• Chart of the Week
  • February 16, 2021

Business incomes at the top

A businessman fills out his income taxes.

Pra Chid

In 1980, the top 1 percent of income-earners in the United States made 10 percent of the total income. By 2019, they earned 19 percent—more than all of the bottom 50 percent of earners combined. This trend has alarmed economists and policymakers, and the COVID-19 pandemic may only be making things worse. 

However, a large portion of the long-run rise in income inequality may be a shift in how the richest individuals report their income, according to economists Wojciech Kopczuk and Eric Zwick.

Their paper in the Journal of Economic Perspectives explored how tax policy shapes the way businesses are organized, which in turn changes how companies distribute economic gains to owners.

The typical top 1 percent earner is not a public company executive or tech billionaire. Most of them are doctors, lawyers, or owners of medium-sized businesses.

After the 1986 tax reform, many in this wealthy group changed their businesses from traditional C-corporations to so-called “pass-through” entities. Profits for these organizations are passed through directly to the owners, which means that business income falls under the individual income tax instead of the corporate tax.

Many standard measures of income inequality don’t reflect this distinction.

Figure 3 from the researchers’ paper shows how much inequality is due to changes in pass-through income.

 

 

Figure 3 from Kopczuk and Zwick (2021)

 

The blue dotted line shows the share of income earned by the top 1 percent, as measured by economists Thomas Piketty and Emmanuel Saez. (All income in this figure is pretax fiscal income including capital gains—without adjustments for broader sources of compensation, such as fringe benefits.) It shows the enormous swings in the share of earnings for the rich over the 20th century.

The red squared line indicates the share of income earned by the richest 1 percent if the share of income from pass-through businesses was fixed at the 1980 level.

A key takeaway from the chart is that nearly half of the recent increase in fiscal income for the top 1 percent comes from pass-through businesses.

The researchers’ work shows the importance of business income—as well as arcane details in the tax code—for the measurement of top incomes. It may help economists pinpoint exactly why inequality is being driven to new heights.