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Thursday, January 5, 2012

Changes in the Distribution of Income Among Tax Filers Between 1996 and 2006: The Role of Labor Income, Capital Income, and Tax Policy

Thomas L. Hungerford
Specialist in Public Finance

Social scientists and philosophers have been concerned with issues surrounding the distribution of income or income inequality for over 200 years—the economist and philosopher Adam Smith discussed these issues as early as 1776. Academic writers have been writing on income inequality measurement issues for at least a century. Policy makers have also long been interested in income inequality issues; for example, the issue came up in Senate debate in 1898. Bills have been introduced in the 112th Congress that address the issue of income inequality by affecting the income of workers and taxpayers in different parts of the income distribution. In the second session of the 112th, Congress will likely debate the scheduled expiration (at the end of 2012) of the 2001 and 2003 Bush tax cuts, which could affect income inequality. This report examines changes in income inequality among tax filers between 1996 and 2006. In particular, the role of changes in wages, capital income, and tax policy is investigated.

Inflation-adjusted average after-tax income grew by 25% between 1996 and 2006 (the last year for which individual income tax data is publicly available). This average increase, however, obscures a great deal of variation. The poorest 20% of tax filers experienced a 6% reduction in income while the top 0.1% of tax filers saw their income almost double. Tax filers in the middle of the income distribution experienced about a 10% increase in income. Also during this period, the proportion of income from capital increased for the top 0.1% from 64% to 70%.

Income inequality, as measured by the Gini coefficient, increased between 1996 and 2006; this is true for both before-tax and after-tax income. Before-tax income inequality increased from 0.532 to 0.582 between 1996 and 2006—a 9% increase. After-tax income inequality increased by 11% between 1996 and 2006. Total taxes (the individual income tax, the payroll tax, and the corporate income tax) reduced income inequality in both 1996 and 2006. In 1996, taxes reduced income inequality by 5%. In 2006, however, taxes reduced income inequality by less than 4%. Taxes were more progressive and had a greater equalizing effect in 1996 than in 2006.

Three potential causes of the increase in after-tax income inequality between 1996 and 2006 are changes in labor income (wages and salaries), changes in capital income (capital gains, dividends, and business income), and changes in taxes. To evaluate these potential reasons for increasing income inequality, a technique to decompose income inequality by income source is used. While earnings inequality increased between 1996 and 2006, this was not the major source of increasing income inequality over this period. Capital gains and dividends were a larger share of total income in 2006 than in 1996 (especially for high-income taxpayers) and were more unequally distributed in 2006 than in 1996. Changes in capital gains and dividends were the largest contributor to the increase in the overall income inequality. Taxes were less progressive in 2006 than in 1996, and consequently, tax policy also contributed to the increase in income inequality between 1996 and 2006. But overall income inequality would likely have increased even in the absence of tax policy changes.

Date of Report: December 29, 2011
Number of Pages: 21
Order Number: R42131
Price: $29.95

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