In this paper, Arnott, Bernstein, and Wu debunk the thesis of the French economist Thomas Piketty, popularized in his 2013 blockbuster tome, Capital in the Twenty-First Century. Piketty warns that wealth inequality is rising rapidly because of a growing pool of dynastic wealth passing from generation to generation. The authors’ empirical analysis of the Forbes 400, as well as other lists of the wealthiest U.S. individuals back to 1918, shows that this is not true. Most wealth is first-generation wealth, held by the entrepreneurs and innovators who built the fortunes. The primary cause of increasing wealth inequality is, in fact, the long-winded bull market of the last four decades. But this windfall of high valuations comes with its own moderating force on wealth: low future expected returns.
The authors begin with a critical exposition of the two “fundamental laws of capitalism” upon which Piketty predicates his argument. The first is that capital’s contribution to national income is a function of the real return on capital (r) and the capital-to-income ratio. The second “law” defines the capital-to-income ratio as the savings rate divided by the real growth rate (g) of the aggregate economy.
In brief, the authors begin by explaining that Piketty’s assumption of an essentially fixed 5% real return on capital is unrealistic. Not only is it a naïve supposition in today’s low-yield world, it is unsupported by historical experience. Common ground, however, is forged between the authors and Piketty on the view that global output is slowing, estimated at 1.5% for the second half of the 21st century. But their opinions diverge on the prospective real returns that the wealthy can earn in this slower-growth environment. Piketty also presumes a constant net savings rate of 10%; the authors show this is far higher than the average U.S. savings rate in the 50 years since 1960.
An even stronger rebuttal of the implausibility of a static 10% savings rate is what would happen (based on Piketty’s second “law”) in a slow-growth environment, which is, after all, the scenario Piketty forecasts. If growth were to slow dramatically, as much as 100% of national income would need to be allocated to investment in order to maintain such a high savings rate—this is, of course, impossible.
In the authors’ view, Piketty overlooks the fundamental reason why the wealth of the wealthiest 1% has grown so rapidly: the phenomenal bull market in core assets since 1975. Piketty focuses instead on what he believes to be an excessive and widening gap between r and g—that is, an unrealistically high r, which allows wealth to grow faster than the macroeconomy and without any obvious limits. The authors point out that Piketty’s r is not the return on investment portfolios, but the real growth in those portfolios, net of the depletion of taxes, spending, division among heirs, and charitable giving.
Ten of these forces are identified by Arnott, Bernstein, and Wu. They include low security returns, investment expenses, income and capital gains taxes, performance chasing and poor investment decisions, charitable giving, hedonic readjustment of the standard of living, division among heirs, estate taxes, estate and tax battles, and last but not least, spending. They estimate the cost of these forces to be 10% a year of return (1% for each) over an investment portfolio’s lifetime. This assumption translates into a real return for an investment portfolio of −5% a year, given Piketty’s assumption of a 5% real return. That means real net worth would be slashed in half every 14 years—and the authors believe this to be a best case scenario.
Because Piketty references the Forbes 400 list as an example of wealth concentration over the last three decades, the authors conduct an empirical analysis of the list since its inception in 1982. In addition, they include earlier lists (1918, 1930, 1957, and 1968) compiled by Kevin Phillips.1 Ostensibly, if Piketty were correct, the composition of the lists would change little from year to year. In fact, only 34 names from the 1982 list appear on the 2014 list, and only 24 names have been included in each of the 33 lists. Grouped by family, the 2014 list comprises 69 families from the inaugural list, and only 36 of these families have made it onto every list. Aggregate wealth of the 69 inaugural families composes 39% of total wealth represented by the Forbes 400 in 2014. The balance of 61% is largely newly created wealth over the last 32 years.
An analysis of the Phillips lists shows that descendants of only 29 of the 76 richest families, very recognizable names such as Du Pont, were able to maintain sufficient wealth to make the Forbes lists. Considering the top 10 families in 1918, 1930, 1957, and 1968, the half-life of their wealth was 13 years, 10 years, 13 years, and 8 years, respectively.
The composition and turnover of the Forbes 400 in the 33 years of its existence is a combination of three factors—on the plus side: 1) new wealth creation arising from innovation, ingenuity, and ideas that generate jobs, and 2) expanding pools of wealth as a result of a prolonged bull market; and on the minus side: 3) wealth erosion from multiple depleting forces. The wealth erosion of surviving members (i.e., those who continue to appear on the Forbes roster) of the 69 inaugural families from 1982 to 2014 is roughly 4% a year. Lengthening the time frame to include the Phillips data, the authors find that the 4% annual erosion rate holds over the period from 1918 to 2014. The erosion rate assumes the best case scenario; that is, that the wealth of the family disappearing from the list is just one dollar less than the threshold amount to get on the list in the year they dropped off, a very generous assumption indeed.
Another finding by the authors is that those who directly inherit from the wealth creator—children and grandchildren—dissipate their largely unearned wealth quite rapidly. The top 30 members on each of the Forbes lists, grouped by generation, are tracked from year to year. Most first generation wealth creators are successful in maintaining their wealth over their lifetimes, but the second generation halves its wealth in 24 years, and the third generation in 11 years. Their respective average dissipation rates are 1.1%, 3.2%, and 6.0%.
The authors state their concerns lie not with the sources of wealth inequality but of income inequality, largely the hollowing out of the middle class, fueled by the excessive compensation packages awarded to corporate managers. They suggest that one way to combat this source of income inequality is for shareholders to be more diligent in their governance monitoring processes.
Arnott, Bernstein, and Wu end by pointing out that policies intended to fix wealth inequality may have the untoward effect of reducing incentives for entrepreneurs and innovators to create great wealth, knowing that it will be taken away. They further observe that wealth inequality may actually not need “fixing” at all because the wealthy are very skilled at dissipating their own wealth, recycling it back to society remarkably quickly, with a half-life of anywhere from 8 to 24 years.
Summarized by Kay Jaitly, CFA.