The Top 10 Percent, Again

This article appeared on on March 9, 2006.

The concept of “income distribution” is fundamentally muddled. Aside from government subsidies and transfer payments, income is not “distributed” at all. Most income is either earned or stolen. If some group’s income was earned by legitimate means, then it is their income, not “ours.” To complain that 10 percent earned too large a percentage of our income is to forget that they actually earned 100 percent of their own income.

Unfortunately, the eternal ambition of Robin Hood economics is to steal money from those who earned it and “redistribute” it to those with more political clout. When in pursuit of such a worthy cause, it appears quite respectable to torture innocent statistics. Those deploying statistics in this campaign take special care to select their favorites.

Washington Post columnist Steven Pearlstein recently confessed: “My favorite statistic comes from a recent study of tax returns by the Internal Revenue Service. It shows that, in 1979, the top 10 percent of households earned 33 percent of all pretax income. By 2003, their share had climbed to 44 percent. The shares of everyone else declined.”

Where did those numbers come from? They certainly didn’t come from the Census Bureau, whose surveys show that the top 20 percent of households earned 49.8 percent of all pretax income in 2003.

The Census Bureau doesn’t add taxable capital gains to income, but the Congressional Budget Office does. Yet Pearlstein’s statistics obviously didn’t come from the CBO, either. The CBO estimates that in 1979 the top 10 percent of households earned 39.3 percent of all pretax income. By 2003, their share had dropped to 38.3 percent (or 33.7 percent after taxes). The shares of everyone else increased.

It is easy to see why the CBO is not Pearlstein’s favorite source of income statistics. It used to be Paul Krugman’s favorite in 1992, but he has since switched to a 2001 study by two French economists, Thomas Piketty and Emmanuel Saez. Yet Piketty and Saez cannot be Pearlstein’s favorite at the moment, because they showed that “the labor share (of national income) has always been around 70-75 percent, and the capital share has always been around 25-30 percent.”

Pearlstein, by contrast, wants us to believe “the share of the economic pie going to workers in the form of wages, salaries and benefits seems to have fallen, while the share going to holders of capital — in the form of interest, dividends and capital gains — has gone up.” His thesis is that globalization has made capitalists more effective at exploiting the proletariat.

As I explained in my last column, labor’s share always rises in recessions (it peaked in 2001) because recessions shrink profits and capital gains. That does not mean workers should welcome recessions just to get a larger share of a smaller pie.

Unlike Pearlstein’s untenable claim that “labor’s share of the economy is shrinking,” the source of his favorite statistic is not a mystery. It comes from a 10-page paper on “retrospective income” prepared for an academic conference by Michael Strudler and Tom Petska from the Statistics of Income division of the IRS, and Ryan Petska from Ernst and Young. But estimates are just estimates, and estimates derived from tax returns (including those from the CBO) are among the worst.

For anyone determined to show that the top 10 percent has a much larger share of total income than the CBO or Census Bureau could find, the trick is to stuff as much as possible into the incomes of the top 10 percent and then exclude as much as possible from everyone else’s income. Strudler, Petska and Petska know how to pad the numerator of this ratio, but also how to shrink the denominator.

They explain, for example, that “Social Security benefits were omitted because they were not reported on tax returns until 1984.” Those dependent on Social Security benefits may be surprised to find that they are counted as having no income at all. But the more income that can be excluded at the bottom, the larger the share left to be assigned to the top.

Piketty and Saez exclude all transfer payments, not just Social Security. Everyone excludes the Earned Income Tax Credit, the largest cash transfer to the poor, by pretending a Treasury check for a few thousand dollars only needs to be mentioned in after-tax income. In an online discussion, Pearlstein wrote, “Liberals like to decry … the increasing inequality being generated in pre-tax earnings. So the government, at their urging, enacts policies that use the tax code to make things fairer in what really counts, after-tax earnings. But then the liberals keep using the data on pre-tax earnings, to suggest nothing has gotten better. That’s disingenuous.” That’s right. Yet his favorite statistic is for pre-tax earnings.

Strudler, Petska and Petska also add capital gains that are realized on tax returns to the incomes of the top 10 percent, and so does the CBO. But nobody counts capital gains on investments inside the IRA and 401(k) plans of Middle America because those gains do not show up on income tax returns until we’re very old. The amount of money going into these tax-deferred plans is vastly larger than the tiny amount being taken out.

The highest incomes are also boosted by adding “depreciation in excess of straight-line depreciation.” Since your neighbor is unlikely to be claiming accelerated depreciation on business equipment, this trick reveals that much of the “household” income among the top 10 percent is really business profit. Many businesses switched to filing under the individual income tax after those tax rates came down in 1987, so their incomes moved from corporate to individual tax returns. Most hedge funds are limited liability corporations, and many banks are now Subchapter S corporations and their profits are counted as “household” income.

Pearlstein will soon offer his favorite solutions to problems described by his favorite statistics. But picking favorite statistics to advance a policy agenda only works if nobody is paying attention to what those statistics really mean.

Alan Reynolds is a senior fellow and a nationally syndicated columnist.