Human Capitalists in the Twenty-First Century

I reread a great research paper recently: “Capitalists in the Twenty-first Century,” from the economists Matthew Smith, Danny Yagan, Owen M. Zidar and Eric Zwick.

After mulling over the authors’ ideas for the last several weeks, a conclusion: What these guys report? It matters to small business owners and entrepreneurs. A lot.

Capitalists in the Twenty-First Century Research

The economists’ research makes a fascinating observation: The largest share of the income earned by the top one percent and the top one-tenth of the top one percent? Non-wage business income earned by partners and S corporation shareholders. And more specifically, typically business owners working in a high-skill, “human capital” business.

Definitely not trust fund babies anxiously awaiting their next distribution. Or passive investors fueling high living with dividends and capital gains. Something much, much different than these stereotypes.

Let me quote from the research to give you their insight about just who makes up the top one percent and top one-tenth of one percent:

The data reveal a striking world of business owners who prevail at the top of the income distribution. Most top earners are pass-through business owners. In 2014, over 69% of the top 1% and over 84% of the top 0.1% earn some pass-through business income.

The research also describes the sorts of firms that top one percenters typically own:

Typical firms owned by the top 1-0.1% are single-establishment firms in professional services (e.g., consultants, lawyers, specialty tradespeople) or health services (e.g., physicians, dentists).

And also the sorts of firms that the top one tenth of the top one percent own:

A typical firm owned by the top 0.1% is a regional business with $20M in sales and 100 employees, such as an auto dealer, beverage distributor, or a large law firm.

This observation challenges the hypothesis presented by French economist and author Thomas Piketty in his bestseller “Capital in the Twenty-First Century.” (You see where Smith, Yagan, Zidar and Zwick got their paper’s name.) And it also challenges the work of Emmanuel Saez and Gabriel Zucman who have employed Piketty’s ideas to develop wealth tax proposals for the United States.

But does the paper from Smith, Yagan, Zidar and Zwick also point out new rules for twenty-first century entrepreneurs? And new rules for today’s investors? I think so. In fact, I see at least three big insights that drop out of their research.

Twenty-First Century Entrepreneurs are Human Capitalists

The first big obvious insight from the research? Simply this: If you want to work as an entrepreneur or own your own business, probably you want to start a human capital business.

You don’t want to be a financial capitalist.

You want to be a human capitalist. A skilled expert who provides an in-demand service. And then you want to work your way into an ownership role in a firm that delivers that service.

So, probably not a real estate thing. Probably not something that uses a factory. And probably not a deal where you raise financial capital from angel investors or venture capitalists or banks.

Rather what you want to think about are business ventures you can only do because you went to medical or law school. Or because you went to college and got a technical degree. Or because you have spent years learning some high-skills trade or craft. And as a result, you personally have acquired a lot of human capital in the form of knowledge, maybe credentials and then also experience.

For example, the top three partnership categories of top one percent earners? A doctor’s office, a technical services firm, and a dentist’s office.

And the top three S corporation categories of top one percent earners? A law firm, a doctor’s office, and an accounting firm.

The list of top earning categories appears at the very end of the 60-page research paper (see link at end of this blog post). But just so you know. All sorts of high skill categories appear on the list, including specialty contractors, restaurants, and you name it. Not just white-collar-y professions. Human capital comes in many colors and sizes.

Wealth Building Works Differently for Human Capitalists

Another actionable insight from the research: People don’t automatically get rich from running a super-successful human-capital business. Or at least not rich as rich gets depicted in movies or books. Or depicted in the research from Piketty, Saez and Zucman.

The Smith, Yagan, Zidar and Zwick research results highlight this reality. They point out that when top one-percent-ers retire or die, the income earned by their human capital business drops by eighty percent or more.

The researchers logically conclude, then, that the business income earned by these firms mostly reflects the labor provided by the firm’s owners.

But here is another take-away for entrepreneurs: Most owners of successful small businesses need to build wealth outside their businesses. By saving a big chunk of the business owner’s income.

In other words, the way to build net worth is not by selling the firm and exiting with a giant windfall. That is not a likely outcome even for super-successful small business owners. Why? Because these firms rely on human capital that evaporates when the owners die or retire.

Rather, the reasonable best-case outcome is probably two or three decades of great income from the business you own. Which small business owners and entrepreneurs should use to fund two or three decades of aggressive saving.

We pointed out in a blog post a couple of years ago, Lifetime Earnings of the Top One Percent, that someone would need to earn a top one percent income and make the maximum 401(k) contribution for three decades to accumulate a couple of million dollars. Which is great, don’t get me wrong.

But there’s a big difference between earning a $300,000 year (which if earned over thirty years might put you in the top one percent) and then drawing $80,000 annually from your $2 million retirement (which would reflect an average rate of return while accumulating and then use of the well-known 4 percent safe withdrawal rate in retirement.)

Is Everyone a Human Capitalist?

Finally, a quick last comment. And this isn’t something Smith, Yagan, Zidar and Zwick say. But I think their research supports the conclusion.

Individuals need to think more about investing in their human capital. Even when they aren’t interested in entrepreneurship or small business ownership.

All the time and energy people spend trying to juice portfolio returns or tweak their asset allocation? (Investing books, time spent in online forums and so on.)

And all the time people spend thinking about and then building and managing a portfolio of rental properties? (Seminars and workshops, books and again online forums.)

I mean, that’s all good. But probably the big money opportunity? Finding a way to grow your or my human capital: a new skill, more knowledge or experience, a credential the economy financially rewards, and other stuff like that.

Related Resources You Might Find Useful

Here’s a link to the paper from Matthew Smith, Danny Yagan, Owen M. Zidar and Eric Zwick: Capitalists in the Twenty-First Century. This obvious comment you don’t need me to make: If you’re an attorney, accountant or investment advisor, you want to read this research paper. Probably more than once. It describes who your (and my) clients are.

Smith, Zidar and Zwick published another research paper that builds on the “Capitalists” paper and provides some updated information: Top Wealth in America: New Estimates under Heterogeneous Returns

Finally, it’s not specifically about twenty-first century entrepreneurs or investing. But we did a blog post on the That Nearly Secret IRS Wealth Study which further discusses the research of Zwick.