Income Inequality and the Myth of Redistribution

I just came across an article in the Wall Street Journal by Scott Hodge entitled “Here’s What ‘Income Equality’ Would Look Like.”  Mr. Hodge is the President of the Tax Foundation, ‘a nonpartisan tax research group in Washington D.C.’  His article was primarily based on a report he co-wrote for the Tax Foundation entitled “The Distribution of Tax and Spending Policies in the United States.”

The goal of the report was fairly straightforward.  It compared the amount of taxes each family paid to the amount of government services they received.  (Government services means all government spending from the Department of Defense to the State Department to the National Archives to Social Security.)  Dividing the population into income quintiles (fifths), it revealed that the bottom 20% received an average of $33,402 per year in government services, the second fifth received $30,052, the middle fifth received $30,144, the fourth fifth received $31,122, and the top 20% of families received $35,141.  The report also demonstrated (and Mr. Hodge’s article trumpeted) that the lowest earners received considerably more government services than they paid for at the expense of the top earners, who received considerably less.  The report (and Mr. Hodge in his article) asserted that the top 40% of Americans have already had $2 trillion of their income ($1.5 trillion federally and $500 million through state and local governments) distributed to the bottom 60%.  Mr. Hodge points out that in order to ensure every American family earns an ‘average’ income, an additional $2.4 trillion would need to be taken from the top 40% and redistributed to the bottom 60%, which, of course, is ridiculous.

I agree it’s ridiculous.  His straw man argument that income inequality can only be dealt with by the government taking money away from the rich and handing it over to the poor is ridiculous, and the entire methodology of the Tax Foundation’s report is ridiculous.

First let’s look at the numbers in the report.  (‘Redistribution’ is the adjusted income of the quintile after the value of government spending has been subtracted from the taxes paid.  For example, as stated above the bottom 20% receives $33,402 in government spending, so 33,402 – 6,331 (taxes) + 9,561 (actual income) = $36,632 (redistribution).)

Quintile          Income          Taxes          Redistribution     % +/-

Bottom 20%   $9,561             $6,331        $36,632                 +283.1%

2nd 20%         $31,053           $11,913      $49,192                 +58.4%

3rd 20%         $56,884           $20,429      $66,599                  +17.1%

4th 20%         $100,242         $35,325      $96,038                   -4.2%

Top 20%        $311,405         $122,217    $224,329                 -28%

(Per the report, income includes wages, business and capital gains income, and health and retirement benefits, but excludes transfers.)

On the surface it looks like the bottom 20% are getting a 283.1% increase in their income, while the top 20% are losing 28%.  My initial reaction to this is that it works, because everyone is getting roughly the same amount of benefit from government spending.  Do we really want the United States government to operate on a fee-for-service basis?  The Federal Bureau of Investigation would only investigate crimes against the wealthy?  (OK, maybe that’s a bad example.)  The Federal Highway Administration would only provide road maintenance and safety standards for those who can directly pay for it?  The Department of Defense would only protect the freedom of the top 40% of earners?  That would be interesting, since the vast majority of those serving in the armed forces aren’t among the top 40% of earners!  Is that the country we want to live in?  These numbers seem like the definition of that ‘fair share’ we hear so much about, so I have no problem with them.

Unfortunately, they’re all a lie.

First let’s look at this idea of every family having ‘average’ income.  The report claims that the ‘average’ income is $81,602.  Given the other numbers provided in the report, I have no idea how they’re arriving at that figure.  But for the sake of argument, let’s just go with it.  Now notice that the bottom three quintiles have an average income that is below the average income.  That means more than 60% of American families are below average.  This is probably because the top earners disproportionately affect the average.  According to the report, the top 10% have an average market income of $469,228, the top 5% earn $713,599, and the top 1% earn $1,992,095.  I can see how those outliers could affect the total.  However the report also states that negative income families (i.e. those who pay more in taxes than they earn in income–highly possible when you remember that sales tax, property tax, excise tax, and a whole host of other taxes are being lumped together along with income taxes), while included in the spending and redistribution totals, are not included in the bottom quintile.  That means those families’ incomes are not included in the average income for American families.  Therefore Hodge’s $81,602 average income target is completely meaningless, and his entire WSJ article is a farcical rant about nothing.

But let’s go even further.  As part of the methodology, the Tax Foundation used the ‘Cost of Services’ approach for calculating total spending.  That means no assumptions are made about how much each family might benefit from any public spending, and the cost is simply divided equally among the families.  I.e. those earning $9,561 per year at minimum wage jobs received the same amount of benefit from TARP as those earning $1,992,095 per year from their stock investments.  Not quite.

In the index, the report at least had the decency to provide the numbers according to the ‘Benefit Principle’ approach, in which benefits from government spending are apportioned according to a family’s share of the nation’s income.  Let’s see how that changes things, shall we?

Quintile          Income          Taxes          Redistribution     % +/-

Bottom 20%   $9,561             $6,331        $25,568                 +167.4%

2nd 20%         $31,053           $11,913      $42,081                 +35.5%

3rd 20%         $56,884           $20,429      $63,579                  +11.8%

4th 20%         $100,242         $35,325      $98,201                   -2%

Top 20%        $311,405         $122,217    $257,734                 -17.2%

While the poor are still receiving more government services than they pay for in taxes and the rich are receiving less, the redistribution is much less dramatic.  Here’s the comparison in benefits received between the two:

Quintile          Cost of Services          Benefit Principle         Difference

Bottom 20%    $33,402                        $22,339                         -33.1%

2nd 20%          $30,052                        $22,941                         -23.7%

3rd 20%           $30,144                        $27,125                         -10%

4th 20%           $31,122                        $33,284                         +7%

Top 20%          $35,141                        $68,545                         +95%

Buried in the report is the acknowledgement that the Benefit Principle approach results in a $1.2 trillion redistribution, opposed to the $2 trillion Hodge is so offended by in the article.  Reality is not nearly as punitive to the rich or as beneficial to the poor as the WSJ article would suggest.

Mr. Hodge uses questionable methodology to determine how much money is being redistributed via taxes and government services, provides a heavily skewed and utterly meaningless ‘average’ income as a target, and then attacks any efforts to address income inequality as exacerbating a situation already unfairly burdening the nation’s higher earners.  And he calls these ‘facts’ the “missing pieces of the current inequality debate.”

No, these are the missing pieces of the current inequality debate:

  • Why are people earning an average of $9,561 per year paying $6,331 (or 66.2%) of their income in various taxes?
  • Why is the average income of the bottom 20% of Americans only $9,561 when that average specifically excludes those who don’t earn anything or earn less than they pay in taxes?
  • Why is there so much distance between the average family income in each of the quintiles?  (224.8% between bottom and 2nd, 83.2% between the 2nd and 3rd, 76.2% between the 3rd and 4th, and 210.7% between the 4th and top; the top quintile earns 3,157% more than the bottom)
  • Why is there so much disparity within the top 20%?  (50.2% between the top 20% and the top 10%, 52.1% between the top 10% and the top 5%, and 179.2% between the top 5% and the top 1%)
  • What are the policies that reward short-term stock returns (business and capital gains income for the wealthy) at the expense of cost-cutting (lay-offs, benefits reduction, and downward pressure on salaries for the working and middle class), and what can be done about them?
  • Is the way the government spends the money it receives from the people beneficial to the people (all of them, not just the ones who pay the most)?

Mr. Hodge and his Tax Foundation report are simply perpetuating the myth that the miscreant poor are living large on the backs of the hard-working wealthy.  Not only does that not contribute to the solution, it denies the very existence of the problem.

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