Thomas Piketty and I still disagree on the impact of the 1986 tax code on his recent bestseller, “Capital in the 21st Century“. However, I do appreciate Russ Roberts at EconTalk conducting a great interview and I thank Dr. Roberts for also posing some of my primary questions to Piketty’s conclusions at the 56:30 mark of his interview. For your reference, see my post “The Piketty Fallacy – His Flaw of Flaws“.
In that post, I elaborate as to how the change in the tax code can artificially drive income inequality – substantially… I will share some additional charts not previously shared in my prior post. The first:
Remember Piketty uses tax data for his estimates. The source of these charts can be found from the IRS here. The table above is representative of business income alone. As a refresher, the C-Corp income is not reported on individual returns which were used to collect his data while personal income is reported by individuals. Personal income represent income from partnerships, S-Corporations, farms, and sole proprietorships. Per my previous post, the Tax Code of 1986 made it much more advantageous to report income as an individual due to lower individual tax rates compared to corporate rates. With this in mind, we saw a shift of income from C-Corporations to pass-through entities reported on individual returns.
By 1987, the Net Income Allocation had shifted:
Did you notice the 14% decrease in corporate net income? Or perhaps the 10% pickup in individual income? Taking this further, the tax code ramifications are perpetual – meaning the impact of reorganizing from a C-Corporation to an S-Corporation is present until the entity structure reverts back to a C-Corp. In addition, future CPA’s must recommend the best entity structure for their client. In a post-1986 world, this usually meant S-Corporations (vs. C-Corporations) unless the quantity of investors was a concern or going public was the desired result.
Dr. Roberts poses the following questions toward the end of his interview – saving the best for last perhaps? :
We’re almost out of time. I want to raise a couple of issues about the American data and get your response. One of the things you ignore, and everybody ignores when they look at the change in the share going to the top 1 or top 10%, say between 1980 and the present where it starts to rise very dramatically in your data, are two things that I’d like to hear you react to. One is: demographics have changed dramatically over that time period. There’s an enormous increase in the divorce rate that begins in the 1970s and continues through the 1980s. As a result the number of households rises much more quickly than population. And since the divorce rate is higher among low income households than high income households, you are going to get a rising share to the top 1 or top 10% simply for that demographic reason. Similarly changes in tax laws encourage people to take income in the form of personal income rather than corporate income starting in 1986. So, when I look at your data, the trend, though it looks “frightening,” because of the increasing share, some of that is a statistical artifact. Do you agree?
Dr. Piketty: No, I disagree with this statement, because in fact, if anything I think top managers are getting even more nontaxable perks like, you know fancy jet or big officers or fancy cars or beautiful hotels and restaurants today than what they did in the 1960s or 1970s. So the view that there was as much inequality in the 1960s than you have today but that people were getting it through fancy cars where at least today they are just getting cash but they have become very virtuous regarding nontaxable perks and fancy jets, I think this is just wrong…
I think if anything we see this seems to be complementary. This seems to be complementary. In the long run I think you see an increase both in cash compensation and in non-cash perks and benefits. So I think–
Dr. Roberts: It’s not non-cash. It’s how I declare it. If I have a small business, it’s now, starting in 1986, it’s advantageous for tax reasons to call that income rather than corporate profit and take it in the form of capital. So, the labor share artificially rises in the 1980s.
Personally, I believe it is Piketty’s lack of understanding of the complexity of the U.S. tax code that gets him in trouble. In addition, please keep in mind that we are not discussing overly complex issues of the tax code here either… Piketty responds:
Dr. Piketty: Right, but this you should see it in capital gains a bit later. Because you know when you have a lot of retained earnings within your corporation, at some point you will want to cash capital gains out of that and so we do take into account this through capital gains, which is a big part of the whole picture. I’m not saying that the change in tax law to not matter for how people reap those income. Of course it does matter. But if anything I think the overall trend would look bigger if we could take into account all the nontaxable forms of compensation.
Piketty defaults not to the details, but to a high-level concept that the income will later be reflected as capital gains. This is not always the case…
Back to the topic at hand, how has the business income distribution been represented in more recent years?
Obviously, since 1987 the personal piece has increased significantly. S-Corporations, partnerships, and sole proprietorships represent an additional 15% at roughly 53% of business net income compared to 1987 figures while C-Corporations share of income fell roughly 16% from 54% to 38%. This appears to essentially be a reflection of tax code changes over time. In 2008, income allocation was represented as follows:What are your opinions? Do my position hold water? Help me provide further insight to an issue dominating headlines.