Tuesday, December 06, 2011

Slamming Economic Inequality -- Not a Slam Dunk

By Ronald Schmidt and Janice Willett
November 16, 2011

Ronald Schmidt is the Janice M. and Joseph T. Willett Professor of Business Administration, for Teaching and Service, at the University of Rochester’s William E. Simon Graduate School of Business Administration.

Janice Willett is a freelance editor and an alumna of the University of Rochester’s William E. Simon Graduate School of Business Administration.

Politicians and pundits, not to mention Occupy Wall Street participants and now Warren Buffett as well, voice concern that economic inequality is increasing and propose to reverse this trend by raising taxes on big earners. But whether or by how much inequality has actually changed is open to question, because the statistical analysis is often misleading.

The recent Congressional Budget Office report on income distribution is a case in point. It states that for the top 1 percent of households, “average real after-tax household income grew by 275 percent between 1979 and 2007,” compared with much smaller rates of increase for the other 99 percent. But a closer look shows that income inequality basically hasn’t changed since a quarter-century ago.

Why the discrepancy? For starters, the CBO report covers the period 1979 to 2007. According to the authors, 1979 was the earliest year for which certain Census Bureau data are available. Fair enough. The report also chose 1979 and 2007 as its beginning and end dates because “both were economic peak years just prior to a recession.” But the peaks were by no means equally intense—and the economic downturn of 2008 and 2009 can hardly be characterized as just “a recession.” It started from a much higher level of economic activity, occurred much more rapidly, and involved a much bigger increase in unemployment than did the recession following 1979.

So does the choice of 2007 as an end date affect the CBO results? The report itself says in passing (and perhaps disingenuously) that “the turmoil in financial markets in 2008 probably reversed some of that growth [in real after-tax income for the top 1 percent of households] but it is not clear by how much or for how long.” And yet the report was released late in 2011—surely the CBO has access to data that would have allowed a more definitive analysis.

According to IRS data, which extend through 2009, the average nominal Adjusted Gross Income (AGI) for filers with AGI of at least $500,000 declined by 17.8 percent from 2007 to 2009, and their average after-tax income declined by 19.9 percent. For those with AGI of less than $500,000, AGI declined by only 2.6 percent, and after-tax income declined by only 1.5 percent. These numbers certainly do not indicate an increase in income inequality.

In fact, there has been a marked decline in income inequality over the last decade. From 2000 to 2009, average AGI declined by 15.0 percent and average after-tax income declined by 11.0 percent for returns with AGI of at least $500,000. (Filers with an AGI of at least $500,000 represent 0.5 percent of all returns in both years, so this comparison is similar in spirit to the CBO report, which looks at the top 1 percent of households.) For all other returns, there were increases of 14.6 percent for average AGI and 17.3 percent for average after-tax income.

The CBO report also examines inequality trends on the basis of a Gini index for “market” income (which includes capital gains but not transfers such as welfare payments) and after-tax income. The Gini index can range from 0 to 1, with higher values signaling a more unequal income distribution. The CBO report shows the index increasing from 1979 to 2007—although almost all of the increase occurs over two periods, 1979 to 1986 and 2002 to 2007. And there’s still the question of what happened in 2008 and 2009.

As it turns out, a Gini index calculated on the basis of IRS data alone closely tracks the CBO Gini index for market income from 2000 to 2007 (the average difference is only .0023)—and its level in 2009 was essentially the same as in 2002. In short, most of the increase in the index from 2002 to 2007 was wiped out by the Great Recession—which means that most of the increase over the full 1979 to 2009 period covered in the CBO report had already occurred by 1986. Basically, the income distribution is the same as it was 25 years ago.

What about the common view that the top 1 percent are always the same people? The Occupiers, with their signs pitting the 99 percent against the 1 percent, have clearly fallen prey to this fallacy. But IRS data reveal that the business cycle creates and destroys high earners, as evidenced by swings in the number of ultra-high-income returns—those with AGI of at least $10 million, for which data were first published in 2000. From 11,215 in 2000, the number of these filers fell by more than half to 5,309 in 2002 before tripling to 18,394 in 2007 and then falling again by more than half to 8,274 in 2009. This does not square with the rich consistently getting richer—or even staying richer.

What could give rise to income inequality in the first place? Consider three males who graduated from high school in 1980 and worked full-time for the next three decades. (We use males and full-time workers only to abstract from variables such as changes in the gender composition of the labor force that could twist historical comparisons of earnings.) For one of them, education ends with high school, while the second gets a college degree and the third earns a graduate degree. In 1987, when these three were between the ages of 25 and 34, the average high school graduate earned $22,595, while a college graduate earned $31,631 and a holder of a graduate degree earned $36,667. But 20 years later, in 2007, the corresponding averages for male full-time workers ages 45 to 54 were $46,667, $88,242, and $120,391.

Unequal? Yes. But the increase in inequality arose because these individuals made different decisions about their education, not because tax policy favors the rich. In essence, economic inequality is another term for incentives that encourage investment in education—or, for that matter, starting a new business. Of course, most new start-ups fail, so there’s a lot of risk involved. But taxing the successful ones will not make failures less likely—and it will discourage the risky investments that are the engine of economic growth. Just ask your local lottery retailer if more tickets are sold when the prizes are large or when they are small.

In short, there has been no significant deterioration in economic equality that could serve as a pretext for raising tax rates. And as has been pointed out elsewhere, there simply aren’t enough rich people—nor do they earn enough money—to close the budget deficit. If we want to solve our budget problems, we need to cut spending. And if the Occupiers really want to help, they might consider that instead of heckling bankers and spending cold nights in a public park, they could study for the LSAT, MCAT, or GMAT and become high-tax-paying citizens.