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Wednesday, April 26, 2017

Reports Of Extreme Income Inequality Are Exaggerated Due To Shift In S-Corporation Income Among The Very Wealthiest

Fatih Guvenen (Minnesota) & Greg Kaplan (Chicago), Top Income Inequality in the 21st Century: Some Cautionary Notes:

Since 2000, different measures of top income inequality have exhibited very different trends. Top income shares based on measures of total income show a continued rise, whereas top income shares based on wage and salary income show no increase in inequality post-2000. The most important difference between these two measures of income is the income that accrues to S-corporations. Moreover, the majority of the recent increase in top income shares is due to an increase in average earnings at very high income levels, much higher than that assumed in typical discussions of top income inequality. Once incomes above the 99.99th percentile are excluded (around $7 million in 2012), we see that little continued growth in top income shares has taken place in the last 20 years. Put simply, so far in the 21st century, all the action in top income shares has been S-corporation income at very, very high income levels. ...

[I]nterpreting trends in the S-corporation component is extremely difficult. Feenberg and Poterba (1993), Gordon and Slemrod (2002), and Cooper et al. (2016) warn that much of the recent increase in S-corporation income is income that previously accrued to C-corporations. Such income is not “new” income earned by top earners but is simply income that was previously labeled as corporate income rather than household income. A large amount of this relabeling occurred in the wake of the reductions in personal income tax rates that were part of the TRA86. This income shifting potentially accounts for all of the increase in S-corporation income at the top of the distribution prior to 2000.

Focusing on W-2 income largely avoids the issue of income moving between the corporate and personal sectors but misses the income sources where all the action at the top of the distribution has been so far in the 21st century. Moreover, W-2 income is not completely immune from income-shifting activities. When an entity switches from a C-corporation to an S-corporation, some of the income that was previously paid to owners as W-2 income will be reclassified as S-corporation income. This could lead to a fall in W-2 income that may partly account for the slight downward trend (or lack of an upward trend) post-2000 in top wage and salary income shares.

Figure 5

http://taxprof.typepad.com/taxprof_blog/2017/04/reports-of-extreme-income-inequality-are-exaggerated-due-to-shift-in-s-coproration-income-among-the-.html

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Comments

This is one of those analytical caveats that gets pointed out -- I recall Allan Reynolds mentioning this, for example -- in think tank/blogsphere commentary, and as it runs counter to popular the narrative in question -- increasing inequality, stagnating compensation, etc -- gets ignored. Great to see this highlighted in an academic setting.

Posted by: MG | Apr 26, 2017 7:06:01 AM

Such income is not “new” income earned by top earners but is simply income that was previously labeled as corporate income rather than household income...When an entity switches from a C-corporation to an S-corporation, some of the income that was previously paid to owners as W-2 income will be reclassified as S-corporation income.

I don't understand. If income is "labeled" as corporate income, is it not just that? And not under the control of an individual? And if it's paid out as dividends, then it would be "labeled" as household income. And when an entity switches from a C-corp to subchapter S, the income may well shift as well. But it will flow through more directly to the owner, perhaps (still) as wages, but more likely as dividends or other distribution of some sort, I suppose.

In short, why would a shift from C-corp to subchapter S mask anything? The income isn't household or, (more accurately, I believe) personal income until it is distributed from whatever type of corporation exists. Is the issue more a difference in tax treatment, rather than how the income is "labeled"?

Can someone explain?

Posted by: jsmith | Apr 26, 2017 7:13:08 PM

jsmith,
S corporation income is deemed distributed to shareholders whether actually distributed as dividends or not and therefore entirely reported as household income. C corporation income is not reported by shareholders as household income until actually receivded as dividends or realized via a sale of stock.

Posted by: Mike Petrik | Apr 27, 2017 8:28:30 AM