Getting Rich … on Paper

November 19, 2007 • Commentary
This article appeared in the November issue of USA TODAY magazine.

Estimates of the top one percent’s share of total U.S. income have been cited widely as evidence of a large and continuous increase in U.S. income inequality since the 1970s. Yet, many changes in U.S. tax laws and regulations after 1980 made a dramatic difference in what is reported as income to the Internal Revenue Service. Lower tax rates on individual income induced thousands of businesses to switch to filing under the individual tax rather than the corporate tax. Corporate executives switched from accepting stock options taxed as capital gains to nonqualified stock options taxed as salaries. New tax‐​deferred savings plans also resulted in much of the dividends and capital gains of middle‐​income taxpayers being shifted away from tax returns, thus making billions of dollars of investment income invisible in tax returns (except at the top). Meanwhile, exclusion of transfer payments in the most widely cited estimates results in exaggerating the increase at the top by ignoring a growing fraction of lower incomes.

Estimates from Emmanuel Saez (professor of economics at the University of California at Berkeley) and Thomas Piketty (of Ecole Normale Supérieure in Paris) indicate substantial responsiveness (“elasticity”) of reported income among high‐​income taxpayers. When top tax rates fall, on salaries or capital gains, a much larger fraction of high incomes shows up on tax returns. This is consistent with international comparisons of top percentile income shares, which rose most where top tax rates were most reduced (the U.S., U.K., and India) and rose least where top tax rates remained very high (France and Japan). Aside from executive and nonexecutive stock option windfalls during the 1997–2000 stock boom, there is little evidence of a significant and sustained increase in the inequality of U.S. incomes, wages, consumption, or wealth between 1986–88 and 2002-03.

Tax return data provides a highly misleading comparison of income distribution before and after such dramatic changes in tax law as those that occurred in the U.S. from 1981–86. Practically every major newspaper and magazine in the U.S. and U.K. repeatedly has reported that the share of national income received by the top one percent has increased enormously and continuously since the 1970s. Of the many difficult statistics used to influence public perception and policy, this one surely is the most often repeated and the least often understood.

Piketty and Saez are not the only economists who have assembled estimates of income distribution based on a sample of individual income tax returns. The Congressional Budget Office has been doing that since 1979, and other economists have since put together quite different estimates in different ways. These varied estimates of the ratio of top incomes to total incomes differ significantly from each other with respect to what is included as income among the top one percent (the numerator) and also what is counted as total income (the denominator). By adopting the broadest conceivable measure of income at the top and the narrowest possible measure of everyone else’s income, the share going to the top one percent can be made to appear deceptively large.

Even if adjusted gross income (AGI) as defined by tax law captured everything that might reasonably be considered income, tax returns do not capture all of AGI. Estimates of AGI based on personal income data are much larger than the amount of AGI reported on tax returns, when such income is otherwise measured in the same way. The Bureau of Economic Analysis estimates that this “AGI gap” rose from 9.7% in 1988 (when the top tax rate was 28%) to 12.7% in 1994 and 14.4% 2003. Assuming for illustration that the top one percent accounted for five percent of the AGI gap, that gap was too small in 1988 to have made much difference in their income share. By 1999, on the other hand, that same assumption would reduce the top one percent’s share by nearly a percentage point.

Although The Economist and others depict the apparent rise in the top one percent’s share as a “truly continuous trend,” the original 2001 Piketty and Saez paper clearly explain that, “a significant part of the gain [in top income shares] is concentrated in two years, 1987 and 1988, just after the Tax Reform Act of 1986.” One very obvious reason for the surge in top incomes after 1986 is well known to economists, including Saez, yet never mentioned by journalists who cite these figures.

“It seems clear,” as Saez wrote in 2004, “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.” One reason this happened, he explains, was income shifting from the corporate to the individual income tax: “Before the 1980s, S‐​corporation income was extremely small, as indeed 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.

“S‐​corporation income increases sharply from 1986 to 1988 and increases slowly afterwards. The sharp increase in S‐​corporation income just after TRA 1986 certainly reflects in large part a shift in the status of corporations from C to S status to take advantage of the lower individual rates.” Even before the Tax Reform Act of 1986, the phased‐​in reductions in tax rates under the 1981 tax law (ERTA 198), “produced a sudden burst of S‐​corporation income (which was negligible up to 1981).… Almost all the increase in top incomes from 1981 to 1984 … is also due to the surge in S‐​corporation income.”

Those attempting to measure incomes by what is reported on individual income tax returns erroneously viewed this as a large increase in income at the top, but it simply was a meaningless bookkeeping change in the way those incomes were reported. Switching from the corporate tax to the individual income tax did not make the rich any richer—it simply made more of their income show up on individual income tax returns and, therefore, in the CBO and Piketty‐​Saez estimates.

About the Author