A new study finds that the increase in income inequality has more to do with a different group of earners (not necessarily idle millionaires): America’s “working rich,” according to a report co-authored by Princeton University.
Entrepreneurs and highly skilled professionals operating businesses prevail among the top 0.01%. These “working rich,” which include lawyers, physicians, financial professionals, auto dealers, and beverage distributors, receive most of their income from human capital, the study reveals.
“We set out to understand what has been driving top incomes in recent years, and that upended some previous findings about the rich,” says co-author Owen Zidar, assistant professor of economics at Princeton University’s Woodrow Wilson School of Public and International Affairs, in a release. “People are earning a lot of dollars through private businesses, and that’s important evidence that should influence the debate around taxing millionaires.’”
Zidar co-authored the report with Matthew Smith of the U.S. Department of the Treasury; Danny Yagan of the University of California, Berkeley; and Eric Zwick of the University of Chicago Booth School of Business.
The team examined more than 11 million firms between 2001 and 2014, before the 2017 Tax Reform was passed, and found the vast majority of the top income comes from “pass-through” businesses wherein profits and losses are passed through the operators themselves. Essentially, the top .01% are not paying corporate and dividend taxes around 50 to 55%, but instead pay 11.6% or less.
The new findings provide valuable insight into the secret world of entrepreneurs whose human capital income is critical for understanding top incomes. Researchers specify the need for a more harmonized business tax system, more highly skilled professionals, and the need to modernize the educational system to produce more innovators and entrepreneurs.
Researchers explained the evolution of the top .01%: Reagan-era tax reforms increased tax liabilities for businesses and reduced them for individuals. While this has been great for small firms over the last three decades, it made the concept of the pass-through business more appealing for large business owners to game the system.
The report said the 2017 tax reform decreased taxes on qualifying pass-throughs. “It’s unclear which businesses qualify as a pass-through for the new deduction, as it’s been done in an ad hoc way. So, architecture and engineering firms receive the new 20% rate, while other service firms and consultancies do not,” explains Zidar. “It’s complicated in terms of who is eligible, but it’s now among the biggest tax breaks in the tax code.”
Zidar said the median number of owners for pass-through companies is generally two people, and these individuals are earning their peak income in their 50s. He pointed out that these high incomes are not based on “idle ownership of financial assets.” For about 9/10 of these businesses, the owners are incredibly active in daily operations. As an example, most income is derived from providing a service, but can also be generated through personal networking, reputation and recruitment abilities of entrepreneurs.
“It’s common to wonder whether business owners grew the pie, or simply extracted more money from workers,” says Zidar. “It looks like both are important, but growing the pie may be more significant.”
Researchers wanted to understand whether the owners were operating their businesses, so they examined what happens when an owner dies or retires. In many cases, profits collapsed by more than 80%.
Zidar also said these findings exemplify what is often overlooked in discussions of income inequality. There is an entire class of wealthy Americans who are gaming the tax system, by the way money flows through in human capital income.
These finds are a wake-up call for the need to reform the business tax system, the urgent need for more skilled workers and the need for better educational opportunities to empower the next generation of innovators and entrepreneurs,
“We show that if you look and decompose this income, a lot of it comes from these pass-through businesses, and that activity more closely resembles labor than the idle rich,” concludes Zidar. “Our results suggest that educating the country’s next generation of innovators may be more important than tax incentives.”
You now know how the top .01% game the tax system.