Where did all that wealth come from?
By: Ian Mulheirn
Tags: Policy, Wealth Inequality, Inequality, Wealth Tax, Economics

Where did all that wealth come from?

Household wealth in the UK has increased by almost £10 trillion in the past 25 years, from just £4.9 trillion in 1995 to £14.6 trillion by 2017 (all in 2017 money). This is a staggering explosion of wealth. No wonder that at a time when the public finances are under pressure, as they have been since the financial crisis, political interest has grown in the idea of a wealth tax — an annual levy on the value of a person’s wealth. But where did these riches come from and does that shed any light on whether or how they might be taxed?

The Warwick-LSE Wealth Tax Commission was set up to explore the case for such a tax and the final report, due next month, will no doubt be a thoughtful and comprehensive piece of work. Ahead of that, the Commission recently published a series of fascinating evidence papers that have fed into their thinking, along with my contribution exploring the sources of UK wealth and their implications.

There has long been huge interest in the level of wealth and its growth— from the Times Rich List to think tank dissections of its distribution. But there has been remarkably little discussion of what caused the explosion of wealth in recent years and what that means. It almost seems to have been taken for granted that the accumulation of wealth should vastly outstrip economic growth, as it has so far in this century. But this recent experience isn’t normal.

For most of the postwar era, household wealth fluctuated between 300% and 400% of GDP. But in the late 1990s it took off, rising to over 700% of GDP by 2017. This manifests itself in much-debated intergenerational inequality, especially when it comes to housing, which translates into intragenerational inequality.

Where did it all come from?

How can this have happened? One widely acclaimed story of wealth accumulation is outlined in Piketty’s Capital in the 21st Century. He argues that the income from capital held by the wealthy outstrips their consumption, causing them to accumulate more and more savings. When the economic growth rate drops, as it did in the late 20th century, that wealth grows as a proportion of GDP.

But this story doesn’t fit the UK story particularly well. While there has been an increase in the share of wealth held by the top 1% (up from 17.6% in the early 1990s to around 20% by the early 2010s), this is nothing like enough to account for the 300%-of-GDP increase in aggregate wealth over the period. Indeed, for the roughly half of households who hold some significant wealth, the increase in the value of their holdings has been broadly similar. With pensions and housing representing 77% of household wealth, it is these categories that have driven the wealth explosion for both the very wealthy and those of more modest means alike.

Nor is the increase in wealth the result of ‘saving’ in any meaningful sense. Rather the overwhelming driver has been capital gains on interest rate-sensitive assets as risk free interest rates have tumbled around the world. Most readers of this will probably be familiar with the growing evidence that falling interest rates explain the doubling of the price-to-income ratio on UK housing.

I find that a similar story is true for pensions. In the Wealth and Assets Survey, just shy of 90% of pension wealth — almost 4 in every 10 pounds of total household wealth — is estimated, rather than directly observed. Estimates are made by applying discount rates to the income streams promised to pension holders in order to back out an implied stock of wealth.

It’s therefore relatively straight forward to see how pension wealth would have changed had interest rates remained at their 2007 levels (when the survey began). I asked the ONS’s wealth gurus — a massive thank you to Hilary Mainwaring and Carla Kidd here— to run that analysis, allowing us to separate the growth in pensions wealth due to interest rates from other drivers.

The chart below shows the results. Had interest rates remained at their 2006-8 level, WAS would have recorded the estimated elements of pension wealth as £3.3 trillion compared to the actual estimate of £5.3 trillion for 2016-18. At least 80% and as much as 90% of the recent increase in total pension wealth is therefore attributable to interest rate falls rather than savings, despite auto-enrolment.

Putting it all together, the overwhelming majority of the £10tr increase in wealth since the mid-1990s would not have occurred but for falling interest rates. This trend gets surprisingly little attention in public debate. But it is having a profound impact on our society and politics in many different ways, as Paul Johnson observed recently. What does it mean for the idea of taxing wealth?

Why does the source of wealth matter for taxation?

The paper draws out what I think are some of the main implications, particularly for taxation. Here are four:

Luck. Increases in wealth, in aggregate at least, have been overwhelmingly down to good luck on the part of people who held assets as interest rates fell. This makes such wealth an attractive target for taxation relative to other things, like labour, that may disincentivise productive activity. The income from this massive increase in aggregate wealth is largely unchanged. When changes in wealth are down to movements in interest rates, the income derived from those assets is, by definition, unchanged. This is easiest to see in the case of a homeowner who enjoys an unchanged value of housing services each year despite their property having doubled in value. That means a millionaire when 10-year gilt yields are 1% (the recent norm) has a substantially lower standard of living than a millionaire when they are 5% (the early 2000s norm). Stocks of wealth aren’t necessarily a consistent guide to the living standards of their owners. Cashing out. It follows from (2) that the beneficiaries of burgeoning asset values can only achieve a higher standard of living from their wealth by liquidating their assets and consuming the proceeds at some stage in their life. This is particularly important because if the value of a person’s house either jumped or crashed on account of interest rate movements just as they came to sell it, then any past levy on the property value would have been either ‘too high’ or ‘too low’ ex post. Winners or losers? A fourth implication of interest rates having been the overwhelming driver of wealth in recent years is that those who appear to be made better off from a jump in the value of their assets may in fact be made worse off over their lifetime as a whole. This can happen because the fall in interest rates not only magnifies the present value of streams of income, but also magnifies the present value of the cost of future consumption. An asset owner can therefore be made worse off when rates fall if they end up needing to save more for their pension, to sustain their living standards, than the jump in the value of their house. This is more likely to be the case for younger workers. Of course, owners of interest rate sensitive assets will always tend the be made better off than non-owners when interest rates fall, which may justify intervention. But two people with the same apparent net wealth may have very different living standards when we consider a comprehensive picture of their balance sheets. This makes imposing a uniform wealth tax problematic from an equity perspective.

Taken together these implications suggest that there is a good case for taxing windfall wealth somehow, but that an annual levy may not be the best way to go. It is particularly hard to know the utility derived by a household from a given stock of wealth because it varies with the prevailing interest rates, it varies according to people’s unseen assets and liabilities, and it varies because any paper gain may have evaporated by the time an owner comes to sell an asset.

Other policy levers may be better able to achieve similar wealth taxation goals in ways that avoid these problems. Notable candidates for reform to this end include the CGT exemption on a household’s main residence and forgiveness of CGT on death, as highlighted by the OTS and the Resolution Foundation last week. The economic justification for these tax breaks was never strong, and in light of the sources of intergenerational wealth inequality in recent decades the moral case for them is even weaker.