Measured Inequality: Fallacies and Overstatements

2012 is an election year, so it shouldn’t be surprising that opinion-editorial pages are increasingly publishing pieces about the rise of income inequality in America. The baton that John Edwards carried with his “two Americas” theme in 2004 has been passed on to others, who, like Steven Rattner in the New York Times, are arguing that “new statistics show an ever-more-startling divergence between the fortunes of the wealthy and everybody else.”

Just as it was back in 2004, many of today’s commentators are overstating the conclusions that can be drawn from the underlying data. For some, the details about what we know and don’t know about income and wealth trends are secondary to President Obama’s populist campaign push for more wealth redistribution. But the details in measuring and understanding what’s going on around the country regarding income trends and economic mobility do matter. This is especially true today because many policymakers are accepting the unqualified narrative that income inequality is becoming a bigger issue, one that is linked to economic mobility and opportunity, and for which there is but only one solution—higher taxes and more wealth redistribution.

The central problem facing the economy is that income growth over the past few years has been modest to nonexistent, as a result of the financial crisis, the subsequent recession, and an extremely modest recovery. Moreover, policies that aim only to redistribute wealth—rather than generate real economic growth and opportunity—are unlikely to solve, or even meaningfully address, the slow growth trajectory for wages.

Specifically, you should consider six complicating factors when you next find yourself reading an op-ed on inequality trends:

1) Top incomes are highly sensitive to the business cycle, and no income group has really seen a sizable gain during the current recovery. The key statistic that Rattner focuses on in his op-ed is that 93 percent of the income gains during this recovery have gone to the top 1 percent. This statistic is from a paper by Emmanuel Saez of the University of California. The table that it was pulled from includes a note stating that “from 2009 to 2010, average real family incomes increased by 2.3 percent and the top 1 percent captured 93 percent of those gains.” The context for this statistic is important. The reason that the share is so large for the top 1 percent is that the gains for the bottom 99 percent were so modest. Imagine that the top 1 percent received a one-dollar increase in wages and the bottom 99 percent saw no increase. In this example, the top 1 percent would have seen a full 100 percent of the growth in incomes over that year—even though the net change was small. Thus, while spotlighting this statistic might be a good way to generate a headline, the underlying dynamics in this instance are not particularly revealing.

A related point that Saez makes in his paper, which underscores today’s broader economic challenge, is that “during the Great Recession, from 2007 to 2009, average real income per family declined dramatically by 17.4%, the largest two year drop since the Great Depression. Average real income for the top percentile fell even faster (36.3 percent decline).” Saez reviews how dramatic the swings have been during recessionary and expansionary environments over some of the past administrations. For example, during the Clinton years (1993–2000), incomes of the top 1 percent went up 98.7 percent, and then down 30.8 percent in the 2001 recession. Incomes climbed 61.8 percent during the Bush years of 2002 to 2007, and then fell 36.3 percent in the most recent recession, only to go back up 11.6 percent during this nascent recovery (see column 2 of table 1 from the Saez paper, which Rattner references as well).

2) The top 1 percent is a different collection of households each year. When it comes to analyzing income distribution, it’s important to keep in mind that the “top 1 percent” covers slightly more than a million tax returns. Comparing the income distributions for a single year is a lot less meaningful than commonly supposed because it’s not clear which of the underlying tax returns remain in the top 1 percent from year to year. Every decade or so, the Treasury department releases a data series that allows one to track the probability that a household in the top 1 percent will remain in the top 1 percent several years later. The Treasury’s most recent release shows that only two out of five households in the top 1 percent are still there ten years later. As the Treasury explains in the study, “[W]hile the share of income of the top 1 percent is higher than in prior years, it is not a fixed group of households receiving this larger share of income.” That is why it’s misleading for Rattner to discuss the top 1 percent as if it’s necessarily the same households that are amassing more and more of the wealth each year. The data that Rattner uses compare tax returns at the same point in the distribution across different years, not the same households across years.

Most of the churn in the top 1 percent is related to life-cycle trends. For example, earners in households within the top 1 percent retire, and their place in the distribution is filled by younger workers and families. Another issue comes from nonrecurring sources of income, such as asset sales. Every year, a portion of the top 1 percent sell family businesses, large stock portfolios, or real estate. As e21 has argued, “These sales may push up the average income of the top 1 percent for that year, but they have no impact on the average earnings of the group.” This is an especially important issue because discussions about income inequality often involve how much someone “makes,” implying that the figures reflect an annual salary (or recurring income).

As a rule of thumb, the share of earnings that comes from wages goes up, the lower that one goes on the income-distribution scale. That is why the previous year’s income level is usually a better predictor for what a person’s income level will be the next year, compared with someone, say, in the top 1 percent. The broader point here is that for the top 1 percent, a one-time event is more likely to skew this year-over-year relationship: a household could contribute meaningfully to the “average” income of the top 1 percent for a single year and then drop out of the top 1 percent entirely the following year.

3) The income threshold for the top 1 percent has declined in real terms since the passage of the Bush tax cuts in 2003. Rather than try to compare “average incomes,” e21 has produced a chart reviewing how the threshold has changed over the years in order for a household to be categorized in the top 1 percent.

As e21 explains:

This chart is instructive because it uses the same type of analysis that Rattner and others rely on to show how far certain tax returns—at different points of the income distribution—are falling behind. One could make the argument that the household at the 99th percentile of the income distribution is “falling behind” because its income has failed to keep pace with inflation since 2003. This would be misleading, of course, because there is virtually no chance that the same household fell at the same point in the distribution each year. But this analysis demonstrates the fallacy of treating different points in the income distribution as though they were the same households.

4) Tax policy affects the flow more than the stock. Tax policy can affect “measured” income inequality but not always the underlying wealth dynamics. “Wealth” is net worth: a household’s assets minus liabilities, with returns on that wealth constituting a form of income. The rich are more willing to report taxable income, organize businesses as partnerships or limited liability corporations (i.e., pass-throughs), sell assets, and hold taxable bond and stock portfolios than they would be if tax rates were higher. That is why a lower tax environment, on the margin, can increase “reported” inequality without affecting real inequality or comparisons of wealth.

The income statistics that analysts use to assess inequality depend critically on the way taxpayers choose to organize their businesses and the types of assets that they hold in their portfolios. That is why income reported on tax returns often gives an incomplete picture of wealth disparities. When rates on a certain form of income are punitively high, the value of tax-planning services increases. (“Tax planning,” in this context, means the use of legal and accounting advice to structure businesses or investments in such a way as to minimize total tax liability.)

If Congress were to respond to the perceived increases in the incomes reported by the rich by increasing tax rates, tax-planning services would increase in value, causing measured income inequality to decline because of the reduction in the amount of income that gets reported in higher tax brackets.

To understand the distinction between forms of income and their impact on measured income disparity, let’s consider a few examples.

• The composition of the top 1 percent’s income in 1979 compared with that in 2007 (the peak of the most recent business cycle) has changed quite a bit. In percentage terms, the category that witnessed the largest increase was business income, which grew at a compounded annual rate of 6 percent. Did the top 1 percent become more entrepreneurial during this period? Probably not—but more research on this issue is necessary. The growth was more likely a function of changes in tax policy that made “flow-through” business income more tax-advantaged. When forming a business, entrepreneurs can choose to incorporate as a C corporation or form a partnership, limited liability corporation (LLC), or S corporation. A C corporation pays taxes at the corporate income-tax rate, while the income of the other business entities “flows through” to the owners, where it is taxed at the individual rate, whether the income is actually distributed to owners or not (i.e., retained earnings are taxed at the individual level).
• In 1979, the top individual rate was 70 percent, while the top corporate tax rate was 46 percent. The differential in tax rates led business owners to prefer to organize their businesses as C corporations, in which case the net income earned by the business would not show up on the owners’ individual tax returns. The elimination of the tax differential (both top rates are now 35 percent) made it far more attractive to organize as a flow-through business. Between 1979 and 2007, the share of business income reported by flow-through businesses such as partnerships and LLCs more than doubled. Nearly all the increase has come in the top tax brackets.

Consider the impact of this tax change on income disparity: income inequality has risen because business income once reported at the corporate level is now being reported at the individual level. Consider a hypothetical business worth $25 million with $10 million in net income. In 1980, the more likely scenario would have been for this $10 million to be reported as the income of a C corporation, which would make the personal income of the owner seem lower than if that income flowed through directly to the owner’s tax return, as occurs with LLCs and S corporations. But in both situations, the economic reality, or household net worth, is the same: the taxpayer is the owner of a $25 million business that generates $10 million in net income.

Had the tax system continued to favor keeping retained earnings inside of C corporations, the reported income of the top 1 percent would be lower—not because of any change in the economic reality (i.e., looking broadly at wealth) but simply because less business income would have been reported at the individual level.

The same result can be observed from the reporting of capital gains income:

• Capital gains are only taxed when realized. The higher the tax rate, the more powerful the incentive to avoid realizations. A “Buffet rule,” or similar device to increase the capital gains tax rate on the top 1 percent, would lead to an economically damaging “lock-in effect,” where capital is not allocated to its most efficient use because of the tax disincentive to liquidate an existing investment. Capital gains loom so large in the taxable income of the top 1 percent that changes to the tax rates on this source of income can swing the average income of the top 1 percent wildly from year to year. But realizing capital gains doesn’t really change the wealth picture for these taxpayers; the only difference is whether that wealth was liquidated and triggered a corresponding tax payment.

Thus, increasing tax rates could meaningfully reduce tax realizations, capital gains income, and reported income inequality; but it could also reduce federal tax revenues and not change the underlying economic reality. The bottom line is that measured or reported income is often an imperfect proxy for examining wealth, and focusing only on reported income can lead to all sorts of incomplete or erroneous conclusions.

5) The Fed’s policies have advantaged some asset holders while holding back small savers, such as seniors and retirees. The Fed has dramatically expanded its balance sheet over the past few years through asset purchases and loan guarantees. It has also reduced short-term interest rates to zero and worked to flatten the yield curve, partly to encourage greater risk taking in the broader economy. Some asset holders, including, of course, those in the top 1 percent, have experienced most of the gains in wealth from these actions. Many seniors and retirees (for example, those without large stock or bond portfolios) looking to earn modest yield on their savings have been left behind. Moreover, the Fed’s policies raise the risk of future inflation. Rising prices at the gas pump and in the grocery store, coupled with the still-fragile labor market, have undermined consumer confidence and helped stoke populist flames about inequality and wealth disparities.

Rattner and Obama are tapping into this frustration but are generally not acknowledging the Fed’s outsize role in the economy today. A cynical interpretation of the Fed’s increasing role in fiscal matters over the past few years is that the president and Congress have been partly shielded from criticism for failing to advance pro-growth policies. More research and study need to be conducted on how the Fed’s recent policies have affected the fundamentals and trends regarding household incomes, but a reasonable early conclusion is that the Fed’s solo act to support economic growth—in the absence of progress on the fiscal front—has contributed to a distorted and fragile recovery.

6) The U.S. tax system is already one of the most progressive codes in the industrialized world. The top 1 percent’s share of all income taxes paid has hovered around 40 percent for the past several years. The share for the top 1 percent was less than 20 percent in 1970. The current share is around the highest in the history of IRS tax statistics and due largely to the progressivity of the tax system rather than income concentration.

Since 2004, the pretax income share of the top 1 percent has been around 20 percent. This means that the share of income taxes paid by the top 1 percent is about twice as large as their share of income. Even when including all federal taxes, including payroll taxes that are paid back to contributors in the form of Social Security and Medicare benefits, the tax share of the top 1 percent is still about 50 percent greater than its income share. Stephen Moore of the Wall Street Journal offered this conclusion in February 2012: “the richest 10 percent of Americans shoulder a higher share of their country’s income-tax burden than do the richest 10 percent in every other industrialized nation, including socialist Sweden.”

The focus on income inequality could certainly be a net positive for the broader public policy debate if only this attention led to the enactment of policies aimed at increasing the income growth of all households. As a Tax Foundation analysis of census data shows, households in the top two income-tax brackets (the cutoff for the tax increase in President Obama’s budget) are nearly three times more likely to have two earners, are much more likely to have college and graduate degrees, and tend to work 27 hours more per week, on average, than households in the other tax brackets. Saez makes a related point in his paper: “The evidence suggests that top incomes earners today are not ‘rentiers’ deriving their incomes from past wealth but rather are ‘working rich,’ highly paid employees or new entrepreneurs who have not yet accumulated fortunes comparable to those accumulated during the Gilded Age.”

Concern about household income trends should focus on developing or advancing public policies that lead to, or generate, job growth and improve educational attainment rather than simply transfer income. Moreover, attempts to “solve” inequality through tax-rate increases are unlikely to work. After all, low rates on high-income earners generate more reported income equality, which, paradoxically, often serves as a rationale for higher rates. Proposals to increase tax rates on the income of the top 1 percent would inevitably lead to a sizable reduction in income reported in those categories where the tax rate is raised. In response to a tax increase, a fair conclusion is that reported income would be shifted to new categories, investment portfolios would shift to tax-favored assets, and consumption would shift to tax-deductible items such as housing, health care, and renewable energy. This may reduce reported or measured income inequality but could actually lead to less revenue (depending on the new tax rates) and would very likely do little to change substantive wealth disparities across households.

Christopher Papagianis is managing director of e21's New York office and previously was special assistant for domestic policy to President George W. Bush.