Commentary

Can the CBO Spell IRA?

By Alan Reynolds and David R. Henderson
This article appeared in the Wall Street Journal on February 6, 2007.

Is the share of income of the top 1% in the United States high and rising? Those who say it is usually base their belief on statistics from one of two sources. One, a paper by Thomas Piketty and Emmanuel Saez, was discussed by Alan Reynolds in the Wall Street Journal on Dec. 14, 2006. The other source is the Congressional Budget Office (CBO). It, too, is wrong.

The CBO’s measure, “comprehensive income,” is vastly larger than our benchmark of personal income and nearly double the Piketty and Saez total of $6.4 trillion for 2004. The CBO adds transfer payments — but it also assigns corporate profits to households, and includes the taxable portion of capital gains. Although that fixes a few statistical headaches, it adds fatal complications.

The CBO’s allocation of most corporate profits to the top 1% implies an average income of $1,259,700, compared to an average income of $940,441 in the most similar Piketty and Saez series (which includes capital gains). As the lower line in the nearby graph shows, the CBO estimate of income among the top 1% was just 21% larger than the figure from Piketty and Saez in 1980, then 26% larger in 1990, 30% larger in 2000 and 38% larger in 2004. The gap widened because of the CBO’s flawed methodology.

The top line in the graph shows that the CBO assigned a high and rising share of capital ownership to the top 1%. Thus Lawrence Mishel and Jared Bernstein of the Economic Policy Institute write that this “shows that those in the top 1% of the income scale received 59.4% of all the capital income in 2004, up from 49.1% in 2000, 39.1% in 1989 and just 37.8% in 1979.” Actually, it shows that if you make goofy assumptions, you get goofy results. Those who measure wealth directly find no such growth in the share of the top 1%.

At the IRS Statistics of Income (SOI) division, Barry Johnson and Brian Raub examined 28,000 estate tax returns to calculate wealth shares. “In 2001,” they noted, “1.0% of the U.S. adult population [2.1 million people] … owned approximately 22.3% of total U.S. individual wealth, a 1.0% decrease since 1998 but virtually identical to the shares of wealth held in 1995 and 1992.”

Federal Reserve Board economist Arthur Kennickell added the Forbes 400 list of wealthiest Americans to the Fed’s Survey of Consumer Finances. He concluded that the top 1%’s share of wealth declined slightly from 34.6% in 1995 to 33.4% in 2004. Yet the CBO says that share rose from 43.2% to 59.4% in those same years. The difference is huge and it has a huge effect. For 2004, the CBO assigned 59.4% of $1.1 trillion in corporate profits to the top 1.2 million households, which added more than a half-million dollars to each of their incomes. That improbable figure has been rising rapidly, pushing the top 1%’s share of “comprehensive” income much higher than otherwise.

imageHow does the CBO get its results? By assumption. Gary Burtless of the Brookings Institution notes that the CBO, unlike SOI and Fed economists, does not actually look at who owns capital. If your tax return shows no income from capital, then, according to the CBO, you own no capital. Can the CBO spell IRA? A huge and growing portion of capital owners in the U.S. earns dividends, interest and capital gains that never show up on tax returns because it is tax-sheltered. And the middle class owns a much higher fraction of its wealth in tax-sheltered assets than does the top 1%.

Andrew Bershadker of the Treasury Department and Paul A. Smith of the Fed compared the interest, dividends and capital gains reported by taxpayers aged 50 or more in 1990 and 2002. They found that “for all ages, the share of [taxable] income arising from assets is strikingly [as much as 36%] lower in the 2002 cross section than in the 1990 cross section.”

In short, taxpayers are moving savings out of the grip of tax collectors. But high-income taxpayers are not allowed to contribute to an IRA or tax-free Roth account, and their contributions to other accounts are tightly limited. As a result, about 95% of the top 1%’s assets are still potentially taxable. And that causes the CBO’s method to show an increase in wealth of the top 1%. As noted, direct studies of wealth show no such increase.

Economist James Poterba of MIT estimated that among those with assets in a tax-deferred account in 1998, the middle 36% (those in a 28% tax bracket) held nearly a third of their assets in tax-deferred accounts. By contrast, the top 1% of wealth holders held just 5.5% of their assets in tax-deferred accounts in 2001, according to Federal Reserve economist Arthur Kennickell.

Jonathan Chait of the New Republic speculates that 401(k) accounts “mostly replaced defined benefit pensions” and that money from 401(k)s does appear on tax returns when the accounts are withdrawn. Nice try, but no cigar. Capital income accruing inside Roth IRA, Roth 401(k) and 529 college-savings plans will never appear on tax returns, nor will up to $500,000 of capital gains on the sale of family homes since 1997.

Moreover, few of those now retired had much opportunity to build such accounts during their prime earning years. James Poterba, Dartmouth economist Steven Venti and Harvard’s David Wise found that in 1984 fewer than 12% of those aged 45 were participating in a 401(k) plan, compared with 57% by 2003. Even the 12% who turned 65 in 2004 cannot be compared with those in defined benefit plans, since such plans would pay only 30% of your salary after 20 years. A 401(k) invested in a mediocre mutual fund from 1984 to 2004 did much better than that.

Those with a defined (fixed) pension must pay taxes at age 65, but the rest of us delay the tax collector. Messrs. Bershadker and Smith found that “roughly half the sample waits until required [at age 70 years, six months] to take the first withdrawal” from an IRA. The required distribution rises slowly to 10% at age 80, and so the untaxed account often keeps growing. Many will die before most funds are depleted, leaving the balance to heirs. Withdrawals from tax-deferred plans (unlike Roth and 529 plans) will eventually appear in tax return data. To say such invisible income is “implicitly” included in recent tax data, as Messrs. Piketty and Saez do, is to admit it is explicitly excluded from such data.

Like most other data, the CBO estimates show a clear increase in income inequality between the stagflation of 1980-81 (which depressed stocks, bonds and business) and the Tax Reform Act of 1986-88 (which encouraged reporting more income on individual tax forms). However, the CBO data show that the top 1%’s share of disposable income, after taxes, was unchanged between 1988 (12%) and 2003 (12.2%). That number picked up in 2004, with more dividends and capital gains being reported at the 15% rate. But defining a trend by one year is nearly as foolhardy as defining a nation’s income distribution by 1%.

The CBO has incorrectly added a huge and rising share of corporate profits to the estimated incomes of the top 1%. Without that, CBO estimates of the top 1%’s share of income would have fallen substantially since 1988. If there is evidence of increased inequality since then, the CBO has not presented it.

Mr. Reynolds, a senior fellow with the Cato Institute, is the author of Income and Wealth (Greenwood Press, 2006). Mr. Henderson, a research fellow with the Hoover Institution, is co-author of Making Great Decisions in Business and Life (Chicago Park Press, 2006).