Thursday, October 27, 2011

Who really is the top 1%?

Every person dialed into the American political discussion knows that a lot of thought and consternation has been applied to the top 1% of income earners.  I decided to use IRS data to determine who exactly is being talked about.

The Tax Foundation has compiled recent IRS data concerning individual income taxes.  Income earners are segmented into progressively smaller portions from the bottom 50% all the way to the top .1%.  This report is ideal to determine just who is the top 1% of income earners in the United States.

Two important characteristics to be examined are:  1. The minimum adjusted gross income (AGI) to be a member of the top 1% and .1%, and 2. The per capita income of members of those two groups.

AGI: Adjusted Gross Income is defined as gross income minus adjustments to income found on the Form 1040 under adjusted income.  AGI is higher than taxable income as credits and exemptions have not been applied yet.

Table 7 in the report shows the minimum AGI of different income percentiles.

At the Peak of the Bubble (2007):
               Minimum AGI to be in the top 1%  = $410,096
               Minimum AGI to be in the top .1% = $2,155,365

Most Current IRS Data (2009):

               Minimum AGI to be in the top 1%  = $343,927
               Minimum AGI to be in the top .1% = $1,432,890

Over those two years the total number of tax filers in the United States dropped from approximately 141,070,000 filers to 137,982,000, a 2.2% decrease (which correspondingly means 2.2% less people in the top 1% of filers, this makes an impact later)

It's expected that the minimum AGI to qualify for the top 1% will increase this year, but unlikely reaching the 2007 level.

To determine the per capita income in the top 1% and .1% I divided - Table 3 - (Total adjusted gross income of taxpayers) by Table 2 - Total returns filed per percentile bracket.

At the Peak of the Bubble (2007):
               Average AGI in the top 1%  = $1,423,104
               Average AGI in the top .1% = $7,439,716

Most Current IRS Data (2009):

               Average AGI in the top 1%  = $960,869
               Average AGI in the top .1% = $4,420,290

Total AGI of the top 1%:  2007 - 2.008T; 2009 - 1.326T.
This is a 34% decline in income going to the top 1% since 2007.  Stated another way - 682B less income (though it is shared with 2.2% less people).

For a comparison, the total decline in AGI between 2007 and 2009 = 974B.  682B/974B = 70% of the total drop in AGI is attributable to the drop in the top 1%'s AGI.

Happy Belated Birthday

The 1986 Tax Reform Act was enacted on Oct. 22, 1986.

The goal was to simplify the tax code and to reduce individual tax rates.  The current tax rates are lower than the pre-1986 top marginal rate of 50%.  However, the Act had originally lowered the top marginal rate to 28%, but it has crept up over the years to the current 35%  (or 39.6% if the Bush Tax Cuts expire).

Unfortunately, the tax code did not remain simplified.  Over the past 25 years, an incredible amount of complexity has been written into the code.  Some provisions satisfy legitimate goals such as accurately taxing global profits.  Other provisions suffer from the problems of the past - penalties or rewards for specific taxpayers and needless complication.  The code is overdue for another comprehensive reform.

The Tax Reform Act saw the birth of IRC 469 - the passive activity loss rule.  This limited loss deductions on passive activities to the amount of gain from those activities.  Meaning if you made $10,000.00 in a business you start that qualifies as a passive activity, you can only deduct expenses against the $10,000.00 earned.

Passive Activities are activities in which the taxpayer does not materially participate, as determined under the code.  Losses will accumulate until the business is sold and only then can the taxpayer realize the loss against his income.

This reform was meant to prevent tax shelters.  An example would be a ranching business owned by a CEO of a company.  The CEO works full time for the company and only works on the ranch on weekends he can leave the office.  Unsurprisingly, the ranch never makes a profit.  Before IRC 469, the losses on the ranch would be deductible against his gross income.

By limiting questionable deductions, like passive activity losses, as well as limiting some corporate tax deductions, the reform act was able to be revenue neutral while lowering the tax burden on most Americans.

The CBO is a Tool...

It can be used to enlighten or mislead.  On Tuesday, the CBO released a new report on the the GINI distribution of income in the United States.

Here is the report and accompanying blog post.  I'd recommend the blog post as it gets the point across neatly and the report is a healthy 50 pages of graphs and methodology.  If you are interested, the report is a great resource on how many complications exist in an analysis on income inequality.

Oddly, the report compiles data from 1979 to 2007, before the current depression.  Greg Mankiw, a Harvard Economics professor breaks down some of the more recent data, 2008-2009, to show how much an effect the choice of date had on the conclusion.  If you go to figure 2 - pg. 3 of the report, the graph shows the volatility of high earner income, and the 2007 snapshot is taken at the peak, just before a massive trough.

Mark Perry, prior to the release of the CBO report had an interesting post on the cause of income differentials between quintiles of the American population - Household Demographics.

I'd like to take note of an additional cause for the inaccuracy of the report.  The report makes note the composition of income in fig. 10, pg. 17.  Business income has greatly increased as a share of total income for the top 1%, while capital income has decreased.  This is due to the tax reform act of 1986, which made pass-through entities - S-corps, LLCs and Partnerships - more tax efficient than traditional C-corps.

This difference was not accounted for by the CBO.  In 1979, a wealthy person who owned a business would pay corporate taxes (the current rate is 35%) on profits.  The after tax remainder would go on their personal return as dividend income.  This would mean that a company with $100 in profit would pay $35.  It would appear as if the wealthy business owner received only $65 in dividend income (taxed at 15%).

If the same wealthy businessperson made the same profit in his new LLC, he would record $100 of business income.  This would then be taxed at the current rate of 35%.

Without accounting for this difference, a business owner appears to be making $35 more on every $100 then they did in 1979, with no change of economic substance.  100/65 = 1.53x growth in "pre-tax" income for the wealthy who changed their corporate form but no increase in reality.  Given the decline in capital income in favor of business income found in the report, the nature of accounting contributes a significant partial share in the increase in income for the top 1%.