Dividends, Capital Gains, and the Growth of Income Inequality

January 2nd, 2012 at 5:53 pm

Yesterday, I posted this analysis of an informative new report from the CRS on the increase in income inequality between 1996 and 2006.  One important finding from the report decomposes the increase in inequality, as measured by the Gini coefficient, into the contributions made by different income types.  Such diagnostics can be very helpful when we’re thinking about prescriptions.

I’ve plotted the results below.  The Gini coefficient is a measure of inequality that ranges between 0 and 1, where higher numbers imply a less equal distribution.  Over these 10 years, the Gini of after-tax income increased from 0.503 to 0.560, an increase of 0.057, or 11%.  The figure below assigns that 0.057 point growth to the different sources of income.  Note that some sources led to higher inequality, while other reduced its growth.  On net, however, inequality grew.

Source: CRS

The largest single contributor to the growth of inequality, 1996-2006, was dividends and capital gains.  Adding in business income, like profits from a hedge fund, comes to 0.061, more than explaining the 0.057 point increase in the Gini index.

It may surprise you that income from earnings reduced inequality’s growth over these years.  It’s not because the distribution of earnings became more equal—to the contrary.  It’s because earnings are a) less skewed than cap gains, dividends, and business income, and b) comprised a significantly smaller share of income in 2006 than in 1996.

In other words, a more equal type of income (earnings) was a smaller share of total income at the end of the period, and visa versa: a more skewed income source comprised a larger share.

Note also that tax changes led to higher inequality.  As I noted in yesterday’s post, and as other analysis has corroborated (see CBO inequality study), and as anyone who’s been paying attention should know, federal taxes have become less progressive over time.

I can think of a good solution to both of these last two problems: the increased inequality-inducing function of cap gains, and the diminished progressivity of taxation.  Tax capital gains and dividends as regular income.  Stop favoring them in the tax code.  The research is quite clear that privileging these income types has little to do with investment patterns, and instead leads to all kinds of timing and game-the-system distortions.

OK?  Problem solved.  Next question?  Bueller?…Bueller?


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12 comments in reply to "Dividends, Capital Gains, and the Growth of Income Inequality"

  1. readerOfTeaLeaves says:

    Great post for the new year.

    The largest single contributor to the growth of inequality, 1996-2006, was dividends and capital gains.

    I hope this becomes a drumbeat. In the 21st century, the rules for capital gains need to change. They are distorting the economic picture in the US (and globally) and feeding nonsensical conversations and policies.

    More, please…!

  2. davesnyd says:

    How about the estate tax as regular income, too? And the hedge fund loophole?

  3. tom says:

    In 1986, the liberals traded treating all income equally for flattening the rate structure. The rates have stayed flat, the treating all income equally was abandoned. Play hardball with the lying b*****ds.

  4. Michael says:

    It feels really useless to talk about economics right now — Obama and his people are so hard-right on the economy that the Republican wingnuttery has no effective counter.

    Indeed, the more one understands about economics, the clearer it is that America is in a state of terrible decline. It’s not that we aren’t implementing good governance. It’s that we aren’t even allowed to discuss policies that might constitute good governance.

    • Comma1 says:

      Agreed. There is no point talking about the finer points of fluid dynamics when the argument at hand is whether witches float.

      After the past decade, to pretend policy is informed by anything other than the self serving notions of .1% of the population is to insult your readers. Your readers care enough about economics to find and read your blog – so just level with us, the greatest nation in the history of the world is being run by sycophants, charlatans and psychopaths. To pretend economics has anything to do with their resulting policy is to deny the last decade of US history.

  5. Greg says:

    Hey Jared:

    Greg, here, Happy New Year! Thanks for your blog, you have an amazing site, I try and check it every day, I love your charts, music suggestions and the way you bring in CBPP stuff as well.

    And I really appreciate you showing this particular chart because, (and I mean this will all due respect because I’m a big fan of your work), it appears you’ve changed your position on taxes and their impact on market outcomes when it comes to inequality.

    It looks like from today’s post, and your use of CRS data, that you’ve changed your position on the primary source or factor driving inequality in America? If so, excellent.

    Previously, you wrote that “factors driving growth in inequality were embedded in the market outcomes.” And I was confused, given the massive tax cuts on capital gains decades ago, I thought it was a straight shot. Federal policies animated inequality.

    This was our exchange back on Dec. 6th, 2011, when I questioned your previous post on taxes and inequality you wrote. “…But the factors driving the growth in inequality are embedded in the market outcomes, and while increased progressivity can dull their edges and even counteract their longer term impacts (as just noted re access to opportunities), they cannot go far enough. Just think about the dynamics here: if, in a climate of increasingly income inequality, you punt on the primary distribution, then you will be depending on the largesse of the Congress (!!??##&!) to continuously increase the progressivity of fiscal policy. Good luck with that.”

    With this CRS data, is it fair to say we not only need “good luck”, but the data shows that “tax policy” from the federal government, not “market outcomes”, are indeed the primary reason for inequality. Since tax rates on dividends and capital gains were slashed, and I may be stretching it here, but is it fair to say they had a direct impact on “primary distribution?”

    As you yourself wrote today, “Note also that tax changes led to higher inequality.” … and that “The largest single contributor to the growth of inequality, 1996-2006, was dividends and capital gains.”

    Given the data you posted and CRS presented, (once again, I love your site) is it correct to say that your statement back in December 6th that “the factors driving the growth in inequality are embedded in the market outcomes,” was wrong.

    • Jared Bernstein says:

      Excellent question which warrants its own post as a response. The answer, which I think I can show pretty convincingly quantitatively using CRS data, is that while we can dampen the growth of inequality with more progressive tax policy, we can’t reverse it in any meaningful way without more equal market outcomes.

      • Greg says:

        Cool beans. For non-economists like myself, it’s helpful to learn where tax policy changes end and market outcomes begin. From a historical perspective, and from a progressive perspective, the changes in tax and trade policies appeared to have a huge impact on inequality in America. Any clarification with good data you can provide will be very much appreciated. Thanks for your time and your expertise. You’ve got a killer site. Very helpful.

        • perplexed says:

          FYI – Dean Baker’s new book “the End of Loser Liberalism” has an excellent discussion the sources of many of these “market” outcomes. The electronic version is available as a free download – great read.

  6. David Miller says:

    But doesn’t this study miss something fundamental?

    The truly wealthy don’t recognize their capital gains, and are never subject to income tax on the unrealized appreciation. When you consider this, aren’t taxes much more responsible for income inequality than the chart suggests?

    Take Warren Buffett. He paid $6,923,494 of tax in 2010 on taxable income of $39,814,784 (17.4%). But his Berkshire Hathaway stock increased by $3 billion that year, and he will never pay any income tax on his appreciation. So his tax rate on economic income (including unrealized appreciation) was more like 0.2%.

    I point out that even if Warren Buffett were taxed at a 100% rate on his recognized income, his effective tax rate on economic income would be only about 1%.

    The tax system need not be based on realization. If we imposed a mark-to-market tax system on the publicly-traded securities of the truly wealthy (i.e, the top 0.1%), then there would be a real dent in income inequality.

    At a 15% rate, Warren Buffett would have paid tax of $450 million — rather than zero — on his $3 billion of appreciation.

  7. Jill SH says:

    This is a good post but a bit wonky and will take me a reading or two to fully grasp your calculations. Likewise your back and forth here with Greg.

    But the overall gist, as well as other posts about income/tax inequality, kinda fly by the whole concept of what gets taxed how and why. And the pocketbook effects of that for the average worker.

    I’m worried that most people don’t get that if they earn $50K as a wage or a salary, they first get taxed at a flat rate with no deductions, then they get taxed in a graduated way, with personal deductions and deductions for stuff like mortgage interest and state taxes.

    But the trust fund baby who has a $50k income from interest, dividends, and/or capital gains doesn’t pay that flat tax, and then has a completely different tax rate than the graduated income tax.

    In all the political back and forth on TV news, what seems to be missing is the basic Econ 101: This is how we tax, and who pays what at what rate. REALLY basic stuff. Maybe throw in a bit of history about how it all started.

    “Tax capital gains and dividends as regular income. Stop favoring them in the tax code.” I agree! Most people may not know why that needs to be done, or why it’s not already the law of the land!

    Any chance you could get your friends on Cable TV to insert about 10 minutes into each broadcast to teaching this very basic stuff, so even a brother-in-law could grasp it?

  8. perplexed says:

    Thanks again for keeping this issue out in front Jared! Hopefully, when people begin to understand the proper role of government and taxation in managing the “arbitrary and inequitable” distributions of wealth and income (in Keynes’ words), their expectations for what their government should be doing on the behalf of all Americans will take a more productive tack. As you and Dean Baker (in his new book “The End of Loser Liberalism”) have pointed out, government and tax policies having been working in the opposite direction over the last 30 years and have actually reinforced the tendencies for wealth and income to concentrate in the hands of a small percentage of Americans. By changing both the pre-tax and after-tax distributions to favor the very top, government policies have assisted in turning us into a banana republic, instead of acting as a counterweight to these destructive trends.

    I’ve mentioned it before, but I’d like to point out again that looking exclusively at income concentration really amounts to a focus on the “tip of the iceberg.” Its only when viewed with the cumulative effects of 30 years of un-managed income concentration that the true picture emerges and the entire “iceberg” becomes visible. Our wealth concentration Gini is .84, much more concentrated than even the extreme annual income concentration Gini’s of .57 would seem to imply. 2/3’s of the wealth of the country is now in the hands of 5% of the population. A big part of the reason that “capital income” has such a huge effect on income concentration is that almost all of it goes to the top 5%; the government just exacerbates the situation by taxing it at a lower rate, thereby enhancing further accumulation at the top.