Return on capital and economic growth

One of the core ideas of "Capital in the 21st Century" is comparing the after-tax return on capital, let me write that a little bit neater: return on capital, to economic growth. The contention is that if the return on capital (r) is greater than economic growth (g), then this would be associated with rising income inequality. More and more income is going to go towards the owners of capital versus labor. Since capital tends to be concentrated, you could view capital as wealth, and since wealth tends to be concentrated, this will only increase the concentration even further, leading to more inequalities in wealth.

Now, before we get into whether you believe that causality or not, let's just understand return on capital and how that might compare to economic growth, and how that might create returns to income for the owners of capital or income for labor. Let's think this through. Consider a very, very simple economy; let's say the whole economy is nothing but a gold mine. This is year one, and the whole value of the economy—all the wealth in it—let's say that we value it as a thousand gold pieces.

Of course, we could dive into how that is valued, etc., but that actually does come into the conversation. Are we thinking about the market value of things, or are we looking at some aspects on a more intrinsic basis? For now, let's go with this simple analogy just to start to wrap our heads around the ideas of return on capital, economic growth, and how they might relate to each other.

The capital, let’s say, is 1,000 gold pieces—I'll write gp for short. In that year, the national income (so it’s a gold mine) is just producing gold. National income, let’s say, had we have a national income of 100 gold pieces. This 100 gold pieces will be split between income to labor, since you need people to work in the gold mine, and the owners of the capital—those who own the land, tools, and so on.

Let’s say that 50 of this 100 gold pieces goes to labor, and 50 gold pieces goes to the owners of capital. We’ll assume there are no taxes involved in this scenario, so this is the after-tax income. We can now calculate the return on capital (r) in year one. The owners of capital got 50 gold pieces, and the capital that they employed was 1,000 gold pieces. So, 50 divided by 1,000 gives us 5 percent.

Now let’s think about this in the context of economic growth as we move from year one to year two. Let’s say, for argument's sake, that all the capital earned by the owners was reinvested back into the gold mine. Now, the value of the gold mine in year two will be 1,050 gold pieces—the original 1,000 plus the 50 we earned and reinvested.

If we say that national income grows by 2 percent, then the national income for year two becomes 102 gold pieces. Now, there are a multitude of ways to split this income, but let’s keep it simple.

Given that we’ve established our growth of 2 percent, the central question of the book arises: just because r is greater than g in this situation, does that lead to more of the national income going to the owners of capital, or does it go the other way around, or does the level of inequality remain neutral?

I encourage you to pause this video right now and think about that on your own. Given all these numbers, come up with different breakdowns of year two’s national income between how much goes to labor and how much goes to capital. Consider whether r being greater than g will always lead to more inequality.

It actually depends on how you break it down this year. You could definitely have a scenario where inequality grows. For instance, labor could still get 50 gold pieces while capital might get 52 gold pieces. The return on capital in this case would be 52 divided by 1,050, which yields almost 5 percent—specifically, approximately 4.95 percent.

In this scenario, r is greater than g, and we see that inequality is indeed increasing as the owners of capital are getting a larger share of the national income. Conversely, things may sway the other way. Perhaps labor had a bit more leverage this year, leading to negotiated wage increases, giving labor 52 gold pieces while capital receives only 50.

Now, calculating the return on capital here: the return is 50 divided by 1,050, which is approximately 4.76 percent.

In this very simplified analysis, just looking superficially at r and comparing it to g doesn’t necessarily mean rising income inequality will result. It can serve as a proxy, but if someone tells you in a given year that r is greater than g, you can’t definitively say that there has been an increase in inequality.

In the next few videos, we will delve deeper into that question, using spreadsheets to look at different scenarios—perhaps holding r constant or g constant to see what happens to inequality. We’ll explore these concepts further in the next video.