Economics 21 on the Sources of Measured Income Disparity

by Reihan Salam

My colleagues at Economics 21 have two new short essays that might be of interest. The following is a passage from “The Paradox of ‘Taxing the Rich’“:

To understand the distinction between forms of income and their impact on measured income disparity, consider the composition of the top 1%’s income in 1979 compared to 2007 (the peak of the most recent business cycle). In percentage terms, the category that witnessed the largest increase was business income, which grew at a compounded annual rate of 6%. Did the top 1% become more entrepreneurial during this period? Probably not. The growth was more likely a function of changes in tax policy that made “flow-through” business income more tax-advantaged.

When forming a business, entrepreneurs can choose to incorporate as a “C” corporation or form a partnership, limited liability corporation (LLC), or S-corporation. A “C” corporation pays taxes at the corporate income tax rate, while the income of the other business entities “flows through” to the owners where it is taxed at the individual rate, whether the income is actually distributed to owners or not (i.e. retained earnings are taxed at the individual level). In 1979, the top individual rate was 70%, while the top corporate tax rate was 46%. The differential in tax rates led business owners to prefer to organize their businesses as “C” corporations, in which case the net income earned by the business would not show up on the owners’ individual tax returns. In 1980, C corporations accounted for more than 85% of total business receipts and nearly 80% of total business net income.

The elimination of the tax differential (both top rates are now 35%) made it far more attractive to organize as a flow-through business. Between 1979 and 2007, the share of business income reported by “flow-through” businesses like partnerships and LLCs more than doubled. By 2004, flow-through businesses accounted for over 50% of all business income and this share continued to grow. Nearly all of the increase has come in the top tax brackets, which Treasury estimates to account for over 70% of flow-through business income and more than 80% of the taxes on flow-through business income. In 2007, the Treasury Department estimated that 75% of the taxpayers in the top tax bracket reported business income and 84% of the tax benefits from a top rate of 35% instead of 39.6% that went to flow-through business owners.

Consider the impact of this tax change on income disparity: income inequality has risen because business income once reported at the corporate level is now being reported at the individual level. Consider a hypothetical business worth $25 million with $10 million in net income. In 1980, this $10 million would have been more likely to be reported as the income of a C corporation, which would make the personal income of the owner seem lower than if that income flowed through directly to the owner’s tax return, as occurs with LLCs and S corporations. But in both situations, the economic reality is the same: the taxpayer is the owner of a $25 million business that generates $10 million in net income.

Had the tax system continued to favor keeping retained earnings inside of C corporations, the reported income of the top 1% in 2007 would have been more than 10% lower, not because of any change in economic reality, but simply because less business income would have been reported at the individual level. (This assumes that reported business income would have grown at the same rate of wages. Although the capital gains on the C corporation stock might be realized and increase capital gains income, such transactions could be avoided by using the stock as collateral for secured loans to finance consumption expenditures.) By incentivizing business income to be reported in “C” corporate form, a large tax increase on the top 1% would also increase the use of internal cash for business investment, which would increase the deferral of personal taxes from dividend and interest income. This means that income that could otherwise have been reallocated by owners for more productive investment gets trapped inside of the corporation because of tax impacts. The net result would be less reported income disparity, less tax revenue from the top 1%, but no material change in the underlying economic circumstance.

There is much more at the link. But the core idea is that increasing taxes on high-earners will tend to reduce taxable income while increasing deductible consumption, e.g., it will tend to increase spending on tax-advantaged goods and services like housing and medical care.

And in “Measured Inequality: Fallacies and Overstatements,” Chris Papagianis expands on some of the themes above while elaborating on churn among the highest-earners.