Martin Feldstein writes in The Wall Street Journal, Piketty’s Numbers Don’t Add Up
The second problem with Mr. Piketty’s conclusions about increasing inequality is his use of income-tax returns without recognizing the importance of the changes that have occurred in tax rules. Internal Revenue Service data, he notes, show that the income reported on tax returns by the top 10% of taxpayers was relatively constant as a share of national income from the end of World War II to 1980, but the ratio has risen significantly since then. Yet the income reported on tax returns is not the same as individuals’ real total income. The changes in tax rules since 1980 create a false impression of rising inequality.
In 1981 the top tax rate on interest, dividends and other investment income was reduced to 50% from 70%, nearly doubling the after-tax share that owners of taxable capital income could keep. That rate reduction thus provided a strong incentive to shift assets from low-yielding, tax-exempt investments like municipal bonds to higher yielding taxable investments. The tax data therefore signaled an increase in measured income inequality even though there was no change in real inequality.
The Tax Reform Act of 1986 lowered the top rate on all income to 28% from 50%. That reinforced the incentive to raise the taxable yield on portfolio investments. It also increased other forms of taxable income by encouraging more work, by causing more income to be paid as taxable salaries rather than as fringe benefits and deferred compensation, and by reducing the use of deductions and exclusions.
The 1986 tax reform also repealed the General Utilities doctrine, a provision that had encouraged high-income individuals to run their business and professional activities as Subchapter C corporations, which were taxed at a lower rate than their personal income. This corporate income of professionals and small businesses did not appear in the income-tax data that Mr. Piketty studied.
The repeal of the General Utilities doctrine and the decline in the top personal tax rate to less than the corporate rate caused high-income taxpayers to shift their business income out of taxable corporations and onto their personal tax returns. Some of this transformation was achieved by paying themselves interest, rent or salaries from their corporations. Alternatively, their entire corporation could be converted to a Subchapter S corporation whose profits are included with other personal taxable income.
These changes in taxpayer behavior substantially increased the amount of income included on the returns of high-income individuals. This creates the false impression of a sharp rise in the incomes of high-income taxpayers even though there was only a change in the legal form of that income. This transformation occurred gradually over many years as taxpayers changed their behavior and their accounting practices to reflect the new rules. The business income of Subchapter S corporations alone rose from $500 billion in 1986 to $1.8 trillion by 1992.
Ignoring such critical data is unprofessional or intentionally misleading. The press does a generally very poor job of reaching for the truth.