When "Progressive" Means Punitive

Alan Reynolds

5/17/2007 12:00:00 AM - Alan Reynolds

In a recent New York Times column, Paul Krugman frets that we are in a "New Gilded Age" because "every available measure of income concentration shows that we've gone back to levels of inequality not seen since the 1920s."

The only estimates that go back to the 1920s are a 1953 study of income tax data by Simon Kuznets and an updated 2001 study along the same lines by Thomas Piketty and Emmanuel Saez. The Kuznets estimates can't possibly be compared with recent data, so Krugman's "every available measure" turns out to be another veiled reference to Piketty and Saez. It echoes an earlier New York Times article by David Cay Johnston, which claimed that in 2005 the top 1 percent of Americans (with incomes above $348,000) received "their largest share of national income since 1928."

Unfortunately, the estimates for 2005 can't be compared with those from 1928, because Piketty and Saez used a much broader measure of total income for 1913-1943 than they did for later years. For 1928, the top 1 percent's income was divided by 80 percent of personal income. For 2005, the top 1 percent's income was divided by a figure only 62 percent as large as personal income. If total income is measured in the same way, then the top 1 percent's share was 13.3 percent in 2005 -- not remotely close to the 19.8 percent figure for 1928.

The Piketty-Saez income figures are before taxes, yet Krugman uses them to propose that we "raise taxes on the rich." He argues, "Taxation has become much less progressive: according to estimates by the economists Thomas Piketty and Emmanuel Saez, average tax rates on the richest 0.01 percent of Americans have been cut in half since 1970, while taxes on the middle class have risen."

That claim about middle class taxes is false. Piketty and Saez show average taxes for the bottom 90 percent falling from 20.4 percent in 1970 to 18.5 percent in 2000.

As for the richest 0.01 percent, that means 7,992 taxpayers in 1970 who reported incomes above $1 million (in 2005 dollars). Piketty and Saez would have you believe those 7,992 households paid an average of 74.6 percent of their income to the federal government alone in 1970. The comparable tax estimate for 2004 is 34.7 percent, which is apparently considered to be obviously less desirable than a 74.6 percent tax, though perhaps not as perfect as 99.9 percent.

Before anyone could possibly believe the nation's most successful people were ever so docile as to fork over three-fourths of their income to the federal government it is essential to understand that Piketty and Saez study "behavioral responses to taxation such as tax avoidance or reduction of labor supply or savings due to taxation." The rich are thus considered so unresponsive that we can safely assume they do not even shift into tax-exempt bonds (whose income went unreported before 1987).

The Piketty-Saez tax estimates are used as a rationale for raising (SET ITAL) individual (END ITAL) tax rates. However, my 2006 column on "The Top One-Hundredth of One Percent" used their figures to show that the top group's income tax rate rose from 25.8 percent in 1990 to 28.1 percent in 2005, while income taxes on the middle fifth dropped from 7.2 percent to 3.3 percent. Piketty and Saez say the reduction of taxes at the top since 1970 was "mainly because of the impact of the corporate income tax and the estate tax." But that is because they "assume that the corporate income tax falls on capital income and that all financial assets (and not only corporate stock) bear the tax equally."

A Congressional Budget Office paper by William Randolph estimates that, "domestic labor bears slightly more than 70 percent of the burden of the corporate income tax. The domestic owners of capital (not just taxable financial capital) bear slightly more than 30 percent of the burden." If Randolph is even partly right, that demolishes the central conclusion of Piketty and Saez that "the greater progressivity of federal taxes in 1960, in contrast to 2004, stems largely from the corporate income tax."

Questions about who pays the corporate tax and income distribution estimates based on individual tax returns are both complicated by the ease of shifting business and professional income between the corporate and individual tax forms. Sheltering personal income inside a corporation was commonplace in the 1970s, but also much earlier. In The American Economic Review in 1937, Roy Blakey noted that, "As the surtax rates for individuals were increased, there was more and more of a temptation and opportunity to avoid the surtax by incorporating." He mentioned "incorporation of yachts and country estates" and "personal holding companies (which) were permitted many deductions not allowed to individuals."

Similar ambiguities affect the estate tax. Piketty and Saez assume that wealthy dead people (rather than their no-income grandchildren) pay the death tax in the year in which they die. In a famous 1978 paper in The Journal of Political Economy, however, Joseph Stiglitz reasoned that the estate tax would ultimately be borne by labor, because it reduces capital formation and therefore productivity and real wages.

The most intractable problem with all such estimates, however, is the demonstrably false assumption that people do not change behavior when tax rates change. In discussing what happened after top marginal tax rates came down, a footnote in Piketty and Saez acknowledges that "it is a disputed question whether the surge in reported top incomes has been caused by the reduction in taxation at the top through behavioral responses."

That is, in fact, the essence of the dispute between us. Taxpayers have always reported more income at the top whenever tax rates have been reduced on salaries (1925 and 1988) or on capital gains (1997) or both (2003). Piketty and Saez depict such increased willingness to report income on individual tax returns as an increase in inequality, while I view it as a predictable response to a change in tax incentives.

Simon Kuznets said his 1953 estimates of income distribution were "as if one tried to paint a fine picture with thick brushes and large blobs of somewhat mixed colors." The newer estimates are almost equally crude, but economists seem not quite as candid or humble as they used to be.