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PASSING FANCY

Lawyers and car salesmen are America’s prototypical capitalists

President Donald Trump grabs a box containing the tax bill after signing it in the Oval Office of the White House, Friday, Dec. 22, 2017, in Washington.
AP Photo/Evan Vucci
Trump signed a tax bill in 2017 that included a big break on pass-through income.
  • Tim Fernholz
By Tim Fernholz

Senior reporter

As US representative Alexandria Ocasio-Cortez proposes a 70% top marginal tax rate and aspiring presidential candidate Elizabeth Warren pitches a 2% wealth tax, the whys and wherefores of taxing America’s highest earners are returning to the policy stage.

These proposals grow from increasingly detailed efforts to measure economic inequality in the US. One finding 1 suggests that only 45% of the income earned by the top 1% of earners—people who made more than $265,000 in 2014— comes from labor. The rest comes from capital earnings, creating an image of the idle rich sitting around waiting for checks from their broker, or corporate executives whose compensation comes largely in the form of stock grants. 

1
That paper, "Distributional National Accounts: Methods and Estimates for the United States," was written by Thomas Piketty, Paris School of Economics; Emmanuel Saez, UC Berkeley; and Gabriel Zucman, UC Berkeley. Piketty helped kick off this conversation with his book "Capital in the 21st Century."

A new paper drawing on a unique dataset of anonymized US tax records 2 shifts this conversation. According to this analysis, 56% of the money earned by the top 1% of earners in the US comes from labor. That’s not a huge departure, but more interesting is that most of that labor income came from businesses these high earners own and operate.

2
The new paper, "Capitalists in the Twenty-First Century," with a title referencing Picketty's book, is by Matthew Smith, US Treasury Department; Danny Yagan, UC Berkeley; Owen Zidar, Princeton; and Eric Zwick, Chicago Booth.

In other words, the researchers suggest that many people in the top 1% aren’t corporate executives or heirs, but in fact owners of mid-sized regional firms.

A certain class of income

One concept is vital to understanding this paper: pass-through income, which is money earned by a business and “passed through” to the owner or partner’s personal income-tax bill, rather than taxed at corporate rates.

The category is nebulous. Because financial businesses like hedge, private equity, and real estate investment funds classify their earnings in this category, it can be considered capital income—or, because lawyers, doctors, and other professionals classify their income as pass-through, it can be considered labor income. Fidelity Investments and the Hobby Lobby are pass-throughs, and your plumber probably is, too.

With the tax debate often cast in terms of capital vs. labor, economists deliberate about what pass-through income should be considered. Anonymized US tax records helped the authors of the latest paper figure out the split. They were able to identify owner-operators of firms, and then see what happened to their firms when they died or retired between 2005 and 2010. This natural experiment allowed the researchers to put an estimate on the value of the owners’ involvement in the firm—in other words, how much their labor mattered.

With the owner removed from business, profits fell considerably. The economists estimated that about 75% of the profits from those businesses were the result of the owner’s human capital, and that 75% of pass-through income should thus be classified as profits from labor, not capital. The researchers describe this as “a world of entrepreneurs hidden from public view,” in contrast with popular depictions of the ultra-wealthy.

The best work in the world

What kind of work are we talking about? A “typical firm owned by the top 0.1% might be a regional business with $20M in sales and 100 employees, such as an auto dealer, beverage distributor, or a large law firm,” the paper notes. “The five largest industries for millionaire-owned pass-through profits are legal services ($28.6B), other financial investment activity ($28.2B), other professional and technical services ($8.2B), offices of physicians ($8.0B), and auto dealers ($6.7B).”

Still, it’s worth noting that even when categorized as labor, these earnings aren’t the result of the invisible hand, but frequently decisions made by government policymakers.  In the case of professional workers, years of costly training and licensing exams give them lucrative skills, but also the ability block out competition. Physicians, paid more in the US than anywhere else, live under misguided policies that make attempting to offer more efficient medical service effectively a waste of their time. Financial investment activity is a kind of labor, but one that depends on access to lot of capital, too—and whether many pass-through investment funds even create much value remains an open question.

The non-professional examples aren’t exactly Thomas Edison creating GE, or even Mark Zuckerberg coding Facebook. Beverage distributors and auto dealerships are built on connections: To succeed, you need to win the right to sell for a major producer, which can require putting down deposits reaching into the millions of dollars, and gaining regulatory permission on multiple levels.

Beyond a guaranteed market, these industries use their political clout to stop taxation. “State legislatures basically vote [beer] distributors the license to print money,” UCLA public policy professor Mark Kleiman told Quartz in 2015. Auto dealerships in 48 states back laws that prevent the direct sales of cars from manufacturers to consumers, a problem that has frustrated start-up automaker Tesla and leaves consumers effectively forced to pay higher prices to a middle-man.

Policy puzzles

Examining the biggest success stories in American capitalism can offer us one reminder: In the hockey-stick curve of US inequality, the top 1% of households isn’t a super useful category, spanning two-earner white-collar families up through titans of industry.

It also adds more evidence to the argument that the tax bill enacted by Congress and signed by president Donald Trump in 2017, which included a large tax cut on pass-through income, largely benefits the highest earners, not the middle class.

And this research doesn’t dispute the idea that inequality has grown in recent years. According to the incomes data, from 1946 to 1980, the middle 40% of Americans say their earnings grow 98%; between 1980 and 2014, they grew 49%. In the same two periods, the top 1% saw their incomes grow 58%—and 194%.

As you go higher, the labor dwindles: Among all million-dollar earners in 2014, just 53% of earnings came from labor. Among the top .1%—people who earned more than $1.1 million in 2014—just 45% comes from labor. That helps explain the focus for Democrats on tackling households with over $50 million in wealth (Warren) or $10 million in income (Ocasio-Cortez). Those people are far above the .1%.

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