Unearned Income

The goose that lays golden eggs has been considered a most valuable possession.   But even more profitable is the privilege of taking the golden eggs laid by somebody else’s goose.

                                                                            —   Louis Brandeis

The New Republic, June 14, 1975

NOT LONG AGO a West Coast bank president men­tioned to me that a piece of land he had purchased near San Francisco, situated alongside a new state highway, had doubled in value in a few years. Several miles away was a low-income Chicano neigh­borhood, and naturally the new highway cut right through it, forcing residents to give up their homes and seek, probably without much success, equivalent low-cost housing elsewhere in the area.  The bank pres­ident noted a certain irony in the fact that the same public investment could cause hardship to low-income families and simultaneously bestow a wind­fall upon someone who scarcely needed it.  But, he added, he would keep the money.

The bank president’s windfall is an example of what John Stuart Mill called the “unearned increment” — the increase in land value brought about by gen­eral progress.  The increment is unearned because the beneficiary has done nothing — other than buy land and wait that might entitle him to be rewarded.

The question of what is earned and unearned be­comes more complex when one considers ownership of capital rather than land.  If a man invests his savings in, let us say, a new brick factory, he is surely entitled to a return on his invest­ment.  Society needs bricks; anyone who builds a brick factory is performing a socially useful task and should be rewarded.  But the potential for unearned gain is pre­sent.  If the brick factory happens to be located in a community that, for one reason or another, begins to thrive and grow, the factory appreciates in value.  Some of the increased value will be attributable to the factory owner, and some to the efforts of others, but the factory owner will reap it all.

Suppose that the factory owner gradually buys out all other brick manu­fac­tu­rers in the area.  Now he will be in a position to reap even more spectacular gains.  The value of all of his factories will go up, as will his operating profits.  That portion of his newly acquired wealth which is attributable to monopoly is clearly unearned.  The factory owner, as monopolist, adds nothing to the gen­er­al wellbeing.  He is not producing more bricks than the individual factories, separately owned, once produced.  He is probably producing fewer bricks and charging higher prices for each.

Observe another change that has occurred.  The factory owner is no longer an original investor; he has become what might be called a second-generation ap­pro­priator.  Whereas original investors are often risk-takers and innovators who contribute to the ad­vancement of society, second-generation appropriators tend to accumulate wealth largely at the expense of others.  Consider the sturdy New York apartment building I once lived in, which was constructed around the turn of the century and had paid for itself many times over before I moved in.  The rents, far from de­creasing after the building was paid for, were climb­ing all the time.  Property taxes and maintenance costs, of course, were rising, but these should have been more than offset by the disappearance of financing costs.  The problem was that financing costs did not disap­pear, but, in fact, grew, because the apartment house was sold and resold every few years, and each new landlord had to collect a return on his investment.  None of the re­sales added anything to the joys of living in New York City; they merely sad­dled the tenants with somebody else’s financing charges and profit margins.

These examples barely touch upon the possibilities for garnering unearned in­come in America.  Bookstores abound with titles such as How To Get Rich While You Sleep—Let Real Estate Do Your Work.  Magazines bring us wondrous tales of fortunes made through the use of leverage (i. e. , other people’s money), of conglomerates whose paper values far exceed the sum of their parts, of tax-shel­tered investments that effortlessly increase the wealth of the already wealthy.

There are, at least in my mind, two prime criteria for judging whether a per­son’s income, or gain in wealth, is earned or unearned: (1) Does the acti­vi­ty which generates the income add to the supply of goods and services available to society?  (2) Is the in­come a result of its recipient’s efforts, or is he merely reap­ing the benefits of others’ exertions?  By these criteria, all income from pro­duc­tive labor, except for inordinately high executive salaries or professional fees, is earned.  Income from the ownership of wealth is not, ipso facto, unearned, but is likely to contain a large unearned element.  The precise categorization of in­come from wealth is somewhat complicated by the separation, in practice, between the earning agent and the beneficiary.  A rise in GM stock may, from GM’s standpoint, be partially earned; but from the stand­point of the absentee stockholder, who does nothing but open his mail, the increment might be con­sidered unearned.  Government handouts and subsidies should undoubtedly be considered unearned.

How large, in a given year, is the unearned segment of national income?  Assu­ming that unearned income is operationally defined as all income other than that earned through labor, before-tax unearned income in 1970 was roughly $200 billion (national income, $800 billion, minus reported wages and salaries, $600 bil­lion).  This includes poor people’s welfare, and, if we might call it that, rich people’s welfare.  A comparison between these two components is interest­ing.  The total amount paid out by federal, state and local gov­ernments for aid to dependent children, general relief and other noncontributory welfare pro­grams for the poor, disabled and aging was $16 billion.  By contrast, the un­earned income going to wealth-owners included $34 billion in interest ($19 billion on the national debt alone), $25 billion in dividends and $23 billion in rent.  And let’s not forget unrealized capital gains and ap­preciations in land value, which are omitted from re­ported income.  These aren’t trifling amounts: the National Commission on Urban Problems, chaired by former Senator Paul Douglas, estimated that land values rose an average of $25 billion per year dur­ing the 1960s, while a study by James D.  Smith of Pennsyl­vania State Univer­si­ty found that, in 1958, top wealth- holders enjoyed a net capital gain of $57 billion.

Rich people’s welfare, besides being more plentiful than the poor’s, is concen­tra­ted among fewer people.  According to IRS figures for 1966, fewer than two percent of all taxpayers received 74 percent of all dividends and 76 percent of all capital gains.  A large number of wealthy welfare recipients have done noth­ing more to qualify for their unearned income than to have the right parents.  According to a study by the Federal Reserve Board, inherited wealth accounted for a “substantial portion” of total assets of 57 percent of those with income of $100,000 or more.

Rich people’s welfare has many advantages over the poor’s.  There’s no legal ceiling, no humiliating means test, no prying by social workers, no questions about men in the house, no public opprobrium, no danger of cutoff.  You can hire accountants, lawyers and lobbyists to do your chiseling, and best of all, you don’t lose a penny if you get a job.

If you happen to be one of those less fortunate mil­lions who do have jobs, you will notice that rich peo­ple’s welfare beats working, too.  There’s no boss to con­tend with, no unsafe working conditions and no need to be competent at anything.  You can sleep late in the morning and not worry about rush-hour traffic.  You needn’t fear illness, sexual discrimination or get­ting fired.  And to top it off, you’re eligible for a daz­zling array of tax breaks and subsidies.

That many forms of unearned income should be more lightly taxed than earned income may appear incongruous in a country that, according to Mr. Nixon, sanc­tifies the work ethic, but the explanation is not hard to fathom: wealth-own­ers have more political power in America than non-owners of wealth.  The list of tax privileges that wealth-owners enjoy runs the gamut from the petty to the grandiose.  The initial advantage is that taxes on unearned income are not withheld automatically, as are taxes on wages and salaries.  Unearned income is also exempt from social security and other payroll taxes, which are the fastest growing federal taxes.  In 1963, payroll taxes raised only 42 percent as much as personal income taxes; in 1973, the proportion will be 68 percent.

Another tax break for wealth-owners is the deducti­bility of depreciation from taxable income, often at accelerated rates.  This amounts to a hefty federal re­im­­bursement for wear-and-tear, general obsolescence and decreasing earning power of wealth-owners’ assets.  There is no comparable compensation for the declin­ing earning power of workers’ bodies and minds; there is, in fact, a re­gress­ive labor depreciation tax (i.e., Social Security).  Some wealth-owners are partic­ularly favored by the depreciation rules.  Real estate wheelers-and-dealers, for example, are permitted high depreciation rates during the early years of own­ing a building; when deductions for depreciation start diminishing on one building, they can sell and start deducting on another.  Owners of timber, oil, coal and other mineral properties receive a special allowance called percentage depletion.  This enables them to deduct from taxable income not the actual de­cline in value of their assets, but an arbitrary percentage of gross revenues.  What they save on income taxes can be many times what they pay for their properties.

y far the largest loophole for wealth-owners is the preferential treatment for capital gains, (i.e., increases in the value of property).  First, unreal­ized capital gains are not taxed at all.  This allows wealth-owners to ac­cumulate wealth without interruption or diminution; if they don’t cash in their holdings before death, their heirs escape taxation on the long-term capital gain.  Second, only half of realized capital gains need be counted as taxable income, or, if all is counted, the tax rate is approximately half the tax rate of income from labor, up to a maximum rate of 35 percent.

The epitome of unearned income is that which de­rives from inherited wealth.  Theoretically, self-per­petuating fortunes could be whittled down by estate, gift and inheritance taxes, and there exists a federal estate tax with a nominal maxi­mum rate of 77 percent on taxable estates over $10 million.  But the tax has be­come increasingly porous since the 1940s.  Through marital and other deduc­tions, gifts and placement of estates in tax-exempt foundations and trusts, most large fortunes can be passed on virtually intact.

One could go on to discuss tax-exempt state and local government bonds, the tax advantages of stock options and various tax-sheltered investment schemes, but the point is clear.  Except for dividends on stock and interest on savings deposits — the^.two types of unearned income most frequently collected by per­sons of moderate means — unearned income is treated by the Treasury with far greater respect than earned in­come.  In other words, wealth-owners not only reap from the labors of others, they pay lower taxes.

It is worth noting that the tax system was not always so one-sided.  The proper­ty tax was, in its historical antecedents, a genuine tax on wealth; only in rela­tive­ly recent times has it become primarily a tax on the aver­age man’s residence (i.e., property on which banks make income, but workers pay taxes).  The feder­al income tax was intended to be a levy upon income “from whatever source derived,” as the 16th Amendment put it, and not primarily a tax upon the wages of labor.  There was once, in fact, a special deduction from fed­eral income taxes for income earned from labor, but it was abolished during World War II for the sake of “simplification of the tax code.”  Nowadays the maxi­mum tax rate on earned income is 50 percent, as op­posed to 70 percent for unearned income, but this is a distinction that benefits salary-earners only at the very top, rather than the bottom, of the wage scale.

Things would be sufficiently out of kilter if govern­ment favoritism for wealth­owners stopped with the tax code, but the state’s generosity goes further.  In addition to the relatively small sums that the govern­ment dispenses to those who are too old, young or sick to earn income from labor, the government ex-pends billions of dollars annually that add to the unearned wealth and income of the propertied.  Some­times the subsidy to wealth-ownership is indirect, as when a government-built highway, irrigation project, airport or other public facility augments the value of nearby land (and, to a degree, capital).  In such cases, workers benefit in that they may use the new facility, or be employed by it, but they enjoy no gain in net worth, and indeed may have to pay user fees (e.g., tolls), higher rents and property taxes.

Often and quite consciously, the subsidy to wealth- owners is direct.  The Joint Economic Committee last January published a rather astonishing study in which it is estimated that federal subsidies to private citizens or businesses, intended to alter their economic be­havior, totaled more than $24 billion in 1970.  These hand­outs were of two basic types: subsidies to con­sumers and subsidies to pro­du­cers.  The former in­cluded food stamps, grants to students and job trainees and a few other items; the latter encompassed every­thing from indem­nities to beekeepers to cash pay­ments to regional airlines.

The justification for subsidizing producers rather than consumers, and among producers, wealth-owners rather than workers, is the old trickle-down thesis: if enough benefits are handed out to wealth-owners, somethingwill seep through to workers.  Some con­sequences of this approach can be seen in two major feder­­al subsidy programs — the section 235 and 236 housing assistance pro­grams of the Department of Housing and Urban Development, and the farm sub­sidy program.  HUD’s section 235 and 236 programs were intended to stim­ulate the construction and rehabilitation of inner city homes and apartments.  The idea was that if HUD subsidized lenders and developers by paying most of the interest cost on housing loans, more units for low-income families would be built.  More units were built, but so many were overpriced and shoddy, and so many inexperi­enced buyers were cheated by subsidy-seeking spec­ulators, that HUD has been racked by scandal and saddled with thousands of repossessions.  Sadder, wiser and billions of tax dollars later, HUD Secretary George Romney now admits it would make a lot more sense to give money directly to poor fami­lies to buy or rent shelter in the regular market.

The farm subsidy program, when it began during the New Deal, was intended to keep impoverished small farmers and sharecroppers on the land.  Since the 1930s, the program has been transformed into a windfall for the biggest owners of wealth.  Payments are made to landowners to take acreage out of pro­duction, not to workers to work, or even not to work.  In 1969, the wealthiest seven per­cent of farm owners received 40 percent of the benefits, while the poorest 50 per­­cent got nine percent, and millions of landless farm workers received noth­ing.  In fact, by paying land‑owners to withdraw land from production, the pro­gram causes a hardship to many farm workers, depriving them of the opportu­ni­ty to earn income from labor.  They then must apply for poor people’s welfare, for which they are roundly excoriated by subsidized landowners.