This is a heavily technical post. If you don't like heavily technical posts, just remember the picture below and skip to Part 2.
Over the next few posts (it’s going to take a few), we are going to take apart this chart.
We’re going to do this for two reasons. First, to make a point that I firmly believe having wandered the world of political websites, namely that you can find someone on some website to say what you believe and maybe even draw such a graph; however, to understand what’s going on, you need to dig into the numbers and dig hard. Second, if you wander the world of political discussions, you invariably get into a discussion about the progressivity of the tax code and, when arguing with someone on the left, you invariably get a version of the chart above because, to a leftist, it says exactly what you want it to say…that is, see how much less the “rich” are taxed today (2004) than they were in the past.
Now before we start deconstructing the chart, it’s important to understand where it comes from. The authors Thomas Piketty and Emmanuel Saez are primarily focusing their attention on tax changes at the very top of the income grid. This influences their approach to analysis in several ways. One of which is:
We exclude all government transfers such as Social Security retirement and disability benefits; government-provided health benefits (Medicare and Medicaid); unemployment and workers compensation; and all cash and in-kind welfare programs. Our admittedly simple approach sidesteps a number of issues about how to measure income appropriately: for example, our income measure does not include the value of imputed rent for homeowners and does not exclude interest payments on debts such as mortgages or consumer credit. Our income measure also excludes nontaxable benefits such as employer-provided health care.
Why is this important to the graph we posted at the top? It’s important because it causes people at the bottom of the income scale to have lower incomes than they would otherwise have (in the case of transfers) and lower relative incomes (in the case of health insurance) because health insurance costs are more evenly spread than base income. In other words, this approach makes relative tax rates look relatively higher for those at the bottom of the income distribution than an alternative approach would. One should not critique the authors however as their logic is sound on this point when they write:
…government transfers, such as welfare programs, accrue disproportionately to the bottom of the income distribution and also reduce inequality in disposable income. Conceptually, transfers should be included (as a negative) in the tax rates to estimate the full redistribution carried out by the government through taxes and transfers. However, as our focus in this paper will primarily be on the top of the income distribution, and since transfers represent a very small fraction of middle- and high-income earners incomes, ignoring transfers has little effect on our results.
However, that little caveat goes unsaid by the people who like to use the graph at the top. And indeed for the balance of this discussion, we are going to ignore it even realizing it’s distorting effects.
Unfortunately, we’re not done with the caveats we have to get into to assess this. There are two more to cover. The authors break Federal taxes into their components: income, payroll, corporate (including capital gains), and estate. The last two however are imputed rather than actual, meaning that the authors have to make assumptions about who pays and how in order to assign them to households. Nothing wrong with this but let’s look at the assumptions they choose to make.
First, on corporate taxes, they make the following assumption, “We will assume that the corporate income tax falls entirely on capital income and that all financial assets (and not only corporate stock) bear the tax equally.” While there are many ways to do this calculation, this is certainly one way to do it although probably not the one I would choose if I were doing the assessment from scratch. In any event, because the tax is derived, it would be better to separate it from the others in the way the data is presented. Again, the authors are quite careful to do this through their paper (see Figures 1A and 1B for example) but the people using their data are not so careful.
Second, we come to the discussion on estate taxes that, in my view, is the far more problematic conversation. The authors write:
The federal estate tax is paid based on total net worth of the decedents after various exemptions such as spousal bequests and charitable donations. Only net estates larger than $1.5 million in 2004 are liable for the estate tax. As a result, only about 1 percent of all adult decedents are liable for the estate tax in 2004. We use IRS published tabulations reporting the number of estates and estate taxes paid by size of estate to estimate the amount of taxes paid by each fractile of decedents (relative to the total number of adult deaths). We then assume that those taxes are borne by the corresponding fractile of tax units. This basic method is valid to the extent that ranking by income is relatively close to ranking by wealth at the top of the distribution.
We’re going to have to unpack this one a bit. First, note that the authors assert that the estate tax is paid by decedents (the people who die) rather than inheritors. This has the effect of concentrating estate taxes as fewer people die than inherit. Second, the authors assume that an estate in the top range corresponds to an income at the top end of the range. Anecdotally, this seems incorrect to me; meaning the largest incomes tend not to be made by people dying but rather by people at the top of their fields (CEOs, hedge fund managers, athletes, and actors). However to tie the estate tax to Households, the authors more or less have no choice but to make this assumption or some other assumption about the incidence of the estate tax.
Finally, it is unclear whether the authors include the proceeds from the estate in their calculations of tax rates. Whichever choice is made carries issues. If the proceeds are included, we are counting accumulated lifetime wealth at death as if it were income for the dead person. If proceeds are not included, we are understating the revenue of this group and overstating their effective tax rate. My guess is the latter approach was taken but I am not sure of this. As a consequence of these issues, it is particularly important to separate the estate tax from other taxes in the calculations.
Next up, a discussion of the implications of looking deeper at the data.