Thomas Piketty’s Capital in the Twenty-First Century has already captured a sizable share of the public’s attention and has prompted a lot of commentary. The commentary has ranged from glowing to lukewarm to extremely critical. Yet despite the many reviews—including my own in Barron’s —much remains to be said about Piketty’s attention-grabbing analyses of modern capitalism.

While discussing late 18th- and early 19th-century Britain, Piketty writes:

[I]t is also quite clear that, all things considered, this high level of public debt served the interest of the lenders and their descendants quite well, at least when compared with what would happen if the British monarchy had financed its expenditures by making them pay taxes. From the standpoint of people with the means to lend to the government, it is obviously far more advantageous to lend to the state and receive interest on the loan for decades than to pay taxes without compensation [130].

Wrong. This passage reveals a surprisingly weak grasp of basic public-finance theory.

Piketty reasonably assumes that if government finances its expenditures with taxes, then the rich would pay a disproportionately large share of those taxes. But he unreasonably assumes that debt financing of government expenditures not only allows the rich to escape higher taxes, but also gives them a lucrative stream of returns that adds to their net wealth. Unfortunately, alas, for the rich (and for everyone else), real wealth cannot be created in this rabbit-out-of-a-hat manner.

To see why, first understand that the value of real resources transferred initially by the rich to the government is the same with public-debt issuance as it is with taxation. (I readily accept Piketty’s assumption that it’s the rich who largely pay the taxes and that, with debt financing, it’s largely the rich who buy the bonds. ) If government today gets X amount more real resources to use, then the private sector has X amount fewer real resources to use. This reality holds true regardless of the method government employs to get these resources. Therefore, during the current period (the period when the loans are made and before interest starts to be paid on the debt), the amounts of real resources at the disposal of the rich are reduced by public-debt issuance as much as by taxation.

The difference is that taxation, unlike debt financing, results in the rich receiving neither repayment of principal nor interest on that principal in the future. But this difference is less real than it appears to be at first glance, especially given Piketty’s assumptions (in his discussion of government debt) that (1) the rich are the main targets of the taxman, and (2) families that are currently rich continue to be rich well into the future.

Of course, the government promises to repay all money that it acquires through borrowing, but it offers no such promise on the money that it acquires through taxation. The value of the prospect of repayment of money loaned to the government seems to mean that the present value of a plutocrat’s wealth will be higher if he or she lends X amount to the government than if he or she is taxed X amount by government. Piketty certainly makes this assumption, and he seems to believe that it will be higher by the full size of the public-debt issue.

But we now ask a crucial question that Piketty ignores: Who will be taxed tomorrow in order for government to get the revenue it needs to pay its bondholders? If we continue with Piketty’s own assumption that the rich are the main source of tax revenues, then the present value of tomorrow’s higher taxes must be subtracted from the value of the assets of the rich in order to determine just how rich the rich are today. Piketty does not make this necessary basic adjustment.

In short, because the bonds that the rich hold today must be repaid tomorrow with higher taxes—taxes to be paid mostly by the rich—the rich are not made wealthier by the government debt that they currently own.

For more on Ricardian Equivalence see “Does It Matter How You Pay for a State Dinner? A Lesson on Ricardian Equivalence”, by Morgan Rose. Library of Economics and Liberty, Sept. 24, 2001.

This conclusion does not depend on Ricardian equivalence. That is, this conclusion does not require today’s rich buyers of government bonds to accurately anticipate and fully internalize the burden of the future taxes that they must pay on those bonds and, hence, to be indifferent between funding government’s activities by paying more taxes today or by lending money to the government. Even if today’s rich buyers of government bonds are utterly unaware that government will raise their taxes tomorrow in order to be able to pay interest (and eventually principal) on those bonds, the fact remains that government must eventually extract more real resources from the private sector in order to meet its debt obligations. Again, if we continue to assume, as Piketty does when discussing government debt, that nearly all taxes will be paid by the rich, then new issues of government bonds do not make the rich richer (unless the government spends the resources in ways that enrich the nation at large).

While this conclusion holds whether or not Ricardian equivalence describes reality, we can see the validity of this conclusion more easily if we assume Ricardian equivalence. It’s intriguing, therefore, that Piketty explicitly argues that in early 19th-century Britain, Ricardian equivalence did indeed hold. This is intriguing because Piketty identifies early 19th-century Britain also as a time and place in which the issuance of government debt made the rich richer by saving them from paying higher taxes. (See the quoted passage above.) Yet if, back then, rich buyers of government bonds truly did anticipate that their and their heirs’ taxes would eventually rise by the full amount required for John Bull to meet his debt obligations, then it’s almost impossible to miss the fact that government-debt issuance does not allow the rich to escape the burden of being taxed to pay for government’s expenditures. Hence, it is also impossible to miss the fact that government debt issued under the conditions assumed by Piketty does not make the rich richer. Yet Piketty manages, inexplicably, to miss this fact.

II. Piketty on the Market for Executive Talent