The Agenda

Incomes in the ’00s

Gary Burtless of the Brookings Institution delves into a new report from the Congressional Budget Office on the distribution of household income and federal taxes from 2000 to 2010, a tumultuous decade that began with a mild recession, was followed by an anemic labor market recovery, and which saw a housing bust, a financial panic, and the sharpest economic contraction since the Depression era in its last few years. He specifically focuses on household income growth and income inequality:

Over longer time horizons and measured over full business cycles the latest CBO numbers confirm that the income gains of the top 1% have been considerably faster than those enjoyed by middle-income Americans. For example, between 1979 and 2010 the after-tax real incomes of the top 1% tripled. Households in the middle three-fifths of the income distribution saw their after-tax incomes grow only about 40% (see Chart 2). What the CBO statistics do not show, however, is that middle- and low-income families have failed to share in the nation’s long-term prosperity. Over the past one-, two-, and three-decade periods, both middle class and poor households have experienced noticeable gains in living standards. Their gains are slower than those experienced by middle-income families in the earlier post-war era, but the gains are well above zero.

One reason that many observers miss these income gains is that the nation’s most widely cited income statistics do not show them. A commonly used indicator of middle class income is the Census Bureau’s estimate of median household money income. Measured in constant dollars, median household income reached a peak in 1999 and fell 9% in the years thereafter. The main problem with this income measure is that it only reflects households’ before-tax cash incomes. It fails to account for changing tax burdens and the impact of income sources that do not take the form of cash. This means, for example, that tax cuts in 2001-2003 and 2008-2012 are missed in the Census statistics. Even worse, the Census Bureau measure ignores income received as in-kind benefits and health insurance coverage from employers and the government. By ignoring in-kind benefits as well as sizeable tax cuts in the recession, the Census Bureau’s money income measure seriously overstated the income losses that middle-income families suffered in the recession. Under the CBO’s most comprehensive measure of income—total after-tax and after-transfer income—the median household income fell less than 1% between 2007 and 2010. Under the Census Bureau money income definition, median household income fell almost 7% (see Chart 3).

The new CBO income statistics show the growing importance of these items. In 1980, in-kind benefits and employer and government spending on health insurance accounted for just 6% of the after-tax incomes of households in the middle one-fifth of the distribution. By 2010 these in-kind income sources represented 17% of middle class households’ after-tax income (see Chart 4). The income items missed by the Census Bureau are increasing faster than the income items included in its money income measure.

The irony of relying on before-tax cash incomes to inform policy debates is that doing so obscures the impact of changes in public policy that have already occurred. When we instead embrace the CBO’s approach and consider after-tax and after-transfer income, we have a more realistic sense of how public policy tools have already been deployed, and what more we can and ought to do to boost low-end incomes.

The broadest and most accurate measures of household income are published by the CBO. CBO’s newest estimates confirm the long-term trend toward greater inequality, driven mainly by turbo-charged gains in market income at the very top of the distribution. The market incomes of the top 1% are extraordinarily cyclical, however. They soar in economic expansions and plunge in recessions. Income changes since 2007 fit this pattern. What many observers miss, however, is the success of the nation’s tax and transfer systems in protecting low- and middle-income Americans against the full effects of a depressed economy. As a result of these programs, the spendable incomes of poor and middle class families have been better insulated against recession-driven losses than the incomes of Americans in the top 1%. As the CBO statistics demonstrate, incomes in the middle and at the bottom of the distribution have fared better since 2000 than incomes at the very top.

Given that the market incomes of the top 1 percent are so cyclical, there is a real danger in building a tax system that relies so heavily on high-earners, as revenues will collapse when you need them most and they will surge during business cycle peaks in ways that might give rise to unsustainable spending commitments.

I would add a minor wrinkle to Burtless’s analysis of high-end incomes, which is that while the the CBO data is very valuable, it misses an important part of the story, as Scott Winship reminded us in October — it only imperfectly captures capital income:

The CBO and Piketty-Saez income figures are only able to account for capital gains that are both taxable and realized. Burkhauser, Armour, and Larrimore point out two big problems with this restriction. First, tax-exempt realized capital gains are ignored, including those from the sale of homes. These constitute a large share of capital gains received by the non-rich, so ignoring them overstates the rise in inequality. Another issue related to tax exemption is that savvy taxpayers at the top can alter their asset allocations so that more or fewer of their realized gains are taxable in response to tax law changes.

Second, and more important, there is a conceptual problem including realized capital gains in “income” but not the gains that accrue on assets that are held rather than sold. For one, the distinction is immaterial. Gains that accrue each year add to the resources available for consumption or saving whether they are realized or not. No less than realized gains, accrued gains not realized constitute part of the annual “flow” of resources properly conceived as “income” (as distinguished from the “stock” of accumulated resources properly thought of as “wealth”). In addition, investors strategically choose to realize capital gains depending on the state of asset markets and on changes in the tax treatment of different assets. Realization of gains accrued over many years tends to show up in tax return data in lumpy ways, as Cato Institute scholar Alan Reynolds has argued. A sizable share of the capital gains accruing to middle class households builds up over adulthood in accounts such as IRAs and 401(k)s and is not realized until retirement.

So the volatility, or lumpiness, Burtless identifies is real, but it is in part an artifact of the fact that tax policy influences when people choose to realize capital gains for tax purposes. The problem, as Winship makes clear, is that it is very difficult to measure fluctuations in the value of assets over time.