Getting Rich … on Paper

This article appeared in the November issue of USA TODAY magazine.
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Estimates of the top one percent's share of totalU.S. income have been cited widely as evidence of a largeand continuous increase in U.S. income inequality since the1970s. Yet, many changes in U.S. tax laws and regulationsafter 1980 made a dramatic difference in what is reported as income tothe Internal Revenue Service. Lower tax rates on individual income inducedthousands of businesses to switch to filing under the individualtax rather than the corporate tax. Corporate executives switched fromaccepting stock options taxed as capital gains to nonqualified stock optionstaxed as salaries. New tax-deferred savings plans also resulted inmuch of the dividends and capital gains of middle-income taxpayersbeing shifted away from tax returns, thus making billions of dollars ofinvestment income invisible in tax returns (except at the top). Meanwhile,exclusion of transfer payments in the most widely cited estimatesresults in exaggerating the increase at the top by ignoring agrowing fraction of lower incomes.

Estimates from Emmanuel Saez (professor of economics at the Universityof California at Berkeley) and Thomas Piketty (of Ecole NormaleSupérieure in Paris) indicate substantial responsiveness ("elasticity") ofreported income among high-incometaxpayers. When top tax rates fall, onsalaries or capital gains, a much largerfraction of high incomes shows up ontax returns. This is consistent with internationalcomparisons of top percentileincome shares, which rosemost where top tax rates were most reduced(the U.S., U.K., and India) androse least where top tax rates remainedvery high (France and Japan). Asidefrom executive and nonexecutivestock option windfalls during the 1997-2000 stock boom, there is littleevidence 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 incomedistribution before and after such dramatic changes in tax law as thosethat occurred in the U.S. from 1981-86. Practically every major newspaperand magazine in the U.S. and U.K. repeatedly has reported thatthe share of national income received by the top one percent has increasedenormously and continuously since the 1970s. Of the manydifficult statistics used to influence public perception and policy, thisone surely is the most often repeated and the least often understood.

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

Even if adjusted gross income (AGI) as defined by tax law capturedeverything that might reasonably be considered income, tax returns donot capture all of AGI. Estimates of AGI based on personal income dataare much larger than the amount of AGI reported on tax returns,when such income is otherwise measured in the same way. The Bureauof Economic Analysis estimates that this "AGI gap" rose from9.7% in 1988 (when the top tax rate was 28%) to 12.7% in 1994 and14.4% 2003. Assuming for illustration that the top one percent accountedfor five percent of the AGI gap, that gap was too small in1988 to have made much difference in their income share. By 1999, onthe other hand, that same assumption would reduce the top one percent'sshare by nearly a percentage point.

Although The Economist and others depict the apparent rise in thetop one percent's share as a "truly continuous trend," the original 2001Piketty and Saez paper clearly explain that, "a significant part of thegain [in top income shares] is concentrated in two years, 1987 and1988, just after the Tax Reform Act of 1986." One very obvious reasonfor the surge in top incomes after 1986 is well known to economists, includingSaez, yet never mentioned by journalists who cite these figures.

"It seems clear," as Saez wrote in2004, "that the sharp, and unprecedented,increase in incomes from 1986to 1988 is related to the large decreasein marginal tax rates that happenedexactly during those years." One reasonthis happened, he explains, wasincome shifting from the corporate tothe individual income tax: "Before the1980s, S-corporation income was extremelysmall, as indeed the standardC-corporation form was more advantageousfor high income individual owners because the top individualtax rate was much higher than the corporate tax rate and taxes on capitalgains were relatively low.

"S-corporation income increases sharply from 1986 to 1988 and increasesslowly afterwards. The sharp increase in S-corporation incomejust after TRA 1986 certainly reflects in large part a shift in the status ofcorporations from C to S status to take advantage of the lower individualrates." Even before the Tax Reform Act of 1986, the phased-in reductionsin tax rates under the 1981 tax law (ERTA 198), "produced asudden burst of S-corporation income (which was negligible up to1981). . . . 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 individualincome tax returns erroneously viewed this as a large increase inincome at the top, but it simply was a meaningless bookkeeping changein the way those incomes were reported. Switching from the corporatetax to the individual income tax did not make the rich any richer—itsimply made more of their income show up on individual income taxreturns and, therefore, in the CBO and Piketty-Saez estimates.