Always Be Careful with IRS Income Data

September 25, 2014

The chart below has been going around the web this week. It is from an analysis by Pavlina Tcherneva of Bard College that used Piketty and Saez IRS data to show that in non-recessionary periods from 1949 to 2012, the share of total income growth has increasingly accrued to the top 10 percent, while the bottom 90 percent’s share has declined.

While this does reflect the general decline in wage growth in the last few decades, there are issues with this data. People reading this chart should keep in mind the major limits to IRS income data, and that this analysis does not account for any declines in income during recessions.

Income at the Top Is Highly Pro-Cyclical

One issue with this chart is that it only looks at boom times, so it doesn’t account for any losses during recessions that could temper, or offset, much of this trend.

The top 10 percent have a much greater share of capital income. Capital income is notoriously volatile over short periods of time. During booms, capital income for an individual could be large, but during recessions, losses could be just as big as the prior year’s gains. Wage income, in contrast, is much more stable and would grow more evenly year-over-year and not suffer the same amount of losses when the economy goes sour.

The following chart shows that while the incomes of the top 1 percent undoubtedly grow swiftly in boom times, they suffer greatly during recessions. Other income groups have a much milder trajectory.

IRS income Data Is Not Very Good Measure of Income

A serious flaw with IRS data is that it is collected in order to raise tax revenue. Consequently, it is not very well suited for other types of analyses. The chief problem is that income that is not taxed by the U.S. government is not tracked by the IRS at all. This could drastically bias an analysis, especially one that looks at incomes. There are two major issues with the data: one deals with health insurance compensation and the other with how capital income is taxed, or often never taxed.

The first is employer-provided health insurance. When an employer compensates workers for their labor, it usually does so with a mix of salary and fringe benefits. One of the most significant fringe benefits is employer provided health insurance, because it is not taxable as ordinary income. As a result, employers have an incentive to compensate workers with generous health insurance plans. This tax exclusion is the largest tax expenditure in the income tax code, costing the government more than $196 billion every year. This is hundreds of billions of dollars of income—mostly going to the bottom 90 percent—that this data does not account for every single year.

The second issue is how the tax code treats capital income. This effects both the top 10 percent and the bottom 90 percent. The U.S. tax code only accounts for capital income (capital gains, specifically) when it is realized. This means that someone may have been accumulating capital gains for 40 years in an investment portfolio, but the IRS only sees the final (sometimes massive) realization. Suppose an individual invested in stock. Each year, the gains were small, but in the 41st year, he realized all of the past years’ gains and earned $1 million in income. IRS data would show that this taxpayer was a millionaire one year (and part of the 1 percent). This is especially important in boom times, given that stock market gains are much greater and could exaggerate income gains of the top earners.

Middle-class taxpayers also have a significant amount of capital income, but it remains hidden from the IRS because it is not taxable. 401(k)s and IRAs are all considered non-taxable. As a result, not a single penny of this income is ever accounted for by the IRS. This is significant for this analysis, given that this wealth and income totaled nearly $19 trillion in 2013. This undoubtedly biases the incomes of the bottom 90 percent downward by leaving out a significant chunk of income.

Wage Growth Is Slow, but It Doesn’t Need to Be

This isn’t to say that wage income hasn’t been subpar in recent years. The economy in general is still struggling to pick up steam, suffering from low levels of investment and low labor force participation. Middle-income earners are worse off because of it. But this doesn’t need to be the case.

Structural reforms that boost investment and bring people back to the work force could go a long way in increasing wages.

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