What Determines How Wealthy You Become?

Summary

• A new NBER paper explores the origins of wealth using a unique granular dataset.
• They find labour income drives wealth inequality for most of the population, but capital income does for the top 1%.
• Inheritance and gifts have no discernible bearing on future wealth, and policies taxing inheritance are largely redundant.
• Children with wealthy parents accumulate wealth through different sources than those with poorer parents. These sources mean they are likely to remain wealthy in the future.

Context – The Origin of Wealth Inequality

Income and wealth inequality have become political flashpoints in recent years. Yet the exact origin of wealth inequality remains murky. Do people get rich based largely on income earned in the labour market? Do large capital gains on real and financial assets matter more? And to whom? Or is wealth inherited, as French economist Thomas Piketty argues?

A new NBER working paper uses a unique Norwegian dataset that studies individuals’ wealth over 20 years. They look at segments of the population, including the super-rich. They find:

• Current wealth proxies potential wealth well, particularly for those at the top. That is, the wealthier an individual is today, the more likely they are to be wealthy in the future.
• Labour income is the most important determinant of wealth, except among the top 1%. Meanwhile, inheritances and gifts do not drive wealth outcomes, even among the top 1%.
• Equalising wages and increasing government transfers to poorer cohorts compresses the wealth distribution, while higher returns on real estate and risky financial assets widen it.
• Parental wealth significantly influences child wealth. Children of the top 1% receive greater inheritances and invest these resources to receive a disproportional amount of their wealth from capital income.

Methodology and Data – Cumulative Wealth and Tax Authorities

The authors create a sample of individuals aged between 26 and 46 in 1994 and record their net wealth at that time. They then also record all the income received from various sources every year from 1995 to 2013. The authors use administrative data on wealth collected from a tax-based register, unique to only a handful of countries. By design, this is more informative than survey-based data used across EU countries. They measure wealth in four ways:

1. Gross wealth. This is financial wealth plus the value of real assets. Financial wealth includes labour income, transfers, capital income, inheritance and gifts, lottery gains, capital gains (includes physical capital help in private businesses but excludes pension wealth).
2. Net wealth. In any given year, net wealth is gross wealth minus income outflows from wealth tax and consumption. Tax authorities and financial intermediaries collect this data.
3. Potential wealth (PW). This is the 19-year sum of all gross wealth inflows minus cumulative wealth tax paid, plus 1994 net wealth. It differs from an aggregated version of net wealth in that it ignores consumption; i.e., it represents the wealth an individual could have accumulated, netting out their spending habits.
4. Deep potential wealth (DPW). This considers just primary sources of income – labour, government transfers and gifts/inheritance. It represents an individual’s potential wealth in 2013 had they consumed nothing and all wealth was invested at a typical rate of return.

Results

Spending doesn’t impact wealth unless you have children

First, the authors check the correlation between net wealth and potential wealth in 2013. Given the difference between the two relates purely to consumption habits, a high correlation suggests that differences in spending and consumption patterns are not a large component of differences in wealth across individuals.

The correlation is high (0.78) and higher for the wealthy in particular. This suggests the wealthy tend to remain wealthy regardless of their spending habits. They also find that net wealth and potential wealth diverge most when households have children, when the majority of their income is labour income, and when they inherit less.

Capital matters for the 1%

Next, the paper examines wealth’s origins. Potential wealth is disproportionately composed of labour income, especially for the bottom 80% of the wealth distribution, with capital gains on real assets (e.g. houses) also playing a big part. For the top 1%, capital gains are the main source of wealth (Chart 2). On the other hand, inheritance and gifts represent only a very small share regardless of wealth (note these are shares – the value of gifts and inheritance varies substantially).

Source: Paper, page 41

The origins of wealth also depend on age. The importance of labour income declines as individuals age, while capital income and, especially, transfer income (which includes pension income) play a larger role. Inheritance and gifts initially play no role, then they increase in significance during middle age before petering out again.

Counterfactuals – What if?

The paper’s method lends itself to the use of counterfactuals. For example, what if the wealthy received a 100% tax on inheritance? In total, the authors create five counterfactual scenarios:

1. Equalising labour income: This has the largest quantitative impact on wealth dispersions; i.e., labour income differences play a large role in creating variation in potential wealth. In an extreme scenario, if everyone had the same pay, inequality would fall by 22%.
2. Redistributing capital gains and returns on risky assets: This would have the second-largest impact on wealth distribution. By giving all individuals across the income distribution the same net capital income (e.g., £5,000 pa), overall inequality would reduce by 20%.
3. Limiting capital income: This also compresses the wealth distribution but has a smaller impact than labour income. Removing capital income for all would increase wealth equality by 15%.
4. Government transfers for everyone: If everyone received the same level of state support, irrespective of wealth, the distribution would become 15% less equal. This is not because the wealthy get richer (government cheques would have much smaller relative impact on the 1%). Rather, there would be a larger fraction of poorer individuals (Chart 3). This is because the bottom end of the distribution would receive relatively less than they already do.
5. Capping inheritance at $6,000: This policy would have very little impact on the wealth distribution. The Gini coefficient stays the same.

Source: Paper, page 50 – note x-axis units are NOK

Do Parents Influence an Individual’s Potential Wealth?

Yes! The authors show that individuals with rich parents get their wealth disproportionately from capital income and returns on financial wealth. This source of wealth is very different from children with poorer parents, who continue to rely significantly on labour income (Chart 4).

Interestingly, the authors show inheritance is not the main driver of a wealthy child’s potential wealth. But they suggest it could still play a role. For example, in absolute terms, wealthy children will receive larger sums of inheritance (say £100,000 vs £10,000). They then invest these resources into financial investments so that they receive a disproportionate amount of capital income in the future. In essence, inheritance crowds-in other forms of income.

Source: Paper, page 57

Bottom Line

This paper makes an important distinction in wealth inequality. The wealth inequality of the top 1% is mainly due to capital, while the wealth inequality in the rest of the population is mainly due to labour income differences. Moreover, inheritance appears not to drive inequality. This has significant policy implications. Policies that tax inheritance are largely political and have little impact on wealth disparities. Government transfers should be conditional on wealth, otherwise they increase inequality. Children with wealthy parents accumulate income through different sources; these sources mean they are likely to remain wealthy in the future.

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