Churn in the Top 1%

by Reihan Salam

My Economics 21 colleagues have written an informative piece on how to understand the top 1% of the income distribution as a moving target. We often observe that the share of income earned by the top 1% has increased over time, with a number of local peaks and valleys. Yet some forget that the composition of the top 1% is fairly volatile, as some individuals might be in the top 1% one year, having achieved some windfall (e.g., having sold a business), and not in another.

[M]ost of the churn in the top 1% over the course of 30 years is related to life cycle trends. Many households that were part of the top 1% in 2005, for example, have since retired and been replaced by households whose primary earners were in more junior positions in their company, attending graduate school, or yet to start their own businesses in 2005. A large number of taxpayers who benefitted from the Bush tax cuts are likely out of the labor force. Raising taxes on the top 1% is therefore not going to impact them.

Beyond life cycle, another issue that’s behind the churn in the top 1% of the income distribution comes from non-recurring sources of income, like asset sales. Every year, some portion of the top 1% sell family businesses, large stock portfolios, or real estate. The capital gains on these sales is non-recurring; the capital gains income from these sales comes in a single year. These sales may push up the average income of the top 1% for that year, but they have no impact on the average earnings of the group. The chart below looks at the share of the income of the top 1% that comes from non-wage income like capital gains, small business earnings, dividends, and interest. In 2007, only 36.3% of the income of the top 1% came from wages (1 – 0.637), while 33.2% came from capital gains (elective asset sales).

The composition of income is clearly significant because discussions about income often concern how much someone “makes.” Implicit to this formulation is that the income comes from salary or recurring income. Generally speaking, the lower on the income distribution, the larger the share of earnings that come from wages and the more likely the previous year’s income predicts income the following year. But for the top 1%, the previous year’s income may be inflated by a one-time event, which means that the household could contribute meaningfully to the average income of the top 1% for a single year and then drop out of the top 1% entirely the following year.

Rather than the average income, the chart below looks at the income threshold for households to be in the top 1%. In 2008 (most recent data available), the income of the 1.4-millionth household from the top was $368,238, down 11% from $414,225 in the previous year. The income of the “theoretical” household on the cusp of the top 1% rose by just 0.7% per year in nominal terms, which means it has declined in real terms since the middle of the decade by about 9% on a cumulative basis. This household’s income has failed to keep pace with inflation. At 3% annual growth between 1988 and 2008, the $269,845 income would equal $491,118 in 2008. Thus, on an inflation-adjusted basis, the earnings of the household at the bottom of the top 1% have actually fallen by more than 25%.

One phenomenon I find fascinating is that lifetime net tax rates are increasing for younger generations. Consumption taxes might capture some of the wealth earned by older generations, who enjoyed low marginal tax rates for a long period of time. Assuming marginal tax rates increase, the young will face a somewhat more challenging climate for wealth-building than their older counterparts. Perhaps young high-earners should advocate transitioning to something like a progressive consumption tax regime, if only in the interests of fairness.

The Agenda

NRO’s domestic-policy blog, by Reihan Salam.