Inequality Debate Is Based On Bad Data

by: John Slater

America is stumbling toward one of the most important decisions it has made in decades: how to bring our financial accounts back to a sustainable balance. Due to a lack of perspective on tax policy over time, the political decision makers and the media have accepted misleading data with regard to an assumed increase in inequality of income as the primary framework for the debate.

With tax receipts at historic lows and expenditures heading for the stratosphere, no rational observer doubts that this decision will entail a combination of both spending cuts and tax hikes. Republican rhetoric aside, the real question on the tax side of the debate is how these tax increases will be structured. The outcome of this debate will have significant implications for investors. If the end result is higher taxes that penalize jobs producing capital, long term economic growth will be retarded and the current long term bear market may be significantly extended.

I am increasingly concerned that Congress will adopt tax law changes, perhaps through inaction on the Bush Era tax cut expiration, that penalizes mid-sized businesses. These growing companies with 50 to 500 employees serve as the backbone of American productivity and are the primary engine of domestic jobs growth. Their health is vital to the prosperity of the more visible public entities that drive the equity markets.

Let’s start with a bit of history from my personal experience, first as a business and tax lawyer and for twenty-eight years as an investment banker serving entrepreneurial businesses in M&A and arranging business financings. When I started in practice, essentially all substantial businesses with which we worked were structured as C Corporations. A typical client might be a manufacturer with 100 plus employees, revenue of $10 million plus and pre-tax profits of $1-2 million. The owner often took a surprisingly small salary, say $100-125,000, paid a small amount of personal expenses from the business and retained the rest of the company’s profits in the corporation.

As a result of changes in federal tax law and the parallel development of Limited Liability Corporations (LLCs), a major shift from C-Corporations to pass-through entities began in the middle 1980s. To demonstrate how dramatic this shift has been, IRS data shows that pass through income (S-Corps, Partnerships, REITs and regulated investment companies) increased from 1.5% of adjusted gross income in 1980 to 14.9% of adjusted gross income in 2008. If we look only at S-Corps and Partnerships, which comprise the core of entrepreneurial America, from 1980 to 2008, these entities’ share of total AGI increased from less than 1% to 9.2% of income. While not all of this income went to the top 1%, a substantial amount did. If we look only at the ratio of S-Corp and Partnership income to top 1% income, the percentage share increased from 7.8% to 46%.

This shift has a dramatic impact on the perception of increasing income at the wealthiest levels of society. To explain why this is the case, consider our example above of a typical entrepreneurial firm. That same highly successful business that generated $10 million in revenues in 1984 and produced pretax profits of $1.5 million might today generate $25 million with pretax profits of $2.5 million, reflecting inflation and a decline in profit margins over the period.

But the impact on the income accounts has been dramatic. Where the owner of the business reported $125,000 in personal income in 1984, in 2011 he will report $2.5 million in personal income because he converted the business from a C-Corp to a pass-through entity (S-Corp or LLC). Most of his after-tax income will be plowed back into the business, leaving him with a salary of perhaps $200,000. So the business owner is actually worse off after inflation than he was thirty years ago in terms of spendable income, but the Occupy Wall Street placards scream that our business owner’s increase in reported personal income from $125,000 to $2.5 million proves that inequality in America has increased alarmingly.

The inequality debate is based on a seminal paper written by Thomas Piketty and Emmanual Saez. This paper depends primarily on a documented shift in the percentage of reported income received by the top 1% of earners from 10% in 1980 to a peak of 23.5% in 2007. Due to the recession, the top 1% share had dropped to 17% by 2009, around the same level as 1998. Proponents of the inequality debate were quick to say that the income differential will rapidly return as the economy improves when, in fact, that income has merely been shifted from corporate to individual income tax returns

Piketty and Saez have generated a highly scholarly and in depth analysis of the shifts in income tax collections over time. If you want to dig into the Piketty and Saez data for yourself, download it here. I don’t fault their data so far as it goes. Instead I take issue with the conclusions reached, because the data is based on income tax receipts and the conclusions fail to take into account one of the most important shifts in American tax policy since World War II. The Tax Reform Act of 1986 caused a major shift in business ownership from C-Corps to pass-through entities and this has skewed the data to make it appear that the top 1% of earners are receiving a larger share of incomes.

The magnitudes of the shift support this conclusion. Pass-through income’s share of net business income reported for tax purposes increased from 4% to 73% of all business income from 1980 to 2008, while C-Corps’ share fell from 75% to 22%. Piketty and Saez’s own data shows the share of what they define as entrepreneurial income (S-Corps and Partnerships) increased from 7.8% of incomes for the 1% in 1981 to 28.3% of top 1% incomes in 2008. These changes are of a magnitude sufficient to explain a significant portion of the shift in incomes to the 1%.

For the President, the implication of the current debate is clear: since the "1%" is taking an ever-increasing share of national income, government's role is to take some of it back with higher taxes. With the debate currently framed around a faulty interpretation of national income data, it appears possible that we are moving toward a policy decision on taxes that will drain a significant amount of capital from the productive economy and retard jobs growth for many years. Based on the history of the late 1930s when the nascent recovery from the Great Depression was stopped in its tracks with ill-timed tax increases, this has the potential to prolong both the financial malaise and the equity market recovery for an extended period.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.