By Sanjay Sanghoee
October 21, 2014

In a recent blog, billionaire and Microsoft (MSFT) founder Bill Gates offered his thoughts on the much talked about book, Capital in the Twenty-First Century by Thomas Piketty. The French economist highlights the scope and peril of rising economic inequality in the world and suggests progressive taxation as a way to remedy it.

Gates’ analysis is simple and powerful. First, he convincingly dispels the myth of the predominance of inherited capital in our economy by pointing out that of the Forbes 400 list of wealthiest Americans, half are self-made entrepreneurs. He then divides the world of the wealthy into three groups: those who invest, those who give to charity, and those who spend.

Gates admits the futility of taxing labor but objects to Piketty’s suggestion of taxing capital on the grounds that it would remove value from our economy. On both these fronts, he is correct. Taxing workers simply leaves less money available for spending and hurts our economy. Similarly, progressive taxation on investments would increase tax revenues for governments but would do so at the expense of the private sector that depend on investments for sustenance and growth.

Gates then goes on to suggest that widening inequality could potentially be solved by a progressive tax on consumption, which is wrong – for two reasons.

For one, consumption is a direct way for the wealthy to contribute back to the economy. For instance, the more houses and cars rich people buy, the more money enters our economic universe. This translates into higher profits for businesses, which in turn (at least ideally), encourages them to pay higher wages to workers and create more jobs. The benefits also ripple out to other businesses that serve housing developers, builders, brokers, car manufacturers, auto dealerships etc…, and so on. Consumption is, in fact, the lynchpin of widespread economic prosperity.

Secondly, one of the big reasons that inequality has widened is that wealthy households tend to spend less of their income than others, leading to more of their money sitting in the bank rather than returning to the economy. This is no surprise since those with less are more likely to spend a greater proportion of their income on food, clothing, rent, and other staples of daily life relative to richer households that meet their basic necessities at a lower threshold and may not choose to consume luxuries. According to a report by NPR, the rich save an average of 15.9% of their income compared to 9.6% of the middle class and only 2.6% of the poor.

What this means is that we need the rich to consume more, not less. Levying a tax on consumption would be a disincentive to doing that.

Gates is clearly concerned about the eventual impact of income inequality and is one of the leading philanthropists in the world. However, his thesis on how to solve this problem does not seem to work. He observes that Piketty does not give enough weight to the impact of consumption in his analysis, and indeed about 70% of the American economy is dependent upon consumption, but then that is precisely why it would be dangerous to tax those who consume.

Sanjay Sanghoee is a political and business commentator. He has worked at investment banks Lazard Freres and Dresdner Kleinwort Wasserstein, as well as at hedge fund Ramius. Sanghoee sits on the Board of Davidson Media Group, a mid-market radio station operator. He has an MBA from Columbia Business School and is also the author of two thriller novels. Follow him @sanghoee.

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