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Mark's Market Blog

Part V: Income Distribution in the US

By Mark Lawrence

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In Money Part I, we saw that money is mostly electronic, and it's created out of thin air by banks. In Money Part II we saw that charging interest on loans requires that the entire economy grow: there must be more and more people borrowing more and more money to consume more and more stuff, or the entire system collapses. In Money Part III we saw that the value people place on money depends on the amount they already have, and that this valuation drives important parts of our country's investments and lotteries. Money Part IV was about the trade deficit and the recent Internet, stock market, and housing bubbles. Today we'll look at the most central aspect of money for most people: do you have any?

We must be careful to define terms right at the start. Wealth means what you already own minus your debts. Wealth includes money in bank accounts, stocks, houses and real estate, the value at sale of your small business, patents and copyrights you might own. In this article we'll only consider income. The distribution of wealth will be considered in a later article.

Income means the money you make, the amount on which, in principle, you pay income tax. Income comes in several forms. Employment income, which comes from the hours you work. Capital gains income is the appreciation on stock prices and increase in housing and real estate values. Capital gains only count when you sell the asset. Interest income is the money you earn on bank deposits and bonds. Rents are the money you earn by renting out property to others for their use. Royalties are money you earn for letting others use your intellectual properties such as books you have written or patents you own. Inheritance is money you get from someone who died.

Capital gains, interest, rents and royalties are called passive income because you make them even when you're sitting on your butt. As sitting on my butt is one of my greatest life skills, I especially appreciate passive income. Capital gains is the income you make on your accumulated wealth. It turns out that only a small percentage of all Americans have any wealth worth talking about, and so these are the people who earn the capital gains. In the chart below, we see that the top 1% of all Americans in terms of wealth earn a bit more than half of all the capital gains; the top 5% earn about two-thirds. This is one of the keys to accumulating wealth: earning money in addition to your salary.

Only 1.6% of Americans receive $100,000 or more in inheritance. Another 1% receive $50,000 to $100,000. 92% receive nothing. Inheritances are actually quite rare: only one person in a hundred will get enough to actually change their life. Still, the topic of inheritance taxes or death taxes is quite heated. Estates in the US which are under $1,000,000 don't pay these taxes, so we see that only a small faction of one percent of Americans will ever pay this tax. People who are against inheritance taxes are actually against large government and redistribution of wealth, as essentially none of them stand to ever pay these taxes.

Taxable income in this country is distributed in a highly unequal fashion. The top 20% of all households take in almost precisely half of all the income, and the next 20% take in almost another quarter. Currently you're in the top 20% if your household income is more than about $92,000 per year. If your income is over about $167,000, you're in the top 5%. $350,000 per year gets you into the top 1%. This fact is a mainstay of liberal politicians who depict the United States as a nation starkly divided between the rich and poor. Vice presidential candidate John Edwards decried "two privileged, the other America that does the work, another that reaps the reward. One America that pays the taxes, another America that gets the tax breaks." Mr. Edwards himself has earned about $50 million as a trial lawyer, but you're supposed to ignore that small man behind the curtain. If the top 20% of the households take in half the income and the bottom 20% take in 3.5%, as the census bureau reported for 2002, then it would seem that the top fifth had 14 times the income of the bottom fifth. Is this correct?

The chart above would seem to indicate that the top fifth of our population is taking in half the pie, leaving the bottom 80% to squabble over the remainder. It's a popular chart, frequently quoted by "progressives" ("liberals" is now a bad word, so they've legally changed their name.) The census bureau generated the data behind this chart by looking at taxable income, which ignores nontaxable income. The government spends about $600B per year on aid to the poor including earned income tax credits, food stamps (now more properly "food visas"), section 8 housing subsidies, medical care, and social services such as subsidized day care. They also spend about $300B subsidizing medical care for the elderly through the Medicare program. This is almost 10% of taxable income transferred primarily from the top fifth through income, social security, and medicare taxes to primarily the bottom fifth. These programs reduce the top fifth's income from 50% to about 45%, and raise the bottom fifth's income from 3.5% to 5.4%. The 14 to 1 income ratio is now 8 to 1.

The census bureau is counting households. In the top fifth most households are a couple of working parents; in the bottom fifth they are most frequently single adults. The top fifth of all households have an average of 3.2 persons and contain 25% of our population, the bottom fifth of households has an average of 1.8 persons and contains only 14% of the population. When we adjust for this imbalance, the top fifth of people, not households, now has 40% of the income and the bottom fifth of people, not households, has 9.4%. Our initial 14 to 1 income figure is now down to a bit over 4 to 1.

Finally, we can adjust the figures for hours worked. The top fifth typically has two working adults per household, while the bottom fifth has typically one, and frequently that person works part time. The top fifth contains 28% of all working adults, the bottom fifth has 11%. Furthermore, the adults in the top fifth work on average twice as many hours per year as those in the bottom fifth. If the adults in the bottom fifth worked as many hours per year as those in the top fifth, their income would increase to 12%, and the top fifth's income would drop to 36%. In terms of pay per hour, the top fifth is making 3 times as much as the bottom fifth, a far cry from the initial 14 to 1 ratio. The adults in the top fifth perform a third of all labor in the economy, receive 45% of the income, and pay 83% of federal taxes. The adults in the bottom fifth perform about 8% of all the labor and pay 1% of federal taxes.

In the current recession, employment in engineering and architecture occupations is down 10.3%, computer and mathematical occupations are down 9.3%, and natural and social science occupations are down 2.3%. Creative professionals, including designers, artists, and performers, is down 11.5% Together these four occupational groups have lost 1 million jobs since August. These are primarily people in the top fifth, the people who also normally pay 83% of the taxes. This is one of the primary sources of the budget crisis in California and many other states: when you skew the taxes to hit only a few, then your revenues become very dependant on those few and their incomes. In California the top 15 percent of taxpayers, those with adjusted gross incomes of $100,000 or higher, paid 84 percent of the personal income tax. The top 1 percent of state taxpayers, those with AGI of over $480,940 paid 48 percent of all personal income taxes. When half of your revenue is dependant on 1% of your citizens, you have what is commonly called "all your eggs in one basket."

There are about 140 million taxpayers in the US. The top 1% is apparently about 1.4 million people. Who are these people? The top executives at Fortune 500 companies only total perhaps 3,000 to 10,000 people, so Obama's promise to limit executive pay is not going to have a profound effect on these 1.4 million. Who are the rest? A look at the Forbes list of the wealthiest people in the US gives us a strong clue: many of these people inherited their wealth, and most of the rest own a business. Very few people get rich by playing professional sports, being famous actors, or running Fortune 500 companies - perhaps 15,000 total of the 1.4 million. So the two best time-tested ways to get rich are to be born rich, or to start a successful business. In fact, the income of the top 14,000 earners is roughly equally split: one third from wages, one third from S-Corp, schedule C and partnership income, and one third from capital gains, dividends, interest and rent. The poorest of these 14,000 made about $6 million in 2005. Below is a chart of how the income of the top 400 tax payers, the top .0003%, has changed over the last 14 years.

Obama has produced a budget which has built into it deficits of over $1 trillion per year for the next ten years. He has promised to limit executive pay, the pay to the people who pay most of the taxes. He has promised to greatly expand government benefits beyond his current budget with universal health care and increased earned income taxe payments. He has promised new programs to improve infrastructure, training, and education. He has also promised that if you make less than $250,000 per year he will not raise your taxes. I think it's pretty easy to see that he is not going to be able to keep all of these promises. The promise to not raise taxes on the middle class is going to have to be broken sooner or later: the current system which takes 85% of the tax revenue from 20% of the households is going to have to change to include more taxes coming from more households.

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