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Betsey from Consumerism Commentary’s series Naked With Cash is 27-year-old government analyst.  She is on the front end of her financial journey.  Betsey August commentary can be found here along with her CFP’s analysis…

BetseyAug2014nw BetseyApr2014ia

Why have these posts?  I think these folks provide a great service to many of us.  The financial topic is a faux pas to discuss socially.  The  – “Hey John, how’s it going?  Oh and by the way, how much do you make, I need an excel file of your budget, and need to you net worth figures – thanks!” – conversation doesn’t work out well.

These posts provide insight into others’ finances and also can provide insight into your.  If you visit over there, please provide them some encouragement!

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TPC Article Supports My Postition

The Tax Policy Center’s Joseph Rosenberg posted an article commenting on the substantial increase of flow through income from 1988 to 2012.

More than 90 percent of businesses, representing
more than one-third of all business activity, in the
United States are structured as flow-through entities
— businesses that do not pay the corporate
income tax, but rather pass profits through to
owners who pay tax under the individual income
tax. Over the past two decades, the importance of
flow-through businesses — partnerships and S corporations
in particular — has grown dramatically.
In 2012 net income from sole proprietorships, partnerships,
and S corporations totaled nearly $840
billion and accounted for more than 9 percent of
total adjusted gross income reported on individual
income tax returns.

Sole proprietor income (reported on Schedule C)
declined gradually as a percentage of AGI beginning
in the mid-1990s, from 4 percent down to just
over 3 percent. In 2012, 23 million returns reported
net income of roughly $300 billion or 3.3 percent of
AGI.

In contrast, income from partnerships and S
corporations has more than tripled as a share of AGI
since the late 1980s. Following the Tax Reform Act
of 1986, partnership and S corporation income
accounted for 2 percent of AGI. Beginning in 1992,
that share increased sharply, reaching 5.4 percent by
2005. Following a drop associated with the Great
Recession, partnership and S corporation income
again rose as a percentage of AGI, reaching 5.9
percent in 2012 (the most recent year IRS data are
available). In 2012, 8.3 million returns reported $535
billion in net income from those sources.

Flow Through Income As Percentage of AGIIn essence, the article supports my position that by using tax data Thomas Piketty’s figures are artificially inflated as businesses have shifted ownership structure from corporations to pass through entities – from form 1120 to form 1040 thus increasing reported AGI.  This effect disproportionately misrepresents post-Tax Act of 1986 income for higher income individuals by shifting income previously reported by corporations (pre-1986) to individuals’ tax returns.

 

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Piketty Addresses My Key Questions

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:

1980 Income Allocation

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:

1987 Income Allocation

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?

2002 Income Allocation

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:2008 Income AllocationWhat are your opinions? Do my position hold water?  Help me provide further insight to an issue dominating headlines.

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Regan Taylor: Minimum Wages vs. Minimum Car Price

Insight from Cafe Hayek patron Regan Taylor:

Minimum wage logic: raising the minimum wage to (at least) $10.10/hr will be good for minimum wage workers. It will put more money in their pockets spurring economic growth.

A few years ago, the federal govt bailed out General Motors. Instead of engaging in such a gross display of corporate welfare, why didn’t we just apply the same logic to help the auto giant? If raising the MW from $7.25 to $10.10 (a 39% increase) helps those who sell their labor at that price, why didn’t the govt pass a law that mandated that all auto firms raise the price of every car, van, SUV, and truck they sell by 39% also – or at least raise by 39% the price of their lowest-priced models? Is there a fundamental distinction between the applications of this logic that says it will help one group but harm another? If the mandated increase benefits those who sell labor at that price why wouldn’t it be beneficial to do the same for those who sell automobiles? Or tennis shoes? Or computers? Or any other industry?

Why do so many people believe that the laws of supply and demand apply to everything that is bought and sold EXCEPT labor?!

 

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Characteristics of a Minimum Wage Worker

Great piece by Timothy Taylor laying out the basic characteristics of minimum wage workers.  Summarizing the data:

  • 3.3 million American workers paid minimum wage or less
  • Minimum wage workers represent 2.4% of the total workforce,  4.3% of the hourly workforce
  • Minimum wage worker tend to be younger:
    • 24.2% are ages 16-19
    • 26.2% ages 20-24
  • Roughly 2/3 or 2.1 million were part-time

Tim also pointed to the March 2014 report from the Bureau of Labor Statistics, “Characteristics of Minimum Wage Workers, 2013.”

Percentage of Hr Workers Earning Min WageHis conclusions were very simple:

Whatever one’s feelings about the good or bad effects of raising the minimum wage, it seems fair to say that those effects will be disproportionately felt by a relatively small share of the workforce, disproportionately young and part-time, and disproportionately in southern states.

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The Piketty Fallacy – His Flaw of All Flaws

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
  • Partnerships
  • 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 31:1120C 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:

1120S1065

 

 

 

 

 

 

 

 

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.

1065 K-1K-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:

Piketty - Income Inequality

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.

Individual versus Coporate Tax RatesSo 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.

Returns by Reporting EntityThe corporations’ share of revenue has never been as high since its decline in the early 1980s.

Receipts by Reporting EntityNote 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:

Piketty Entrepreneurial IncomeNotice 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

19846.16
19856.58
19867.08
19879.73
198812.26
198912.47
199012.34
199112.46
199212.98
199313.11
199414.09
199514.36
199614.63
199714.74
199815.06
199915.19
200014.76
Source: World Top Incomes Database

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.

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What’s More American Than the Wild, Wild West

You may (or may not) have noticed the 2-week hiatus from EconomicNudity.com.  The blogging continues…  But not before I share some pics from out west.

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IMG_0688

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How Much is the American Dream?

A recent article from USA Today highlighted the costs of living the American dream.  Very interesting.  Hat-tip to the clothed economist for sending my way.

No idea is more central to Americans’ outlook than the American dream — the belief that with hard work and the freedom to pursue your destiny you can achieve success and provide better opportunities for your children.

/wp-content/uploads/2014/07/dream.jpg

 

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I have been following Million Dollar Journey for some time now.  He had started his blog in 2006 with a net worth of $198,000 and a goal of having a net worth of $1 million by age 35 (end of 2014).  In June, the “FrugalTrader’s” goal of achieving a net worth of $1 million was accomplished.  His last net worth update before reaching his goal was posted in May.

His numbers:

Assets$1,197,685 (+0.78%)

  • Cash: $4,500 (+0.00%)
  • Savings: $20,000 (+0.00%)
  • Registered/Retirement Investment Accounts (RRSP): $182,500 (+1.00%)
  • Tax Free Savings Accounts (TFSA):  $65,000 (+1.56%)
  • Defined Benefit Pension: $48,800 (+0.83%)
  • Non-Registered Investment Accounts: $199,500 (+1.27%)
  • Smith Manoeuvre Investment Account: $158,600 (+2.32%)
  • Corporate Investment Account: $200,000 (+0.00%)
  • Principal Residence: $318,785 (+0.00%) (purchase price adjusted for inflation annually)

Liabilities$227,350 (+0.66%)

  • Principal Residence Mortgage (readvanceable): $0 (0.00%) (Paid off in 2010!)
  • Investment LOC balance: $118,600 (+0.25%)
  • Future Tax Liability: $108,750 (+1.12%)

Total Net Worth: ~$970,335 (+0.81%)

More amazing is the chronology of his achievement:

million-dollar-journey-net-worth-chart1

Why have these posts?  I think these folks provide a great service to many of us.  The financial topic is a faux pas to discuss socially.  The  – “Hey John, how’s it going?  Oh and by the way, how much do you make, I need an excel file of your budget, and need to you net worth figures – thanks!” – conversation doesn’t work out well.

These posts provide insight into others’ finances and also can provide insight into your.  If you visit over there, please provide them some encouragement!

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So how does redistribution alter the shares of national income?  The Tax Foundation provides an interesting graphic to that effect in their post, “Redistribution Alters the Share of National Income“.  The Tax Foundation laid out the following conclusions:

  • Prior to redistribution by government, the top 20 percent of families earned 55 percent of the nation’s income. After government’s tax and spending policies, these families earned 39.6 percent of the nation’s income.
  • The bottom 20 percent of the population earned 3.1 percent of total income in 2012, but redistribution from all government sources increased their incomes by $1.1 trillion, raising their share of the nation’s income to 11.8 percent.
  • The middle quintile gained from redistribution raising their share of the nation’s income from 14% to 16.4%

Credit to Scott Hodge and Andrew Lundeen:

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