Inherited wealth

By Buttonwood

WHILE Downton Abbey may be a popular TV series, not many people see it as a model for how society should function. The age of aristocracy, along with inherited wealth and privilege, are behind us; we are all meritocrats now.

But is that really true? Once again, Thomas Piketty, in his book "Capital in the 21st Century", has come up with some interesting insights (for more posts on the book, see here and here). His primary thought is that

Whenever the rate of return on capital is significantly and durably higher than the growth rate of the economy, it is all but inevitable that inheritance (of fortunes accumulated in the past) predominates over saving (wealth accumulated in the present).... Wealth originating in the past automatically grows more rapidly, even without labour, than wealth stemming from work, which can be saved.

How does one measure the importance of inheritance? One approach is to rely on tax data but this is often incomplete and makes international comparisons difficult (because of the different tax treatment of asset classes). So the alternative approach, favoured by Piketty, is to look at the economic flows.

To spare you the algebra, the key measures are the capital/income ratio (the ratio of wealth to GDP), the mortality rate (the proportion of the population that dies in any year) and the ratio of average wealth at the time of death to the average wealth of the living.

So if the capital/income ratio is 600%, the mortality rate is 2%, and the dead are twice as wealthy as the living, then the annual inheritance flow will be 600%x2%x2, or 24% of national income.

As will be apparent to those who watched an earlier TV equivalent to Downton Abbey, Upstairs Downstairs, the importance of inherited wealth declined significantly in the middle of the 20th century; the great landed estates fell into disrepair or become tourist traps. As Mr Piketty shows, all three elements of his ratio played a part. The capital/income ratio in Europe fell heavily; high taxes ruined estates, inflation eroded holdings of government bonds and nationalisation destroyed the value of holdings in equities. Mortality fell, so that in any given year the proportion of inherited wealth declined. And the dead briefly became less wealthy than the living.

If this last point seems surprising, it is what the data from France (Mr Piketty's homeland) shows. In 1913, the ratio of octagenarian wealth to that of fiftysomethings was 257%; by 1947, that ratio had dropped to 62%. If you lose your wealth in your 80s, you have no chance to rebuild it; at least fiftysomethings have a few years of work left.

By the 1950s, the idea that the best route to wealth was by inheritance (a commonplace of novels by Jane Austen or Honore de Balzac) had vanished. Inheritances as a proportion of national income fell from 24% to 1900 to around 4% by 1950. Another way of looking at the issue is to look at the share of inherited wealth as a proportion of total wealth; this was 90% before the First World War but fell to 45% by 1970. Meritocracy appeared to have triumphed.

But from the 1950s onwards, two of Mr Piketty's factors started to shift back; the capital/income ratio and the dead/living wealth ratio. Inheritances are back at 11% of French national income. How will this change going forward? On Piketty's central assumption of 1.7% annual economic growth and a 3% return on capital, inheritance flows will rise to around 16-17% of national income by mid-century and then stabilize. A more pessimistic view (1% growth rate and 5% return on capital*) would see the ratio get back to 24-25% of national income, the pre-1914 state. In this latter case, inherited wealth would be 90% of all wealth.

The key point is that if wealth is concentrated (as it is increasingly becoming) and if the return on capital is high enough, then the wealth becomes self-perpetuating. Another way of looking at the data, provided by Mr Piketty, is to see what fraction of each birth cohort will receive a sum in the form of inherited wealth that is larger than the lifetime income earned by the bottom 50% of the population. Around 10% of those born in 1830 (who inherited in the late 19th century) acheived this feat. Only 2% of those born in 1910 (whose parents thus died in the 1950s) did so. The ratio is climbing again; Mr Piketty estimates that 12% of those born in 1970 may cross this threshold.

Is France an outlier? The reason Mr Piketty focuses on it is that the government has collected very detailed data on wealth since the revolution. The German pattern (in terms of inheritance flows, at least) looks fairly similar; Britain saw a similarly big decline but has not seen the same rebound. (British pensions have to be invested in annuities, which expire on death, and nursing home fees eat up a high proportion of middle-class nest eggs.) The American data are not great; but such evidence as there is suggests the cycle has been smoother. The US was less unequal than France pre-1914, saw less of a battering for wealth in the mid-20th century (the wars had less impact) and has seen a rebound but not to French levels.

Finally, what should we think about all this? Many people pay lip service to meritocracy but get very het up about inheritance taxes, or death taxes as they like to call them. It is often said that inheritance taxes represent double taxation but in many cases that isn't true; for middle-class people, their biggest asset is usually their home on which capital gains tax is not paid. Similarly, business owners only pay capital gains tax when they sell; by definition, if they are passing a company on to their heirs, they have not sold.

If one assumes that an economy functions best if the most talented people rise to the top, then inherited wealth rigs the deck. There is a lottery effect; if your parents owned property, or die early (before they spend their savings on nursing care), then you have a big advantage over others who may be just as hard-working or talented. Wealthy people already pass on a lot of advantages to their children; they can afford better education, and a better environment at home (more books, quiet places to study etc).

History, as well as fiction, suggests that being born to inherited wealth is not normally a spur to greater effort; instead, life is devoted to social display or indolence. The world hardly needs a new class of Bertie Woosters.

* Before anybody complains that you can't get 5% these days, the return on capital for this measure includes profits; much private wealth is in the form of ownership of companies.