Are the Rich Rentiers or Superordinate Workers?

This is the third post in our series discussing The Meritocracy Trap by Daniel Markovits. Click here to read all posts in the series. 

Daniel Markovits –

I am grateful to the LPE Blog for hosting this exchange about The Meritocracy Trap. Today’s post will take up Hart’s and Steinbaum’s post and focus on facts, and tomorrow’s will turn to Gordon’s post and take up values.

Hart and Steinbaum claim that The Meritocracy Trap fails to recognize deep “differences between rich professionals and the ultra-wealthy capitalist class.” They also propose that the book exaggerates meritocratic inequality’s economic rationality, that “[i]t is not the meritocrats’ skills that bring in their high salaries.” In short, Hart and Steinbaum propose that the rich are not superordinate workers paid on account of their enormous productivity but rather are rentiers who exploit their capital to extract rents.

Hart and Steinbaum suggest that The Meritocracy Trap overemphasizes the rising labor incomes of the merely very rich and underemphasizes the exploding capital incomes of the super-rich. But in fact, although the past half-century has seen a shift of income against labor and in favor of capital, this shift is much too small to account for rising top income shares. Instead, rising economic inequality is principally caused by a shift of income within labor’s share, away from middle-class and towards superordinate workers.

The Bureau of Labor Statistics estimates that capital’s share of national income has grown by perhaps 8 percent since 1960 (other estimates are lower). Meanwhile, the top 1 percent of Americans by income hold roughly one-third of all capital. Therefore, capital’s rising share of national income cannot contribute more than 1/3 * 8 ≈ 2.5 percent to the increase in the top 1 percent’s share of income, overall. But the top 1 percent today captures roughly 10 percent more of national income than it did in 1960. This leaves ­­an increase of roughly 7.5 percent—or three-quarters of the total change—unexplained by a transfer from labor to capital. That increase—from redistribution within labor’s income share—is due to the decline of middle-class workers and the rise of superordinate ones.

In addition, the rich now derive the bulk of their incomes from selling their own labor. Thomas Piketty, alongside coauthor Emmanuel Saez, thus observes that by 1999, the wage share of the top 1 percent’s income (excluding capital gains from both the numerator and denominator) had reached fully three-fifths, while the wage share of the top 0.1 percent had exceeded half. Piketty, to be sure, also reports that the wage share of top incomes fell in the first decade of the new millennium, although it appears to have stabilized or even recovered slightly in the second.

Moreover, a mismatch between the categories that the U.S. government uses to report incomes and any fundamental distinction between labor and capital leads these writers to underestimate the labor share of top incomes. A comprehensive accounting attributes substantially more than half of 1-percenter income, now including capital gains, to labor.

Many measures fail adequately to account for the labor income of owner-operators of firms taxed as pass-through entities. The BLS, for example, assumes that proprietors “earn the same hourly compensation as the average employee working in their sector.” But this is increasingly too little. This effect alone accounts for perhaps a third of the decline the BLS estimate of labor’s income share.

Those who emphasize capital’s contribution to top incomes similarly underestimate the share of entrepreneurial income attributable to labor. Piketty typically apportions 70 percent of entrepreneurial income to labor and 30 percent to capital and applies this split uniformly both across income classes and across time. But the labor/capital ratio of entrepreneurial income has almost certainly been rising over time. The Meritocracy Trap therefore adjusts the share of top earners’ entrepreneurial income that it attributes to their labor so that it follows, in every year, the ratio of top earners’ core labor income (wages plus pensions) to their core capital income (dividends plus interest plus rents). This is a rough-and-ready approach. But its account of the labor share is surely more accurate than alternatives that assume a constant ratio. And recent, more high-tech work reaches broadly consistent conclusions.

Capital gains present a second important source of difficulty in allocating income between capital and labor. “Capital gains” is a term of art from tax law, and some capital gains income is, fundamentally, a return to the labor of the superordinate workers who capture it. “Carried interest” income—captured by hedge fund managers for investing funds that they administer but do not own—is a direct substitute for management fees that they would otherwise charge, just as a lawyer’s contingency fee is a direct substitute for the hourly fees that she would otherwise charge. This is why progressives have long objected to the beneficial tax rates that capital gains treatment gives carried interest income and argued that it should be taxed as wages, at so-called “ordinary income” rates. Certain income associated with the stock or stock-option components of compensation paid to top managers and income attributable to “founders shares” held and eventually sold by entrepreneurs are also, fundamentally, a return to these elite workers’ labor.

To be sure, all these forms of income often arise in the vicinity of capital, and some of them are even doled out as shares of returns to capital. But they all remain labor income, just as a plumber who installs luxury bathroom fixtures captures labor income even when her customers are capitalists and her rates depend on their wealth. Economic form and moral attribution can come apart, and income that takes the form of a return to capital (the hedge fund manager’s carried interest) might be rightly attributed to labor (the manager’s investment skill and effort, applied to capital she does not own), at least from the perspective of meritocratic morals and politics.

Many observers, following Piketty, nevertheless allocate capital gains entirely to capital rather than labor income. The Meritocracy Trap again takes a different view, and allocates some “capital gains” to labor income. This makes a consequential difference to the composition of top incomes. Hedge funds, for example, take a distinctive legal form that makes it possible to see that carried interest income’s contribution to the total capital gains reported each year has grown from negligible at mid-century to substantial today.

These effects significantly increase the labor share of top incomes. The adjustment for proprietor’s labor income, taken alone, leads Matthew Smith, Danny Yagan, Owen Zidar, and Eric Zwick, to conclude that the 1 percent owes more than half of its total income to its labor. The Meritocracy Trap estimates that overall “both the top 1 percent and even the top 0.1 percent today receive between two-thirds and three-quarters of their income in exchange not for land, machines, or financing but rather for deploying their own effort and skill.”

These facts matter politically. The 1 percent’s sense of entitlement may be offensive, but it not conjured in a moral vacuum. Instead, it rests on powerful ideals of merit and desert that condemn leisured aristocrats but valorize meritocratic industry and accomplishment. It would be convenient—both for social theory and political practice—if the new rich were just like the capitalists from the past. But the facts tell a different story, and the book follows the facts.

Hart and Steinbaum propose a second ground for skepticism of The Meritocracy Trap’s claim that 1 percent incomes are dominated by labor. Although all economic output in a society must come from just two inputs, capital and labor, an individual’s share of output might helpfully be said to turn on a third input, namely strategic advantage. Hart and Steinbaum thus claim that, rather than being a return to skills or productivity, the income that The Meritocracy Trap attributes to labor is in fact a rent—“the return to economic control and the power to coerce.”

Elite rent-seeking and even outright fraud and theft are of course real and likely rising. But these effects, as The Meritocracy Trap explains, are again much too small to account for the explosion of top incomes. For example, the most careful study finds that rents contributed little to rising finance-sector incomes from the 1970s through the 1990s and that, since the 1990s, between 20 and 30 percent of the increase to risk-adjusted finance wages stems from rents, with between 70 and 80 percent stemming from finance workers’ rising skill. Similarly, “the level of CEO pay in companies owned by private equity firms is statistically indistinguishable from the level of pay in comparison firms” that are publicly held, which suggests that CEOs do not simply exploit diffuse shareholders and fix their own pay.

At least as importantly, the book also explains that even if the income paid to elite workers should be attributed to labor rather than rents for purposes of meritocratic moral accounting, this does not make the income earned or deserved. In fact, The Meritocracy Trap argues, a better accounting reveals that the labor income in question is not deserved at all. The left need not get the facts wrong to get the values right.

The Meritocracy Trap’s core ambition is to develop arguments that explain why meritocratic inequality—accurately measured and rightly understood—remains offensive. This brings us to the historical background and policy insights that Jeff Gordon’s post engages, and which tomorrow’s post will pursue.

Daniel Markovits is Guido Calabresi Professor of Law at Yale Law School and author of The Meritocracy Trap.