Many of you may of heard of the recent best-selling economist Thomas Piketty and his book, “Capital in the Twenty-First Century”. Yes you may need to re-read that sentence because a 685 page book about economics was a best seller. His work has faced both unrelenting praise and skeptical criticism. My purpose is to reflect upon what I know about the topic.
The intent is not to discredit Piketty, but only to interpret the exact same data that Piketty uses and address it for what it it truly is – wrinkles and all. Piketty himself states on page one that ‘the answers contained herein are imperfect and incomplete’. He has re-emphasized the imperfection in an interview with NPR. Despite this, many economists – Krugman, Thoma, Reich, etc. – continue to tout the findings as undeniable. I disagree with them.
In understanding Piketty, it is critically important to understand how individuals and businesses pay their taxes. Understanding is even more so crucial when considering that Piketty bases his conclusions on IRS tax data. When reading previous essays and papers by Piketty, these concerns with using the tax data had cropped into my mind. However, when Piketty’s co-author and colleague, Emmanuel Saez, has been interviewed to address critics of Piketty, he addressed most issues except the two most significant: 1) effects of the 1986 tax law and 2) the introduction of 401k savings plans in 1978. This post serves to discuss the former which I believe to be the most salient argument.
So how do businesses and individuals pay taxes?
The latter may be more obvious since most this form of taxation is more common. There are various ways businesses are taxed and it mostly stems from their choice of entity. The primary choices of entity are:
- C Corporations
- S Corporations
- Sole Proprietorships
The business structure is important because this impacts many things in your business plan and strategy. How many investors do you want to have? S Corporations are limited to 100 and sole proprietorships to one. What kind of liability protection to you need? Partnerships and sole proprietorship do not have any protection unless they have filed for LLC status within their state. This brief synopsis is only to say that there are many reasons to choose a particular entity. Some CPAs and attorneys only focus on choice of entity in their practice. The primary reason we are considering choice of entity is for tax purposes.
Each entity above reports and pays their taxes differently. The primary difference stems from pass-through entities compared to C Corporations. C Corporations report their income at the corporate level while pass through entities report income at the individual level.
Note that C Corporations’ tax due is calculated on line 31:C Corporations actually send in federal tax payments with their tax returns. Pass-through entities do not. Their is not any tax due on form 1120S or form 1065:
Instead, pass-through entities receive K-1’s that allow individuals to report their share of pass-through income on their own individual tax returns. Many have never had interest in an S corporation or partnership so I have included a K-1 below.
K-1 income all “passes through” to the individual’s 1040. Interest is reported on Schedule B, rental income on Schedule E, capital gains on Schedule D, etc… The business income from these entities are subject to that individuals’ tax rates – not corporate rates. This fact re-emphasizes the importance of focusing the tax discussion on individual tax rates vs. corporate tax rates.
Why again does this matter to the inequality discussion?
The tax law in effect today is the Tax Reform Act of 1986. This law included changes in both the corporate income tax rate and the individual rates. Here is how Piketty (pg. 24) describes income inequality in the United States:
Notice the soft increase in the late 1970’s and early 1980’s and then the drastic increase in the mid-late 1980’s. What actually happens in 1986 is a shift to lower individual income tax rates. Because of how business income was taxed, proprietors understood the benefit of individual taxation versus corporate taxation. Entity organization as a partnership, S-Corporation, or LLC had its benefits.
So when people began moving from essentially the only form of business organization at the time, a C-Corporation, to more attractive entity structures such as an S-Corporation, partnership, or LLC, they were able to both recognize a substantial tax benefit as well as retain the same levels of asset protection. In terms of measuring inequality, however, there was a drastic shift in the income that was reported on individuals’ and households’ income tax returns. Income that never hit an individual’s tax return prior to the rate changes enacted via the tax code of 1986, now became reflected in individual income after an entity switched from C-Corp status to a more favorable S-Corp or partnership. Ever since 1986, per the IRS SOI Tax Stats (table 1) the C-Corp as an entity structure has been in decline.
Note that Piketty is very aware of this anomaly. Piketty defines this income of individuals as “entrepreneurial income”, and rightfully so as it represents small business income from S-Corps and partnerships. When I pulled the share of income from the top 20% derived from entrepreneurial sources from Piketty’s own excel workpapers, this is the trend I found from 1985 through 2011:
Notice the steep climb between 1986 and 1988. This merely represents a transfer of income from one bucket to another – from C-corp income to pass-through income. There is not an exuberant increase in inequality from 1984 to 1988. Inequality has essentially not changed, but the data used to interpret inequality levels has been perverted. In addition, this impact is not a “one-off” phenomenon. It was a change in perpetuity meaning that the same income from that C-corporation that converted to a pass-through in 1986 will be present on the individuals tax return in 1987, 1988, and so on. Though it has changed, we still operate in a similar environment today under the same tax code passed in 1986.
Note the top 10%’s change in entrepreneurial income from 1984-1988. The composition of entrepreneurial income went went 6.16% of their income to 12.26% over the course of four years with a 2.65% increase from 86-87 and 2.53% from 87-88.
Top 10%'s Entrepreneurial Income
The point being that there are significant deficiencies in using tax data to measure income inequality. When guys like Mark Thoma and Robert Reich point to the undeniable inequality evinced by Piketty’s work, they overlook Piketty’s own comments regarding the imperfections of his work. At the end of the day, all I am saying is Piketty’s conclusions are significantly skewed because he has used tax data. Setting political ideology aside, everyone should be able to agree with that.