CBO Report: The Distribution of Household Income and Federal Taxes

The Congressional Budget Office (CBO) has just released a report that should end the factual debate about income inequality but probably won’t.

Let’s begin with inflation-adjusted market income.  (Market income is defined as “labor income, business income, capital gains, other capital income, and income received in retirement for past services.”) Between 1979 and 2011, CBO calculates, inflation-adjusted market income for the bottom 20 percent of households rose by 16 percent.  For the middle three quintiles of households (the 21st to the 80th percentile, this income also rose by 16 percent.  For households between the 81st and 99th percentile, it rose by 56 percent.  And for the top 1 percent of households, it rose by 174 percent.

Let’s translate this into annual increases.  For the households in the first through fourth quintiles, income rose at the barely perceptible pace of 0.45 percent per year.  (On average, a household with an income of $50,000 in year 1 would have $50,225 in year 2—an extra $4 per week.)  For households in the 81st to 99th percentiles, income rose three times as fast, at an annual rate of 1.35 percent.  And for households in the top 1 percent, the annual rate of growth was 3.10 percent.

Conclusion: left to its own devices, the market nearly excluded the bottom 80 percent of households—the middle class, the working class, and the poor—from sharing the fruits of economic growth since 1979.

But of course we didn’t leave the market to its own devices.  Instead, we changed both our tax code and our social programs to lean against the market’s roughest edges.  After taking taxes and transfer payments into account, the bottom quintile of U.S. households experienced growth of 48 percent in their inflation-adjusted incomes while the middle three quintiles had income growth of 40 percent.  The 81st to 99th percentiles grew by 67 percent; and the top 1 percent, by 200 percent. 

It doesn’t take an advanced degree in statistics to see that if the income of households in the top 1 percent tripled after taking taxes and transfer into account while the income of the 99 percent grew by about 50 percent, income inequality increased.  CBO finds, however, that inequality is 26 percent lower than it would have been if we had left the 1979 tax code and income support programs unchanged.  More robust transfer programs accounted for a 19 percent reduction, and tax reforms for the rest.

Bottom line: even with government doing everything that was politically possible, the rich have gotten richer very fast since 1979, while the poor, middle classes, and even upper middle classes have improved their lot much more slowly—so slowly that they feel as though they’re treading water.

To explain what’s going on, CBO took a closer look at the sources of market income.  For all households, labor income (wages and benefits) accounted for 74 percent of the total, and capital income 10 percent.  There wasn’t much variation within the bottom 99 percent.  For example, affluent households between the 96 and 99th percentiles derived 73 percent of their income from labor and 10 percent from capital. The picture was very different for the top 1 percent, who obtained only 37 percent of their income from labor and fully 36 percent from capital, much of that in the form of capital gains. 

We can view this snapshot against changes over time in the distribution of our economy.  Since 1979, the share of GDP going to labor in the form of wages and other compensation has declined sharply, while the share going to capital has risen significantly.  The tax advantages that capital income enjoys over labor income have increased the impact of these trends. 

A key role of modern government is to mitigate market-driven inequalities without choking off economic growth.  Unless market forces start increasing the share of national income going to wages, salaries, and fringe benefits, it’s only a matter of time before elected officials begin to question the logic of taxing capital gains at a much lower rate than ordinary income.