Semi-Daily Journal Archive

The Blogspot archive of the weblog of J. Bradford DeLong, Professor of Economics and Chair of the PEIS major at U.C. Berkeley, a Research Associate of the National Bureau of Economic Research, and former Deputy Assistant Secretary of the U.S. Treasury.

Friday, December 15, 2006

Don't Believe It, Matt! Income Inequality Did Rise! A Lot!

Matthew Yglesias falls into a trap. He makes the mistake of crediting an empirical claim--in this case Alan Reynolds's claim--on the editorial page of the Wall Street Journal. The claim is that there is: no clear trend toward increased inequality after 1988 in the distribution of disposable income, consumption, wages or wealth. The incessantly repeated claim that income inequality has widened dramatically over the past 20 years is founded entirely on [Piketty and Saez's] seriously flawed and greatly misunderstood estimates of the top 1%'s alleged share of something-or-other. The politically correct yet factually incorrect claim that the top 1% earns 16% of personal income appears to fill a psychological rather than logical need. Some economists seem ready and willing to supply whatever is demanded. And there is an endless political demand for those able to fabricate problems for which higher taxes are, of course, the preferred solution. In Washington higher taxes are always the solution; only the problems change.

Matthew writes:

Matthew Yglesias / proudly eponymous since 2002: Alan Reynolds' argument that we've been mis-measuring inequality by using flawed tax return data.... [T]his seems like an important project and I'll be eager to read the lengthier, non-op-ed form of his argument along with, one hopes, commentary on it from people better-equipped than I to evaluate the work...

Matthew thus forgets the two rules of reading the editorial page of the Wall Street Journal:

  1. When you feel tempted to credit a surprising empirical claim found on the editorial page of the Wall Street Journal, your first step should be to lie down until that feeling goes away.
  2. When you are tempted to believe that something on the editorial page of the Wall Street Journal brings new information to the party and sheds new light on the facts, don't.

One thing you can't learn from Reynolds's op-ed is that, back in their original paper that they wrote six years ago and published in 2003, Thomas Piketty and Emmanuel Saez thoughtfully considered many of the claims made by Alan Reynolds. Here is some of what they wrote back then:

[W]e build new homogeneous series on top shares of pretax income and wages in the United States... based primarily on tax returns data published annually by the Internal Revenue Service... as well as on the large micro-files of tax returns released by the IRS since 1960.... We argue that both the downturn and the upturn of top wage shares seem too sudden to be accounted for by technical change alone. Our series suggest that other factors, such as changes in labor market institutions, fiscal policy, or more generally social norms regarding pay inequality may have played important roles in the determination of the wage structure. Although our proposed interpretation for the observed trends seems plausible to us, we stress that we cannot prove that progressive taxation and social norms have indeed played the role we attribute to them. In our view, the primary contribution of this paper is to provide new series on income and wage inequality.

One additional motivation for constructing long series is to be able to separate the trends in inequality that are the consequence of real economic change from those that are due to fiscal manipulation. The issue of fiscal manipulation has recently received much attention. Studies analyzing the effects of the Tax Reform Act of 1986 (TRA86) have emphasized that a large part of the response observable in tax returns was due to income shifting between the corporate sector and the individual sector [Slemrod 1996; Gordon and Slemrod 2000]. We do not deny that fiscal manipulation can have substantial short-run effects, but we argue that most long-run inequality trends are the consequence of real economic change, and that a short-run perspective might lead to attribute improperly some of these trends to fiscal manipulation....


[T]he evidence suggests that the twentieth century decline in inequality took place in a very specific and brief time interval. Such an abrupt decline cannot easily be reconciled with a Kuznets-type process. The smooth increase in inequality in the last three decades is more consistent with slow underlying changes in the demand and supply of factors, even though it should be noted that a significant part of the gain is concentrated in 1987 and 1988 just after the Tax Reform Act of 1986 which sharply cut the top marginal income tax rates (we will return to this issue)....


Our long-term series place the TRA86 episode in a longer term perspective. Feenberg and Poterba [1993, 2000], looking at the top 0.5 percent income shares series ending in 1992 (respectively, 1995), argued that the surge after TRA86 appeared permanent. However, completing the series up to 1998 shows that the significant increase in the top marginal tax rate, from 31 to 39.6 percent, enacted in 1993 on did not prevent top shares from increasing sharply. From that perspective, looking at Figures II and III, the average increase in top shares from 1985 to 1994 is not significantly higher than the increase from 1994 to 1998 or from 1978 to 1984. As a result, it is possible to argue that TRA86 produced no permanent surge in top income shares, but only a transitory blip. The analysis of top wage shares in Section IV will reinforce this interpretation. In any case, the pattern of top income shares cannot be explained fully by the pattern of top income tax rates....


From 1970 to 1984 the top 1 percent share increased steadily from 5 percent to 7.5 percent (Figure IX). From 1986 to 1988 the top shares of wage earners increased sharply, especially at the very top (for example, the top 1 percent share jumps from 7.5 percent to 9.5 percent). This sharp increase was documented by Feenberg and Poterba [1993] and is certainly attributable at least in part to fiscal manipulation following the large top marginal tax rate cuts of the Tax Reform Act of 1986 (see the discussion in Section III above). However, from 1988 to 1994, top wage shares stay on average constant, but increase very sharply from 1994 to 1998 (the top 1 percent wage share increases from 9 percent to 11 percent). While everybody acknowledges that tax reforms can have large short-term effects on reported incomes due to retiming, there is a controversial debate on whether changing tax rates can have permanent effects on the level of reported incomes. Looking at long-time series up to 1998 casts doubts on the supplyside interpretation that tax cuts can have lasting effects on reported wages.

Part of the recent increase in top wages is due to the development of stock options that are reported as wages and salaries on tax returns when they are exercised. Stock options are compensation for labor services, but the fact that they are exercised in a lumpy way may introduce some upward bias in our annual shares at the very top (top 0.1 percent and above). To cast additional light on this issue and on the timing of the top wage surge, we look at CEO compensation from 1970 to 1999 using the annual surveys published by Forbes magazine since 1971. These dataprovide the levels and composition of compensation for CEOs in the 800 largest publicly traded U. S. corporations.... Consistent with the evolution of top wage shares, average CEO compensation has increased much faster than average wage since the early 1970s. Therefore, the increase in pay gap between top executives and the average worker cannot be attributed solely to the tax episodes of the 1980s....


Similarly, the huge increase in top wage shares since the 1970s cannot be the sole consequence of technical change. First, the increase is very large and concentrated among the highest income earners. The fractiles P90–95 and P95–99 experienced a much smaller increase than the very top shares since the 1970s. Second, such a large change in top wage shares has not taken place in most European countries which experienced the same technical change as the United States. For example, Piketty [2001a, 2001b] documents no change in top wage shares in the last decades in France. DiNardo, Fortin, and Lemieux [1996] argue that changes in institutions such as the minimum wage and unionization account for a large part of the increase in U. S.... Changing social norms regarding inequality and the acceptability of very high wages might partly explain the rise in U. S. top wage shares observed since the 1970s...


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