Taxable Income vs. Economic Income and the Inequality Debate

Bruce Bartlett makes an important observation about the limitations of adjusted gross income or taxable income as a tool for understanding income trends over time:

Adjusted gross income excludes a number of important sources of income for the wealthy, including unrealized capital gains and interest on state and local government bonds. There are also a number of deductions from gross income to derive adjusted gross income, including contributions to retirement plans, alimony paid and others. Thus, adjusted gross income is considerably lower than what economists would call economic income — the total increase in someone’s ability to command resources during a year.

Bartlett raises this point in the context of the debate over the share of the federal income tax burden borne by high-earners, but it also has implications for the discussion over how income inequality has changed over time, as Phillip Armour, Richard V. Burkhauser, and Jeff Larrimore have suggested:

Recent research on United States levels and trends in income inequality vary substantially in how they measure income. Piketty and Saez (2003) examine market income of tax units based on IRS tax return data, DeNavas-Walt, Proctor, and Smith (2012) and most CPS-based research uses pre-tax, post-transfer cash income of households, while the CBO (2012) uses both data sets and focuses on household size-adjusted comprehensive income of persons, including taxable realized capital gains. This paper provides a crosswalk of income growth across these common income measures using a unified data set. It then uses a more consistent Haig-Simons income definition approach to comprehensive income by incorporating yearly-accrued capital gains to measure yearly changes in wealth rather than focusing solely on the realized taxable capital gains that appear in IRS tax return data. Doing so dramatically reduces the observed growth in income inequality across the distribution, but most especially the rise in top-end income since 1989. 

If we agree with Bartlett’s (implicit) take that “the total increase in someone’s ability to command resources during a year” is what matters most, it is interesting, if nothing else, that recent decades have seen a relatively modest increase in top-end economic income between 1989 and 2007:

[W]hen we include yearly-accrued capital gains excluding housing gains and private business gains, instead of taxable realized capital gains, the inclusion of these gains slows income growth in all but the bottom quintile of the distribution. Thus, when using this measure that is more in line with Haig-Simon’s income principles, the top quintile of the distribution had the least growth in income from 1989 through 2007 while the bottom quintile of the distribution had the most. Measured in this way income inequality fell between 1989 and 2007.

How is it possible that the choice of treatment of capital gains can have such a dramatic difference? It results from both the timing of realizing gains and from the likelihood of assets appearing in taxable accounts for individuals at different points in the income distribution.

One assumes that the picture has changed since 2007, and I await the evidence on how it has changed.

Reihan Salam — Reihan Salam is executive editor of National Review and a National Review Institute policy fellow.

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