Interpreting statistics

That the same set of statistics can lead to impressively contrasting sets of conclusions is well acknowledged. Here is one such example, courtesy Geoff Colvin in the Fortune (April 14, 2008).

The US IRS statistics for 2005, the most recent year for which data are available, reveals that the top 10% of tax payers paid 70% of the total income tax. The top 1% paid almost 40% of all income tax, a proportion that has jumped dramatically since 1986. Further, the bottom 40% of Americans by income had, in the aggregate, an effective tax rate that is negative - receiving more money through earned income tax credit, than they paid. All this gives the clear impression that American tax system has suddenly become progressive.

Or is it that simple? Are the rich being penalized for their wealth and industriousness? Closer analysis reveals that the rich are actually paying lower effective taxes. In fact, the top 1% paid an effective tax rate of 23% in 2005, down from 27.5% in 2001.

If the rich are paying more income tax, despite being taxed at a lower rate, it only means that their incomes are growing much faster than the rest of the population. While in 1986, an income of $119,000 got you into the top 1%, in 2005 it rose to $365,000. Adjusted for inflation, the price of admission still rose by 72%. In contrast, the inflation adjusted definition of a median tax payer did not budge.

About the Bush tax cuts, while it is true that the bottom 50% got a much bigger tax cut than the top 1%, its dollar value went mostly to the rich! Why? Again because the incomes of rich grew much faster, thereby reducing their effective tax rates.

Geoff Colvin feels that the whole tax debate should be about why some people's incomes are growing so much faster than the others, and not why the rich should pay most of the income tax.

Update 1
Harvard Professors Claudia Goldin and Lawrence F. Katz in their forthcoming book traces "the sharp rise in inequality (in the US) due to an educational slowdown."

Greg Mankiw sums up the work of Prof Goldin and Katz thus, "According to Professors Goldin and Katz, for the past century technological progress has been a steady force not only increasing average living standards, but also increasing the demand for skilled workers relative to unskilled workers. Skilled workers are needed to apply and manage new technologies, while less skilled workers are more likely to become obsolete."

In 1980, the top 0.01 percent of the population had 0.87 percent of total income. By 2006, their share had more than quadrupled to 3.89 percent, a level not seen since 1916. One out of every 10,000 American families has income in excess of $10.7 million. These lucky duckies number less than 15,000.

In 1980, each year of college raised a person’s wage by 7.6 percent. In 2005, each year of college yielded an additional 12.9 percent. The rate of return from each year of graduate school has risen even more — from 7.3 to 14.2 percent.