Paul Krugman won the Nobel Prize this week and that tells you all you have to know about how politicized the award has become. American writers no longer win prizes for literature because they are "no longer mainstream," but Paul Krugman -- well, he hates the Bush Administration! He's one of us.
There's more to Krugman's fame, though, than just pandering to European aristocrats. In one of the shallowest intellectual gambits of recent decades, Krugman has been the point man for the bizarre thesis that America has become the "land of inequality." For the last five years Krugman has used his New York Times column to trumpet the theory that nearly all the wealth creation since the Reagan Era has accrued to approximately 13,000 families at the top while the rest of America wallows in squalor. Here's the way he puts it on his website:
Since the late 1970s the America I knew has unraveled. We're no longer a middle-class society, in which the benefits of economic growth are widely shared: between 1979 and 2005 the real income of the median household rose only 13 percent, but the income of the richest 0.1% of Americans rose 296 percent.… [T]he winners' circle is actually very small. Even households at the 95th percentile… have seen their real income rise less than 1 percent a year since the late 1970s. But the income of the richest 1 percent has roughly doubled, and the income of the top 0.01 percent... has risen by a factor of 5.
Krugman's thesis -- "Income inequality in America is now the greatest since the 1920s" -- has become an article of faith in liberal politics, endlessly reiterated in New York Times editorials and among Democratic politicians. And it has become the main impetus for Barack Obama's "spread the wealth" tax plan that will supposedly lower everyone's taxes except that undeserving top 5 percent, who have been hogging all the wealth since 1980. So let's see where Krugman gets his information and what the effect of Obama's plan is going to be.
Although crusading American economists have been massaging the numbers ever since Bill Clinton left office, the chef d'oeuvre was performed by two Frenchmen, Thomas Piketty and Emmanuel Saez, in a 2001 paper written for the National Bureau of Economic Research and titled "Income Inequality in the United States, 1913-1998," At the time Piketty had barely visited the United States and Saez had parachuted into Berkeley where he found a warm welcome. Without taking much time to examine American society the pair reached the astounding conclusion that 90 percent of Americans were living on an average income of $25,000 a year -- barely above the poverty line of $20,000 -- while the rest of America's wealth was concentrated at the very top. In other words, conditions were not much different from France at the outbreak of the French Revolution.
NOW LET'S START with a little common sense. Look around you. Does America seem to you like a country where 90 percent of the population is living barely above the poverty line? One out of every twelve Americans annually visits Disney World, making Orlando the nation's 9th busiest airport. With children in tow, the trip easily costs several thousand dollars yet the place is always packed. Eighty percent of American homes now have air conditioning. Almost everyone owns a television set. Seventy-five percent have a cell phone. The poorest in America -- the people in the bottom "quintile" -- live as well as the average American did in 1970. Calorie intake is now perfectly level across all classes in America -- meaning we have reached the millennial dream where everyone has enough to eat.
In fact if the rich suffer at all today it is because what were once considered exclusive luxuries have become accessible to the masses. Nantucket, once a hideaway for the rich, has been invaded by McDonald's. BMW now sells a luxury car for downscale buyers. Americans now employ 9,000 personal chefs, as opposed to only 400 a decade ago. Godiva chocolate, once available only in Neiman Marcus, has now invaded Hallmark Card. The situation got so bad that Godiva finally brought out a special "G" line of handmade chocolates at $100 a pound in order to keep its richest customers happy.
So how did Piketty and Saez get things so wrong? Probably a third grade math teacher could figure it out.
First of all, they measured income by looking at individiual income tax returns. Right away you can see the problem. People working part time file income tax returns. Teenagers with summer jobs file returns. Babies in their crib with college funds file. This wildly distorts the picture. Say you're a married couple making $150,000 a year with three teenagers in the house. All three have summer jobs each making $3,333.33. That makes your household income $160,000. You'll have to file four income tax returns. That makes the average income $40,000 and the median $3.333.33. It's easy to see why personal tax returns do not reflect family or household income.
In fact the average household income has risen from $44,000 in 1980 to $57,000 in 2006, a 30 percent increase. Yet even that doesn't really capture rising affluence. Over the same period the size of the average household has shrunk from 3.2 persons to 2.6. That's because families are smaller, elderly persons live more independently, and children are more likely to move out on their own. Alan Reynolds, who has critiqued the entire Piketty/Saez/Krugman axis in his book Income and Wealth, points out that Krugman and other interpreters continually misrepresent P&S by saying they measured "household" and "family" income rather than individual tax filings. Reynolds probably won't win the Nobel Prize for his effort.
Another amazing distortion is that Piketty and Saez's database does not reflect taxes, Social Security or any other government transfers. The "rising inequality" Democrats have detected over the past eight years doesn't include those government programs designed specifically to redistribute income. When these are included the "Gini coefficient," a mathematical equation that expresses income inequality, falls 25 percent.
Still, the biggest distortion is yet to come. It turns out that the "individual income tax filings" no longer represent only individuals. Half the corporations in America now file "personal" income tax returns under Subchapter S. The big switch came after the 1986 tax reform, which lowered personal rates from 64 to 70 percent down to 28 percent, while corporate rates remained at 30 percent. At the time thousands of doctors, lawyers and farmers were forming C corporations so they could file at the lower corporate rate. All that changed after 1986 and corporations began switching to subchapter S to file personal returns. In 1986 S-corporations with up to 35 stockholders were eligible. This was expanded to 100 stockholders in 1990 and the Small Business Protection Act of 1994 allowed banks to file under subchapter-S. One-quarter of all business profits in the country now file under personal income taxes. These are the figures Piketty, Saez and Krugman are reading when they discover the "super-rich" who have been hogging America's income over the last twenty years.
AND SO WE COME to the crux of why Barack Obama's "share-the-wealth" program will stifle the economy and why John McCain is absolutely right when he says small businesses are the real target. Most of the supposed "growing inequality" in America simply reflects the migration of small businesses into personal income filings. Now Barack Obama is going to try to punish these job-generators by going after them with higher taxes. As everyone now knows after Wednesday's Hofstra debate, the plan was on display this week when Joseph Wurzelbacher, a self-employed Ohio plumber, told Obama, "I work 10 or 12 hours a day to build my business. Don't you believe in the American dream? Why do you want to raise my taxes?" To which Obama responded: "I want to make sure that everybody who is behind you, that they've got a chance for success, too. I think when you spread the wealth around it's good for everybody."
Good for everyone, that is, except those who work hard. As Reynolds points out, 80 percent of the high earners in the upper quintile are career couples holding down two full-time jobs. People in the top quintile work the longest hours in the economy while people in the bottom quintile work the least. High-income households now have an average of three people in the work force while those in the bottom quintile have only .5. Of course much of this only means that people in the bottom quintile are retired people living on pensions and Social Security or young people just starting out on their own. Forty-six percent of people living in poverty own their own homes and the poverty rate -- 11 percent -- is now the lowest in history.
So what will be the outcome of this misguided effort to redress a problem that doesn't exist? Small businesses will simply migrate back to C-corporation status, where the tax rate of 35 percent is still the second-highest in the world. Tax revenues will fall. Job creation will decline and more work will be outsourced. Two-career couples will cut back on their grueling workload and start looking for tax shelters instead. Meanwhile, the welfare system will be reinvented as a "refundable tax credit" that is nothing but a government check. People at the bottom will once again find it more rewarding to live on the dole while people like Joseph Wurzelbacher will decide maybe the American Dream isn't worth all that work after all. Poverty rates will increase because, in a strange way, poverty has become more attractive. Stagflation is the probable result. And all because crusading economists decided to play a few new tricks with numbers.
Is there a recall system for Nobel Prizes? Maybe it's time to start considering one.