A State of Disunion

Feb 8, 2012

The president’s State of the Union (SOTU) address in January focused less on unity and more on inequality and punishing successful individuals and companies. The rhetoric was strident, and the facts were scarce or well hidden. So I thought it would be helpful to set the record straight.

The Current Economy

There is no doubt that the president inherited a very weak economy. While the recession officially ended over 2½ years ago, we are still facing incredibly high unemployment and underemployment, and economic growth has yet to consistently exceed its long-run potential. Since the beginning of the recovery, the economy has grown at a 2.4% annual rate. This is well below the historic norm of 3.3% and below more recent estimates of about 2.5%. Not only are we below potential, but we do not seem to be gaining momentum. In the first year after the recession ended (in the wake of a large stimulus package), we grew at a 3.3% annual pace. But even that weak growth rate faded, and over the last year we have only managed a real growth rate of 1.7%. Growth picked up a bit in the fourth quarter of last year, but most of that was inventory rebuilding. And the consensus is that growth will slow again in the first half of this year. 

That growth has produced a modest uptick in jobs. We created 1.6 million net new jobs last year but just under 2 million jobs since the end of the recession. However, we remain down by about 5½ million jobs since the start of the recession. The stronger pace of growth at the end of 2011 has produced some improvement in the pace of job creation—about 157,000 net new jobs per month on average in the fourth quarter of 2011—which was a bit faster than in the previous two quarters. Nevertheless, we started off Q1 2011 at a much faster pace of 192,000 jobs per month. January 2012 numbers were much better at 243,000, but the question is: Will it hold?

Despite this relatively weak job growth, the unemployment rate has fallen from 9.1% in August to 8.3% in January. While no one should ignore this good news, it is a bit puzzling and has occurred only because the labor participation rate has dropped dramatically over this time to a level not seen since 1983. Some older workers may be retiring early, and more people have become discouraged over job prospects or otherwise stopped looking for work. Without such a drop in the labor force, the unemployment rate would be about 8.8%.

There are over 2.5 million individuals who are not counted in the workforce because they are not actively seeking work, and there are just over 8 million working part time because they cannot find full-time work. Both numbers are up significantly from their prerecession levels.

So without being overly pessimistic, the economy is really neither doing that well nor showing clear signs of improving.

Household Inequality

Instead of outlining a clear plan to improve the economy, the president chose to emphasize the inequality in our economy—an inequality that has become consistently worse over the past three decades. Here, again, the facts seem to mess up a good story.

One often used measure of inequality is the Gini coefficient. It is a number that ranges from 0, which represents perfect equality, to 1, which represents complete inequality. This measure has risen under both Republican and Democratic administrations. It rose during the Clinton administration and its tax increases, the Bush administration and its tax cuts, and the Obama administration and its tax rhetoric. Most researchers believe that the increase is driven by a technologically advancing workplace coupled with a stagnant education and skill set among the workforce. The decline of the manufacturing sector also seems to play a prominent role.

In the SOTU, however, the leading culprits and the favored “solutions” seemed to revolve around perceived inequities in the tax code and the growth of American worldwide companies. The proposed solution was to increase taxes on successful individuals and small businesses and on companies that compete internationally.

Unfortunately for the president, the facts reveal a different side of the story.

According to the Congressional Budget Office’s (CBO’s) report Average Federal Tax Rates in 2007, the higher income groups have consistently paid a disproportionately large share of the tax bill. The data show that the top 1% of all households paid 39.5% of total federal income taxes while earning 19.4% of total income in the economy. The top 20% paid 86% of total income taxes while earning 55.9% of total income. In contrast, the lowest quintile had a negative tax liability of 3.0% and an income share of 4.0%. This demonstrates that our current tax code is highly progressive and that the higher income groups actually pay more than a proportional share. Whether that is “fair” is in the eye of the beholder.

The code’s progressivity is further demonstrated by effective tax rates. The effective rates on all federal taxes in 2007 were lower than in 2000 for all income groups. However, the biggest percentage drops occurred at the lower end of the income distribution. The average rate for the top quintile dropped by 10.4%, while the lowest quintile declined by 37.5%. The same trend holds if we just look at income taxes. The top quintile saw its effective income taxes drop by 17.7%, while the lowest quintile dropped 47.8%.

Corporate Revenues

Contrary to the president’s speech, American worldwide companies also contribute to both the economy and the tax rolls. They maintain a large presence in America relative to the size of their foreign operations. In other words, U.S. tax policy does not encourage U.S. companies “to ship jobs overseas” as the president would have people believe. Foreign operations serve as a complement, not a substitute, for U.S. activities.

In 2009, American worldwide companies employed a total of 33.9 million employees. Of these, 23.1 million, or almost 70%, were employed by the U.S. parent compared with 10.8 million employed by foreign affiliates.

As for whether corporations pay their “fair” share, it is true that their share of total tax revenues dropped significantly during the recession. That’s to be expected, however, since many corporations had no profits during this time. As a percentage of federal revenues, corporate income taxes for 2006 and 2007 represented 14.7% and 14.4% of the total, respectively—the highest shares since 1978—and higher than at any time during the Clinton years. They dropped to only 6.6% in 2009 but are a bit above that trough now at 7.9%. The snapback in corporate income taxes has likely been delayed by the steepness of the recession (there were more losses to carry forward) and the investment incentives, such as bonus depreciation and expensing, that were included in stimulus packages and are due to expire at the end of this year. The CBO expects corporate income taxes to return to their historic share as the economy improves.

Moreover, for those concerned that corporations don’t pay their “fair share,” the federal government investigates what it calls the tax gap, the difference between what is paid and what is owed. The most recent IRS data reports that the tax gap is a staggering $450 billion but they attribute only 18% of the tax gap to corporations.

We can and should have a vigorous debate about income and wealth distribution, the tax code, the labor market, and the economy, but we should check the political hyperbole at the door and start with the facts.

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