How the rich get richer
Wealth begets wealth. This simple concept of privilege has added to growing discontent with inequality that has escalated under the shadow of the COVID-19 pandemic.
A paper co-authored this year by economists from the IMF and other institutions confirms that wealthier people are more likely to earn higher returns on their investments. It also shows that the children of wealthy people, while likely to inherit that wealth, aren’t necessarily going to make the same high returns on investments.
Detailed data on wealth are extremely rare, but 12-years of tax records (2004-2015) from Norway have opened a new window into wealth accumulation for individuals and their offspring.
The Nordic country has a wealth tax that requires assets to be reported by employers, banks and other third parties in order to reduce errors from self-reporting. The data, which are made public under certain conditions, also make it possible to match parents with their children.
The data show that an individual in the 75th percentile of wealth distribution who invested $1 in 2004 would have yielded $1.50 by the end of 2015—a return of 50 percent. A person in the top 0.1 percent would have yielded $2.40 on the same invested dollar—a return of 140 percent.
Another significant finding: High returns both bring individuals to the top of the wealth scale and prevent them from leaving it. Controlling for age, parental background and earnings, moving from the 10th percentile to 90th percentile of wealth distribution increases the probability of making it to the top 1 percent by 1.2 percentage points compared to an average probability of 0.89 percent.
Read: Global bank post-Covid asset quality varies by market – Fitch
Why do rich people earn high returns? Conventional wisdom suggests that richer individuals put more of their assets toward high risk investments, which can result in higher returns.
But our research finds that wealthy people often earn a higher return even on more conservative investments. Richer individuals enjoy pure “returns to scale” to their wealth. Specifically, for given portfolio allocation, individuals who are wealthier are more likely to get higher risk-adjusted returns, possibly because they have access to exclusive investment opportunities or better wealth managers.
Financial sophistication, financial information, and entrepreneurial talent are also important. These characteristics make the returns to wealth persistent over time. This research is the first to quantify this mechanism and show that it is likely to matter empirically.
Do high returns persist across generations? The answer is a qualified yes. Wealth has a high degree of intergenerational correlation, but there are important differences in how returns to wealth accrue across generations.
The children of the richest are likely to be very rich, but unlikely to get as high returns from this wealth as their parents did. This suggests that while money is perfectly inheritable, exceptional talent is not.
