Wednesday, November 24, 2010

Income Inequality, Wall Street Bonuses, and Proof that Krugman and Reich are Idiots

Paul Krugman and Robert Reich love to talk about the fact that there's growing income inequality, and that the main people who are benefiting are "fat cats on Wall Street" and "hedge fund managers."

Based on news coverage of a few aberrant cases, it's easy to believe these claims by Krugman, Reich, and their ilk. But how true are their claims? The IRS Publication "The 400 Individual Income Tax Returns Reporting the Highest Adjusted Gross Incomes Each Year, 1992-2007"4 lists the sources of income for the top 400 earners each year. The income of the top 400 earners in 2007 breaks down like this:

Net business income (from Schedule C & F) -- 0.11%
Salaries and wages (i.e., W2 income) -- 6.53%
Dividends -- 7.11%
Taxable interest -- 7.85%
Partnership and S Corp Net Income -- 12.16%
Net capital gains -- 66.29%

What's interesting about this is what it doesn't show. What it doesn't show is the average person in the Top 400 earners getting a large bonus. Most income is from net capital gains, dividends, and interest. Overall, 81% of the income is investment income. Employers have to report bonuses, even very large Wall Street Fat Cat bonuses, as W2 income. But only 6.53% of the top earners' income is W2 income, which means that they aren't getting their money from large bonuses. They're getting their money from investments. And THAT means that the top 400 earners are not Wall Street hedge fund managers whose firms pay them enormous bonuses; they're investors who have invested their money themselves.

Why is it important to Krugman and Reich to characterize the top earners as hedge fund managers and Wall Street fat cats when they are not? They want to imply that Wall Street workers are frequent recipients of windfall bonuses and don't really deserve them. This is another link in their argument designed to convince people that the rich don't deserve the money they've earned. If they don't deserve it, we should feel fine about taxing it! Who deserves their money more? A hedge manager who receives a huge windfall, or a careful investor who has patiently watched his investment grow for years before realizing a long-awaited payout?

It's easier to demonize the hedge fund manager than the patient investor, which is why Krugman and Reich characterize top earners the way they do. But as with so many of their other arguments, when we peel back the top layers of the onion we find have to make up facts to support points they want to make. The real facts don't support their arguments.

Taxes and Two Kinds of Fairness

When people talk about something being "fair," they are generally referring to one of two kinds of fairness.

The first kind of fairness is "results fairness." We look at the results and conclude they are fair. If two kids each get the same size piece of cake, that result is fair. If one kid baked the cake while the other kid played video games, and the baker gets a larger piece than the gamer, most people would still consider that result to be fair.

The other kind of fairness is "process fairness." In this case we assume that if the process is fair, the results will also be fair. With a piece of cake if a parent says, "One of you gets to cut the cake and the other gets to choose their piece first," we view that as a fair process -- even if one kid ends up with a bigger piece of cake than the other. Our criminal justice system is based on this kind of fairness -- each side has a zealous advocate; an impartial jury hears both sides of the argument, and as long as the process is fair (i.e., no one bribes the jury), we believe the result will be fair -- or at least as close to fair as we're capable of getting.

What does this have to do with fairness of the federal income tax system? We have been at a point for many years where very few people believe that the federal income tax system demonstrates either results fairness or process fairness. We know that the results aren't fair because we hear too many stories of billionaires who pay little or nothing in taxes. We know that the process isn't fair because there are too many loopholes in the tax code, and we believe that those loopholes are exercised more often by affluent tax payers than by poor tax payers. (I will comment on the numerous ways in which the tax system is unfair in future articles.)

The concept of fairness is one reason that I advocate a flat tax. I believe the federal income tax system should be structured as a flat percentage tax on all income, regardless of source, with no deductions except for a a standard deduction of $10,000 per taxpayer. This would replace federal income tax and employee social security and medicare tax and would be "revenue neutral" at a rate of approximately 24%.

This system has several advantages in fairness over our current system:
  • It's simple enough that people can understand it without an accounting degree.
  • It doesn't tax very low income people, which social security and medicare currently do.
  • It doesn't have any loopholes. There are no deductions except for one personal deduction, which is the same for everyone.
  • It doesn't have any hidden tax rates. One of the reasons the rich pay less in taxes is that most of their income tends to be capital gains, which is currently taxed at only 15%.
  • It applies the same tax rate to everyone because the rate is flat. The rich pay more, but they don't pay disproportionately more.
Does the flat tax exhibit results fairness? I think it does, but you have to make sure you're asking the right question. The right question on that topic is "Does flat tax demonstrate results fairness compared to our current tax system?" Compared to our current system, it is more fair. The poor don't get taxed via social security, and the rich don't get a tax break via a lower capital gains rate.

Does the flat tax exhibit process fairness? Yes, that is its strength. The process is simple, easy to understand, and applied without exception. If you earn more, you pay more. But you don't get punished for being rich, which I think should be anathema to anyone who believes in America as The Land of Opportunity.

Tuesday, November 23, 2010

Income Inequality: Who Are The Rich in the Top x%?

It's easy to find liberal pundits who make statements like the following: "the richest 1 percent possessed about 15 percent of the nation's income."1 or "Income inequality between the classes is the greatest it's ever been since they first introduced the metrics (to measure same) in this country."2

The big flaw in this argument is that, as is so often the case, the argument confuses income with wealth. Being "rich" is more about having wealth than it is about earning a high income. When a person earns a high income over time, he can eventually become wealthy or rich. Income inequailty is a different story than wealth inequality.

The statistics that are cited to refer to growing income inequality are always income statistics (duh). The assumption buried so deep that it takes a jackhammer to uncover it, though, is that the "the richest 1 percent" that's earning 15 percent of the nation's income is the same 1 percent year after year after year. If one year, it's one group of people in that 1 percent, and the next year it's a mostly different group of people, and the next year, it's a mostly different group of people again, then we don't have the same issue.

The liberals who cite the fact that "the richest 1 percent possessed about 15 percent of the nation's income" are trying to make the point that "the rich are getting richer." But if it's a different 1 percent every year, then that doesn't prove the rich are getting richer. It's more like different people are taking turns winning the lottery, and a lot of people are becoming better off. Only in reality it is probably more like different people taking turns cashing in on IPOs, receiving huge investment fund bonuses, and so on.

The IRS Publication "The 400 Individual Income Tax Returns Reporting the Highest Adjusted Gross Incomes Each Year, 1992-2007"4 sheds a little light on this topic. Table 4 on the last page of the report contains the data of interest.

In the 16 years from 1992-2007, 72% of the people who appeared in the top 400 appeared only one time in 16 years. 90% appeared three times or less in a 16 year period. Only 0.2% of people appeared all 16 years.

So among people with the very highest incomes, the group composition is highly volatile and does not support the claim that "the rich are getting richer." It says rather that Americans are taking turns having extremely high incomes, which actually seems very positive.

While income inequality might be increasing, wealth inequality has been decreasing since the mid 1970s,3  which is what you would expect to see when high incomes are being spread around to different people from year to year rather than concentrated on the same people every year.


Note: I need to find data on how stable the composition of the group of top 1% and top 0.1% of wage earners really is. [I know I saw this in an IRS publication once, but I can't find it again.]

Sunday, November 21, 2010

Robert Reich, Executive Mansions, and The Secret Pot of Money

Robert Reich's editorial in the Sunday San Francisco Chronicle repeated his oft-cited reference to "multimillion-dollar home-interest deductions on executive mansions." The problem with this claim is that there is no such thing. The "home interest" deduction is limited to $1 million and has been for many years. Reich rationalizes his argument by saying that the rich can have their corporations pay for their housing, and that can involve mortgages higher than $1 million, and their corporations can potentially deduct that interest.

There are a numerous problems with this back door argument.

First, a picky point. That isn't "home mortgage interest." It's a business finance charge. Reich's use of the phrase "home mortage interest" seems intended to deceive readers into thinking that the rich somehow get to use a different set of tax laws than the middle class does, and that is not true.

Second, the business can only write off the interest if the home mortgage is a legitimate business expense. Someobody's going to pay the tax -- either the executive or the business. If the business provides the executive mansion to the executive as a benefit, it will have to count the value of that benefit as income to the executive. Would it make sense to do this?

The Tax Math of a Business Paying for an Executive Mansion

I start with the premise that the business is going to pay the executive whatever it pays the executive. The business doesn't really care how the executive compensation is structured as long as it costs the same in the end to the business.

Table 1 shows how this scenario plays out, assuming the business makes a gross profit of $25 million (excluding executive comp). This is an arbitrary number chosen so I can show tax implications. Table 1 also assumes the exec has a base salary of $5 million, and that in one scenario the exec gets an additional $2 million as a straight bonus, and in the other scenario the exec gets the $2 million in the form of the company paying for an executive mansion. I assume that the mansion costs somebody $2 million either way, whether the business pays or the exec pays.

Who Pays for Exec Mansion?
Company Preliminary Profit      25,000,000       25,000,000
Exec Preliminary Comp        5,000,000         5,000,000
Exec Bonus        2,000,000                    -  
Company House Payment                   -           2,000,000
Total Exec Cost to Company        7,000,000         7,000,000
Company Taxable Profit      18,000,000       18,000,000
Company Tax Rate
Tax paid by Company        6,300,000         6,300,000 This is simplified for purposes of illustration
Exec Gross Comp        7,000,000         5,000,000
Taxable Benefits                   -           2,000,000
Exec Mortgage Payment        2,000,000                    -  
Mortgage Deduction       (1,000,000)                   -   Interest deduction is limited to max of $1M
Exec Taxable Comp        6,000,000         7,000,000 Gross comp + taxable benefits - deductions
Exec Tax Rate
Exec Taxes        2,100,000         2,450,000 This is simplified for purposes of illustration
Exec Comp (Net of Housing, Taxes)        2,900,000         2,550,000
Total Taxes Paid (Exec + Company)        8,400,000         8,750,000

As the table illustrates, it doesn't matter to the business whether it spends $2 million on housing or $2 million on a bonus -- it gets to deduct 100% of that value either way.

On the executive side, it does matter. If the exec gets that $2 million as straight income and pays for the house himself, he can take the maximum $1 million deduction for his house payment. (He can't deduct the whole $2 million because the deduction is limited to a maximum of $1 million.) If the company pays for the house, the $2 million in housing value has to be reported as executive income, and the exec can't deduct anything for the house payment, so the executive is worse off if the company pays for his house.

Although a business could pay for an executive mansion in the way Reich describes, there isn't any rational reason for the business to want to do that, and there's a rational reason for the executive to want not to do that.

The Flaw in Reich's Argument: The Secret Pot of Money

Reich is a smart man, but the only way his argument makes sense is if he employs a logical fallacy common among people who have never run their own business. I refer to this fallacy as the "secret pot of money" fallacy.

In this case, the way the Secret Pot of Money argument would be applied is if Reich says, "Yes, but you're assuming the business pays $7 million either way. What if in one scenario the business paid the executive $5 million and no bonus, and the other scenario the business paid the executive $5 million AND paid for the $2 million mansion?"

My response is, Why on God's Green Earth would any business do that? Where do you think the business is going to get that extra $2 million? A business can't just wave a magic wand and come up with an extra $2 million. That money would have to be taken from someplace else. The business is not going to pay an executive $2 million extra in benefits unless it has to. Businesses don't do that. The exec gets what the business has agreed to pay him, and there's no secret pot of money to give him an extra $2 million in one scenario that isn't available in the other scenario.

Bottom line is that there's no rational, fact-based basis for Reich's claim of "Executive Mansions" for high income earners. It's legally possible for a business to structure executive compensation the way Reich describes, but there's no financial benefit to anyone from doing it that -- except for the federal government, which would receive more in taxes.

Typical "Steal Their Money" Rhetoric

Robert Reich's editorial in the Sunday San Francisco Chronicle was a pithy summary of the typical ultra-left justification for high/punitive taxes on the rich:
"Let's hope the president holds his ground on not extending the Bush tax cuts to the richest Americans - who don't need it, don't deserve it and won't help the economy if they get it.
This in a nutshell is the ultra liberal rationalization for why it's OK to soak the rich.

"Who don't need it." Need is a relative term. The rich don't need a tax cut so they can buy a bigger yacht, but the middle class don't need a tax cut so they can buy a bigger flat screen TV, either. If Reich's plan was to put all the extra tax revenue into a fund to help the poor, that would be one thing. But he wants the extra taxes from the rich to increase the standard of living for the middle class, and that's a different matter.

"Don't deserve it." Reich's argument here is based on statistics. He argues that most of the increase in earnings in the 2000's accrued to the top income earners rather than to the middle class. But that does not ipso facto mean the rich don't deserve it, as I've argued before. The fact that the middle class deserved to do better (if they did), does not imply that the rich deserved to do worse, or that the rich benefit at the expense of the middle class.

"Won't help the economy if they get it back." This is based on the argument that the rich don't spend as high a percentage of their incomes. Probably true, but what do the rich do with their money? Reich seems to assume they put it into under mattress where it doesn't do anyone any good. But of course that isn't what they do. They invest it. So the rich don't spend their money on consumer goods, but they do make their money available so that other people can use it. That seems like the same thing to me.

Thursday, November 18, 2010

Krugman and Private Property

One of my friends mentioned that there is a small minority of people in America who just don't believe in private property ownership. I think he's right, and I think that one of those people is Paul Krugman. How else do you explain Krugman's completely radical insistence in spending trillions more to stimulate the economy than were spent? His stated reason doesn't make sense, and he's a smart guy, so he must have some unstated reason. I think his unstated reason is that he thinks that will bring about an economic collapse that will in turn lead to government control of a much higher percentage of private property than we have now.

Sunday, November 14, 2010

UK view of Bush vs. Obama Now

For my friends who like to say they like Obama because the world likes Obama, this article from the Daily Telegraph (British newspaper) shows an interesting perspective.

This whole thing reminds me of my trip to Europe & the middle east in 1981. The Washington State view was that Reagan getting elected in 1980 was a disaster. But our tour in Rome, and Italian woman, volunteered that Italians were much happier with Reagan. Of Carter, she said, "He's a very nice man, but was not a good president."

In the line with the Daily Telegraph article, just as Carter begat Reagan, Bush begat Obama.