The Top 1%…of What?

December 14, 2006 • Commentary
This article appeared in The Wall Street Journal on December 14, 2006.

As many others have done, Virginia’s Democratic Senator‐​elect Jim Webb recently complained on this page of an “ever‐​widening divide” in America, claiming “the top 1% now takes in an astounding 16% of national income, up from 8% in 1980” (“Class Struggle” Nov. 15). Those same figures have been repeatedly echoed in all major newspapers, including this one. Yet the statement is clearly false. The top 1% of households never received anything remotely approaching 16% of personal income (national income includes corporate profits). The top 1% of tax returns accounted for 10.6% of personal income in 2004. But that number too is problematic.

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, aside from a meaningless one‐​time jump in 1993 when, as the Economic Policy Institute noted, “a change in survey methodology led to a sharp rise in measured inequality.”

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 lower line in the graph shows that 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.

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.

The politically correct yet factually incorrect claim that the top 1% earns 16% of personal income appears to fill a psychological rather than logical need. Some economists seem ready and willing to supply whatever is demanded. And there is an endless political demand for those able to fabricate problems for which higher taxes are, of course, the preferred solution. In Washington higher taxes are always the solution; only the problems change.

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