IRS Income Data a Poor Measure of Inequality

By on August 21, 2014 in Current Events with 4 Comments

A new report from the Tax Foundation says that IRS income data are frequently used to show more about a person’s overall financial health than they should.

One of the biggest limitations the report cites is that IRS income data show incomes from individuals for one year. Given this short time frame, the datasets are a poor proxy for showing standard of living since peoples’ lives play out over a much longer period of time.

On this issue, the report states:

Income data is almost always reported in annual terms. This makes a great deal of sense to the IRS. The IRS is tasked with collecting revenue on an annual basis, and it collects revenue based largely on what people earned in the past year.

This turns out to be of limited usefulness in describing people’s general wellbeing. People can shift spending money between years by saving, drawing down savings, or borrowing. They also plan their careers on horizons of decades or more. One year’s data tells us very little about someone’s life.

Individuals’ incomes tend to peak when people are between the ages of 45-64 and then they drop back down as they reach retirement. The report notes that annual income data miss this trend:

Effectively, you end up comparing people to older or younger versions of themselves. There is a substantial mathematical inequality between a 21-year-old with a $16,000 income and a 56-year-old with an $80,000 income. Among those two, five-sixths of the income accrues to the 56-year-old. Yet it would be a mistake to draw a larger narrative about haves and have-nots from these two average individuals. Any model of social inequality that can be driven by perfectly average individuals is unrealistic. Average people can’t be drivers of any meaningful inequality, virtually by definition.

Another problem with income data from the IRS is that it lacks non-wage income. The report explains this problem:

The largest problem of all with income data is that it isn’t even a good measure of income. There’s a simple reason for this. The IRS is the only government agency that rigorously requires you to report your income. But some of your income is not taxable, and some of it is not even reported to the IRS.

The problem starts with capital gains, which are measured only when realized. This creates extreme spikes in measured capital income, when in truth the capital income was accrued over many years. If you invest in stock at age 25 and then cash it out at age 65 to fund your retirement, all forty years of capital gains will be counted at age 65.

This same inconsistent measurement process occurs with shares of S corporations as well. If you are a small business owner, the growth of your business’s equity value is not recorded as income until you sell it.

The bottom line is the report concludes that the IRS collects income data for the sole purpose of raising revenue for the government annually, but the data were never intended for measuring peoples’ overall financial wellbeing, although this is often how they are used.

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About the Author

Ian Smith is one of the co-founders of FedSmith.com. He enjoys writing about current topics that affect the federal workforce. Ian also has a background in web development and does the technical work for the FedSmith.com web site and its sibling sites.

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