Brookings Papers on Economic Activity: Fall 2010

Overview

Brookings Papers on Economic Activity (BPEA) provides academic and business economists, government officials, and members of the financial and business communities with timely research on current economic issues.

Contents:

• Editors' Summary

• The Increase in Income Cyclicality of High-Income Households and Its Relation to the Rise in Top Income Shares
By Jonathan A. Parker and Annette Vissing-Jorgensen ...

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Overview

Brookings Papers on Economic Activity (BPEA) provides academic and business economists, government officials, and members of the financial and business communities with timely research on current economic issues.

Contents:

• Editors' Summary

• The Increase in Income Cyclicality of High-Income Households and Its Relation to the Rise in Top Income Shares
By Jonathan A. Parker and Annette Vissing-Jorgensen (Northwestern University)

• The State of the Social Safety Net in the Post-Welfare Reform Era
By Marianne P. Bitler (University of California, Irvine) and Hilary W. Hoynes (University of California, Davis)

• The Impact of No Child Left Behind on Students, Teacheres, and Schools
By Thomas S. Dee (University of Virginia) and Brian A. Jacob (University of Michigan)

• How Useful Are Estimated DSGE Model Forecasts for Central Bankers?
By Rochelle M. Edge (Board of Governors of the Federal Reserve System) and Refet S. Gürkaynak (Bilkent University)

• Regulating the Shadow Banking System
By Gary Gorton and Andrew Metrick (Yale University)

• State Fiscal Policies and Transitory Income Fluctuations
By James R. Hines, Jr. (University of Michigan)

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Product Details

  • ISBN-13: 9780815721574
  • Publisher: Brookings Institution Press
  • Publication date: 3/16/2011
  • Series: Brookings Papers on Economic Activity
  • Pages: 350
  • Product dimensions: 5.90 (w) x 9.00 (h) x 1.00 (d)

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Brookings Papers ON ECONOMIC ACTIVITY


BROOKINGS INSTITUTION PRESS

Copyright © 2011 THE BROOKINGS INSTITUTION
All right reserved.

ISBN: 978-0-8157-2157-4


Chapter One

JONATHAN A. PARKER Northwestern University

ANNETTE VISSING-JORGENSEN Northwestern University

The Increase in Income Cyclicality of High-Income Households and Its Relation to the Rise in Top Income Shares

ABSTRACT We document a large increase in the cyclicality of the incomes of high-income households, coinciding with the rise in their share of aggregate income. In the United States, since top income shares began to rise rapidly in the early 1980s, incomes of those in the top 1 percent of the income distribution have averaged 14 times average income and been 2.4 times more cyclical. Before the early 1980s, incomes of the top 1 percent were slightly less cyclical than average. The increase in cyclicality at the top is to a large extent due to increases in the share and the cyclicality of their earned income. The high cyclicality among top incomes is found for households without stock options; following the same households over time; for post-tax, post-transfer income; and for consumption. We study cyclicality throughout the income distribution and reconcile our findings with earlier work. Furthermore, greater top income share is associated with greater top income cyclicality across recent decades, across subgroups of top income households, and, in changes, across countries. This suggests a common cause. We show theoretically that increases in the production scale of the most talented can raise both top incomes and their cyclicality.

Since the early 1970s, economic inequality in the United States—as measured by the distribution of wages and salaries, or of income more broadly, or of consumption expenditure—has been steadily increasing. The consensus explanation for the general increase in inequality is that skill biased technological change has raised the earnings of individuals with more skills, as measured, for example, by education. However, accompanying this steady rise in inequality has been a much larger and more rapid increase in the income share of those at the very top of the income distribution. The share of (non-capital gains) income accruing to those in the top 1 percent of the income distribution increased from 8 percent in the early 1980s to 18 percent in 2008; the income share for those in the top 0.01 percent increased from around 0.7 percent to 3.3 percent over the same period (Piketty and Saez 2003, Saez 2010). Both the suddenness and the magnitude of these increases have shifted perceptions about the importance of technological change as the cause of increased income inequality generally and raised the possibility of an important role for other factors, such as "changes in labor market institutions, fiscal policy, or more generally social norms regarding pay inequality" (Piketty and Saez 2003, p. 3).

In this paper we bring together evidence from a variety of datasets to show that, as first argued in Parker and Vissing-Jorgensen (2009), another fundamental shift has occurred across the U.S. income distribution. During the past quarter century the incomes of high-income households have become much more sensitive to aggregate income fluctuations than previously. Before the early 1980s, the incomes of high-income households were more often than not less cyclical than the income of the average household. But since around 1982 the incomes of the top 1 percent have become more than twice as sensitive to aggregate income fluctuations as the income of the average household.

The fact that this increase in the cyclicality of income of the top 1 percent coincides with the increase in their income share suggests that a common cause underlies both phenomena. We provide further evidence for a link between increased income inequality and increased income cyclicality at the top by documenting, first, that across income groups within the top 1 percent, higher average income is associated with higher income cyclicality in the 1982–2008 period; second, that across decades since the 1970s, cyclicality of the top 1 percent increases decade by decade as that group's income share increases; and third, across countries, increases in income cyclicality of the top 1 percent are highly correlated with increases in their income share.

We argue that these facts are not inconsistent with the hypothesis that the increase in top income shares was caused by rapid technological progress in information and communications technologies (ICT) since the early 1980s. If improvements in ICT have increased the ability of the most talented workers to handle more work or to scale their ideas by working with more production inputs, then the ICT revolution could have caused the incomes of the highest paid both to rise and to become more sensitive to economic fluctuations. The intuition is that individuals who have less decreasing returns to scale will operate at a greater scale (that is, with more production inputs) and have lower ratios of gross revenue to production costs, and therefore have greater sensitivity of earnings to business cycles.

Expanding on these contributions, we begin in section I by focusing on the details of the change in income cyclicality of top income groups in the United States. We use the Statistics of Income (SOI) data of Thomas Piketty and Emmanuel Saez (Piketty and Saez 2003, Saez 2010), which are based on tax records, to show that the average income (before taxes and transfers and excluding capital gains) accruing to those in the very top of the income distribu-tion has moved substantially more (in percentage terms) than the overall average in each boom and each recession since 1982, on average rising 5.0 percentage points more per year in each boom and falling 3.7 percentage points more per year in each recession. Before 1982, however, this was not the case.

This high cyclicality is not simply due to capital or entrepreneurial income. High-income tax units (one or more individuals filing a single return) tend to have a significant share of income from wages and salaries (including bonuses), and this type of income has roughly the same exposure to fluctuations as their nonwage income. Wage and salary income is also a major source of the change in cyclicality of top incomes. Before 1982 the wage and salary income of high-income tax units was roughly acyclical, but since 1982 it has been highly cyclical. Also, we show that the top 1 percent of earners come from a broad range of industries and occupations, and we argue that no one industry's or occupation's pay structure is driving our finding.

Further, we provide three pieces of evidence that although high-income households are more likely to have stock options, our main finding is not driven by the potentially endogenous timing of the exercise of stock options. First, in the period since 1997 for which we have data, only about 22 percent of households in the top 1 percent have stock options (that is, were given stock options during the preceding year or owned stock options when surveyed), and income cyclicality of households in the top 1 percent is roughly similar if one leaves out households with stock options. Second, for a sample of top corporate executives for whom we have information about the value of options granted, we find that income calculated by including options only when granted, rather than when exercised, is highly cyclical. To be clear, this evidence in no way rules out a causal explanation that involves a general rise in pay for performance—indeed, options income is highly cyclical for those who have options, and bonus income may serve a similar purpose for those in the top 1 percent without options income. Our point is simply that the high cyclicality of the wage and salary (and overall) income of the top 1 percent is not spuriously generated by a correlation between the timing of options exercise and aggregate fluctuations. Third, as a further piece of evidence that the high cyclicality is neither due to endogenous timing of income without economic significance nor due to other measurement problems in income data, we show that the cyclicality of the consumption of households in the top of the consumption expenditure distribution—specifically, the top 5 percent by initial consumption—is also more than twice that of the average household.

Additional evidence confirming the high cyclicality of top incomes comes from verifying the out-of-sample forecasts made in Parker and Vissing-Jorgensen (2009) based on cyclicality estimates that excluded the recent recession. Income data for 2008 and consumption expenditure data through February 2009 show sharp declines for the top 1 percent during the recent recession, consistent with these predictions.

How does this new fact relate to the prior literature that concludes that low-income households bear the brunt of recessions and benefit the most from expansions? In section II, using data from the Current Population Survey (CPS), we show that the incomes of low-education households are more cyclical than those of high-education households and that the greater cyclicality of the top 1 percent does not appear in the CPS before 1982. Further, looking at the whole distribution using a dataset from the Congressional Budget Office that merges the CPS with the SOI tax data on high incomes, we find that the sensitivity of the wage and salary income of households in the bottom two quintiles to fluctuations in aggregate income is slightly higher than that of households in the third and fourth quintiles and than that of households from the 80th to the 99th percentiles.

However, in the public CPS data for the period since 1982, when one ranks by percentile in the income distribution, the top 1 percent have a higher cyclicality than even the lowest education group (those with less than a high school diploma). The cyclicality of the top 1 percent is even higher when measured using the CPS top 1 percent income series constructed by Richard Burkhauser and coauthors (2008, 2009) from underlying CPS data not subject to the top coding applied to the public files. Thus, top incomes are highly cyclical, but it is harder to observe this high cyclicality in the publicly available CPS data alone because of top coding, and because cyclicality is high only for very high income households. We conclude that across the distribution of incomes, cyclicality is asymmetrically U-shaped: it is higher for the bottom quintiles than for the middle and the upper-middle class, but much higher for the top 1 percent, and especially for the very highest incomes.

Different cyclicalities of taxes and transfers at different points in the income distribution can lead to differences in cyclicality between pre-tax, pre-transfer cash income and disposable (post-tax, post-transfer) income. We show that taxes and especially transfers significantly reduce the cyclicality at the bottom of the income distribution while making less difference to the cyclicality of the very top. Thus, the cyclicality of top 1 percent incomes relative to the rest of the population is even greater for disposable income than it is for pre-tax, pre-transfer income.

Having established and explored our main finding for the United States, in section III we present evidence from Canada, which has a different tax system, slightly different culture, and better available information on top incomes from tax records. In the Canadian tax data, top income cyclicality is quite similar to that in the United States during the past quarter century. Further, in the Canadian data we are able to follow families across years (that is, we use panel data). Families in the top 1 percent of the income distribution in one year have income changes to the next year that are almost twice as cyclical as for the average. This higher cyclicality for the top 1 percent is similar in repeated cross-sectional data and in panel data, suggesting that the availability of only repeated cross-sectional data in the U.S. tax data is unlikely to substantially affect the estimated U.S. cyclicalities.

Section IV presents evidence of a strong link between increased income inequality and increased income cyclicality at the top by exploiting variation across groups, decades, and countries. We split the top 1 percent into three groups (percentiles 99–99.9, 99.9–99.99, and 99.99–100) and document for the period since 1982 that across these groups, the higher the average income, the higher the income cyclicality. Furthermore, calculating cyclicalities by decade since 1970, we show that for a given top group, as its income share increases, the cyclicality of its income increases. Finally, comparing the period 1970–82 with the period 1982&ndas;2007 using data for 10 countries, we find that those with larger increases in the income share of the top 1 percent also have larger increases in the income cyclicality of the top 1 percent.

The link between increased inequality and increased cyclicality suggests a common cause of the two phenomena. In section V we argue that the increase in cyclicality is not inconsistent with an explanation of the increase in top income shares based on market-driven changes in incomes rather than, for example, changes in social norms. Specifically, we outline an explanation for both phenomena based on the rapid improvements in ICT in recent decades. Skill-biased technological progress that takes the form of lowering the degree of decreasing returns to scale for the highest-skill individuals naturally leads to increases in both the incomes and the income cyclicality of these individuals.

We emphasize that our results do not imply that the utility or happiness of high-income households is more cyclical that that of the average household. In fact, if risk aversion is lower at high expenditure levels, the utility of high-income households may be less cyclical than that of lower-income households, even with higher income cyclicality. Instead, our main finding establishes a new fact that is informative about changes in incomes and the labor market for high earners and of particular relevance for theories of the recent rise in income shares of high-income households.

I. The Changing Cyclicality of High Incomes

In this section we document the changing cyclicality of the income that accrues to top percentile groups in the income distribution, using the Statistics of Income data compiled by Piketty and Saez (2003) and extended by Saez (2010). In doing so, we study the timing of the change in cyclicality documented by Parker and Vissing-Jorgensen (2009). We show that the dramatic increase in the cyclicality of high incomes started in the early 1980s, and that this increase is significantly due to earned income and not just due to the (potentially endogenous) timing of executive stock option compensation.

I.A. The Main Facts

The main advantage of the Piketty-Saez data is that since they are based on administrative data from the Internal Revenue Service (IRS) on individual income tax returns, they provide extensive and accurate measurement of the very top of the income distribution. However, since some low-income households do not file tax returns (and even fewer did in the earlier years covered by the data), there is little detail on the low end of the income distribution. Piketty and Saez use aggregate personal income data from the national accounts to calculate aggregate taxable income up to 1944; after 1944 they use the available tax return data plus an assumption about the incomes of nonfilers. Using these data, Piketty and Saez track the trend in the income share of the top 1 percent, 0.1 percent, and 0.01 percent of the income distribution, information simply not available in survey-based datasets on wages and incomes. The detail available on tax returns allows the measurement of pre-tax, pre-transfer cash income excluding realized capital gains. We exclude capital gains because our focus is on the timing of income, and the data contain only measures of realized capital gains, not capital gains as they accrue.

The data have some shortcomings, however. First, income excludes income paid as benefits (such as employer-paid health benefits and contributions to pensions) and excludes the employer share of payroll taxes (Social Security, Medicare, and unemployment taxes). Second, the unit of observation in these data is a tax unit, not an individual or a household. There has been a steady downward trend in the number of individuals per tax unit over time. This is a concern for measurement of trends if this ratio changes unevenly across income groups, but it poses less of a concern for our measurement of business cycle exposure. Third, the data are repeated cross sections and contain little information on demographics or other information that could allow one to track income changes for a constant population of households. Thus, the changes in income we report are based on income and income rank for groups of households that overlap but are not completely identical across years.

(Continues...)



Excerpted from Brookings Papers ON ECONOMIC ACTIVITY Copyright © 2011 by THE BROOKINGS INSTITUTION. Excerpted by permission of BROOKINGS INSTITUTION PRESS. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

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Table of Contents

Contents

Editors' Summary....................vii
The Increase in Income Cyclicality of High-Income Households and Its Relation to the Rise in Top Income Shares JONATHAN A. PARKER and ANNETTE VISSING-JORGENSEN....................1
The State of the Social Safety Net in the Post–Welfare Reform Era MARIANNE P. BITLER and HILARY W. HOYNES THOMAS S. DEE and BRIAN A. JACOB....................71
How Useful Are Estimated DSGE Model Forecasts for Central Bankers? ROCHELLE M. EDGE and REFET S. GÜRKAYNAK....................209
Regulating the Shadow Banking System GARY GORTON and ANDREW METRICK....................261
State Fiscal Policies and Transitory Income Fluctuations JAMES R. HINES JR....................313
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