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February 20, 2014
News Analysis: The Gatsby Effect and the Middle Class
by Lee A. Sheppard

Full Text Published by Tax Analysts®

This article originally appeared in the February 17, 2014 edition of Tax Notes.
By Lee A. Sheppard --

The late Sir James Goldsmith predicted that if globalization went too far and the elites got too piggy, the middle class would disappear and with it consumption. Everything he predicted is happening. Consumption, except at the highest and lowest ends of the spectrum, is falling off a cliff. Goldsmith also predicted social unrest, which has not come to pass in the heavily policed United States, except sporadically with outbursts like the Occupy movement.

Edward Kleinbard of the University of Southern California Gould School of Law hosted a conference February 7 to explore the role of tax policy in inequality -- the fashionable word for the gradual destruction of the middle class. Although the term inequality is terse, and the president uses it, it is inapt, at least in the United States. Americans don't believe in equality. They believe that each generation should have a better life than the previous one, that houses should always appreciate, and that they should have a better car than their neighbors.

Before we explore the tax policy, let's look at a few causal factors in the decline of the middle class that were not explored at the USC conference.

The fall of communism. For decades, U.S. policymakers had no idea that the Communist countries were not the threat they imagined. Sure, they were heavily armed, but their economies were unproductive and shrinking. Three hundred million Russians produced the output of 90 million Westerners. But, convinced by silly CIA statistics, U.S. policymakers saw to it that U.S. workers were well paid so they wouldn't vote for Communist parties.

The destruction of unions. Once communism fell, the gloves were off. The Reagan administration's put-down of the air traffic controllers' strike gave business executives the signal that unions could be defied. The defanging of the National Labor Relations Board followed. Now, some of the largest employers in the United States, like Wal-Mart, are vigorously anti-union.

Globalization. Globalization is supposed to be the conversation stopper, but few analyze what it means. It was always possible for the United States to refuse to import products made by teenage girls locked in dingy factories, but labor standards were deliberately kept out of multinational trade agreements. Globalization was the trade liberalization agenda deliberately designed to hammer down U.S. wages. It succeeded admirably. U.S. workers are continually told that there is no entitlement to a living wage or a decent life for having been born in the United States.

Technology. Another conversation stopper. We are supposed to accept that all productivity increases resulting from technology accrue to the investor class. Blue-collar jobs are replaced by robots. Pink-collar jobs, and increasingly white-collar jobs, are replaced by computers. Digerati snobbery ensures that the populace believes that this new technology is good for everyone. But technological development does not dictate a top-heavy distribution of productivity gains, as even the Financial Times recognized (Financial Times, Feb. 12, 2014, p. 13).

Bank deregulation. When Glass-Steagall was repealed in 1999, the largest banks not only entered investment banking but began to model themselves on hedge funds. Recall what investment banking is supposed to do -- move money from investors to new companies that need it. Banks did some of that. But mostly, the former investment banks and the new universal banks turned themselves into giant trading and derivatives dealing operations -- backstopped by depositor money and government guarantees. Traders were paid according to reported profits lest they decamp to hedge funds. The Dodd-Frank Wall Street Reform and Consumer Protection Act has only dinged this business model.

The recession. A red herring. The mortgage meltdown that destroyed the big banks did not have to leak into the real economy. People with underwater mortgages could have been relieved of the debt exceeding the value of their houses through workouts and cramdowns in bankruptcy. That didn't happen. Instead, corporate executives glommed onto the bank meltdown as cover to fire large swaths of workers who had become unnecessary because of changes in technology.

Reagan Tax Cuts

Let's get back to the taxes. Research by Maria Guadalupe at Columbia University Business School documented that in times of high individual tax rates, executives of public companies did not pay themselves high salaries because they wouldn't keep as much of the money. When the Reagan tax cuts came in 1981, and the Tax Reform Act of 1986 cut rates further, they started paying themselves more. The 1992 enactment of section 162(m), which was intended to put a lid on executive compensation, backfired. Compensation based on share prices -- exempt from the statutory cap -- took off.

What does this mean for income distribution? About 30 percent of the 1 percent are executives of nonfinancial public companies. This does not include employees of the too-big-to-fail banks, which are technically corporations. Those employees would be among the 14 percent of this 1 percent who are financiers, which would include also hedge fund and private equity managers. Only 2 percent are entertainers. Los Angeles has some catching up to do. (Prior coverage: Tax Notes, Oct. 17, 2011, p. 307.)

Economist Emmanuel Saez of the University of California, Berkeley, presented statistics about what U.S. executive pay practices do to income distribution. Unfortunately, researchers are stuck using income tax data, which do not capture unrealized capital gains, and household surveys, which can be flaky, especially at the top end (what rich person would volunteer information?). But the data do show that pay practices didn't go crazy in countries like Germany and France, where individual rates were not lowered.

Saez demonstrated that the United States has returned to lopsided levels of income and wealth distribution last seen in 1927 -- also a period of technological upheaval and unregulated finance. The 1 percent get 50 percent of the income. Their income has a large capital gain component, but as Saez demonstrated, the salary component has increased markedly in recent years. "The working rich have replaced the rentiers," he said.

But the salary component proportion is starting to reverse. Saez explained that the 1 percent own 40 percent of total wealth. In 1927 the 1 percent owned 60 percent of total wealth. Now, however, the 0.1 percent own 20 percent of total wealth. This phenomenon has been called the Gatsby effect.

The 1 percent pay an average federal income tax rate of 22 percent, an amount equal to 3 percent of GDP. "They have a large potential tax capacity," said Saez, hinting that their taxes could be raised. Nonetheless, he believed that evasion would increase if tax rates were put up too much. Many live in New York, California, and Illinois, putting their total tax liability higher, and they are thought to flee high-tax states. "California is a great experiment," Saez quipped. For Saez, the question is whether the gains of the 1 percent have damaged the 99 percent.

Scott Winship of the Manhattan Institute for Policy Research demonstrated that the income tax data do not count transfer payments going to the 99 percent that reduce income inequality. These include food stamps (going to 1 in 6 households), Temporary Assistance for Needy Families, Medicaid, Social Security, and Medicare. Saez countered that transfer payments do not affect his argument. Indeed, when transfer payments are included, the prosperity of the middle class can be distorted by a large number of elderly people receiving Social Security.

"The elderly make out like bandits in dollar terms," Kleinbard said later. The elderly receive roughly 70 percent of all transfer payments -- which results in a net benefit (after taxes) of $20,000 per household. Should all of Social Security benefits be taxed? Kleinbard's view was that taxation wouldn't make a dent in inequality, but that removal of the income limits on Social Security taxes would reduce income inequality.

Winship noted that productivity gains were shared with workers when unions were strong. He mentioned the dirty little secret of middle-class prosperity -- the white male wage of the '50s and '60s, which he called the family wage. We're not being racist here -- a worker had to be white and male to earn a wage that would support a family of four or more, with a defined benefit pension and first-dollar health insurance. Blue-collar workers got this deal through unions. White-collar workers were virtually guaranteed a floor under their wages if they had college degrees -- any kind of college degree.

Saez and Winship agreed that the U.S. consumer price index deflator is flawed, but their prescription was chained CPI, rather than inclusion of food and fuel in the calculation.

Capital Gains Preference

Eric Toder of the Urban Institute noted that tax policy affects market outcome -- as the Saez data demonstrated. The rich have a high propensity to save tax cuts, while the lower classes spend them, increasing consumption (70 percent of U.S. economic activity).

"The rich are different from you and me. They have more assets. We tax those assets lightly," said Steven Rosenthal of the Urban Institute, continuing the Gatsby theme. He noted the lack of IRS enforcement, especially the failure to audit large partnerships.

Rosenthal advocated taxing capital gains at ordinary rates, provided those rates are not too high. Indeed, a notable trend among the American panelists -- Saez is French -- was a reluctance to raise individual rates on the highest earners.

There was also an obsession with Bill Gates and other founders sitting on billions of unrealized capital gains -- although your correspondent did not succeed in prodding any commentator to endorse marking publicly traded shares to market. Victor Fleischer of the University of San Diego fretted that marking would discourage public listing.

Fleischer wanted to levy an extra tax on the extra-normal component of founders' gains (most capital gains are inflationary). Well, gee, don't we want to reward sweat equity, as opposed to backstabbing corporate executives with share-based compensation? "People would have started their companies anyway," said Fleischer. So there is no need to subsidize this activity with a lower capital gains rate.

Todd Molz of Oaktree Capital Group LLC acknowledged that "we have a fundamentally elective tax regime." He no doubt depressed many in the room when he noted that he used to be a tax lawyer. Molz maintained that the administrative treatment of profits interests was an essential part of subchapter K, which has its own special logic that should not be messed with by something like the proposed section 710 ordinary income treatment.

"Subchapter K did not come down from the mountain on stone tablets with Moses," Kleinbard reacted.

"Private equity exalted the sweat equity idea into an art form," said Rosenthal. Managers' profits interests represent labor income taxed at capital gains rates, he said. "There shouldn't be a license to leverage and manipulate the system," he said. Private equity and hedge funds have so much debt that the equity component is essentially an option.


Since Reagan, redistribution has become a dirty word in U.S. politics. Right-wing think tanks have labored for years to convince politicians and the populace that market outcomes are just and divinely mandated, so that messing with them is heresy. As Eric M. Zolt of UCLA School of Law noted, the debate must be moved away from the idea that the market is some kind of magic.

"The enmity of the rich makes the process stickier," said Kleinbard, advocating that the words "social investment" be substituted for redistribution.

"Government doesn't exist to redistribute. Government exists to spend," said Kleinbard. "We overstate the importance of progressive taxation. We need to think about progressive spending. Progressive taxation is not enough to get us to a progressive system."

Indeed, a comparison of the U.S. and European systems shows that while the United States has very progressive taxation, its system as a whole is shockingly regressive. Government taxation and spending move the U.S. Gini coefficient from a high 46.4 to a still high 38.4. Taxation alone takes the Gini coefficient to 44.

European systems are the opposite. Regressive taxation (with a heavy reliance on VAT) and a larger government role in the economy support highly progressive spending. "It's OK to have regressive taxes to fund progressive transfers," said Kleinbard. "VAT is a regressive tax but a progressive fiscal instrument."

Kleinbard advocated raising income taxes on the middle class to Clinton-era levels to fund progressive transfers. "We have lots of room in the income tax to raise revenue without increasing the top rate. But we need progressive spending, including progressive tax expenditures." He bemoaned the top-heaviness of tax expenditures.

Donald Marron of the Urban Institute explained that a high level of redistribution and achievement of rough income inequality are feasible, but not necessarily desirable. That is because it would assume that all government spending is good.

The United States spends a quarter of its budget on the military -- 44 percent of total world military spending. What former Rep. Barney Frank dubbed "weaponized Keynesianism" is actually a drain on the real economy, even if it boosts employment in some congressional districts.

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