Half the Country Doesn't Pay Income Tax-- Again

The Internal Revenue Service just released new 2011 data on individual income taxes. 

Once again, half the people in this country pay 97% of the income taxes, while the other half essentially pays nothing ( which Mitt Romney was pilloried for saying last year). Is it any wonder, then, that half the country thinks of government spending as a Free Lunch?

And just 5% of us pay over half the total tax bill. I can't recall . . . did the President bring that up in his rant about "income inequality"? 

Table 1. Summary of Federal Income Tax Data, 2011
	Number of Returns*	AGI ($ millions)	Income Taxes Paid ($ millions)	Group's Share of Total AGI (IRS)	Group's Share of Income Taxes	Income Split Point	Average Tax Rate
All Taxpayers	136,585,712	8,317,188	1,042,571	100%	100.0%
Top 1%	1,365,857	1,555,701	365,518	18.7%	35.1%	> $388,905	23.5%
1-5%	5,463,429	1,263,178	223,449	15.2%	21.4%		17.7%
Top 5%	6,829,286	2,818,879	588,967	33.9%	56.5%	> $167,728	20.9%
5-10%	6,829,285	956,099	122,696	11.5%	11.8%		12.8%
Top 10%	13,658,571	3,774,978	711,663	45.4%	68.3%	> $120,136	18.9%
10-25%	20,487,857	1,865,607	180,953	22.4%	17.4%		9.7%
Top 25%	34,146,428	5,640,585	892,616	67.8%	85.6%	> $70,492	15.8%
25-50%	34,146,428	1,716,042	119,844	20.6%	11.5%		7.0%
Top 50%	68,292,856	7,356,627	1,012,460	88.5%	97.1%	> $34,823	13.8%
Bottom 50%	68,292,856	960,561	30,109	11.55%	2.89%	< $34,823	3.13%
*Does not include dependent filers.

Public Pensions Increasing Risk Levels

Andrew Biggs writes in the Wall Street Journal about how defined benefit pension funds are taking bigger and bigger portfolio risks. These plans (mostly government employee pensions) were created using an assumption that portfolios would return around 8% annually. This certainly hasn't been the case, and is not likely to in the near future. One option would be for government to raise taxes to increase its contributions to the pensions. This is somewhere between unlikely and impossible. The only alternative for these funds is shift investments into much riskier assets in search of a higher returns.

A more prudent move would be for governments to convert pensions into defined contribution plans -- as almost the entire private sector has done. But given that most governments are controlled by public employee unions, that's not likely either. Historically, investment strategies that greatly expand risk have very unhappy endings. It may be that's what it will take to get government to face reality. Unfortunately that means that there are probably a lot more Detroit scenarios on the horizon.

Obama's Deceit Extends to Income Equality

The Congressional Budget Office's new report is especially timely in light of the President's rant last week about "income inequality".  As you can see from the table below, if you're talking about market income -- that which you actually earn -- the distribution is highly unequal. The highest household quintile earns almost 30 times what the bottom  one does (household income  can be very mislead itself because the household composition is very different between the upper and lower quintiles). But after tax and government payments? That ratio drops to less then 6x.

What's even more remarkable is to examine the incentives for working. Those in the second quintile earn on average $46,700 more than those in the lowest quintile. Yet, after taxes and transfers those people are only $26,600 better off -- because they actually pay some tax, and they lose a lot of their government transfer payments. That's an effective marginal tax rate of 43% . Do you think the average middle class family really understands that the federal government is imposing a 43% tax on their work? I'd say about as well as they understood that they would be able to keep their health plan under Obamacare.

Stock Market Risk -- Reversion to the Mean

As the stock market reaches new highs and optimism grows, it is worth considering a couple of charts that should give caution. The first one is the ratio of corporate profits to GDP. It's currently at an all-time high of 10%. That isn't going to continue. At some point it will revert to more historically normal levels. Ultimately, share prices have to be related to earnings. 

The second is the Shiller PE Ratio between share prices and trailing 10 year inflation-adjusted earnings. The Shiller ten-year P/E Ratio also suggests the market is expensive. In 2000 the ratio was 44, the highest level on record. At the top of the market in 2007, the Shiller was 27. The long-term average is 16.5. By that estimate, the stock market was 63% overvalued in 2007. Right now the Index is at 25, which suggests an overvaluation of 50%.

Overvalued assets can become even more overvalued as we saw in the 90s, but the more expensive stocks become, the higher the risk of a big drop.  About the only thing you can say with any certainty is that over the next few years there’s more risk on the downside than on the upside. Of course, you could have said that in 1997 as well. Bob Shiller did, and he missed out on a couple more years of share price inflation. Investor psychology seems to fear losing out on a big upswing more than experiencing a big loss. Certainly that was what drove real estate in the mid-aughts. But history suggests that reversion to mean is an even more powerful force.