Is rising income inequality just an illusion?

One of the Biden administration’s top priorities is to tackle income inequality in the United States. It stems from a widely held view that the gap between rich and poor has widened steadily since the 1980s when the Reagan administration cut the highest marginal tax rate from 70 percent to 28 percent. To address this issue, President Biden is proposing tax increases for corporations and households with annual income of more than $400,000.

But is this perception accurate? A recent op-ed by Phil Gramm and John Early asserts that it is an illusion that results from the U.S. Census Bureau failing to account for taxes and transfer payments in its measures. When both items are taken into account, they assert that income inequality is actually lower than it was 50 years ago. 

This conclusion, however, is at odds with studies by academics and public institutions. They find that U.S. income inequality has increased over the past four decades, but the estimates vary considerably depending on the methodology used. 

Within the federal government, the Congressional Budget Office (CBO) conducts periodic studies of household income distribution and reports results both before tax and transfers as well as after taxes and transfers. CBO’s calculations of income before taxes and transfers includes benefits such as Social Security and Medicare. But they exclude means-tested transfers such as Medicaid, the Children’s Health Insurance Program (CHIP), the food stamp program and others designed to assist low-income families. 

As one would expect, the inclusion of taxes and transfers lessens the gap in income inequality. For example, in 2017 (the latest survey), average income before transfers and federal taxes for the lowest quintile was $21,200 versus $309,400 for the highest quintile. After transfers and taxes, the averages were $36,000 and $230,000. In other words, transfers boosted the average income of the lowest quintile by 70 percent, while federal taxes lowered the average income of the highest quintile by 25 percent. 

Still, CBO finds that the top 1 percent’s share of after-tax income increased from 7.4 percent in 1979 to 15.1 percent in 2012, and then declined to 12.4 percent in 2013 as a result of the Obama tax hikes. During the entire period, the source of income that grew the fastest was “business income,” which includes partnerships, dealerships and other enterprises. 

Apart from taxes and transfers, there are numerous complexities in measuring income inequality over time, depending on how “income” is defined. In principle, what is produced in an economy in a given year should equal the total income received by various entities. But there are practical difficulties encountered when workers receive noncash benefits such as employer-provided health insurance, pensions, retirement benefits and life insurance accounts that are not captured as income.

Academic economists have tried to compute what income inequality would look like if items such as these were included in measures of income. Emmanuel Saez and Gabriel Zucman at the University of California, Berkeley, along with Thomas Piketty of the Paris School of Economics have been leaders in combining tax, survey and national accounts data to estimate the distribution of U.S. national income since 1913 on both a pre-tax and post-tax basis.   

In an NBER paper, they found that from 1980 to 2014 there was a sharp divergence in the growth of incomes by the bottom 50 percent of adults versus the top 1 percent in pre-tax income after adjusting for inflation. Second, government redistribution offset only a small fraction of the increase in pre-tax inequality. According to their data, the top 1 percent’s share of national income after taxes rose from 9.1 percent in 1979 to 15.7 percent in 2014. 

These findings were subsequently challenged by Gerald Auten and David Splinter, economists at the Joint Committee on Taxation and the U.S. Treasury Department. They found that the comparable increase was from 8.4 percent to 10.1 percent — or less than a third as large.

According to Auten and Splinter, the increase in inequality from 1980 is largely a consequence of money being reshuffled by corporations to executives in response to tax law changes. They argue that during the 1960s and 1970s, companies usually reinvested profits rather than award raises to executives due to the 70 percent marginal tax rate that applied. Much of the compensation that executives received came via stock appreciation. After the tax cuts in the 1980s, companies paid out more money as raises to executives, which created the appearance of greater income disparity.

Auten and Splinter argue that this boost is largely an illusion: They estimate that 85 percent of the apparent rise in the top 1 percent’s share of after-tax income since 1960 was due to the switch in the method of compensation. Another consideration is that marriage rates have fallen substantially over the last 50 years, but there has been little or no decline among the wealthiest Americans, which skews the distribution of income.

So, where does this leave us? A report by Stephen J. Rose of the Urban Institute compares the results of the studies cited. It shows that estimates of the top 10 percent’s share of economic growth from 1979 to 2014 range from a high of 55 percent to a low of 31 percent, with CBO’s estimate in the middle, at 46 percent.

This wide dispersion of results suggests policymakers should be skeptical of claims that income inequality has improved in the past 40 years or that it is the most unequal since the Gilded Age of the 1920s. The reason: There are many complex issues that make measurement of inequality inherently difficult, which they need to consider when drafting legislation. 

Nicholas Sargen is an economic consultant and is affiliated with the University of Virginia’s Darden School of Business. He has authored three books, including “Investing in the Trump Era: How Economic Policies Impact Financial Markets.”