This column by ACRU General Counsel and Senior Fellow for the Carleson Center for Public Policy (CCPP) Peter Ferrara was published September 9, 2011 on Forbes.com.

For the last two weeks, we have discussed the broad prosperity throughout society produced by Reaganomics and the resulting 25 year economic boom that started in 1982. We have shown how that has been obscured by changing demographics, cultural factors, work patterns, and some basic, fundamental misunderstandings regarding the true statistics themselves. But today we are going to discuss the most important intellectual blunder of all regarding analysis of economic inequalities during the Reaganomics boom.

Again the best work on these issues is the brilliant 2006 book by Alan Reynolds, Income and Wealth. I reprise and add to this analysis in my own recent book, America’s Ticking Bankruptcy Bomb.

Studies and media reports in recent years have raised alarms about supposed soaring incomes over recent decades concentrated among the top 1%. These statistics arise from trends of reported incomes on tax returns over these decades, going all the way back into the 1960s in some cases.

The fundamental blunder in all of these studies and reports is that the 1986 tax reform radically changed what is reported on income tax returns, so income before is not comparable to income after. As Reynolds notes, the Statistics of Income Division of the IRS itself tried to warn about this, saying, “Data for years 1987 and after are not comparable to pre-1987 data because of major changes in the definition of ‘adjusted gross income’ (AGI).” But the studies and media reports of the class warriors began doing precisely that.

The most important change is that the much lower individual income tax rates after tax reform, from a top rate of 70% when Reagan entered office to 28% after the reform, caused billions in business income to switch from corporate tax returns to individual tax returns as subchapter S corporations, partnerships, LLCs (limited liability partnerships), and proprietorships. These billions in business income naturally appeared primarily among the top 1% of income earners, causing the reported income for these upper earners to appear to soar during the 1980s, from before the 1986 tax reform to after the 1986 tax reform.

This is exactly the period when the results of Reaganomics were coming in. Studies and media reports consequently sounded the alarm that Reaganomics was causing massive increases in inequality and the incomes of the richest to soar compared to everyone else. But this was all based on a misunderstanding of the data. All that had changed was the way in which the income of the highest income earners was reported on different tax returns, as the IRS had tried to warn.

Moreover, more income from companies started since 1986 has also been reported on individual returns than would have been the case before the tax reform. That and the growth of the other businesses now reporting as individuals has made the top income shares measured by tax return data continue to appear to rise more rapidly since then.

By 1997, more than half of all U.S. corporations were subchapter S corporations reporting their income on individual income tax returns, primarily among the top 1%. By 2001, subchapter S corporations accounted for almost one-fourth of all before-tax corporate profits. Starting in 1996, banks were allowed to report their incomes as subchapter S corps. By 2003, over 2,000 banks were doing so, with the largest at $9 billion in assets.

Failure to understand this is confusing policy and the political debate to this very day. President Obama is dead set on increasing the tax rates for virtually every major federal tax on singles making over $200,000 a year, and families making over $250,000. That is the top 3% of taxpayers, including close to two-thirds of all small business income. Yet it is precisely these small businesses which are the economy’s most important job creators.

In addition, money losing businesses with negative incomes now reporting on individual tax returns were counted after 1986 among the bottom income earners as a result, which would further exaggerate supposed inequality. As Reynolds reports, “What looks like a very low income ‘household’ in the tax return data can include many normally profitable businesses having a tough year.” Indeed, subtracting these business losses from the bottom income shares makes entire population subgroups seem to be earning less than they really are.

Another important change is that until the 1986 tax reform, interest income on the trillions in municipal bonds was not required to be reported on individual tax returns. Afterwards, all that income concentrated among the wealthiest income earners was counted in the top income shares, again appearing to show rapidly rising inequality, as a result of “Reaganomics.” Yet, it was really just a result of tax reform, changing how income is reported on tax returns.

Moreover, most income from executive stock options is now reported as W-2 wage income, while before tax reform it was reported as capital gains when exercised. So studies of wage, salary and labor income count this large source of income concentrated among the top income earners in the later years, but not in the earlier years, showing a large increase in inequality and in the incomes of the top earners over the years. Yet that would be solely due to counting income in the later years that they did not count in the earlier years.

At the same time, after tax reform investment income of the more middle income workers was increasingly not counted because a rising share of that income was held in IRAs or 401(k)s, and so not reported on income tax returns. Indeed, the contributions to these accounts were even sometimes subtracted from taxable income, further reducing reported incomes among middle income workers. Reynolds notes that with $10 trillion in these accounts by 2002, at just a 7% return that would amount to $700 billion in investment income that year alone; mostly for more middle income earners not reported on income tax returns, and therefore not counted by income distribution studies based on tax return data.

Reynolds adds that the stock market boom in the 1990s caused IRA and 401(k) plans to triple in the 1990s, from about $2 trillion to nearly $6 trillion. Yet while the great majority of that $4 trillion in capital gains went to the bottom 99% of income earners, none of it was reported on income tax returns, and, therefore, none of it showed up in income distribution studies based on income tax return data. Yet, the great majority of the capital gains of the rich from the stock market boom were outside such accounts, and, therefore, were reported on income tax returns.

As Reynolds further explains:

Before these tax-favored savings plans became commonplace, virtually every dollar of investment income from the savings of middle-income taxpayers was reported as taxable income and therefore counted as income in studies that use those older tax returns to estimate income distribution. Today, by contrast, most investment returns from the savings of middle income taxpayers are rarely or never taxed. This makes it singularly inappropriate to use tax data to compare income shares before and after the explosion of tax deferred accounts.

Tax reform’s sharply falling tax rates themselves would cause the upper income earners most punished by the former high tax rates to report more income after tax reform. The lower rates would cause more income to rise and be reported out of tax shelters, and to be taken in taxable and reportable cash rather than in tax exempt benefits. The capital gains tax rate cuts in 1997 and
2003 caused a surge in reportable capital gains realizations outside tax protected retirement accounts. The sharp cut in the tax rate on dividends in 2003 caused a similar surge in dividends paid and reported. All of these effects caused further sharp distortions in comparing the trends in incomes for top income earners compared to others in the years before the tax changes relative to the years after the tax changes.

Tax return data is unsuited for measuring income distribution for other reasons as well. Transfer payments are not reported as income on tax returns, so all of this income for lower income households is missed. Moreover, many low income families do not even file income tax returns. Such tax returns consequently cannot give an accurate picture of income inequality or concentration.

Reynolds notes finally that more accurate CBO data on income distribution trends shows that after the 1986 tax reform “the top 1 percent’s share of pretax household income fell with the stock market crash of October, 1987 and surged with the stock market boom in 1996-2000, but otherwise showed no significant and sustained upward trend.” The media institutions that trumpeted the grossly misleading studies and reports of soaring tax returns based on confused tax return data over decades badly misled their audiences, and failed to do their job of reporting what is happening in the real world.