On Economic Myth #2- The Top 1% of Taxpayers

Last month, The Wall Street Journal published an editorial by noted economist Alan Reynolds, entitled "The Truth About the Top 1%," the day after publishing an editorial concerning middle-class job growth, about which I wrote a post yesterday.

In his editorial, Reynolds demolishes the evolving Democratic claim that our country's income distribution is 'the most unequal that it's ever been.'

He begins with this passage,

"The argument for these proposals has nothing to do with the impact of higher tax rates on incentives and the economy. It is all about "fairness" -- defined as reducing the top 1%'s share of income.

This political exercise invariably begins by citing dubious statistics about pretax incomes among the top 1% (1.3 million tax returns) as an excuse for raising tax rates on the top 5%, among others. Echoing speeches from Sen. Clinton, Business Week recently exclaimed, "According to new Internal Revenue Service data announced last week, income inequality in the U.S. is at its worst since the 1920s (before the Great Depression). The top percentile of wealthy Americans earned 21.2% of all income in 2005, up from 19% in 2004."

These statistics are extremely misleading.

First of all, the figures do not describe the top percentile's share of "all income," but that group's share of "adjusted" gross income (AGI) reported on individual tax returns. For one thing, thousands of professionals and business owners who used to report most of their income under the corporate tax responded to lower individual income-tax rates after 1986 and 2003 by reporting more income under the individual tax as partnerships, LLCs and Sub-S corporations."

This is critically important. So much so that President Bush commented on it extensively in his speech when he visited Lancaster, Pennsylvania a few months ago. Nobody commented on this aspect of his talk, nor his command of this particularly important nuance of the tax code.

But it's a fact. I've been paying taxes on income flowed through Subchapter S or LLC entities for about a decade. For anyone planning to do any significant business outside a large corporate structure, 1040s alone no longer represent a clear picture of how incomes are earned.

Reynolds elaborated by writing,

"It is this bookkeeping shift, moving business income from the corporate to the individual tax, not CEO pay, which raised the top 1%'s share on individual tax returns. Income reported on W2 forms -- salaries, bonuses and exercised stock options -- accounted for only 57.2% of total income among the top 1% in 2005, down from 63% in 2000 and 65.7% in 1986. Real compensation among the top 1% actually fell 7% from 2000 to 2005."

Wow. Imagine that! The top taxpayers weren't all Fortune 500 CEOs!

Then there's the matter of the denominator of the "1%." On this topic, Reynolds wrote,

"Turning to the denominator of this ratio ("all income"), a huge portion of middle and lower income is no longer reported on tax returns. A larger and larger share of middle-class investment income is now accumulating outside of AGI because it is inside IRA, 401(k) and 529 savings plans.

The CBO reckons the top 1% accounted for more than 59% of all capital gains, interest, dividends and rent reported on individual tax returns by 2004. Yet estimates of the share of national wealth of the top 1% range from 21%-33%.

If the top 1% own 21%-33% of all capital, how could they be collecting 59% of the income from capital? They can't and they aren't. The top 1% is simply reporting a rising share of capital income because those with more modest incomes are keeping a rising share of their capital income unreported -- in IRA, 401(k) and 529 accounts. Millions also shrink their "adjusted" incomes by subtracting contributions to IRAs unavailable to the rich."

So the income base on which the disparities are calculated aren't even fully representative. Significant income among the middle class is 'hidden' among legal tax shelters, such as IRAs and 401(k) plans.

Gee, this is getting complicated, isn't it? Far moreso than Hillary or Edwards campaign-trail sound bite? You betcha!

But wait....there's more.

Reynolds goes on to add transfer payments as an omitted income source,

"Another huge swath of middle and lower income is excluded because AGI includes only the taxable portion of Social Security benefits and totally misses most other transfer payments such as Medicaid, food stamps and the Earned Income Credit. The Canberra Group, an international group of experts on income statistics brought together from 1996-2000 by the OECD, World Bank, U.N. and others, insisted household income must include everything that "increases the recipients' potential to consume or save." Government transfers amounted to $1.5 trillion in 2005 -- more than the total income of the top 1% in the basic Piketty and Saez estimates ($1.2 trillion).

As a result of such huge omissions, and tax avoidance, the AGI of $7.5 trillion in 2005 was $3.7 trillion smaller than pretax personal income (personal income was $10.3 trillion in 2005, after subtracting $875 billion of payroll taxes). Anyone suggesting AGI is a more accurate measure than personal income is obliged to argue that GDP in 2005 was exaggerated by 29.4%."

So there's another leak in the AGI measurement which underpins the disparity claims.

Then there's a really innocuous aspect of the claims. They are frequently based on per tax return data, being, well, tax data. But Reynolds notes how this distorts reality,

"Estimated income shares from the IRS or Messrs. Piketty and Saez are not about income per household, but income per tax return. That matters because the top fifth of households average two salaries per tax return. The Census Bureau reports that the top fifth accounted for 26.8% of all full-time works last year while the bottom fifth accounted for just 5.7%. In fact, 64.5% of the households in the bottom fifth had nobody working, not even part time for a few weeks. When labor economists discuss income inequality, they habitually switch to speculating about skill-based differences in hourly wages, totally ignoring differences in hours worked."

Then Reynolds presents evidence you won't read elsewhere about another key component of the alleged rising incomes disparity- changes in the IRS definition of AGI. He wrote,

"Third, the latest IRS figures are not comparable with those of 1986, much less with 1929, because the definition of AGI changes with changes in tax law. Such estimates differ greatly, with the IRS saying the top 1% received only 11.3% of income in 1986 (because AGI then excluded 60% of capital gains) while Messrs. Piketty and Saez put that year's figure at 13.1% and the CBO says it was 14%.

The IRS figures only go back to 1986, so the Business Week comparison with the 1920s is invalid.

If total income for 2005 was defined as it was for 1928, then the share of the top 1% would have dropped to 13.3% in 2005, compared with 19.8% in 1928. Besides, as Messrs. Piketty and Saez explained, "our long-run series are generally confined to top income and wealth shares and contain little information about bottom segments of the distribution." "

Wow! That means that, unadjusted for Reynolds' other findings of fallacious left-wing incomes analysis, if you simply compared 2005 with 1928, the top 1% share of incomes has actually dropped!

Finally, Reynolds notes how tax rates affect reported income, as distinct from actual total income, especially among, well, those top 1%,

"A fundamental problem with all tax-based income data involves "taxable income elasticity." Numerous studies, some by Mr. Saez, show that the amount of top income reported on individual tax returns is highly sensitive to changes in marginal tax rates on individual income, corporate income and capital gains. After the tax on dividends was reduced in 2003, for example, top-bracket investors held more dividend-paying stocks in taxable accounts (rather than in nontaxable accounts) and fewer tax-exempt bonds.

Even if estimates of the top 1%'s income share were not so sensitive to changes in tax rates, they would still tell us nothing about what happened to incomes among the other 99%. The top 1%'s share always falls in recessions, even aside from capital gains. But that certainly doesn't mean recessions raise everyone else's income.

"It is a disputed question," wrote Messrs. Piketty and Saez, "whether the surge in reported top incomes has been caused by the reduction in taxation at the top through behavioral responses." In fact, their data clearly suggest that higher tax rates on top incomes, dividends and capital gains would sharply reduce top incomes, dividends and capital gains reported on individual tax returns. Such behavioral responses would have little impact on actual income or wealth at the top, while nonetheless leaving middle-income taxpayers stuck with a much larger share of the tax burden."

Putting all of Reynolds' points together, it's clear that you can't say anything defensible, on the basis of tax data, about whether the US is experiencing growing income disparity between the top and bottom extremes of household incomes.

If Democratic Presidential candidates, and Republican one, as well, are going to continue to harp on this chimera, they'll have to look elsewhere for reliable data on which to base the accusation.

On Economic Myth #1- Middle Class Job Loss

Much consternation has been raised lately by Democrats who contend that US income inequality between upper and lower earners has increased.

Nevermind that they can't articulate, quantitatively, what is normatively bad about this. They simply feel it's wrong.

However, three articles have appeared in the pages of the Wall Street Journal recently which refute various pieces of this Democratic assault on economically successful Americans. One has to do specifically with middle-class job growth and loss. Another analyzes the Americans at the top of the taxpaying heap by percent of income. The third focuses on a dynamic view of US personal incomes, rather than static views of the lowest and highest incomes at points in time.

Late last month, the Wall Street Journal published an editorial by Stephen J. Rose, a senior economic fellow at the Progressive Policy Institute, entitled "The Myth of Middle-Class Job Loss."

Mr. Rose's analysis is quite in-depth, and I can't hope to capture it all in this commentary. For those who are interested, it appeared in the Wednesday, October 24, 2007 issue of the Journal, on page A21, entitled, "The Myth of Middle-Class Job Loss."

In part, Mr. Rose writes,

"The assertion that the American middle-class is disappearing along with manufacturing jobs is, put simply, based on an outdated view of how the economy operates, and is empirically wrong. Nonetheless, the view that the economy has failed the middle class is widespread. The outsourcing of jobs to low-wage countries is, of course, the latest culprit. Polemicists from all sides find it irresistible to blame expanding trade for middle-class decline. But how widespread a problem is outsourcing, exactly?

It is certainly true that many jobs in manufacturing clothing, steel, metal products and automobiles have gone overseas. Plant closures not only devastate the workers who are displaced, but they have also undermined the vitality of whole communities in North Carolina, Pennsylvania, New York, Michigan, Ohio and Wisconsin, to name just a few places. But while such communities are a clear sign of the decline in some sectors of the economy, there has been strong employment growth in many other sectors. In research just published by the Progressive Policy Institute, I show that incomes and employment have grown by substantial amounts in every state (even in the so-called Rust Belt) since the passage of the North American Free Trade Agreement in 1993.

In fact, there is no convincing, data-driven proof that trade has led to any overall job loss during the last 30 years. To the contrary, the economy has grown at a slow but steady rate (a few brief recessions notwithstanding) with trade and employment rising in tandem.

To prove that there has been substantial growth of middle-class jobs, I compare the situation that existed in 1979 with that of 2005. The base year is 1979 because it represents the last business-cycle peak before income inequality and the U.S. trade deficit began to grow quickly in the 1980s. To make the comparison fair, earnings in 1979 are increased by almost 150% to adjust for inflation.

Nevertheless, there has clearly been a sharp increase in female middle-class employment. As recently as 1979, 61% of female workers were in jobs that paid less than $25,000, and only 3% earned more than $50,000 a year. By contrast, more than 36% of new jobs that opened since 1979 for women pay more than $50,000 and only 17% pay less than $25,000.

Critics who bemoan the trajectory of the American economy over the past three decades somehow find it convenient to overlook or play down this historic improvement in the employment status and income levels of women. While women still lag in pay compared to men of similar educational attainment, the extraordinary rise in women's income since 1979 is a fact at odds with the notion of an overall decline in the American middle class.

For men, the change in employment since 1979 has not been quite as clear-cut, or as positive. There has been a tremendous growth in the number of men in high-paying jobs: In 1979, just 10% of male workers earned above $75,000, while fully 34% of new jobs since 1979 have paid this amount or more.

However, there was also growth in the share of male workers earning less than $25,000 a year, from 23% in 1979 to 36% by 2005. This rise of low-paying jobs hit less-educated men particularly hard. For those with just a high school diploma, 87% of the new jobs paid $25,000 or less.

Here's the bottom line: For three-quarters of the workforce (women and the top half of male earners), economic growth translated into earnings gains. But for male workers in the bottom half of the earnings distribution, the decline of unionized manufacturing employment has led to the drying up of some middle-class jobs for those with no post-secondary education.

Using a framework that I developed in the 1990s, I find that most of the employment gains over the last 30 years have been in business-management activities (administration, sales, finance and business services) as well as in professional services such as health care and education. While the percentage of U.S. jobs derived from manual work in agriculture, mining, timber and manufacturing has declined, the share of jobs related to low-skilled retail and personal/food services has remained steady.

The economy can expand and provide more good jobs as long as workers have the education and training required to succeed. Talk of the "disappearance of the middle class" is actually counterproductive, because it distorts the real challenge. This is to make sure that our young men and women are better prepared to enter the workforce of the 21st century."

Rose's work clearly indicates that one has to measure the US economy's middle class by earnings, not job type. Contrary to Democratic beliefs, keeping old-line manufacturing jobs is often a 'one-way ticket to Palookaville' for blue-collar workers. Rather, better education continues to be the way forward.

So, millions for education- but not a dime for old manufacturing job protection!

Next in this short series will be a piece discussing the misconceptions about America's top taxpayers.