Unpicking Piketty on pensions

According to columnists on the left, Thomas Piketty’s new book, Capital in the Twenty-First Century, has not been adequately answered by those who believe in free-market capitalism.

One obvious policy response to a tome that argues that the owners of capital will do better than the rest is a return to the agenda of popular capitalism. This was implicitly referred to in a ConHome post by Garvan Walshe. Politicians have deserted that agenda. The property owning democracy is under threat from planning laws and, in addition, private pensions have been undermined in recent years. In 2016 the government will be abolishing the last vestiges of the 50-year-old policy of allowing people to opt out of part of the state pension and make private provision instead.

If capital grows at a higher rate of return than the economy as a whole, signalling to the bottom 40 per cent of the income distribution that they do not need to save and that the state will provide, will exacerbate inequalities. In fact, back in the late 1990s, I coined the term ‘pensions apartheid’ (which is now often used in the different context of the public sector pensions debate) to describe the phenomenon whereby the better off will receive their income largely from private capital accumulation through pension funds and those below median earnings will receive only a state pension and thus be excluded from the process of capital accumulation.

We need to change course. In a paper that will be released by the IEA later this month, a new proposal for pension privatisation will be presented proposing that people should be allowed to ‘contract out’ of part of the state pension again. They would receive a rebate from the state equal to the value of the state pension that they would forego by contracting out, even if that rebate were greater than the level of national insurance contributions made by the individual. In other words, all the redistributive aspects of the current state pension system would be preserved but everybody – including the less well off – would be able to opt for private pension provision and build up a pool of capital.

The value of the state pension accumulated by a 40 year old (who would have accrued about 60 per cent of his total potential state pension rights by that age) would be about £120,000, so the capital that could be accumulated if people were able to opt out of the state pension would be meaningful. Specifically, the paper proposes that people can replace half the state pension with private provision.

Currently, non-housing capital accumulation amongst the poorest half of the population is as close to zero as makes no difference. Instead the less-well-off have the value of their accrued state pension rights. However, with a simple policy change, the less-well-off could participate in the capitalist economy rather than having a claim on future taxpayers.

Piketty argues that the rate of return on capital is higher than the rate of growth of the economy as a whole and so those without capital will, relatively speaking, suffer. However, for those whose only asset is a state pension, the future is even grimmer. Given low fertility rates and increased life expectation, taxes have to rise to pay for a given level of state pension. These taxes are levied on wages and not on capital.

Piketty did not neglect the fact that his work might imply that social security systems should be privatised. He considers the proposal and dismisses it on spurious grounds leading one to wonder whether it is the economics or the politics that his driving his policy conclusions.

Firstly, Piketty argues that there are transition problems to a fully-funded pension system. That is true. However, they have been written about widely and are certainly no insurmountable. Piketty then says that the rate of return on capital is very variable and, as such, funded pensions are risky. He suggests that the rich can wait ten or 20 years to allow the volatility of investment returns to smooth out. However, pensions are savings vehicles with a time horizon much longer than that.

Piketty also suggests that there is the potential of poor returns over a whole generation and that funded pensions would be betting everything on the role of a dice. By a whole generation, does he mean more than ten years? If so, then it is also the case that a generation of rich people could lose all their wealth and, as such, the interpretation of his thesis that suggests that rising inequality is inevitable must be called into question.

Finally, Piketty ignores altogether the huge systemic and completely unmanageable risks of demographic decline leaving countries with unaffordable state pensions (and healthcare) systems. Not only that, the empirical link between low birth rates and state pensions is well known: in other words, the state pension systems that Piketty supports actually help create the conditions for their downfall and lead to the increase in labour-market taxes which will penalise the people he suggests are most vulnerable to rising inequality.

In short, Piketty’s analysis in this area seems to be driven by his desired conclusions. This is not good economics – nor does it lead to good policy.

This article was originally published by ConservativeHome.

Academic and Research Director, IEA

Philip Booth is Senior Academic Fellow at the Institute of Economic Affairs. He is also Director of the Vinson Centre and Professor of Economics at the University of Buckingham and Professor of Finance, Public Policy and Ethics at St. Mary’s University, Twickenham. He also holds the position of (interim) Director of Catholic Mission at St. Mary’s having previously been Director of Research and Public Engagement and Dean of the Faculty of Education, Humanities and Social Sciences. From 2002-2016, Philip was Academic and Research Director (previously, Editorial and Programme Director) at the IEA. From 2002-2015 he was Professor of Insurance and Risk Management at Cass Business School. He is a Senior Research Fellow in the Centre for Federal Studies at the University of Kent and Adjunct Professor in the School of Law, University of Notre Dame, Australia. Previously, Philip Booth worked for the Bank of England as an adviser on financial stability issues and he was also Associate Dean of Cass Business School and held various other academic positions at City University. He has written widely, including a number of books, on investment, finance, social insurance and pensions as well as on the relationship between Catholic social teaching and economics. He is Deputy Editor of Economic Affairs. Philip is a Fellow of the Royal Statistical Society, a Fellow of the Institute of Actuaries and an honorary member of the Society of Actuaries of Poland. He has previously worked in the investment department of Axa Equity and Law and was been involved in a number of projects to help develop actuarial professions and actuarial, finance and investment professional teaching programmes in Central and Eastern Europe. Philip has a BA in Economics from the University of Durham and a PhD from City University.