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Executive Summary #1791 on Taxes

August 24, 2004

August 24, 2004 | Executive Summary on Taxes

Executive Summary: Two Americas: One Rich, One Poor? UnderstandingIncome Inequality in the United States

Class warfare has always been a mainstay of liberal politics. For example, vice presidential candidate John Edwards has declared, "There are two Americas...one privileged, the other burdened ...one America that does the work, another America that reaps the reward. One America that pays the taxes, another America that gets the tax breaks."

This week, the Census Bureau will release its annual income and poverty numbers. The Census report will also contain the income distribution figures that serve as the foundation for most class-warfare rhetoric. The new figures can shed light on the true picture.

The Census measures income distribution by ranking U.S. households according to income, dividing them into five groups or quintiles, and then measuring the share of total income going to each quintile. In 2002, the Census reported that the top fifth of households had 49.7 percent of income, while the bottom fifth had only 3.5 percent. Thus, the top appeared to have $14.20 of income for every $1.00 at the bottom. (The figures for 2003 will be nearly identical since the data change only minutely from year to year.)

The Census figures, however, are incomplete and therefore misleading. In the first place, they ignore taxes and most of the social safety net. Each year, higher-income working families pay heavy taxes to support safety net benefits for the less affluent. For example, in 2002, government spent over $500 billion on means-tested welfare (including cash, food, housing, and medical care) for the poor and near poor and over $250 billion subsidizing medical care for the elderly through Medicare. These benefits absorb over 8 percent of total personal income and represent a massive shift of economic resources from higher-income families to those with less. They also represent a mammoth transfer of resources from those who work a lot to those who work less or not at all: a shift that is not reflected in conventional Census income inequality figures.

Fortunately, the Census collects data on taxes paid and benefits provided. These more complete income figures are seldom publicized, but they provide a more accurate--and very different--picture of income inequality. When taxes and benefits are counted, the gap between the affluent and the poor shrinks noticeably: The top fifth has $8.60 for each $1.00 at the bottom. But even these figures are misleading, since the Census fifths or quintiles do not contain equal numbers of persons. Each quintile does contain the same number of households, but the households at the bottom have few people while those at the top are large and have multiple earners. Consequently, the bottom income quintile has only 14 percent of the population while the top quintile has 25 percent. The bottom quintile has less income in part because there are relatively fewer people in it.

A simple adjustment of the boundaries of the income quintiles so that each fifth contains an equal number of people alters the income distribution numbers considerably. The post-tax/post-benefit income of the bottom rises to 9.4 percent of income while the top drops to 39.6 percent. Overall, the top fifth has $4.20 of income for each $1.00 at the bottom.

Much of the remaining inequality stems from inequality in work performed. Income inequality is, to a great degree, proportional to inequality in work performed. According to the conventional Census figures, the top quintile of households performs over a third of all paid labor, while the bottom performs only 4.3 percent. The low level of work at the bottom is due in part to a shortage of working-age adults within the bottom quintile, but it also reflects the fact that non-elderly adults at the bottom, on average, work half as many hours per month as do their higher-income counterparts. If the quintiles are adjusted to contain equal numbers of persons and non-elderly adults at the bottom work as many hours as adults in the rest of society, the income share of the bottom quintile would rise to 12 percent. The top quintile would have only $2.91 in income for every $1.00 at the bottom.

Is the distribution of income becoming less equal over time? According to conventional Census numbers, the income share of the top five percent of households rose from 15.8 percent of total income in 1980 to 21.7 percent in 2002. But all of that increase occurred in the 1980s and mid-1990s. For the past five years, the distribution of income has remained static. In 2002, after adjusting quintiles to contain equal numbers of persons, the ratio of the income of the top quintile compared to the bottom quintile was exactly the same as in 1997.

The top fifth of U.S. households (with incomes above $84,000) remain perennial targets of class-warfare enmity, but these families perform a third of all labor in the economy, contain the best educated and most productive workers, and provide a disproportionate share of the investment needed to create jobs and spur economic growth. Nearly all are married-couple families, many with two or more earners. Far from shirking the tax burden, they pay 82.5 percent of total federal income taxes and two-thirds of federal taxes overall. The bottom quintile pays 1.1 percent of total federal taxes.

In one sense, John Edwards is correct: There is one America that works a lot and pays a lot in taxes and another that works less and pays little, but the reality is the opposite of what he suggests. It is the higher-income families who work a lot and pay nearly all the taxes. Raising taxes even higher on hard-working families would be unfair and, by reducing future investments, would reduce economic growth, harming all Americans in the long run.

Robert Rector is Senior Research Fellow in Domestic Policy Studies, and Rea S. Hederman, Jr., is a Senior Policy Analyst in the Center for Data Analysis, at The Heritage Foundation.

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