Errors about CBO Errors

The Wall Street Journal article I wrote with David Henderson, critiquing the way the Congressional Budget Office (CBO) allocates corporate profits, must have been unclear in some respects because the main points have been misunderstood by Thoma and perhaps also Burtless.

In the National Income accounts, a distinction is made between the capital income of persons (included in personal income) and the retained earnings of corporations (included in national income). This distinction is also present in the Piketty-Saez study, and all other income distribution studies except those of the CBO. Yet Thoma depicts the distinction between corporate and personal income as a mere semantic quibble. He notes that I “didn’t like the use of the word capital income and wanted ‘corporate profits’ to be used instead, even though the issue is the income of the top 1% of Americans. That’s fine, call it what you want; it doesn’t change the point.” On the contrary, the table below shows that simply substituting Federal Reserve wealth statistics for the CBO’s invalid proxy reduces the CBO’s estimates of the top 1 percent’s pretax income from 16.3% in 2004 to 11.3%, and turns an apparent increase in that share into a decline.

The CBO is the only agency that attempts to distribute corporate profits among households. They do that because they are trying to estimate who bears what share of the corporate income tax. But that, in turn, requires adopting a theory about the incidence of the corporate tax.

The 1962 theory chosen by the CBO back in the seventies was based on a closed economy, and assumed that none of the corporate tax could be shifted to workers or consumers. The corporate tax was assumed to be borne by domestic owners of capital in general (because of arbitrage) – not just owners of corporate stock, and not just the owners of taxable investments. This old theory now has plenty of critics, including CBO economist William Randolph, who estimates that labor bears about 74% of the corporate tax.

What is critical to understanding the Reynolds-Henderson analysis, however, is to realize that the CBO theory about the incidence of corporate taxes does not suggest that the corporate tax is borne in proportion to income from capital (much less the small fraction of such income that is realized and taxable). Using capital income as a proxy for wealth distribution was simply a statistical shortcut. It is grossly erroneous for the CBO to use taxable capital income as a roundabout proxy for the top 1 percent’s share of wealth, for reasons the Reynolds-Henderson article explains. Besides, we have much better direct estimates of wealth distribution.

Thomas says, “there has been substantial growth in asset holdings for [the top 1%], and therefore the misallocation does not appear to be very large if it is there at all.” Using the same wealth data that Thoma cited we showed the misallocation is enormous. We wrote that, “Kennickell … concluded that the top 1 percent’s share of wealth declined slightly from 34.6% in 1995 to 33.4% in 2004. Yet the CBO says that share rose from 43.2% to 59.4% in those same years.”

Thoma replies that “the 39% to 59% increase he cites says nothing by itself. That is simply the amount of corporate profits allocated to the top income group.” What is the word “simply” doing here? Could anyone possibly imagine that “simply” adding 59% of corporate profits to the top 1 percent “says nothing by itself”? Compared with the Kennickell estimates (which are higher than most), the CBO’s technique inflates the top 1 percent’s income by 25% in 2004.

Thoma goes on to say, “that figure [39% or 59%] says nothing at all about whether the growth in capital income reflects the actual change in asset holdings for this group.” That is an argument with the CBO, not with me. Asset holdings are precisely what these percentages are assumed to reflect, according to the CBO’s incidence theory. The figures 39% and 59% reflect percentages of corporate profits allocated to the top 1 percent in the past and present. That is not the “capital income” of the top 1 percent, as Thoma believes. On the contrary, it is added on top of the interest, dividends, capital gains that taxpayers report. As the graph in Reynolds and Henderson shows, that is why the CBO’s estimates of average incomes of the top 1% are so much larger than those of Piketty and Saez (which do not include corporate profits).

The Table below show what the top 1 percent’s share of combined personal and corporate income – before taxes – looks like after we substitute Kennickel’s direct estimate of the top 1 percent’s share of wealth for the CBO’s invalid proxy. By correcting this one error, the top 1 percent share of pretax income no longer appears to rise from 12.5% in 1989 to 16.3% in 2004 but instead falls from 11.8% in 1989 to 11.3% in 2004.

Table

Before CBO statisticians can estimate what share of the corporate tax is borne by the top 1%, they must first estimate the top 1 percent’s share of all assets — not just corporate assets, and not just taxable assets. To do that, the CBO relies on shares of “capital income” income received from taxable investments as a proxy for the distribution of assets in general, whether those assets are taxable or not. In their own words,“CBO assumes that corporate income taxes are borne by owners of capital in proportion to their income [reported on tax returns] from interest, dividends, capital gains and rents.”

The CBO has surely been missing a rising amount of unseen income of middle-class taxpayers, but (contrary to Thoma) that is not our main point. Our main point is that this causes them to hugely exaggerate the level and trend of average incomes among the top 1%. That, in turn, is due to the untenable way by which they allocate corporate profits — not capital income — by income group.

Thoma says, “The main thing to notice is how Reynolds uses misleading statistics in an attempt to support his case. Saying, as he does, that ‘The CBO added 39% of corporate profits to top 1% incomes in 1989 and 59% in 2004, thus fabricating a wholly artificial increase in the top 1 percent’s share’ implies that all of the increase represents a misallocation when that’s not the case at all. It is the change from 39% to 59% relative to the change in asset holding across groups that matters.” That comment is nearly indecipherable, but let’s try. The CBO infers that the top 1 percent now holds 59% of assets which, by definition, must mean “relative to … asset holding across groups.” That’s what 59% means. In reality, the 59% figure is derived from the top 1 percent’s observed share of taxable capital income, since the CBO has no estimates of asset holdings (much less nontaxable asset holdings) and chooses not to use the Fed’s. Unlike Thoma, the CBO certainly does not confuse corporate profits with personal income from dividends, capital gains, interest and rent. The CBO uses personal income from dividends, capital gains and rent as a proxy for asset ownership in general. The point of the Reynolds-Henderson article is to show that this procedure does not result in a credible approximation of the top 1 percent’s share of wealth, and to explain why.

Thoma’s latest post says no single measure is perfect, which is why I have presented a wide variety of measures of inequality of disposable income, consumption, wage and wealth and also discussed some of the data problems (such as the data breaks of 1986 and 1993). I also discuss some problems with Gini coefficients in pages 14-20 of my book, which displays real income data by quintile (from Census and CBO) rather than relying on summary measures.

Thoma claims increased inequality of something (income?) since 1988 “has been documented elsewhere in many different ways,” but I have explained why the outside sources he previously mentioned (notably, Ben Bernanke) were mistaken. Thoma even claims “there’s overwhelming evidence,” but never explained what it is or where it is. He thinks the government has underestimated the profit share of national income. But I noted that a low profit share has normally been associated with nasty recessions like 1982, not with prosperous periods like the 1960s. The share going to the top 1% has also fallen in every recession since 1920, according to Piketty and Saez, but that certainly does not demonstrate that recessions must be good for workers because they “reduce inequality.”

Also from This Issue

Lead Essay

  • Income Distribution Heresies by Alan Reynolds

    A headline in today’s Wall Street Journal reads “Fed Chief Warns of Widening Inequality.” Bernanke worries that inequality erodes tolerance of the “dynamism” that lays the golden eggs of “economic progress.” But is inequality widening at all? Cato Institute senior fellow Alan Reynolds has his doubts. Following up his own controversial Wall Street Journal op-ed, a Cato Institute policy forum, and a new Cato policy paper, Reynolds in this month’s lead essay digs yet deeper into the mysteries of the official numbers and comes up with … not much: “If there were any [good] data showing a significant and sustained increase in the inequality of disposable income, consumption, wages, or wealth since 1988,” Reynolds concludes, “I suspect someone would have shared it with us by now.”

Response Essays

  • Ben Bernanke is Right by Gary Burtless

    Gary Burtless agrees that analysts of the American income distribution should “take seriously some of Reynolds’s criticisms of the data on income disparities.” “Reynolds points to some serious problems,” Burtless concedes, “and in many cases fair-minded experts will agree with him.” Nevertheless, Burtless dissents sharply from Reynolds’s larger claim that inequality apparently stopped increasing in the late 1980s. “Income inequality was higher at the end of the 1980s than it was in the beginning of that decade,” he states, “and it was higher in 2005 than it was in 1989.” According to Burtless, Reynolds can reach his unorthodox conclusion only by manipulating the evidence. “The problem is,” Burtless charges, “he is harshly critical of data series that do not support his views, while he is usually silent about equal or more serious problems with data sets that show little change in inequality.”

  • Yes, Virginia, Income Inequality is Still Rising” by Mark A. Thoma

    In his response to Alan Reynolds, Mark Thoma invites us to “step back” and survey the wider picture of data and expert opinion on income inequality. The verdict? Fed Chairman Ben Bernanke, and the consensus generally, has got this one right. “The preponderance of evidence and of professional opinion,” writes Thoma, “clearly indicates that inequality has been rising since [at least] 1988.” Like Burtless, Thoma finds little in Reynolds’ analysis to agree with, describing his main points as “either too inconsequential to change the inequality picture,” suffering from “an incomplete presentation of the evidence, or rebutted by other work.” Thoma then goes a step further, pointing to new evidence suggesting that income inequality might be even greater than currently estimated.

  • Measuring Economic Well-Being: What, How and Why by Richard Burkhauser

    Invoking Kurosawa and Derrida, Richard Burkhauser dives into the contested complexities of the Current Population Survey data on household income. His conclusion: “Over the 1990s business cycle the entire distribution moved to the right with little or no change in income inequality. Since 1989 household income inequality has risen very little and much less than in the previous decade. This is very good news that matters.” Burkhauser admits that the CPS data are not well suited to tracking trends for the top 1 percent of earners. “But does this really matter?” he asks. “Our economy is not a zero sum game. My gain does not mean your loss or vice-versa. I know of no evidence that increases in the incomes of the top 1 percent of our population are the root cause of the challenges faced by those at the other end of the distribution.”

  • Inequality in What? by Dirk Krueger and Fabrizio Perri

    Dirk Krueger and Fabrizio Perri suggest that we shift our attention away from inequality in current incomes. “[I]f one is ultimately interested in the distribution of well-being across U.S. households,” they write, “the object of study ought to be the joint distribution of lifetime consumption and leisure across them.” Unfortunately, good data on lifetime consumption are not available. However, citing Milton Friedman and Franco Modigliani, Krueger and Perri contend that “if households can borrow and lend on financial markets, then there is a strong link between the lifetime resources of a household (sometimes also called its permanent income) and its current consumption.” And the trends in current consumption data show that “the increase in income inequality in the U.S. has been much more pronounced than the corresponding increase in consumption inequality.”

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