What Warren Gets Wrong About the Rich

(Bloomberg) —

Massachusetts Sen. Elizabeth Warren’s proposal for a “wealth tax” is the latest example of the Democratic impulse to soak the rich. The idea seems to be that higher tax rates will prevent them from getting so much money and power in the first place — and that this in itself is a worthwhile goal, aside from any revenue such a tax might raise.

As one of Warren’s economic advisers has written, higher tax rates are necessary as a way of “safeguarding democracy against oligarchy.” Her plan would impose a 2 percent marginal tax on net worths above $50 million, and 3 percent for each dollar above $1 billion. Meanwhile, an adviser to Rep. Alexandria Ocasio-Cortez (D-N.Y.) has renamed his Twitter account, “Every Billionaire Is a Policy Failure,” and a former adviser to Senator Bernie Sanders has observed: “No one makes a billion dollars. You TAKE a billion dollars.”

But what if the rich aren’t quite who Democrats think they are? What if most of them get their income not from capital, but from labor? That’s the intriguing question raised in a recent economic paper titled, “Capitalists in the 21st Century.”

The title is a provocative riff on Tomas Piketty’s 2014 bestseller “Capital in the 21st Century,” the 700-page treatise that helped ignite the inequality battle among economists. The paper takes on one of Piketty’s [most condemnatory] claims: that, since 2000, rising inequality has been driven by gains to the owners of capital at the expense of workers. Left unchecked, this trend would inevitably produce a new aristocracy of capital owners, commanding an increasing share of society’s resources.

Not so fast, the paper argues. Most of the income that Piketty and other researchers have attributed to capital actually comes from what are known as pass-through entities — that is, partnerships or so-called S-corporations, which have a limited set of owners.

The median number of owners of a pass-through entity, the paper notes, is two, while the very largest still average only 3.4 owners. And 93 percent of those owners are actively engaged in the operations of their businesses. These owners saw their income peak in their 50s, matching the peak earning years for high-salaried professionals; in contrast, landlords, bondholders and other idle owners of capital usually see their peak earnings at age 70.

This suggests that the capital income of pass-through owners is really compensation for their work, which is concentrated in professional services, especially legal services. Moreover, pass-through companies that have the highest-earning owners also have the highest profits per worker. This suggests that owner-managers are effectively being compensated for better performance.

Granted, a question remains: Are they overcompensated? This is an allegation frequently leveled at corporate CEOs, and it has proved very difficult to answer. With smaller businesses, however, the answer is clearer: The paper looks at what happens to a pass-through entity when a manager dies or retires. In both cases, the profitability of the firm falls by more than 80 percent, and the decline is permanent. Without the owner-manager, the business simply isn’t as profitable.

These findings have profound implications for the larger debate over inequality. If this income is from labor instead of capital, then it changes the picture of what’s happened in America over the last two decades. Rising inequality is quite real — but maybe it’s the result of ever higher compensation for superstar entrepreneurs and skilled professionals, not of outsized gains to idle capitalists.

Nor is the stage being set for an oligarchical takeover. When these owners die or retire, the incomes they were earning are not passed on to their heirs. Just as important, 91 percent of the entrepreneurs in the top 1 percent had parents who were not in the top 1 percent.

Rising inequality in America is a serious concern. But the main cause is a shortage of highly skilled professionals and entrepreneurs. The goal should be to solve that problem, ideally by making it easier for people to get advanced degrees and start new businesses. The goal should not be to soak the rich.

Smith is a senior fellow at the Niskanen Center and founder of the blog Modeled Behavior.

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