Hundreds of commentators have warned that extreme concentration of wealth threatens democracy and social stability. Not a day goes by without a new article with details on the unprecedented growth in income inequality and its dire consequences.
Something is missing, though. No one is proposing measures that would take away wealth from the 600 or so U.S. billionaires and the 20,000 families with hundreds of millions. Why not? Apparently, there is some tacit agreement that even the very richest earned their money, and therefore it would be immoral and un-American to take it away. Certainly the wealthy promote this idea, but why is it so universally accepted?
I suggest it is because our economic models don’t provide any alternative explanation for wealth accumulation. The classic models view output as a function of capital, labor and technical change. There is no room in these models for gigantic, undeserved bonanzas going to the few. It follows logically from these models that those who acquire vast fortunes must have exceptional gifts. They deserve their fortunes.
When one looks beyond the classical models, one sees clearly that those who have accumulated large fortunes did not in any sense earn them. They captured for themselves wealth that rightfully belongs to society at large. There is a strong, logical case for the government to tax all huge fortunes down to the level that society considers acceptable.
The Concepts of Potential Wealth and Wealth Surpluses
What the standard models miss is that in the real world, major economic disturbances, innovations, new resources and new markets all create huge amounts of potential wealth where the costs of transforming the potential into actual wealth are far less than the wealth produced. When these wealth surpluses are captured by individuals rather than spread widely across the population, large fortunes are created.
To clarify these concepts, consider a concrete example – an oil field that contains oil worth a billion dollars on the open market. The oil field is not yet discovered. Its potential wealth is a billion dollars. Suppose the costs of exploration, drilling, and all other costs of delivering all the oil to market (actualization costs) were 400 million dollars. The wealth surplus gained from actualizing the wealth of the oil field would be $600 million dollars — one billion dollars (potential wealth) minus $400 million dollars (actualization costs).
Who should get the wealth surplus? The oil field developer has no special moral or economic claim to it. The actualization costs of $400 million, which include a market rate of return on capital, fully compensate the developer for all costs incurred. If the oil field were part of a “commons,” it would belong to all members of the commons. Government would appropriately collect the wealth surplus and use it for the good of all members of the common.
Under the legal rules of capitalism as currently practiced, all the wealth surplus from the oil field goes to private interests (the developers and financiers). None goes to the public. This is neither equitable nor socially desirable.
As will be shown, the concepts used to explain the oil field example apply equally to potential wealth that is not tangible, for example, unrealized wealth opportunities in finance and technology.
There is no room in standard economic models for fortunes derived from wealth surpluses. In a world of perfect competition, where prices reflect the costs of production, there are no large wealth surpluses to be captured by an individual. The real world is very different. History shows that in times when huge wealth surpluses come into being, large portions of these often have been captured by a few individuals.
The Gilded Age
The Gilded Age of the 1800’s exemplifies the appropriation of wealth surpluses by a few individuals — the railroad, steel, and oil monopolists, to cite the most prominent examples. They didn’t create the railroad, steel and oil refining technologies. These grew out of a large body of evolving knowledge developed by many scientists, engineers, and individuals over many years. The monopolists simply got “legal” titles to the wealth that arose from the new technologies. If these particular owners hadn’t gained these legal titles, others would have. In a more perfect society, the steel and railroad and oil refining technologies, would have been considered social assets, belonging to all of the people. The wealth that arose from their development would have been broadly distributed, not flowing disproportionately to a few.
As an example, look more closely at railroads. The introduction of railroad technology transformed transportation. Prior to the railroads, all transportation not by water was by animal-drawn wagons, which were slow and uncomfortable for people and slow and expensive for goods. Suddenly, it became possible to move goods and people incredibly faster and cheaper. This was an economic discontinuity even greater than those created by the automobile and the internet. The wealth surpluses created by the introduction of railroad technology were enormous, unprecedented in magnitude.
The huge wealth surpluses created by railroads attracted every major entrepreneur and speculator of the era. Railroads were the perfect vehicle for accumulating fortunes. Not only did the first railroads create large wealth surpluses, they were natural and completely unregulated monopolies. Owners could charge whatever the traffic would bear, allowing them to appropriate much of the wealth surpluses that the railroads actualized.
According to standard economic models, the introduction of railroads should have increased the wealth of Midwest farmers. Suddenly, the cost of transporting their wheat and corn to market would have fallen precipitously; so their income should have risen accordingly. This did not happen. The railroads set their rates at levels far above the true costs, keeping the farmers in poverty and capturing the created wealth surpluses for themselves.
The wealth surpluses appropriated by the railroad owners made them incredibly wealthy. In a listing of the seventy-five richest people in recorded history, twelve acquired their wealth primarily through ownership of US railroads.
Is anyone willing to argue that the railroad millionaires (billionaires in today’s dollars) created the wealth they accumulated? They didn’t create the technology. They didn’t do the physical labor or produce the materials needed to build the railroads. All that they did was to acquire legal title to the railroads, ownership that allowed them to transfer the wealth surpluses to themselves.
The Robber Barons of the Gilded Age were ruthless businessmen, single-minded in their pursuit of riches, without legal or moral scruples, and gifted with a political and legal environment where greed and survival of the fittest were guiding principles. In a real and concrete sense, they stole most of their fortunes from the general public by establishing monopolies that allowed them to set unfairly high prices.
The Dynamics of Surplus Wealth Appropriation
When major innovative technologies emerge, they bring with them major wealth surpluses. What appears to be a repeating pattern is that early pioneers use their quickly generated wealth to establish market dominance, if not complete monopoly, by buying up or crushing competitors. They then are able capture a large share of the wealth surplus for themselves. When there is a surge in wealth surpluses such as occurred in the late 1800s, a further dynamic seems to that the courts and Congress come to reflect the interests of the rich and powerful.
In the United States in recent decades, most fortunes have arisen from micro-chip technology, globalization of trade, innovations in financial markets and, most recently, by capturing a large share of the wealth surpluses arising from the internet.
As was true in earlier eras, the recent entrepreneurs who have reaped large fortunes from wealth surpluses have no economic or inherent right to retain them.
The internet provides the most compelling and significant example of fortunes arising from private appropriation of wealth surpluses. For the sake of brevity, only the internet example is examined here is detail, but examining fortunes derived from financial innovations and trade globalization would lead to similar conclusions.
From an economic viewpoint, the emergence of the internet can be compared to the discovery of a hugely valuable, virgin, unowned land. The sudden ability to transmit vast volumes of information virtually instantaneously at almost no cost created a myriad of hugely valuable wealth opportunities. The costs of transforming these potential wealth opportunities into actualized wealth have been relatively small. Huge amounts of wealth surplus have been created. Individuals, investors, and corporations, have taken title to much of the wealth surplus, creating a new generation of ultra rich.
There is no valid argument that the individuals who gained fortunes from the internet have a “right” to keep them because they “created” the wealth they gained. That internet billionaires didn’t “create” the wealth is made obvious by considering what would have happened if Mark Zuckerberg and his backers had not developed Facebook. Absent Zuckerberg, does anyone doubt that something essentially identical would have come into existence at about the same time? Others would be the billionaires, but the functionality would be essentially the same. It is the capitalist system of ownership that has allowed private individuals and corporations to capture the vast surplus wealth of the internet.
Internet Wealth Surpluses Rightfully Belong to Society as a Whole
It needs to be emphasized again that a wealth surplus is the excess of actualized wealth over all the actualization costs (which include a market return on invested capital). Actualization costs fully and fairly compensate the actualizers for their services. Wealth surpluses are windfalls that arise from external factors, not from the labor, capital, and other resources used to transform potential into actual wealth.
Arguably, the potential wealth of the internet should be treated as residing in a commons. No individual or company created more than a miniscule fraction of the complex web of knowledge and equipment that constitute the internet. No individual or single company developed de novo the technology of the internet. The internet is a consequence of fifty years of inventions, innovations, development and marketing carried out by innumerable individuals, private and publicly funded colleges and research institutes, and corporations. The activities that brought into being and sustain the internet were and are inextricably interwoven into the web of our society. Society as a whole has a just claim to all of the wealth surpluses arising from the internet.
We have only looked at the internet in detail, but the same reasoning and findings apply to major fortunes however acquired. Those that gained huge fortunes did not create their wealth. External conditions created huge wealth surpluses, and through luck, skill, or influence, certain individuals were able to transfer a major share to themselves.
Upon close examination, all wealth-generating activities are seen to be dependent on society’s infrastructure, and thus society has a just claim on all wealth surpluses privately appropriated.
Rate of Return on Capital Measures the Magnitude of Privately Appropriated Wealth Surpluses
The rate of return on capital equals the amount of annual profit as a percentage of the amount of invested capital. In a perfectly operating, competitive free-market economy, the returns to capital wherever invested will tend to cluster around a “normal market rate of return,” adjusted for risks of individual investments. Shortages and market dislocations may raise rates of returns, but the rises will be temporary.
In contrast, investments that capture substantial wealth surplus will have rates of return on capital that are substantially greater than the normal market rate of return.
Consider Google and Facebook, two quintessential internet companies. Google’s profit in 2017 was $34.9 billion, compared to total capital invested in property and equipment of $42.3 billion, yielding a one-year rate of return of 81%. Facebook did even better. Its 2018 profit was $24.3 billion compared to invested capital of $13.7 billion, a one-year rate of return of 177%.
There is room for disagreement on what constitutes a normal rate of return on capital, but there is no question that Google and Facebook had rates of return that are multiples of a normal rate of return. Arguably a normal rate of return is around 8%. This is the average return on investments for the very wealthy, but using a higher value would not change the conclusion that Google and Facebook are capturing huge amounts of wealth surplus.
Rates of return on capital combine the financial benefits of wealth surpluses and monopoly pricing. Google and Facebook have captured such large amounts of wealth surplus because they are unregulated monopolies. Both bought up or crushed all significant competitors.
A Progressive Tax on Excess Profits
Rates of return on capital far above normal are concrete proof a company is transferring to itself wealth that rightfully belongs to others. There is a strong case for a progressive tax on such excess profits. It could start at zero on profits providing a normal rated of return. Marginal rates would rise along with rates of return. For rates of return unarguably above a normal return, a marginal tax rate of 90% or even higher is socially and economically justified.
Actual implementation of a tax on such excess profits would need to address numerous practical issues, many of which are common to any tax on company profits, but some of which are specific to this type of tax. One specific issue is setting a value for a “normal” rate of return. Various approaches will yield different values. Those affected will weigh in heavily, and the value chosen will be arrived at through negotiation. Still, history provides some guide. During WW I and WW II the US and England imposed excess profits taxes based on the rate of return on investment. The values chosen were in the range of 6% to 10%, with 7% and 8% being most common.
Some other issues are: How are capital investments to be valued? How to allow for depreciation, and obsolescence? How to deal with fluctuations in profits?
While complex and challenging, issues related to implementing an excess profits tax seem no more so than those related to the existing taxation of corporate profits.
Taxation of Wealth
Because those with large fortunes did not create the wealth they hold, they have no inalienable right to keep it. When individuals gain so much wealth that their economic and political power threatens democracy or harms the general well being, society is fully justified to take away that wealth. Although an excess profits tax and a sharply progressive tax on all sources of income would greatly reduce individuals’ ability to join the ranks of the ultra wealthy, these would not affect existing fortunes.
Individual wealth in the billions of dollars (and arguably, considerably lower levels) creates a threat to social stability and to the continuation of our democracy. A way to reduce socially excessive wealth holdings is through a tax on such holdings that exceeds the return on that wealth. High wealth holders earn an average annual return of about 8% on their wealth; thus the tax rate on excessive wealth holdings would need to exceed 8%. It would need to be significantly greater than 8% on extreme levels of wealth in order to bring them down to an acceptable level in a reasonable period of time.
Progressive taxes for the purpose of reducing excessive wealth holdings would be revolutionary and vigorously resisted by the wealthy. Because they address a critical need, they deserve careful consideration.
Vince Taylor is an economist, entrepreneur, and activist. He is currently focused on developing public support for taxation to reduce holdings of wealth that threaten democracy.