has changed for Bob! The value of his company is "paper wealth."

We compare Bob to Sally, who earns $100,000 per year wages and has no assets. The distribution of income and of consumption is entirely flat. But the distribution of wealth was already concentrated: Bob had  $1,000,000 of wealth, because we ignored Sally's human wealth, the present value of her salary. Now wealth inequality is 10 times worse, because we also ignore the higher capitalized value of Sally's human wealth.

But why should we care? Bob and Sally are both marching along unchanged.

Well, you say, I just assumed Bob didn't change consumption. He should sell some stock and go out on a round-the-world private jet tour. Or, what gazillionaires really do, he should start a foundation and give it away. But Bob won't do that for a simple reason. Originally, he wanted to spend $100,000 per year. Originally, if he sold his company for $1,000,000 and invested it at 10%, he could spend $100,000 per year. Now if he sells his company for $10,000,000, he can only invest that at 1% per year so the most he can spend is still $100,000!

People don't want to consume in one big spurt. They want to spread consumption out over their and their heirs lifetimes. When the interest rate goes down, it takes more wealth to finance the same consumption stream.
  • Consumption should not respond (much) to increases in wealth generated by lower discount rates for the same cashflows.  
The present value of liabilities -- consumption -- rises just as much as the present value of assets. This is a rather deep point that gets lost all too often in the static Keynesian consumption function thinking about "wealth effects of consumption" that still pervades macroeconomics.

If the rise in asset value is because people expect the income stream to grow a lot in the future, at unchanged discount rates, then indeed Bob is truly more "wealthy" than before. But that is emphatically not the situation of today's market value of wealth in the US, at least on average. If you think internet companies have enormous stock values because their profits will continue to grow at astronomical rates, I have some 1999 dot com stock to sell you.

(A refinement: lower real interest rates do generate a "substitution effect." You should rearrange consumption to be earlier in time rather than later in time. But the central point is that the lower interest rate does not have a "wealth effect." Though the asset is worth more, you cannot consume more in every year than you could before. The original flat consumption path is still just affordable.)

Now there are good questions to be asked about the distribution of consumption, and in particular lifetime consumption. If Bob averages $100,000 consumption over his life, and Sally only $10,000 that's an interesting observation about our society and we might want to think about the economics, politics, justice if you wish and so forth of the situation. But why should we worry about an increase in mark-to-market "wealth" that has no implications for the overall command over resources that "wealthy" people have?

Is this a big effect? Yes. Here is a simple plot of real interest rates, computed as the 10 year bond rate less the university of Michigan inflation survey. It declines from nearly 10% to negative numbers. (If you want to make "wealth distribution" look bad, start capitalizing incomes dividing by zero and then negative numbers!)

In sum, much of the increase in "wealth inequality," to the extent it is there at all, reflects higher market values of the same income flows, and indicates nothing about increases in consumption inequality, or if you prefer "command over resources."

Just why should we carte about wealth inequality?  Obviously, many smart people are very animated by it, including apparently about half the job market candidates on this year's PhD market. What is the question to which wealth inequality is the answer? Stay tuned for part III..

(Note: As a commenter on the last post pointed out, Larry Summers made this point in the excellent
Saez Summers Mankiw debate about wealth and taxes.)

On to Part III


  1. The stock market has risen a lot over recent years. It would seem that we are all a lot wealthier. In a sense we are. Each one of us can sell our stock and buy many things we could not afford before. However, we can't all do this. If a significant fraction of us tried to, our attempts to sell would drive the stock market down. The recent stock market rise has not made us wealthier in aggregate. We are simply suffering from delusions of grandeur.

    Paper wealth is wealth only to the extent we can use it to buy things we like. But we can only buy things that exist. The stock market's rise has not been matched by an equivalent increase in the number of things that exist. There is not much more production equipment and plant. Neither is there much more of most other things that we like to have, such as cars and houses. Thus, the increase in the per capita number of things has not matched the stock market’s increase. Indeed, things per capita can't change a lot over a few years, because it takes time to make a lot of things.

    If things per capita can't increase significantly over a few years, it is plainly impossible to buy or hold significantly more things per capita over a few years. Society as a whole is not wealthier just because the stock market goes up a lot over the short term, no matter how far it goes up.

    If you need more convincing, consider the implications if the stock market were to rise suddenly so high that all of us were worth ten million dollars, on paper. This is enough for all of us to retire, if you believe that stock market wealth is real wealth. Suppose everybody did retire. Nobody would be working, so production would cease. Consequently, there would be nothing to consume, and consumption would cease. We would all be poor, no matter what we were worth on paper.

    If a sudden big stock market rise doesn't make us significantly wealthier in aggregate, then a big stock market decline doesn't make us much poorer in aggregate. So, when the crash comes, just don't read the paper, listen to the radio, or watch TV, and you'll be all right if you've avoided undue borrowing. This, of course, presumes that Government, various regulators and experts, and business leaders act sensibly. Hmm, maybe you should be a little concerned, after all. You never know what will go through these peoples' heads.

    Is the stock market likely to crash, or at least have very disappointing performance? All it takes is the reverse of what made it go up so high. What was that? Simply investors' desire, on average, to have a little more of their portfolios allocated to stocks.

    Consider an example. Suppose the financial market consists of $50 of cash and $50 of stock. Then total wealth is $100 and the average investor's equity allocation is 50%. Suppose the average investor decides that he wants an equity allocation of 60%. Then stocks must go up until they represent 60% of the total market. This means that stocks must rise from $50 to $75. The stock market rises 50%. This may make investors so optimistic about the stock market that they decide stocks should be 75% of their portfolios. This requires a stock market worth $150. Stocks are now up another 100%, for a total of 200% (You did catch that 50% plus 100% equals 200%, didn't you?).

    At some point, investors' are satisfied with their stock allocation, and the stock market stops rising. Then, the average investor may decide the action is over or he may try to enjoy his newfound wealth, say by selling some of his stock to buy a bigger house. Put more precisely, the average investor may decide to reduce his equity allocation proportion to 60% from 75%. The stock market then drops, instantly, from $150 to $75, a decline of 50%. This happens before the average investor can sell his stock, because the average investor can’t sell his stock. He doesn't get to buy his house, after all.

  2. The Real Heart of the Problem is the Centralization of POWER to DC, London,etc Because this has allowed Wall Street/ BUY THIS CONSOLIDATED POWER! The Goldman Sachs entities....PURCHASE the favor of a select group of powerful people....and you end up with a TAX CODE...that places LOOPHOLES for the richest to keep their riches...whether renewables projects whose funding allows massive tax write offs(30 year project write off against ONE YEAR OF INCOME AT GOOGLE, BUFFET, etC), Carried Interest, Al Sharpton or Clintons money laundering bribes via their "charities", sham holding companies or how every democrat kid appears to be a lobbyists for billionaires. Whether you make $100k in income or your stocks increase $100k, your house value increases $ pay the same LOW TAX! 80% of DC functions should be spread across the dilute the POWER and stop GROUP THINK! Just take a drive to upstate NY where 1/2 the houses are UNPAINTED!

  3. Ben Bernanke was reward with MILLIONS for Printing $4 Trillion and giving away that money to banks and billionaires for STOCKS and TAKING HOUSES and PROPERTY they caused overinflate in value? Rewarded with no show high paying jobs and speeches...lesson...REWARD THE RICHEST! Capitalism appears to mostly dead...with crony government capitalism and wall streetism.

  4. I am on the side of the argument that wealth inequality has grown in an exaggerated way, and also, in a destructive way. That said, I also believe in capitalism and democracy. The growing wealth dispersion is putting both at risk.

    Your example compares 2 people who have essentially equal means. Your scenario does not examine the multitudes of people who have lost bargaining power due to the dissolution of unions and bargaining power. Lower wage workers have had their wages competed away by foreigners and technological efficiencies, a true benefit to those of us who pay for goods and services, but not so good for people who are struggling to keep up with basic living expenses, rising healthcare expenses, and savings needed for an elongated life expectancy.

    On the flip side, those making salaries of amounts that far exceed even a high standard of living expense, including best schools for their children, vacation expense, and savings for older years, have been able to save and invest in markets that have provided exaggerated returns due to falling interest rates. Those savings have grown at exaggerated rates and the wealthiest of that set have used the bloated assets of this "exaggerated wealth dispersion" for uses that corrupt democratic election systems, stall efforts to protect natural resources, and have deterred reasonable government investment in infrastructure. Exaggerated wealth has also translated into well funded communication vehicles that support outright fabrication and that slander the free press, the lifeblood of our democracy.

    Finally, the swinging pendulum of lessening personal income taxes for the wealthy has absolutely exaggerated the growing wealth dispersion. Increased government sponsored investment in infrastructure, paid for by higher taxes on the wealthy is one example of an obvious win for our country, despite the small hit to accumulated wealth of the wealthy set.

  5. John Cochrane does an excellent job in describing why measuring wealth is a very dubious process.

    Perhaps even more dubious is measuring income, as domestic and international personal and corporate income and tax collection has become a shell game Gong Show. Then we have 80,000 pages of tax code and ideas such as adjusted gross income.

    It appears obvious that migrating our tax system to one based on property taxes, pollution, consumption, and imports would be a sensible move. But that will never happen. The question is why.

  6. Oh, mercy brothers and sisters: Tax consumption, and be done with it. Battalions of accountants would be put out of employment, who can then be free do useful things.

    1. I'm with you Frank. I find that property taxes have been the most unfair for me. If I earn $10,000 and spend it going on a spendy vacation to an exotic place, I get taxed for earning the money and probably for spending it. However if I instead use it to make an addition to my house, I get taxed for earning it, taxed for spending it, and then taxed every year for the rest of my life for the audacity of actually improving my surroundings. So unfair IMO to be taxed heavily if I improve my property, but far less if I blow my money on something that doesn't last.

    2. Right Dennis. The insidious part of property taxes is taxing unrealized profits. Compounding this travesty is being taxed when you sell your property.

    3. David, only if you realize capital gains on the selling.

      Property taxes are, very likely, the best way of financing a whole array of municipal services you get for free. Public school included.

      Consumption tax, property taxes and CO2 emissions are the most efficient and most pro-growth way of financing the government.

      We have to remember that "all we need is growth" ... Pigou would tell us that if we need growth it does not make any sense to tax "the growthers".


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