What if We're Looking at Inequality the Wrong Way? Richard V. Burkhauser, a professor of public policy at Cornell and an adjunct scholar at the American Enterprise Institute, is fast becoming a champion of the right, challenging the conventional wisdom about income inequality. The last time Burkhauser appeared in this column, he had provided ammunition for conservatives to dispute liberal orthodoxy on the issue of growing inequality (along co-authors Jeff Larrimore and Kosali Simon). That ammunition was contained in a 2011 paper, "A "Second Opinion" on the Economic Health of the American Middle Class," which lent support to the conservative cause. By defining income as "post-tax, post-transfer, size-adjusted household income including the ex-ante value of in-kind health insurance benefits," Burkhauser and his co-authors achieved two things: a diminished degree of inequality and, perhaps more important, a conclusion that the condition of the poor and middle class was improving. The 2011 Burkhauser paper found less inequality than other measures, but did not claim that income inequality did not exist: from 1979 to 2007, Burkhauser argued, those in the bottom quintile saw incomes increase by 26.4 percent, but those in the top quintile saw their incomes grow 52.6 percent. Those in the top 5 percent saw a 63 percent increase in their income. Now Burkhauser and his allies have returned with a new paper, "Levels and Trends in United States Income and Its Distribution," which was publishedearlier this month. In the 2013 paper, written with Larrimore and Philip Armour, Burkhauser has come up with statistical findings that not only wipe out inequality trends altogether but also purport to show that over the past 18 years, the poor and middle classes have done better, on a percentage basis, than the rich. The debate over income inequality has been going on for decades. It remains bitterly disputed. In an e-mail, James Wetzler, the former chief economist of Congress's Joint Committee on Taxation who also served as New York State Tax Commissioner, described some of the complexities of the debate to me: You get different answers depending on whether you measure income before or after taxes and transfers, whether you count fringe benefits (mainly health insurance), and whether you look at families or households, and whether you count the big hitters as the top 20% or the top 1 percent. Counting health care mutes the increase in inequality, but that really means that most of the increase in working class incomes has been siphoned off to medical providers. Looking at households has the same effect. Including transfers is interesting because middle class transfers like Social Security and Medicare have grown faster than transfers to poor people like welfare and food stamps. Taxes, of course, have become less progressive, at least until this year. Douglas A. Hibbs Jr., a former professor of economics at the University of Gothenburg, wrote me that Burkhauser's 2013 discussion of proper income concepts and the problems implementing those in available data is excellent. I doubt many or any who know the lay of the land would object. The favored "income" concept for analysis of annual changes in inequality, namely annual consumption plus annual changes in net wealth, is exactly on target. In the highly charged atmosphere of the inequality debate, however, Burkhauser's work has provoked harsh criticism. Lawrence Katz, a Harvard economist, wrote in an e-mail that the data used by Burkhauser in his 2013 paper are not up to the task. And the results are likely to be greatly overstated and hinge on what seem to me to be rather implausible assumptions in which the authors impute the annual accrual of capital gains income from quite poor household data on asset classes combined with the assumption that everyone gets the average rate of return so that no one is lucky, no one is skilled in investing. If you eliminate the possibility of anyone doing really well in terms of their investments, you can make it look like the capital incomes of the top end did not do so well. Emmanuel Saez, a University of California, Berkeley, economist considered by many to be a leading expert on income trends, wrote: For the U.S., you should not trust any paper on top incomes that uses Current Population Survey data. Survey data cannot get at top incomes well because the surveys have too small samples of top earners to be reliable. That's the very basic reason why our research on top incomes estimated with tax data adds value. In a nutshell, Burkhauser et al. will never say anything interesting about top incomes if they start from CPS data, although they might say interesting things on bottom 99 percent incomes. Edward N. Wolff, an economist at New York University, noted in an e-mail that work he did with Ajit Zacharias, using methods similar to Burkhauser's, reached the opposite conclusion: I am surprised by the Burkhauser result. We did something very similar in 2012 and did not find his result. We included imputed rent to owner occupied housing and a yearly estimate of annual capital gains (both realized and unrealized). Our data went through 2007. If anything, we find a sharper rise in inequality using our measure of comprehensive income than using standard income. Along the same lines, Timothy Smeeding of the University of Wisconsin, writing with Jeffrey P. Thompson, measured income trends from 1989 to 2007 and concluded that "inequality measures peaked in 2007 at their highest levels in 20 years." The following charts reflect the scope of the challenge Burkhauser has mounted to liberals, including President Obama, who worry about upward distribution of income. First, take a look at Figure 1, a 2011 Congressional Budget Office chart showing significant inequality in the distribution of income gains from 1979 to 2007. Many on the left consider work done by the C.B.O. to be the gold standard of inequality measurement: Burkhauser's 2011 methodology worked to make the pattern appear far less extreme, as illustrated by Figure 2: In his 2013 paper, Burkhauser and his two co-authors have completely upended the thrust of Figures 1 and 2. The charts in Figure 3 and Figure 4 are derived from data in the 2013 Burkhauser paper, which covers the years from 1989 to 2007. Figure 3 shows the percentage change in income by quintile and for the top 5 percent using Burkhauser's measure of "household size-adjusted post-tax, post-transfer income plus in-kind income" plus "accrued capital gains, including housing." And Figure 4 shows the percentage change in income by quintile and for the top 5 percent using the same measures as in Figure 3, but adding "accrued gains including housing and privately held businesses." If - a virtually impossible if - the economic and policy-making community were to reach even a rough consensus in support of Burkhauser's 2013 analysis, the victory for the right would be hard to overestimate. If Burkhauser's approach was accepted, it would render moot the basic political and philosophical tenets of the Obama presidency, which he expressed most articulately at the start of the last presidential campaign: For most Americans, the basic bargain that made this country great has eroded. Long before the recession hit, hard work stopped paying off for too many people. Fewer and fewer of the folks who contributed to the success of our economy actually benefited from that success. Those at the very top grew wealthier from their incomes and their investments - wealthier than ever before. But everybody else struggled with costs that were growing and paychecks that weren't - and too many families found themselves racking up more and more debt just to keep up. Not only would Burkhauser lay waste to a core liberal argument - inequality is worsening - but his claim that a declining share of income is going to the wealthy could be used to justify further tax cuts for the affluent in order to foster top-down investment and growth, just as Republicans justified the Reagan tax cuts of 1981 and the Bush tax cuts of 2001 and 2003. Burkhauser et al. achieve their reversal of past income distribution data by amending the definition of income developed in their 2012 paper - "post-tax, post-transfer, size-adjusted household income including the ex-ante value of in-kind health insurance benefits" - to incorporate another accounting tool: "yearly-accrued capital gains to measure yearly changes in wealth." Although "yearly-accrued capital gains" sounds innocuous, it is a game changer. Burkhauser attempts to measure the year-to-year increase in taxpayers" assets - stocks and bonds, housing and privately held businesses - and to count those annual increases as income. Increases in the value of such assets do not show up in tax data because they are taxed by the federal government only when the asset in question is sold and the increased value is realized as taxable gains. Burkhauser and his co-authors provided me with the following four-paragraph explanation to clarify their logic: Consider a couple with one child making $50,500 (2013 dollars) in 1989 before considering capital gains (this is roughly the mean income of the middle quintile). This couple owns a home worth $120,000, $10,000 of taxable investment assets and about $3,000 in IRA accounts, but didn't sell any assets in the year so no capital gains appear on tax returns. This is in-line with the assets of a middle-income household in 1989. In line with the average asset appreciation in the year, the value of the couple's house increased by about $800 in the year and the value of their investments increased by $3,000. So their income including accrued capital gains was $54,300. In 2007, the couple at the same point in the distribution would make $61,000 before capital gains. This is a 20% increase. The couple owns a home worth $185,000, has taxable investment account assets of $30,000 and retirement account assets of $20,000. Again, this is in-line with the assets of a middle-income household in 2007. In line with the average asset appreciation in the year, the value of the couple's house fell by $8,500 while their investments increased by $1,750. So their income including accrued capital gains was $54,250. So the incomes of couples at the middle of the distribution are basically flat once including accrued capital gains. Now consider a high-income couple with one child making $200,000 (in 2013) dollars in 1989 (this is roughly the mean income of the top 5%) excluding capital gains, but sold stock for a capital gain of $20,000 in the year so $220,000 appears on their tax return. This couple owns a home worth $300,000 and has investments of $150,000. In line with the average asset appreciation in the year, the value of this couple's house increased by about $2,000 in the year and the value of their investments increased by $35,000. So their income including accrued capital gains was $237,000 ($200,000 of earned income plus $37,000 of accrued capital gains). In 2007 a couple at the same point in the distribution would make $230,000 and may have sold assets to make about $65,000 in taxable capital gains for a total income on their tax return of $295,000 - an increase of 34%. Looking at their assets this couple owns a home worth $500,000 and has investments worth $500,000. In line with the average asset appreciation in the year, the value of this couple's house fell in value by about $23,000 and the value of their investments increased by about $18,000. So their income including accrued capital gains was just $225,000. So when using this measure more in-line with Haig-Simons (a classic economists" definition of income), the income of the couple fell by 5% - worse than that of the middle income couple. The Burkhauser approach does a number of things. First, it spreads and flattens income from capital gains over the duration of ownership. For a wealthy individual who makes a huge killing selling stock or a businesses, his or her income does not spike in the year of the sale, but emerges instead as a series of yearly incremental gains. For assets that have been held for a long time, the Burkhauser system effectively backdates much of currently realized capital gains onto earlier years. This is especially significant in calculating income gains from the current sale of assets purchased in the 1980s and 1990s, since much of the added value was acquired in those earlier decades. "The high taxable realized capital gains income observed on tax returns today are not necessarily a reflection of higher current incomes," Burkhauser and co-authors write in the 2013 paper, but are instead "more likely to be a residual effect of previously accrued capital gains that are only now being realized." In a series of e-mail exchanges with me, Burkhauser justified his methodology as follows: You want to use the accrual value this year in your concept of income this year since that is how much your capital changed this year and that is how much your income this year changed because of it. If you have a stock that increases in value this year, you have the option to sell at the end of the year for a gain now so your available resources increased even if you don't sell. The fact that you did not realize those gains this year simply means that you "saved it." I raised the following question: Is it a fair measure of a person's well-being to include unrealized capital gains? Their house or other assets may have increased in value, but their standard of living has not changed. Burkhauser's reply: You are asking me if "it is fair" to use this concept? This is a profound question. I think it is, but will save a longer answer for the day you invite me for at least two beers. The unfairness of Burkhauser's approach is clearly acute at the bottom and middle of income distribution. The most common large asset for those on the bottom rungs is a house. Burkhauser would increase the income of those below the median lucky enough to own a home by the annual appreciation in the value of the home through 2007. For many of these families, however, selling their home is not an option. In Burkhauser's view, their income goes up even if their living conditions remain unchanged. It is important to note that Burkhauser is respected by his peers; his critics, including some friends, do not accuse him of ideological bias. In addition to A.E.I, he has received support from such center-left institutions as the Pew Foundation, Brookings Institution and the Russell Sage Foundation. Giving the quality of Burkhauser's work a favorable review, Daron Acemoglu, an economist at M.I.T., responded to my inquiry by email: Burkhauser is a very serious researcher, and knows the data well. The point they make is a valid one: because of our tax code, people realize capital gains in some years and not others, but this doesn't really mean that income inequality is higher in the years they realize the capital gains. Capital income conceptually corresponds to a wealth/stock measure (I become richer this year even if I don't realize any of my capital gains, but I know that my portfolio's value has doubled). Acemoglu cautioned, however, that the "problem is that in such things, especially when it is a difficult task based on lots of new data sources, the devil is in the details. It's pretty hard to judge those details without doing a substantial amount of work. Acemoglu's conclusion: "Bottom line: conceptually there is a valid point here, and this is a serious paper. The rest is to be determined. "Rich Burkhauser's work is really the state of the art - the most important research on inequality being done, in my view," Scott Winship, of the Brookings Institution, e-mailed me. Winship voiced some concern over the reliability of the statistical data used by Burkhauser, but concluded: All that said, I think Rich's paper is incredibly disruptive for many fields of research in labor economics and other social sciences, and potentially it could change our entire view about rising inequality over the past few decades. Many others commenting on the Burkhauser paper were less complimentary. Isabel V. Sawhill, a senior fellow in economic studies at Brookings, wrote: Really weird. Markets up; housing prices up; but people with a lot of investment in both have falling incomes when include portfolio and housing gains in their incomes over this period? How could this be? In addition, Sawhill raised a fundamental question about the validity of using accrued but unrealized capital gains: "You can't use accrued gains to pay for basic living costs. They are not income; they are paper gains. Dean Baker, co-director of the Center for Economic and Policy Research, contended in an e-mail that the method of calculating capital gains used by Burkhauser and his co-authors "strikes me as more than a little off-base": If they want to make a big point of saying that middle and low income people would not have been harmed by inequality over the years 1989-2007 if they could have all sold their homes at peak bubble prices, they are welcome to do so, but that seems more than a bit silly to me. We know what this measure would look like today with the real value of homes down by around 30 percent and homeownership rates in the bottom two quintiles down by around 10-15 percent. Are we supposed to ignore that fact? Gary Burtless, a senior fellow at Brookings, replied to my inquiries with the most comprehensive commentary: In calendar 2008 stock prices fell so much that I lost two or three times our household's annual labor income (pre- or post-tax). In 2009 stock and bond prices rose so much I recouped a sizeable share of those losses, probably an amount that was at least 50% larger than our annual labor income. So, in 2008 my (Burkhauser) income put me in the bottom 2 percent or 3 percent; in 2009 it put me in the top 5 percent. Burtless continued: The problem with the authors" estimates of accruing capital gains is that those numbers are wholly made up based on a prediction that everyone is equally successful in finding homes, stocks, bonds and other assets to invest in. But they're not: Some people are wildly successful, and get into the 1%; others are horribly unsuccessful and become paupers (or receive foreclosure papers); and most earn mediocre returns that are - surprise! - a bit lower than the economy-wide average. Burkhauser et al. measure the period from 1989 to 2007 because those are both peak years in the business cycle. This timing results in a failure to account for the consequences of the 2008-9 financial crisis and the subsequent struggle toward recovery accompanied by persistent high levels of unemployment. On Monday The Wall Street Journal reported that Nearly 12 million Americans were unemployed in May, down from a peak of more than 15 million, but still more than four million higher than when the recession began in December 2007. Millions more have given up looking for work and no longer count as unemployed. The share of the population that is working or looking for work stands near a three-decade low. During the post-crisis years 2009-11, according to the Pew Center, the wealthiest mean of the nation saw the value of their assets grow by 28 percent, to $3.17 million from $2.48 million, while the bottom 93 percent saw their net worth drop by 4 percent, to $133,816 from $139,896. From September 2008 to October 2012, there were an estimated 3.9 million completed home foreclosures. The median market value of the foreclosed houses was $242,400 - the kind of homes owned by middle income Americans. In May, the St. Louis Federal Reserve reported that United States households had regained less the half of what they lost in the Great Recession. In 2008 and 2009, a total of $16 trillion in household wealth disappeared, and in the subsequent years, only 45 percent of those losses have been regained. The Washington Post reported in May that "most of the improvement in household wealth [since the 2008 meltdown] was due to gains in the stock market, which primarily benefit wealthy families. That means the recovery for other households has been even weaker. The families that suffered the most in the meltdown and its aftermath, according to the St Louis Fed report, were the most vulnerable: the less well educated, minorities and the young, many of whom had little in saving but had accumulated high debt levels. Wealth trends since the 2008 crash, shown in Figure 5, demonstrate an extraordinary growth in inequality, suggesting that Burkhauser's findings - restricted to his carefully tailored definition of income - are fatally flawed as an instrument to assess the current real-world position of the poor and middle class compared with the very rich: A key purpose in measuring both wealth and income is to determine what kind of standard of living is possible for those at the top, the middle and the bottom. Do individuals, families and households have enough to provide for themselves, perhaps most importantly for their children? Do they have the financial resources to enter the highly competitive global marketplace? On that score, Burkhauser's use of "yearly accrued capital gains" fails the test of measuring what is most significant to know in policy making and in assessing the true quality of life in America.