Has U.S. Income Inequality Really Increased?

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Executive Summary

There are frequent complaints that U.S.income inequality has increased in recentdecades. Estimates of rising inequality that arewidely cited in the media are often based on federalincome tax return data. Those data appear toshow that the share of U.S. income going to thetop 1 percent (those people with the highestincomes) has increased substantially since the1970s.

However, there have been large changes inU.S. tax rules over time that have made a dramaticdifference on what is reported as incomeon individual tax returns. Tax changes inducedthousands of businesses to switch from filingunder the corporate tax system to filing underthe individual tax system. Corporate executivesswitched from accepting stock options taxed ascapital gains to nonqualified stock options taxedas salaries. The huge growth in tax-favored savingsplans, such as 401(k)s, has resulted in billionsof dollars of investment income disappearingfrom tax returns. Meanwhile, studies ofinequality that are based on tax return data usuallyexclude transfer payments, which results inexaggerating the shares of income received bythose at the top by ignoring growing amounts ofincome at the bottom.

Measurements of inequality have also beenaffected by large reductions in income tax rates,particularly in 1986. Estimates by many economistsindicate that the reported income of highincometaxpayers is very responsive to tax rates.When top tax rates on wages or capital gains fall,reported incomes rise, and a larger fraction of theincomes of those at the top show up on taxreturns. International comparisons show thatreported income shares of those at the top haverisen the most where top tax rates have been cutthe most (the United States, the United Kingdom,and India) and have risen the least where top taxrates have remained very high (France and Japan).

In sum, studies based on tax return data providehighly misleading comparisons of changes tothe U.S. income distribution because of dramaticchanges in tax rules and tax reporting in recentdecades. Aside from stock option windfalls duringthe late-1990s stock-market boom, there is littleevidence of a significant or sustained increase inthe inequality of U.S. incomes, wages, consumption,or wealth over the past 20 years.

Alan Reynolds

Alan Reynolds is a senior fellow at the Cato Institute and author of Income and Wealth (Greenwood Press, 2006).