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%.
Not only was there significant variation in income increases between 1996 and 2006, there were lso large differences in the composition of income among the income categories as well as significant changes in the composition. Table 1 reports the share of income (before taxes) received by tax filers from a variety of income sources in 1996 and 2006. For tax filers with income below the 80th percentile (i.e., the bottom 80%), the major source of income is from wages and salaries, which accounted for 82% of total income in both 1996 and 2006. The share from capital income (that is, capital gains, dividends, and business income) was very small in 1996 (about 4%) and fell to less than 3% in 2006. The share from retirement income (from pensions and IRAs) and other income (such as Social Security, unemployment compensation, and interest income) increased slightly between 1996 and 2006.
The situation at the top of the income distribution is very different. For the top 20%, wages and salaries make up a smaller share of total income (60% in 1996) and this share fell by 10 percentage points between 1996 and 2006 to 50%. The share from capital income increased over this period, especially from capital gains and dividends. The situation is even more different for the top 0.1% of tax filers—wages and salaries account for about 20% of total income, with the share falling from 23% in 1996 to less than 19% by 2006. In both years, about half of the total income of the top 0.1% comes from capital gains and dividends; the share from capital gains and dividends increased by 6 percentage points between 1996 and 2006.
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.