How the Top's Share of Income Changes with Comprehensive Measurements

The following is an excerpt from Economics21's new inequality primer, Income Inequality: Myths and Facts.

Few serious scholars

believe that middle class and poor households have seen the income growth experienced by top earners in recent decades. Both the ubiquitous estimates from economists Thomas Piketty and Emmanuel Saez and figures from the Congressional Budget Office show dramatic increases in the share of income received by the richest one percent of Americans. Between 1979 and 2007, the Piketty-Saez numbers rise from 10 percent to 24 percent, and the CBO share increases from 7 to 17 percent. Attempts to deny that the top has pulled away have, generally, been wholly unpersuasive. However, this does not mean the conventional wisdom is correct.

My colleagues, Richard Burkhauser (Cornell University) and Jeff Larrimore (Joint Committee on Taxation), and I use data from the Bureau of Labor Statistics's Current Population Survey to mimic the approach used by Piketty-Saez, which focuses on the incomes on tax returns, before accounting for taxes and transfers. Doing so shows that from 1979-2007 the bottom quintile's income fell 33.0 percent, the middle quintile's income rose just 2.2 percent, and the top quintile's income rose 32.7 percent. If these numbers are representative of the economic situation in the United States, an argument can be made that there is cause for concern.

But are tax returns the best way to measure income trends? Examining size-adjusted household income is far better. "Tax units" are neither individuals—a married couple filing jointly is a tax unit—nor households (two roommates filing returns constitute two tax units). Furthermore, household needs have declined with household size.

Using households, and adjusting incomes for their size, lowers but does not eliminate the measured increase in income inequality. All groups experienced income growth with this methodology: the incomes of the bottom quintile rose 16.5 percent; those of the middle rose 20.2; and those of the top rose 41.0 percent.

But using pre-tax, pre-transfer income—also known as "market income"—to evaluate effects of more progressive taxation and redistribution is pointless. If only market income is used, then no matter how much is redistributed through taxation and spending, inequality will be unaffected. When taxes and transfers are included in household income, it becomes clear that government programs have been successful in mitigating income concentration.

Non-cash transfers, including SNAP benefits (food stamps) and government health coverage, financed by taxes on the wealthy, are major tools used to combat inequality. Taxes, it is true, have declined across the board, increasing take-home pay. Additionally, more and more compensation going to middle class workers has come in the form of employer-provided health insurance.

Once these factors are taken into account, incomes of those in the bottom quintile improved 31.8 percent, those in the middle quintile saw incomes rise 34.4 percent, and those in the top saw an increase of 54 percent. While inequality did increase, everyone is now substantially better off. For those at the bottom, an increase of 31.8 percent in income is far different than a decrease of 33 percent (Piketty-Saez methodology). 

From 1989 to 2007 (again comparing peak years), the bottom fifth, middle fifth, and top 5 percent saw gains of 26 percent, 20 percent, and 17 percent, respectively, indicating a decline in inequality. A problem with these estimates, however, is that they do not include any income from capital gains. Capital gains derive from assets that appreciate in value, and since assets are especially unequally distributed, inequality estimates that leave capital gains out are potentially problematic. We can incorporate capital gains into our income measure starting in 1989 by imputing amounts to households using information from other datasets.

To facilitate comparability with the CBO and Piketty-Saez figures, gains that are both taxable and realized must be added in first. These are gains which result in taxable income directly received as a consequence of selling assets in a given year. After doing so, the data show the top 5 percent pulling away from everyone else, even from 1989 to 2007. The poorest fifth of Americans saw their incomes rise by 28 percent, the middle fifth by 22 percent, and the top 5 percent by 52 percent.

CBO's estimates confirm both the decline in poor-middle inequality and the disproportionate rise in income at the top. After applying the same cost-of-living adjustment as in our paper, CBO income figures show gains for the bottom fifth, middle fifth, and top 5 percent of Americans of 31 percent, 23 percent, and 81 percent from 1989 to 2007. While the CBO figures combine tax return and CPS data, Piketty-Saez rely entirely on tax return data. They ignore the bottom and middle fifth but show an 87 percent increase in the income of the top 5 percent of "tax units". CBO and Piketty-Saez both show bigger income gains for the top 1 percent (116 percent and 123 percent, respectively). The survey we used cannot reliably capture changes in income in the top 1 percent, but it is safe to say that if it could, it would show a rise similar to that in the CBO figures.

But this is not the last word, either. The CBO and Piketty-Saez income figures are only able to account for capital gains that are both taxable and realized. We point out two big problems with this restriction. First, tax-exempt, realized capital gains are ignored, including those from the sale of homes. These constitute a large share of capital gains received by the non-rich, so ignoring them overstates the rise in inequality. Another issue related to tax exemption is that savvy taxpayers at the top can alter their asset allocations so that more or fewer of their realized gains are taxable in response to tax law changes.

Second, and more important, there is a conceptual problem including realized capital gains in "income", but not the gains that accrue on assets that are held rather than sold. For one, the distinction is immaterial. Gains that accrue each year add to the resources available for consumption or saving, whether they are realized or not. No less than realized gains, accrued gains not realized constitute part of the annual "flow" of resources properly conceived as "income" (as distinguished from the "stock" of accumulated resources properly thought of as "wealth"). In addition, investors strategically choose to realize capital gains depending on the state of asset markets and on changes in the tax treatment of different assets. Realization of gains accrued over many years tends to show up in tax return data in lumpy ways, as Cato Institute scholar Alan Reynolds has argued. A sizable share of the capital gains accruing to middle class households builds up over adulthood in accounts, such as IRAs and 401(k)s, and is not realized until retirement.

When we incorporate estimates of all capital gains accrued by a household over the past year—taxable or tax-exempt, realized or not—from investments in public companies and housing into our findings, a shocking result emerges. From 1989 to 2007, the incomes of the bottom and middle fifth rise (by 13 percent and 6 percent), but the income of the top 5 percent declines by 5 percent. Inequality—even between the top and everyone else—falls. The decline is even more pronounced when we incorporate gains from privately-held businesses.

Should our results be discounted because they cannot capture the incomes of the very rich, as Saez argues? This is surely a relevant question. Note, however, that the top 5 percent's income growth taking only realized capital gains into account is eliminated by taking into account how much smaller total accrued gains were in 2007 than in 1989. At the very least, then, the income growth of the top 1 percent or the top 1 percent of the top 1 percent also would be expected to be significantly lower after accounting for accrued gains. Furthermore, our imputation of accrued gains draws from the Survey of Consumer Finances, which is designed to give reliable estimates for the top 1 percent.

Is our research the final word on inequality trends? Of course not. Of necessity, we use non-ideal imputation strategies to assign accrued gains to people. Our findings cannot tell us very reliably what happened to incomes at, say, the 99.9th percentile. There is little to suggest, however, that the ideal set of estimates would look qualitatively different from our results. The rise in income concentration has been drastically overstated.

Taken from the Economics21 issue brief, Income Inequality: Myths and Facts.

Philip Armour is a Ph.D. student at Cornell University.

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