Month: December 2006

…The
architects of these estimates, Thomas Piketty of École Normale
Supérieure in Paris and Emmanuel Saez of the University of California
at Berkeley, did not refer to shares of total income but to shares of
income reported on individual income tax returns-a very different
thing. They estimate that the top 1% (1.3 million) of taxpayers
accounted for 16.1% of reported income in 2004. But they explicitly
exclude Social Security and other transfer payments, which make up a
large and growing share of total income: 14.7% of personal income in
2004, up from 9.3% in 1980. Besides, not everyone files a tax return,
not all income is taxable (e.g., municipal bonds), and not every
taxpayer tells the complete truth about his or her income.

For
such reasons, personal income in 2004 was $3.3 trillion, or 34.4%,
larger than the amount included in the denominator of the Piketty-Saez
ratio of top incomes to total incomes. Because that gap has widened
from 30.5% in 1988, the increasingly gigantic understatement of total
income contributes to an illusory increase in the top 1%’s exaggerated
share.

The same problems affect Piketty-Saez estimates of share of
the top 5%, which contradict those from the Census Bureau (which also
exclude transfer payments). Piketty and Saez figure the top 5%’s share
rose to 31% in 2004 from 27% in 1993. Census Bureau estimates, by
contrast, show the top 5%’s share of family income fluctuating
insignificantly from 20% to 21% since 1993. The top 5%’s share has been
virtually flat since 1988…

Unlike
the Census Bureau, Messrs. Piketty and Saez measure income per tax unit
rather than per family or household. They maintain that income per tax
unit is 28% smaller than income per household, on average. But because
there are many more two-earner couples sharing a joint tax return among
high-income households, estimating income per tax return exaggerates
inequality per worker.

…the
amount of income Messrs. Piketty and Saez attribute to the top 1%
accounted for 10.6% of personal income in 2004. That 10.6% figure looks
much higher than it was in 1980. Yet most of that increase was, as they
explained, "concentrated in two years, 1987 and 1988, just after the
Tax Reform Act of 1986." As Mr. Saez added, "It seems clear that the
sharp, and unprecedented, increase in incomes from 1986 to 1988 is
related to the large decrease in marginal tax rates that happened
exactly during those years."

That 1986-88 surge of reported high
income was no surprise to economists who study taxes. All leading
studies of "taxable income elasticity," including two by Mr. Saez,
agree that the amount of income reported by high-income taxpayers is
extremely sensitive to the marginal tax rate. When the top tax rate
goes way down, the amount reported on tax returns goes way up. Those
capable of earning high incomes had more incentive to do so when the
top U.S. tax rate dropped to 28% in 1988 from 50% in 1986. They also
had less incentive to maximize tax deductions and perks, and more
incentive to arrange to be paid in forms taxed as salary rather than as
capital gains or corporate profits.

The top line in the graph shows
how much of the top 1%’s income came from business profits. In 1981,
only 7.8% of the income attributed to the top 1% came from business,
because, as Mr. Saez explained, "the standard C-corporation form was
more advantageous for high-income individual owners because the top
individual tax rate was much higher than the corporate tax rate and
taxes on capital gains were relatively low." More businesses began to
file under the individual tax when individual tax rates came down in
1983. This trend became a stampede in 1987-1988 when the business share
of top percentile income suddenly increased by 10 percentage points.
The business share increased again in recent years, accounting for
28.4% of the top 1%’s income in 2004.

As was well-documented years
ago by economists Roger Gordon and Joel Slemrod, a great deal of the
apparent increase in reported high incomes has been due to "tax
shifting." That is, lower individual tax rates induced thousands of
businesses to shift from filing under the corporate tax system to
filing under the individual tax system, often as limited liability
companies or Subchapter S corporations.

IRS economist Kelly
Luttrell explained that, "The long-term growth of S-corporation returns
was encouraged by four legislative acts: the Tax Reform Act of 1986,
the Revenue Reconciliation Act of 1990, the Revenue Reconciliation Act
of 1993, and the Small Business Protection Act of 1996. Filings of
S-corporation returns have increased at an annual rate of nearly 9.0%
since the enactment of the Tax Reform Act of 1986."

Switching income
from corporate tax returns to individual returns did not make the rich
any richer. Yet it caused a growing share of business owners’ income to
be newly recorded as "individual income" in the Piketty-Saez and
Congressional Budget Office studies that rely on a sample individual
income tax returns. Aside from business income, the top 1%’s share of
personal income from 2002 to 2004 was just 7.2%-the same as it was in
1988.

In short, income shifting has exaggerated the growth of top
incomes, while excluding a third of personal income (including transfer
payments) has exaggerated the top groups’ income share. [emphasis added]

There are
other serious problems with comparing income reported on tax returns
before and after the 1986 Tax Reform. When the tax rate on top salaries
came down after 1988, for example, corporate executives switched from
accepting stock or incentive stock options taxed as capital gains
(which are excluded from the basic Piketty-Saez estimates) to
nonqualified stock options reported as W-2 salary income (which are
included in the Piketty-Saez estimates). This largely explains why the
top 1%’s share rises with the stock boom of 1997-2000 then falls with
the stock market in 2001-2003.

In recent years, an increasingly
huge share of the investment income of middle-income savers is accruing
inside 401(k), IRA and 529 college-savings plans and is therefore
invisible in tax return data. In the 1970s, by contrast, such
investment income was usually taxable, so it appears in the
Piketty-Saez estimates for those years. Comparing tax returns between
the 1970s and recent years greatly understates the actual gain in
middle incomes, and thereby contributes to the exaggeration of top
income shares.

In a forthcoming Cato Institute paper I survey
a wide range of official and academic statistics, finding no clear
trend toward increased inequality after 1988 in the distribution of
disposable income, consumption, wages or wealth. The incessantly
repeated claim that income inequality has widened dramatically over the
past 20 years is founded entirely on these seriously flawed and greatly
misunderstood estimates of the top 1%’s alleged share of
something-or-other.

Opinions?  I am embarrassed to admit I have yet to read Pikaetty and Saez.  If you would like an alternative perspective from that offered by Reynolds, here is Paul Krugman.

Addendum: Here is Greg Mankiw on same, with related links.