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 fed-eral income 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 dra-matic difference 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 sav-ings plans, such as 401(k)s, has resulted in bil-lions of dollars of investment income disappear-ing from tax returns. Meanwhile, studies ofinequality that are based on tax return data usu-ally exclude transfer payments, which results inexaggerating the shares of income received by

those 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 econo-mists indicate that the reported income of high-income taxpayers 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 pro-vide highly 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, consump-tion, or wealth over the past 20 years.

Has U.S. Income Inequality Really Increased?

by Alan Reynolds

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

Executive Summary

No. 586 January 8, 2007�������

PA Masthead.indd 1PA Masthead.indd 1PA Masthead.indd 1PA Masthead.indd 1PA Masthead.indd 1PA Masthead.indd 1PA Masthead.indd 1PA Masthead.indd 1PA Masthead.indd 1PA Masthead.indd 1PA Masthead.indd 1PA Masthead.indd 1PA Masthead.indd 1PA Masthead.indd 1PA Masthead.indd 1PA Masthead.indd 1PA Masthead.indd 1PA Masthead.indd 1PA Masthead.indd 1PA Masthead.indd 1 2/9/06 2:08:34 PM2/9/06 2:08:34 PM2/9/06 2:08:34 PM2/9/06 2:08:34 PM2/9/06 2:08:34 PM2/9/06 2:08:34 PM2/9/06 2:08:34 PM2/9/06 2:08:34 PM2/9/06 2:08:34 PM2/9/06 2:08:34 PM2/9/06 2:08:34 PM2/9/06 2:08:34 PM2/9/06 2:08:34 PM2/9/06 2:08:34 PM2/9/06 2:08:34 PM2/9/06 2:08:34 PM2/9/06 2:08:34 PM2/9/06 2:08:34 PM

Introduction

Major newspapers and magazines repeated-ly report that the share of national incomereceived by the top 1 percent in the UnitedStates (the roughly 1.3 million tax returns withthe highest reported incomes in the UnitedStates) has increased enormously and continu-ously since the 1970s. Of the many difficult sta-tistics used to influence public perception andpolicy, this one is surely the most often repeat-ed and the least often understood.

In February 2006, The Economist noted thatThomas Piketty (of Ecole Normale Supérieurein Paris) and Emmanuel Saez (of theUniversity of California at Berkeley) had “cal-culated a long-run distribution of income inAmerica from information on tax returns.Their latest study shows that the top 1 percentof Americans now receive 15 percent of allincome, up from about 8 percent in the 1960sand 1970s.”1 In June, another story in TheEconomist cited the same study and concluded:“The one truly continuous trend over the past25 years has been toward greater concentra-tion of income at the very top.”2

After 35 years of writing on economicissues, I do not recall any other private andunofficial estimates that were as widely anduncritically repeated as the Piketty-Saez esti-mates on income shares of the top 1 percent.The influential New York Times columnistPaul Krugman dubs Piketty and Saez “theleading experts on long-term trends ininequality,” and quotes them endlessly.3

Searching Google for “Emmanuel Saez” inearly October turned up 51,700 entries,including 871 that also involved the New YorkTimes. Similar searches yielded 814 joint ref-erences to Saez and the Washington Post, 568for the Wall Street Journal, 375 for the FinancialTimes, and 319 for USA Today.

Other economists have assembled estimatesof income distribution based on income taxreturn data, including economists at theCongressional Budget Office. Various estimatesof the ratio of top incomes to total incomeshave differed substantially because of what iscounted as income for the top 1 percent (the

numerator) and what is counted as totalincome for the nation (the denominator). Byadopting the broadest conceivable measure ofincome at the top and the narrowest possiblemeasure of everyone else’s income, the sharegoing to the top 1 percent can be made toappear deceptively large and growing.4

The Piketty-Saez figures are by far the mostpopular income distribution estimates amongnews reporters, editorial writers, and colum-nists. The authors’ original study in 2001 cov-ered the years from 1913 to 1998 (subsequent-ly updated through 2001), using detailedmicro data from the Internal Revenue Service.5

They have also produced more recent estimatesfor 2002 to 2004 that were not taken fromthese micro files but “were estimated from thepublished IRS tables,” which show tax returnsgrouped by broad income bracket. Piketty andSaez claim that “the thresholds [defining thetop 1 percent and other fractiles or groups] areusually very close to one of the income bracketthresholds.”6 If so, they argue, “one can usestandard Pareto interpolation techniques inorder to estimate the top fractiles’ incomethresholds and income levels of the tax unitdistribution of net income.”7 In other words,Piketty-Saez income shares for 2002–2004 arejust estimates, rather than actual IRS data.

This paper reviews the estimates of theincome shares of the top 1 percent, includingthe Piketty-Saez and CBO figures. It findsthat income equality studies that are basedon data reported on federal tax returns canbe highly misleading. Table 1 lists sevenmajor factors that have seriously distortedmeasurements of income inequality in recentdecades. The following sections examinethose factors and discuss the extent to whichthey have affected published inequality data.

Tax Rate Cuts and theConversion of Corporate to

Individual IncomeThe Economist has depicted the apparent

rise in the top 1 percent’s share as a “trulycontinuous trend.”8 But that is not what the

2

Seven majorfactors have seri-

ously distortedmeasurements of

income inequalityin recent decades.

data actually show. Instead, the reportedincome share of the top 1 percent haschanged sharply in periods when tax ruleshave changed. The 2001 paper by Piketty andSaez clearly explained that, “a significant partof the gain [in top income shares] is concen-trated in two years, 1987 and 1988, just afterthe Tax Reform Act of 1986.”9

The top 1 percent’s share jumped from 9.1percent in 1985 and 1986, when the top taxrate was 50 percent, to 13.2 percent in 1988when the top tax rate dropped to 28 percent.

That was not a sudden two-year spurt ininequality. It was a sudden increase in theamount of high income reported on individ-ual income tax returns rather than being con-cealed, deferred, or reported on corporateincome tax returns. Dramatic changes in taxlaws have changed the way that income hasbeen reported on tax returns over time.

As discussed below, many studies of theelasticity (responsiveness) of reportedincome to changes in marginal tax rates byEmmanuel Saez and others show that when

3

The reportedincome share ofthe top 1 percenthas changedsharply in peri-ods when taxrules havechanged.

Factor Main Effect of Factor

Business Income. Shifting of business Great expansion of reported income at the top.

from corporate tax returns to individual

tax returns after individual tax rates fell.

Personal Savings. Large expansion in Reduced reported investment income among

the use of tax-favored savings vehicles middle-income taxpayers, which raised the

including 401(k)s and IRAs. top’s apparent income share.

Transfer Payments. Large growth in Reduced the total income denominator

transfer payments for low-income of income distribution in estimates

families—income that is excluded of income shares at the top.

from most tax-return-based studies.

Capital Gains. Boom and bust cycle of Comparisons of income shares changes

capital gains realizations and stock and stock market trends between two

option exercises as a result of tax rate. atypical years need not represent sustained

trends.

Stock Options. Change in stock options Increased top incomes in comparison of

for executives and workers from a type capital gains and ordinary income with

taxed as capital gains to a type taxed as the 1970s in those studies that exclude

salary in response to changes in tax rates. capital gains.

Tax Rate Changes. Marginal tax rates Marginal tax rate changes may have large

changed in 1981, 1986, 1990, 1993, effects on reported income at the top, in

2001, and 2003. Income reported by situations where actual income may not

high-income taxpayers is highly have changed very much.

responsive to such rate changes due to changes

in avoidance, evasion, and other behaviors.

AGI Gap. The AGI gap of unreported May have exaggerated the apparent

income on tax returns has grown growth of top incomes due to greater

since 1988. underreporting of other incomes.

Table 1

Factors Affecting Estimates of Income from Individual Tax Returns

the highest tax rates are reduced, the amountof income reported on tax returns rises. Thetwo-year spurt in income reported by the top1 percent is therefore exactly what econo-mists would have expected to happen afterthe top tax rate on income was cut from 50percent in 1986, to 37.5 percent in 1987, andto 28 percent in 1988.10

One obvious reason for the surge in topincomes after 1986 is well known to econo-mists, including Saez, yet never mentioned byjournalists who cite these figures. “It seemsclear,” Saez wrote in 2004, “that the sharp,and unprecedented, increase in incomesfrom 1986 to 1988 is related to the largedecrease in marginal tax rates that happenedexactly during those years.”11 One reasonthat happened, he explained, was shifting ofincome from corporate tax returns (business-es reporting as C-corporations) to individualtax returns (businesses reporting as S-corpo-rations and other business structures):

Before the 1980s, S-corporation incomewas extremely small, as indeed the stan-dard C-corporation form was moreadvantageous for high-income individ-ual owners because the top individual taxrate was much higher than the corporatetax rate and taxes on capital gains wererelatively low. S-corporation incomeincreases sharply from 1986 to 1988 andincreases slowly afterwards. The sharpincrease in S-corporation income justafter TRA1986 certainly reflects in largepart a shift in the status of corporationsfrom C to S status to take advantage ofthe lower individual rates.12

Even before the 1986 tax act, the phased-inreductions in tax rates under the EconomicRecovery Tax Act of 1981 “produced a suddenburst of S-corporation income (which was neg-ligible up to 1981) . . . . Almost all the increasein top incomes from 1981 to 1984 . . . is alsodue to the surge in S-corporation income,”according to Saez.13

In the late 1970s, the top individual incometax rate was 70 percent on taxable income above

about $100,000 (for single filers).14 Corporatetax rates were lower—46 percent on incomeabove $100,000 and reduced rates below thatlevel.15 The much higher tax rates on businessesfiling under the individual tax code provided astrong incentive for those with substantial busi-ness income (such as professionals and farm-ers) to file as regular C-corporations.

When individual tax rates were reduced afterthe 1981 tax act and again after the 1986 tax act,it provided a strong incentive to shift fromreporting business income on corporatereturns to individual returns by filing as S-cor-porations, limited liability companies (LLCs),partnerships, or proprietorships. In all thesecases, business profits flow through to individ-ual returns rather than being taxed at the cor-porate level on corporate tax returns.

One result is that those attempting to mea-sure incomes by what has been reported onindividual tax returns may erroneously viewthese large increases in income at the top as realchanges in American’s incomes. Instead, theywere simply the result of a bookkeepingchange in the way business incomes werereported. Switching income from corporatereturns to individual returns did not make therich any richer—it simply made more of theirincome show up as “individual income” in theCBO and Piketty-Saez estimates.

Figure 1 shows that business profitsaccounted for more than 27 percent of theincome of the top 1 percent reported on indi-vidual tax returns since 2002, up from just7.8 percent in 1981. Most of the widelyreported increase in the top 1 percent’s sharewas simply due to this income shifting fromthe corporate to individual tax returns afterindividual income tax rates came down. AsInternal Revenue Service economist KellyLuttrell explained:

The long-term growth of S-corporationreturns was encouraged by four legislativeacts: the Tax Reform Act of 1986, theRevenue Reconciliation Act of 1990, theRevenue Reconciliation Act of 1993, andthe Small Business Protection Act of 1996[which allowed banks to file as Subchapter

4

When individualtax rates were

reduced, it provided a strongincentive to shift

from reportingbusiness income

on corporatereturns to indi-vidual returns.

S corporations]. Filings of S-corporationreturns have increased at an annual rate ofnearly 9.0 percent since the enactment ofthe Tax Reform Act of 1986. During thesame period, taxable [Subchapter-C] cor-porations have experienced an averageannual decline of 1.3 percent.16

The broader problem of relying on tax returndata while ignoring tax-caused shifts in incomereporting has been recognized by economistsJagadeesh Sivadasan and Joel Slemrod. Theyhave warned against “studies of wage inequalitythat rely on data that could be polluted by tax-induced income-shifting behavior.”17 Some ofthe most dramatic reactions to lower U.S.income tax rates in the 1980s involved threetypes of “income shifting”: (1) shifts betweencorporate and individual income tax returns, asnoted, (2) shifts between incentive stock optionsand restricted stock taxed as capital gains andnonqualified stock options taxed as salaries, and(3) shifts between investment income reportedon tax returns and investment income divertedto tax-deferred savings accounts.

Here I only adjust for the first variety ofincome shifting, but Table 2 shows that thisadjustment is sufficient to leave almost noincrease in the top 1 percent’s income sharebetween 1988 and 2003. The first column ofTable 2 shows the Piketty-Saez data illustrat-ing an apparent rise in the top 1 percent’sincome share. (Note that their estimate for2004 appears somewhat anomalous, as dis-cussed below).

The second column of Table 2 shows thePiketty-Saez estimates of the top 1 percent’sshare of income adjusted to exclude theincreasingly huge share of income on individ-ual returns coming from S-corporations, LLCs,and other businesses. The growing numberand size of businesses filing under the individ-ual income tax made little difference in the top1 percent’s share until 1987. By 2004, however,this type of income shifting added 4 percent-age points to the top 1 percent’s share. In short,shifting between the corporate and individualtax systems has accounted for more than half ofthe apparent increase in the top 1 percent’sincome share since 1986.

5

Shifting betweenthe corporate andindividual taxsystems hasaccounted formore than half ofthe apparentincrease in thetop 1 percent’sincome sharesince 1986.

7.8 8.29.8

17.2

21.2

11.1

22.3

26.2

9.9

26.825.6

27.7

24.7

11.0

23.6

26.5

28.427.4

26.126.626.8

23.823.022.3

0

5

10

15

20

25

30

198

1

19

83

198

5

19

87

198

9

199

1

199

3

199

5

19

97

199

9

20

01

200

3

Figure 1

Business Share of the Income of the Top 1 Percent

Per

centa

ge

of

Tota

l In

com

e

Source: Thomas Piketty and Emmanuel Saez, “Income Inequality in the United States,” as updated at

http://emlab.berkeley.edu/users/saez.

This bookkeeping change related to wherebusinesses report their income is only one factorof many that distorts often-cited measures ofincome inequality. But this factor alone is reasonenough to make it illegitimate to use individualincome tax data to compare shares of incomeover time, particularly before and after the monu-mental tax law changes of 1981 and 1986.

Increasingly InvisibleInvestment Income

A variety of factors have served to depress thedenominator of the ratio of top incomes to total

incomes in recent decades. If large amounts ofincome for those near the bottom and in the mid-dle are not reported on tax returns, it means thatthe income share of those at the top is being exag-gerated. A very important factor in this regard isthat prior to the 1980s nearly all income frominvestments (dividends, interest, and capitalgains) was reported on individual tax returns.18

But in recent years, an increasingly large share ofmiddle-income investment returns have beensheltered inside tax-favored accounts, such as401(k)s, Individual Retirement Arrangements(IRAs), and 529 college savings plans. Investmentincome accruing in tax-favored savings plans isnot recorded on income tax returns.

6

Income accruingin tax-favored

saving plans isnot recorded on

income taxreturns.

Table 2

Estimated Share of Income of Top 1 Percent

Piketty and With Business Portion due to

Year Saez Estimates Income Excluded Business Income

1981 8.0 7.4 0.6

1982 8.4 7.7 0.7

1983 8.6 7.8 0.8

1984 8.9 8.0 0.9

1985 9.1 8.0 1.1

1986 9.1 8.1 1.0

1987 10.8 8.9 2.8

1988 13.2 10.1 3.1

1989 12.6 9.8 2.8

1990 13.0 10.1 2.9

1991 12.2 9.4 2.8

1992 13.5 10.3 3.2

1993 12.8 9.8 3.0

1994 12.9 9.4 3.5

1995 13.5 9.9 3.6

1996 14.1 10.4 3.7

1997 14.8 10.9 3.9

1998 15.3 11.3 4.0

1999 15.9 11.8 4.1

2000 16.5 12.4 4.1

2001 15.4 11.3 4.1

2002 14.6 11.0 3.6

2003 14.9 10.8 4.1

2004 16.1 11.5 4.6

Source: Based on Thomas Piketty and Emmanuel Saez, “Income Inequality in the United States” as updated at

http://emlab.berkeley.edu/users/saez.

Note: Income is adjusted gross income, plus adjustments, minus capital gains and transfer payments.

The earnings build-up inside tax-favoredsavings plans is income in exactly the samesense that taxable capital gains, dividends,and interest are income. However, this invest-ment income is no longer visible on taxreturns, as was most investment income ofmiddle-income families in the 1970s andbefore. This factor has thus exaggerated theincrease in top income shares by omitting agrowing fraction of the denominator. Bycontrast, the bulk of investment income ofthose in the top 1 percent is still reported ontax returns, because most of it is taxable andnot in the various tax-favored accounts suchas IRAs and 401(k)s.

When various tax-favored accounts werebeing created and expanded in recent decades,there was a lively debate about the extent towhich contributions to such accounts wouldrepresent new savings or income shifting—transferring existing savings from taxableaccounts to tax-deferred or tax-exemptaccounts. There was no serious dispute, how-ever, that there would be considerable incomeshifting for many years. Yet this variety ofincome shifting, despite its vast scale, has notpreviously been brought into discussionsabout the validity of using income tax data toestimate multi-decade changes in the distribu-tion of total income—including income fromsavings as well as work.

Piketty and Saez’s 2001 paper did men-tion retirement savings accounts, but only inthe context of one form of investmentincome (dividends) and only with respect totop income shares (the numerator). Theyobserved:

The ratio of dividends reported on indi-vidual tax returns to personal dividendsin the National Accounts has declinedcontinuously . . . to less than 40 percentin 1995. But the point is that this declineis due mostly to the growth of fundedpension plans and retirement savingsaccounts through which individualsreceive dividends that are never reportedas dividends on income tax returns. Forthe highest income earners, this addi-

tional source of dividends is likely to bevery small relative to dividends reportedon tax returns.19

Yet such invisible dividends are not smallfor those who are not the highest incomeearners. And that is also true of the tax-deferred or tax-exempt capital gains andinterest income of middle-income savers thatare also unreported on income tax returns.

Economist James Poterba of M.I.T. esti-mates that those in the (middle) 28 percent taxbracket held 32.1 percent of their assets in tax-deferred accounts in 1998.20 By contrast,Federal Reserve Board economist ArthurKennickel estimates that in 2001 the top 1 per-cent of wealth holders had only 5.5 percent oftheir assets in such unreported form.21

“At the end of 2002,” notes the CBO, “$10.1trillion was in tax-deferred retirement plans, ofwhich $9 trillion was taxable upon withdraw-al.”22 If that $10.1 trillion earned a middling 7percent return, the investment income alonewould be $707 billion in the first year—$707 bil-lion that could not appear in tax-based studiesof income earned by those who own thoseaccounts. Much of it should eventually showup as ordinary income upon withdrawal, butusually not for many years (or generations,since heirs do not have to tap an inherited IRAuntil they reach age 70.5).

Before a variety of tax-favored savingsplans became commonplace, virtually everydollar of investment income from the savingsof middle-income taxpayers was reported astaxable income, and it was therefore countedas income in studies that use tax returns toestimate income distribution in the 1970s.Today, by contrast, most investment returnsfrom the saving of middle-income taxpayersare rarely or never taxed. This makes it singu-larly inappropriate to use tax data to com-pare income shares before and after theexplosion of tax-deferred accounts. Doingso makes it appear as though middle-incomeinvestors had a far larger share of capitalgains, dividends, and interest income in the1970s than they did in the 1990s, simplybecause those investments used to be fully

7

The earningsbuild-up insidetax-favored sav-ings plans hasexaggerated theincrease in topincome shares byomitting a grow-ing fraction ofthe denominator.

taxable and now are not. The actual increaseof incomes among middle-income house-holds since the 1970s is therefore greatlyunderstated in tax data because an increas-ingly huge portion of their investmentincome is no longer reported on tax returns.The resulting statistical illusion shrinks thedenominator of the ratio of top income tototal income over time and thereby increasesthe apparent increase in the income sharerevealed within the top 1 percent of individ-ual income tax returns.

Just like income shifting from the corpo-rate to the individual tax system, the incomeshifting of middle-income savings from tax-able to tax-deferred accounts has led to anunderstatement of the amount and growthof investment income of millions of taxpay-ers in all studies that use only the incomereported on tax returns to estimate actualincome, including the Piketty-Saez and CBOstudies. This factor is not as easy to quantifyas income shifting between corporate andindividual tax returns, but it clearly presentsa huge and rapidly growing problem withrespect to all efforts to estimate incometrends from tax returns. And it makes it ludi-crous to compare today’s tax-based incomedistribution estimates with those of the1970s, when tax-deferred accounts for mid-dle-income taxpayers were virtually nonexis-tent. Middle-income taxpayers appeared tohave a larger share of before-tax income inthe tax return data of the 1970s simplybecause their yearly income from their invest-ments was taxed, and now most of it is sim-ply invisible on tax returns.

There are other types of income that havedisappeared from tax returns. The basic mea-sure of income on tax returns, adjusted grossincome (AGI), does not capture everything thatmight reasonably be considered income. Inaddition, tax returns do not capture all of AGI,which is evident when one considers that esti-mates of AGI based on personal income dataare larger than AGI reported on tax returns. TheBureau of Economic Analysis estimates thatthis “AGI gap” rose from 9.7 percent in 1988(when the top tax rate was 28 percent), to 12.7

percent in 1994, and to 14.4 percent in 2003.23

Assuming for illustration that the top 1 percentaccounted for 5 percent of the AGI gap, thatgap was too small in 1988 to have made muchdifference in their income share. By 1999, onthe other hand, that same assumption wouldreduce the top 1 percent’s share by nearly a per-centage point. The larger size of the AGI gapbefore and after the Tax Reform of 1986 is justone of many reasons why it is risky to compareincome data from tax returns between greatlydifferent tax regimes.

Top 1 Percent of What?

Media reports about the supposed rise inthe income share at the top, including refer-ences to the Piketty-Saez studies, never both-er to ask the most basic question of all: thetop 1 percent of what?

Most people assume that the “top 1 per-cent” and other income shares refer to the toppercentiles of household or family income. NewYork Times columnist Paul Krugman wrote:“According to Piketty and Saez . . . in 1998 thetop 0.01 percent received more than 3 percentof all income. That meant that the 13,000richest families in America had almost asmuch income as the 20 million poorest house-holds.”24 Yet the Piketty-Saez figures do notrefer to households nor families (much lessboth)—they refer to “tax units,” which can bemuch different.

Piketty and Saez point out that “averagehousehold income is about 28 percent high-er than average tax unit income.”25 In somecases the differences are much larger thanthat. Two unmarried working people livingtogether constitute one household but twotax units; their household income could betwice as large as their income per tax unit. Orconsider that children with investmentincome above $750 are required to file taxreturns, with the result that they show up asextremely poor “tax units” in the Piketty-Saezfigures, even though they are unlikely to beliving in poor families.

Pointing to the Piketty-Saez data, the pre-

8

Middle-incometaxpayers

appeared to havea larger share of

before-tax incomesimply because

their yearlyincome from

their investmentswas taxed, and

now most of it issimply invisible

on tax returns.

ceding remark by Paul Krugman claimed the13,000 richest “families” received “more than3 percent of all income.” But these are not“families,” they are tax units. Also note thatPiketty and Saez do not measure “allincome.” The authors do not include benefitpayments from Social Security, TemporaryAssistance for Needy Families, the EarnedIncome Tax Credit, Supplemental SecurityIncome, or other government programs.Since not all income is counted, such figurescannot possibly tell us what share of allincome was received by those at the top.

In 1970, wages and salaries accounted for 65.8percent of personal income, while transfer pay-ments accounted for just 8.5 percent.26 In 2005,wages and salaries accounted for 55.3 percent ofpersonal income, while transfers accounted for14.5 percent. Because transfer payments have rep-resented a rising share of total income, ignoringthem makes the top 1 percent’s share appear toincrease because a growing fraction of other peo-ple’s income is not counted. Yet there is no logicalreason to arbitrarily exclude such benefits asSocial Security from measured income, whileincluding comparable benefits from privateretirement plans.

The top 1 percent’s share of income is aratio—the top 1 percent’s income is the numer-ator, and that plus everyone else’s income is thedenominator. Excluding transfer paymentsfrom the denominator makes the top 1 per-cent’s share appear larger than it really is, but italso makes the top 1 percent’s share appear torise more than it has because transfer pay-ments have accounted for a rising share ofactual total income (the denominator).

Income Share TrendsSince the 1980s

Table 3 presents data covering 1981 to2004 to highlight the effects of transfer pay-ments and capital gains on the top 1 per-cent’s income share. Column 1 in the tableshows CBO data for the income share of thetop 1 percent including capital gains.27 Tomake these CBO figures more comparable to

those of Piketty and Saez, column 2 uses cap-ital gains data from Piketty and Saez toapproximate what CBO estimates would be ifthey excluded gains. Including realized capi-tal gains causes large variability in the data—it adds 4.3 percentage points to the top 1 per-cent’s share in 1986 and 2.6 points in 2000.

Note that the CBO data includes transferpayments. Thus, the adjusted CBO data incolumn 2 can be compared to the Piketty-Saez data in column 4, which also excludescapital gains and includes transfer payments.

Neither of the two CBO series show anysignificant increase in the top 1 percent’sshare between the late 1980s and the mostrecent years. Those determined to find anupward “trend” can always select some pairof years to create that impression. Theywould simply start with a year in which thenumber was relatively low (such as 1989 or1994 in the Piketty-Saez series), end with ayear that was unusually high, and show thepercentage change between them.

The CBO series that includes capital gainsrises in the late 1990s because of the stock mar-ket boom. But even the series without capitalgains rises with the stock market boom, whichlikely reflects the proliferation of nonqualifiedstock options granted after 1986, most ofwhich were exercised long after stocks recoveredfrom the 1991 recession. The 1993 tax law con-tributed to the rise of such stock optionsamong top executives because corporationscould deduct the cost of exercised options butnot salaries above $1 million.

The last two columns of Table 3 are themost significant, and they are also shown inFigure 2. Column 4 (Piketty-Saez with transferpayments) simply adds transfer payments(from the Bureau of Economic Analysis’ per-sonal income data) to the Piketty-Saez mea-sure of total income. (This includes therefundable portion of the Earned Income TaxCredit.) This results in reducing the top 1 per-cent’s share of total income by rising amountsover time, reaching three percentage points by2004.28 Since total income grows more rapidlyin this data series, due to the rapid growth oftransfer payments, it diminishes any upward

9

Excluding trans-fer paymentsmakes the top 1percent’s shareappear largerthan it really is.

trend in the top 1 percent’s share. The increasein the top 1 percent’s share from 1988 to 2003was just 0.8 percentage points when transfersare included in the denominator, which com-pares to 1.7 percentage points when they arenot. Similarly, the 1988 to 2003 increase in thetop 1 percent’s share in the CBO series wasnegligible because the CBO data includestransfer payments.

Column 5 of Table 3 (and the bottom linein Figure 2) adds transfer payments to thedenominator and subtracts business incomefrom the numerator. That leaves nonbusinessincome of the top 1 percent—mostly salaries,exercised stock options, and dividends—as apercent of total income, including transfers.The point of this exercise is the same as inTable 2, where we showed that about half of

10

Table 3

Estimates of the Pretax Income Share of the Top 1 Percent

5. Piketty-Saez

(including

transfers and

1. CBO 2. CBO 3. Piketty-Saez 4. Piketty-Saez excluding

(including (excluding (excluding (including business

capital gains) capital gains) capital gains) transfers) income)

1981 9.1 8.2 8.0 6.9 6.3

1982 9.6 8.3 8.4 7.1 6.5

1983 10.3 8.6 8.6 7.2 6.5

1984 10.9 9.1 8.9 7.6 6.8

1985 11.5 9.4 9.1 7.8 6.9

1986 14.0 9.7 9.1 7.8 6.9

1987 11.2 10.2 10.8 9.2 7.6

1988 13.3 12.0 13.2 11.3 8.9

1989 12.5 11.4 12.6 10.8 8.4

1990 12.1 11.4 13.0 11.1 8.6

1991 11.2 10.7 12.2 10.2 7.8

1992 12.3 11.7 13.5 11.2 8.5

1993 11.9 11.1 12.8 10.5 8.0

1994 12.1 11.4 12.9 10.6 7.7

1995 12.5 11.6 13.5 11.1 8.1

1996 13.8 12.3 14.1 11.6 8.5

1997 14.9 13.0 14.8 12.2 9.0

1998 15.7 13.6 15.3 12.8 9.4

1999 16.7 14.4 15.9 13.3 9.9

2000 17.8 15.2 16.5 13.9 10.5

2001 14.8 13.6 15.4 12.8 9.4

2002 13.5 12.5 14.6 12.0 9.0

2003 14.3 13.1 14.9 12.1 8.8

2004 NA NA 16.1 13.1 9.4

Source: Based on Congressional Budget Office, “Historical Effective Tax Rates: 1979 to 2003,” December 2005,

Table 1C; and Thomas Piketty and Emmanuel Saez, “Income Inequality in the United States,” as updated at

http://emlab.berkeley.edu/users/saez.

Note: Column 2 is Congressional Budget Offfice data as adjusted by the author to exclude capital gains based on

the percentage of income attributed to capital gains by Piketty-Saez. Columns 1, 2, 4, and 5 include transfer pay-

ments. Columns 1, 2, 3, and 4 include business income.

the rise in the top 1 percent’s seeminglyincreased share of income (excluding trans-fers) was the result of income shifting fromthe corporate to the individual tax.

After making just those two adjustments,the apparent increase of 1.7 percentage pointsin the top 1 percent’s share from 1988 to2003 in the unadjusted Piketty-Saez esti-mates becomes no increase. Thus, thePiketty-Saez results that show an increasedepend on two factors: (1) excluding transferpayments from income, and (2) treating theincome shifting between the corporate andindividual tax as an actual income increaserather than merely a matter of choosing toreport income on different tax forms.

To summarize the results so far: Aside fromthe two-year spike in the 1980s that Pikettyand Saez mentioned, which was due to the TaxReform Act of 1986, there has been no sus-tained increase in the top 1 percent’s sharethrough 2003 that cannot be entirelyexplained by either (1) the arbitrary exclusionof transfer payments, or (2) income shiftingbetween corporate and individual tax returns.

What about 2004? The unadjustedPiketty-Saez estimates suggest that the top 1percent’s share in 2004 of 16.1 percent wasnearly back to the level during the stock mar-ket peak in 2000 of 16.5 percent. However, ifwe set aside the increased share from busi-ness income (28.4 percent of the total in2004), the top 1 percent’s remaining 9.4 per-cent share of total income in 2004 was morethan a percentage point lower than the 2000peak. Yet the 2004 figure, if it is sustained, isnonetheless a bit higher than the peakreached during the late 1980s.29

When transfer payments are counted aswhat they are—income—and any adjustment ismade for the rising share of business incomereported among the top 1 percent of “individ-ual” incomes, it is clear that most of the sup-posedly continuous upward trend in the top 1percent’s share happened during the periodbetween the horrific stagflation of the early1980s (which did slash top investor incomes)and the spurious 1986 to 1988 spurt in report-ed incomes due to the 1986 tax act. There is alsoa four-year increase after the capital gains tax

11

Neither of thetwo CBO seriesshow any signifi-cant increase inthe top 1 per-cent’s sharebetween the late1980s and themost recentyears.

0

2

4

6

8

10

12

14

16

18

198

1

198

3

198

5

19

87

19

89

199

1

19

93

19

95

19

97

19

99

20

01

20

03

Piketty-Saez

Piketty-Saez with Transfer Payments

Piketty-Saez with Transfer Payments but Excluding Business Income

Figure 2

Estimates of the Top 1 Percent’s Share of Income

Per

centa

ge

of

Tota

l In

com

e

Source: Author's calculations and data in Thomas Piketty and Emmanuel Saez, “Income Inequality in the

United States,” as updated at http://emlab.berkeley.edu/users/saez.

rate was cut in 1997, which will be discussedbelow in connection with capital gains, stockoptions, and CEO pay.

Before-Tax and After-TaxIncome

The exclusion of transfer payments, as dis-cussed in the prior section, is particularly inap-propriate for those economist such as PaulKrugman who cite the Piketty-Saez estimates toargue for greater redistribution of income. Tothe extent that high tax rates on the rich mightactually be collected (an issue discussed below),such taxes might equalize after-tax incomes—even though they would not necessarily redis-tribute a dollar to the poor. Because the Piketty-Saez figures discussed above are before taxes,Krugman’s rhetorical attempts to link those fig-ures to “Bush tax cuts” are clearly irrelevant.30

The CBO’s tax-return-based estimates ofincome distribution suffer most of the sameshortcomings as the Piketty-Saez estimates,including business income being shifted toindividual tax returns. But the CBO is uniquein providing after-tax estimates, which are clear-ly more relevant to actual differences in livingstandards. CBO estimates of the top 1 per-cent’s share of after-tax income (which are notshown in Table 3) jumped from 9.9 percent in1984 to 13.2 percent in 1986 and 12 percent in1988.31 Unsurprisingly, the top 1 percent’sreported income also rose with the stock mar-ket boom of 1997–2000 (when the capitalgains tax rate was cut). By 2001–2003, however,the top 1 percent’s after-tax share had droppedback to about where it had been in 1988: 12.6percent in 2001, 11.5 percent in 2002, and 12.2percent in 2003. It is impossible to find any“continuous” upward trend in such figures, asThe Economist suggested occurred, despite mas-sive income shifting from the corporate to theindividual tax. That may explain why the CBOestimates have received far less media attentionthan the Piketty-Saez figures.

To the extent that more generous transferpayments to the poor do not discourage theirefforts to earn, such payments could redistrib-

ute incomes from those who earned them tothose who did not. Because the Piketty-Saezdata exclude transfer payments, however, theirmeasure of income distribution cannot possi-bly be directly affected by anti-poverty pro-grams (or by taxes). Even doubling the size ofmeans-tested transfer payments cannot helpsolve inequality if “inequality” is defined toexclude transfer payments.

The CBO, by contrast, does make an effortto determine the distribution of disposableincome—including subtracting taxes fromhigher incomes and adding transfer paymentsto lower incomes. But the CBO’s “comprehen-sive” measure of expanded income includesinterest on tax-exempt municipal bonds.32 Thatintroduces another difficulty with comparingdata before and after the 1986 Tax Reform Act.Interest on tax-exempt bonds was not reportedon tax returns before 1987. Thus tax returndata before that date cannot reveal a very popu-lar source of income among affluent taxpayersin the 1970s, when top tax rates on taxableinvestments were 70 percent or more. That isanother reason why recent income share mea-sures based on tax returns cannot be sensiblycompared with those of 1985, much less thoseof 1973 or 1979 (years commonly selected forcomparison because they were cyclical peakspreceding miserable years).

CBO’s estimates of the effective individualincome tax rate paid by the top 1 percent,including taxes on capital gains and divi-dends, are also interesting. The effective ratewas 21.8 percent in 1979 when the top taxrate was 70 percent, 20.7 percent in 1988when the top tax rate was 28 percent, and20.8 percent in 2003 when the top tax ratewas 35 percent. If it is hard to believe thatlower marginal tax rates had so little impacton average taxes paid, just wait until we get toa later section on “taxable income elasticity.”

Capital Gains and Stock Options

The treatment of capital gains in studiesof income shares raises many issues. The

12

Aside from thetwo-year spike inthe 1980s, which

was due to theTax Reform Act

of 1986, there hasbeen no sustained

increase in thetop 1 percent’sshare through

2003.

CBO data includes only the portion of capi-tal gains that shows up on tax returns butexcludes capital gains accruing within tax-deferred savings accounts, the sizable exclu-sion of capital gains from home sales since1997, and capital gains that are unrealizedbecause the assets are not sold.

Many academic and government studieshave shown that the amount of capital gains“realized” each year—by selling stock or otherassets—is enormously affected by the top taxrate on such gains.33 For example, CBO’s esti-mates show the top 1 percent’s share of expand-ed income jumping in 1986 to avoid the highercapital gains tax in 1987. And CBO’s estimatesshow the top 1 percent’s share rising sharplyagain in 1997–2000, after the top capital gainstax was cut from 28 to 20 percent.

Piketty and Saez wisely exclude capital gainsfrom their basic series, but include gains inanother series. The difference between the twoseries provides a handy measure of the chang-ing importance of capital gains.

Figure 3 shows that a substantial share ofthe top 1 percent’s broader income (including

capital gains) consists of capital gains. Changesin the capital gains share illustrate to someextent another important example of “incomeswitching.” There has been substantial switch-ing between (1) incentive stock options orrestricted stock taxed as a long-term capitalgain and (2) “nonqualified” stock optionsreported as salaries when cashed in and taxed atordinary income tax rates.

Figure 3 shows that capital gains account-ed for 18 percent or less of all the broadlydefined income (including those gains)reported on the top 1 percent of individualincome tax returns in the early 1980s. Theunprecedented spike to a 30.5 percent sharein 1986 was clearly just a matter of timing—cashing out early to beat the higher 28 per-cent tax on gains in 1987.

Starting in 1987, capital gains became amuch smaller portion of the income of thetop 1 percent, dropping to an average of just7.3 percent for the following 10 years. Forbusiness executives, however, receiving asmaller share of total compensation fromcapital gains (incentive stock options or

10.1

14.0

18.0

30.5

8.510.2

8.7

6.04.3

5.26.35.8

7.5

10.913.0

14.5

8.37.4

8.59.910.7

13.613.6

10.7

16.416.4

0

5

10

15

20

25

30

35

19

79

19

81

198

3

198

5

198

7

198

9

199

1

19

93

19

95

19

97

199

9

200

1

200

3

13

By 2001–2003,the top 1 per-cent’s after-taxshare haddropped back toabout where ithad been in 1988.

Figure 3

Capital Gains Share of the Income of the Top 1 Percent

Per

centa

ge

of

Tota

l In

com

e

Source: Author’s calculations based on data in Thomas Piketty and Emmanuel Saez, “Income Inequality in the

United States,” as updated at http://emlab.berkeley.edu/users/saez.

restricted stock) can often reflect renegotiat-ing compensation packages to receive a larg-er share from salary, bonuses, or nonquali-fied stock options. Such changes in the formof executive compensation do not make peo-ple richer or poorer, but they do affect thePiketty-Saez estimates because those esti-mates exclude capital gains.

The top 1 percent received a much largershare of their income in the form of realizedcapital gains from 1979 to 1986 than theydid from 1987 to 1995. That doesn’t meanthat they received less income in the latterperiod—only that they received it as nonqual-ified stock options, salary, or bonus taxed assalaries rather than as restricted stock orincentive stock options taxed as capital gains.Because the Piketty-Saez estimates excludecapital gains (correctly, in my judgment), thissort of income switching means that theirestimates from 1979 to 1986 were artificiallydepressed (because a larger share of topincomes came from capital gains and aretherefore not counted) relative to those from1987 to 1995. And that, in turn, created alargely illusory increase in the top 1 percent’sincome share between those two periods.This form of income shifting is yet anotherreason why such income share figures cannotbe properly compared before and after 1986.

When the capital gains tax rate was cutfrom 28 to 20 percent in 1997, capital gainsrose sharply as a share of the top 1 percent’sincome (Figure 3), before stocks crashed in2001. But realization is not a meaningful con-cept of income or a meaningful proxy for unre-alized capital gains. Selling stock is no differentfrom selling a house or car—it does not makeanyone wealthier and is not income.

An additional issue is that investorresponses to changes in the capital gains taxrate create serious problems for tax-return-based measures of top incomes, regardless ofwhether the capital gain is included or not.The CBO’s income distribution estimates(which include capital gains) are obviouslydistorted by changes in the frequency andtiming of asset sales in response to actual oranticipated changes in the capital gains tax.

On the other hand, estimates that excludereported capital gains (such as Piketty-Saez)are distorted by another form of income shift-ing—between compensation reported onSchedule D as capital gains and compensa-tion reported on form W-2 as salaries. Animportant example is stock options grantedto hundreds of corporate executives and mil-lions of other employees.

Some stock options are “nonqualified,” andare reported on W-2 forms as salaries when theyare “exercised” (cashed-in after three years ofvesting but before the 10-year expiration date).“Incentive stock options,” by contrast, must beheld for a while after they are exercised and aretherefore taxed as long-term capital gains.Restricted stock is also held for a vesting periodand, with luck, sold as a capital gain.

Economist John Karl Scholz rightly notesthat, “there have been important changes incompensation in recent years in the U.S.—namely, there were unusually large increasesin the use of [nonqualified] stock options.These have been shown by others to be a verysubstantial portion of the incomes of topearners.”34 However, as Carola Frydman andRaven Saks point out, “because gains fromstock options prior to the 1970s were notgenerally taxed as personal income and con-sequently not recorded on personal incometax returns, tax returns may provide a biasedestimate of the incomes of top earners.”35

Before 1972, the top tax rate on ordinaryincome was 70 percent, so sensible executivesnegotiated to receive incentive stock options(ISOs), taxed at much lower capital gains taxrates of 25–34 percent. Any gains from non-qualified stock options granted in 1972 orlater could eventually be taxed at a lower 50percent rate on “earned income,” but onlyafter another 3 to 10 years, when they werevested and exercised. Virtually all gains fromexercising executive stock options before1980 appeared as capital gains and are there-fore invisible in 1970s salary data. This isanother reason, in our growing list, whyrecent Piketty-Saez data are not comparableto those of the 1970s.

When the top tax rate on salaries was

14

There has beensubstantial

switchingbetween (1) incen-tive stock optionsor restricted stock

taxed as a long-term capital gain

and (2) “nonqual-ified” stock

options reportedas salaries.

reduced from 50 percent in 1986 to 28 per-cent in 1988, that provided a huge incentiveto delay cashing in any nonqualified optionsuntil 1988. That is one reason why salaryincome jumped dramatically in 1988. Andbecause the tax on capital gains also rosefrom 20 percent to 28 percent in 1987, thatprovided a huge incentive to cash in olderincentive options in 1986. That is why CBO’sestimates of top income shares, whichinclude capital gains, spike the most in 1986rather than 1988. What appears as a bigincrease in annual income in both 1986 and1988 was simply a matter of when incomewould be realized. Timing is everything, buttiming isn’t really annual income.

Because the 1986 tax act slashed tax rates onsalaries and raised the tax rate on capital gains,it promoted an increasingly wide distributionof nonqualified options (taxed as salary) andnearly killed incentive stock options (taxed ascapital gains). The net result was massiveincome switching from 1986 to 1988—fromreporting exercised stock options as capitalgains to reporting them as salary income.

Nonqualified options granted between1988 and 1992 were not vested until 1991 to1995, and few were willing or able to exercisesuch options in the recession of 1991. By thetime most of such options could be exercised,it was 1993, and the tax rate had gone up.That did not indicate that executives don’trespond to tax rates. It just meant nonquali-fied stock options can only be exercised 3 to10 years after they are granted, and, mean-while, the rules may have changed.

Most of the executive and non-executivestock options cashed in during the stockboom of 1997 to 2000 were counted assalaries, whereas comparable stock optionsin the 1970s were of a different variety thatdid not appear in the salary data. As dis-cussed earlier, tax-return-based income-dis-tribution estimates from the 1970s are sim-ply not comparable to data from recent years.

Since executives can choose the timing ofstock option exercises and capital gains real-izations, they naturally report most of suchincome in boom times and very little in

slumps. The resulting cyclicality of the top 1percent’s share of reported income makesthis a paradoxical way to define “inequality.”Recessions increase the poverty rate andunemployment rate, yet appear to “reduceinequality” according to this “top 1 percent”criterion—partly because capital gain realiza-tions and stock option exercises dry up.

Even in the series without capital gains, thePiketty-Saez estimates of top 1 percent incomeshares always fell, without exception, wheneverthe real economy and stock market contracted.The top 1 percent’s share fell in 1920, 1929–32,1938, 1949, 1953, 1957–58, 1960, 1970,1975–76, 1981, 1991, and 2001–2002. If reduc-ing the top percentile’s share of income was asensible policy objective, a dozen recessionstaught us how to do that.

CEOs and Celebrities

Income shifting and other varieties of tax-able income elasticity are consistent with theU.S. time series data on top income shares. Analternative explanation, supported by Pikettyand Saez and others, is that the observedincreases in income reported by the top 1 per-cent of U.S. taxpayers since the 1970s has beendue to large increases in the pay of chief execu-tive officers. The market for CEOs is hypothe-sized to be limited to English-speaking coun-tries, which is thought to explain why topincome shares rose more dramatically in thosecountries than in France or Japan. According toIan Dew-Becker and Robert Gordon, “CEOstogether with sports and entertainment starsexplain what is going on in the top 1 percent ofthe income distribution.”36

There are now more than 1.4 million U.S. tax-payers in the top 1 percent. The only evidence thatPiketty and Saez offer to suggest that the averageincome of those 1.4 million could be explained byCEO pay is an annually changing sample of thetop 100 CEOs (those who happen to exercise oldstock options in any particular year). Yet thePiketty-Saez estimates of average pay for that elite100 fell by more than 54 percent from the year2000 to 2003 (from $40.4 million to $18.5 mil-

15

Changes in theform of executivecompensation donot make peoplericher or poorer,but they do affectthe Piketty-Saezestimates.

lion apiece).37 That huge decline in top CEO paywas certainly not matched by a comparable dropin the estimated income share of the top 1 per-cent. But there was no reason to expect it to havehad much impact, since the combined incomesof the top 100 CEOs in 2003 was only $1.85 bil-lion—just two-tenths of 1 percent of the $886.5billion that Piketty and Saez attributed to the top1 percent.

Figure 4 shows that the rise and fall of payamong the Standard & Poor’s 500 chief exec-utives, as calculated by Lucian Bebchuk andYaniv Grinstein, was closely tied to the riseand fall of the S&P 500 index itself, whichproves the vast majority of CEO pay at thebiggest firms is tightly tied to stock perfor-mance (up to 78 percent of top 100 pay wasstock-based in a Piketty-Saez sample).38

Top CEO pay is clearly insufficient toaccount for the level or growth of incomeamong the top percentile. The proliferationof nonqualified stock options among severalmillion non-executive employees in the1990s is a far more plausible explanation ofthe obvious 1997–2003 link between the

stock market’s ups and downs and the unad-justed Piketty-Saez estimates of top per-centile shares. Estimated income shares ofthe top 1 percent soared with the stock mar-ket in 1997–2000 and then fell with the mar-ket in 2001–2003. That was even true of esti-mates that excluded taxable capital gains,which suggests the link between top per-centile pay and stock prices was dominatedby nonqualified stock options.

Reported Income Dependson Marginal Tax Rates

The numerator of the ratio of topincomes to total incomes has been seriouslycorrupted by tax-induced income shiftingfrom the corporate tax to the individual tax,from taxable to tax-favored savings accounts,and from stock options taxed as capital gainsto stock options taxed as salary. Yet this sortof income shifting is merely a partial mani-festation of a broader phenomenon—namely,the elasticity of taxable income.

16

0

2

4

6

8

10

12

14

16

18

20

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

0

200

400

600

800

1000

1200

1400

1600Average CEO Pay for

S&P 500 Firms

S&P 500 Stock Index

Recessionsincrease the

poverty rate andunemploymentrate, yet appear

to “reduceinequality.”

Figure 4

Standard & Poor’s 500 Stock Index and Average CEO Pay

Aver

age

CE

O P

ay (

$ m

illi

ons)

S&

P500 S

tock

Index

Source: Lucian Bebchuk and Yaniv Grinstein, “The Growth of Executive Pay,” Oxford Review of EconomicPolicy 21, no. 2 (2005).

Reductions in marginal tax rates mayinduce people to alter their taxable income inmany ways. Executives may negotiate forshares in their companies, for example,rather than receiving cozy salaries and tax-exempt perks.39 Entrepreneurs may startmore businesses, spouses of high-brackettaxpayers may join the labor force, those pre-viously working in the underground casheconomy may take jobs that require taxes tobe paid, skilled professionals may work hard-er and retire later, executives may negotiatefor cash rather than perks, high-incomeinvestors may hold fewer tax-exempt bondsand trade stocks more frequently, taxpayersmay not try so hard to maximize tax deduc-tions and adjustments.40

More than a dozen highly-regarded stud-ies have shown that the amount of incomereported by those facing the highest margin-al tax rates is extremely sensitive to changesin those rates. This responsiveness goes bythe cumbersome name of “taxable incomeelasticity.” The elasticity of taxable incomerefers to how much reported income willchange when marginal tax rates are changed.

Economist Wojciech Kopczuk came upwith an estimated elasticity of 0.53 for all tax-payers.41 The Federal Reserve’s Adam Looneyand Harvard’s Monica Singhal “estimate asignificant elasticity of family labor incomeof 0.75 for families with base-year earningsbetween $35,000 and $85,000.”42

Studies that focus on taxpayers in the high-est tax brackets generally find higher elasticities,which seems logical. At the lower end of therange for such estimates is a study by JonGruber and Emmanuel Saez, which found that“taxpayers who have incomes above $100,000per year . . . have an elasticity of 0.57.” 43

At the high end, Harvard’s Martin Feldsteinrecently reported that estimates for high-income taxpayers show that “the elasticity ofincome with respect to one-minus-the-mar-ginal-tax rate is about one.”44 Thus, if the toptax rate drops from 40 to 30 percent, theamount of every extra dollar a taxpayer getsto keep (one minus the marginal tax rate)would rise by nearly 17 percent—from 60 to

70 percent. An elasticity of one means thatthe amount of income reported would alsorise by 17 percent. In place of an extra $100taxed at 40 percent ($40), the IRS wouldreceive $117 taxed at 30 percent ($35).

The point is that all of these estimates oftaxable income elasticity, including two byEmmanuel Saez, predict that a substantialreduction of top tax rates should be followedby a very substantial increase in the amountof income reported on tax returns by high-income taxpayers. And that is exactly whathappened when U.S. tax rates on salaries(and S-corporation profits) were sharplyreduced after 1986. According to EmmanuelSaez, “income shares within the top 1 percentshow striking evidence of large and immedi-ate responses to the tax cuts of the 1980s, andthe size of those responses is largest for thevery top income groups.”45

With the capital gains tax, the estimates oftaxable income elasticity are generally higher,averaging at least 0.9 among a dozen leadingstudies.46 That implies that reported incomefrom realized capital gains should have beenexpected to increase substantially just after theU.S. capital gains tax was reduced from 28 per-cent to 20 percent in 1997. And Figure 3 showsthat that is exactly what happened (partlybecause of income switching).

Raj Chetty and Emmanuel Saez found asurge in dividend payouts following the 2003reduction in the top U.S. dividend tax ratefrom 35 to 15 percent.47 Between 2002 and2004, the amount of dividend income report-ed on individual tax returns nearly doubled—dividends increased from $103.2 billion in2002 to $198.8 billion in 2004.48 Under theplausible assumption that a large fraction ofthe dividends were reported by high-brackettaxpayers, the reduction of the dividend taxfrom 35 to 15 percent helps account for theotherwise anomalous magnitude of thePiketty-Saez estimate on income shares(Table 2) for 2004. But these higher dividendpayouts mainly represent income shifting.After the dividend tax was cut, a smallershare of corporate income was retained orused for stock buybacks, so more profits were

17

The combinedincomes of thetop 100 CEOs in2003 was only$1.85 billion—just two-tenths of1 percent of the$886.5 billionattributed to thetop 1 percent.

paid out to stockholders and reported as tax-able individual income. And a greatlyreduced portion of dividend-paying stockswas held in tax-deferred accounts or by tax-exempt foundations and institutions, while alarger share was willingly held by investorshappy to pay a 15 percent tax (yet easily ableto avoid a 35 percent tax).

Despite all the evidence from Saez and oth-ers that taxable income elasticity is enormouslysignificant for high-income taxpayers, for capi-tal gains realizations, and for the taxable por-tion of dividends, Piketty and Saez werenonetheless strangely puzzled that “while topincome shares have remained fairly stable incontinental European countries or Japan overthe past three decades, they have increasedenormously in the United States and otherEnglish-speaking countries.”49 Yet that is exact-ly what all the estimates of taxable income elas-ticity should lead us to expect. “While progres-sivity has unambiguously declined in theUnited States and in the United Kingdom,”note Piketty and Saez, “it has increased some-what in France.”

We should have expected top incomeshares to have remained stable in France (andJapan) but to have increased enormously inthe U.S. and other countries that cut tax ratessharply. Countries that cut top marginal taxrates in half, such as the United States, theUnited Kingdom, India, and New Zealand,experienced the largest increases in reportedpretax income among top income groups.Countries that cut marginal tax rates lessaggressively, such as Canada and Australia,experienced significant yet less dramaticincreases in reported top income shares. Andthose countries that kept combined nationaland local income tax rates near 50 percent,such as Japan and France, did not experiencea significant increase in top income shares.These international comparisons are entirelyconsistent with U.S. estimates of taxableincome elasticity.50 They show that havingthe top 1 percent report more income or cap-ital gains on tax returns, simply because thetax penalty for doing so came down, saysmore about how people react to tax rates on

added income than it does about how muchincome or wealth (such as unrealized capitalgains) they actually have.

Income Trends since the 1970s

The widespread impression that theUnited States has experienced a large andcontinuous increase in income inequalitysince the 1970s is almost entirely dependenton the disingenuous practice of using esti-mates based on income tax returns to com-pare the distribution of incomes before andafter the dramatic tax changes of 1981 and1986. If the Piketty and Saez estimates actu-ally demonstrated a continuous and credibleupward trend toward greater inequality sincethe late-1980s, all other estimates of incomedistribution would have to be wrong—including those of the Census Bureau, theCBO, and the Federal Reserve Board.

In a recent column, Paul Krugman com-plained about “the amount of time that inequal-ity’s apologists spend attacking a claim nobodyis making: that there has been a clear long-termdecline in middle-class living standards.”51 Yet,in a 2004 column Krugman said, “according toestimates by the economists Thomas Pikettyand Emmanuel Saez—confirmed by data fromthe CBO—between 1973 and 2000 the averagereal income of the bottom 90 percent ofAmerican taxpayers actually fell by 7 percent.”52

For Krugman to assert that there was a 7percent drop in real income for 90 percent oftaxpayers over 27 years certainly sounds like a“clear long-term decline in middle-class livingstandards.” To question such claims requiresno straw man. On the contrary, Krugman’sastonishingly incorrect assertion provided anexcellent example of how remarkably uncriticaleven professional economists have becometoward the Piketty-Saez estimates.

Piketty and Saez recently acknowledged that,“our long-run series are generally confined totop income and wealth shares and contain littleinformation about bottom segments of the dis-tribution.”53 Yet one of their figures from their

18

A substantialreduction of toptax rates shouldbe followed by avery substantial

increase in theamount of

income reportedon tax returns by

high-incometaxpayers.

2001 paper (Figure A-1) encouraged the exactopposite impression. The figure appeared toshow 27 years of real income stagnation (notdecline) for the bottom 99 percent of taxpayersrather than Krugman’s bottom 90 percent. In akey footnote to that graph, however, theyexplain that “from 1973 to 2000, the averageincome of the bottom 99 percent would havegrown by about 40 percent in real terms insteadof stagnating (as displayed in the figure above) ifwe had included all transfers (+7% effect), usedthe CPI-U-RS (+13% effect), and especiallydefined income per capita (20% effect).”54 That40 percent increase in per capita real income forthe bottom 99 percent makes it quite impossiblethat income of the bottom 90 percent ofAmerican taxpayers “actually fell by 7 percent,”as Krugman wrote.

CBO’s estimates began in 1979, not 1973,and they certainly do not “confirm” whatPiketty and Saez deny (in the footnote). Between1979 and 2000, the CBO estimates indicate thatthe average real income of the bottom 80 per-cent of American taxpayers rose by 12 percentbefore taxes and by 15 percent after taxes.55 Realafter-tax income of the middle quintile rosefrom $38,900 in 1979 (in 2003 dollars) to$44,700 in 2000, according to the CBO.

Census Bureau estimates of mean house-hold income among the bottom four quin-tiles rose from $32,786 in 1973 (in 2005 dol-lars) to $40,640 in 2000.56 That is, Censusestimates show a 24 percent real increase forthe bottom 80 percent—with all of that gainoccurring since 1982. In fact, the Census esti-mates show an accelerating pace of gainsamong the bottom 80 percent, with realincome in that group rising 7.6 percent from1970 to 1980, 9.6 percent from 1980 to 1990,and 12.4 percent from 1990 to 2000.57

Aside from the Piketty-Saez comparisons oftop income shares before and after the TaxReform Act of 1986, there is surprisingly littleU.S. evidence of any significant and sustainedincrease in inequality of income, wealth, wages,or consumption since the late 1980s.

The Census Bureau’s conventional measureof household income distribution (whichexcludes taxes and transfer payments) shows lit-

tle change in recent years aside from a one-timejump in 1993 when “a change in survey method-ology led to a sharp rise in measured inequali-ty.”58 Figure 5 shows that the top 5 percent’sshare of family income was virtually constant inrecent years, drifting between 20 percent and 21percent from 1993 to 2004. The Census esti-mates are in marked contrast to the Piketty-Saezestimates for the top 5 percent of tax units,which were much higher than the conventionalCensus figures (even though both series excludecapital gains and transfer payments) and fluctu-ated much more with the stock market and withchanges in business income reported on indi-vidual tax returns. The Census estimates of theshare of income received by the top 5 percentcast considerable doubt on the much higherand more volatile Piketty-Saez series, for reasonsthis paper explains.

The Census Bureau also uses Gini coeffi-cients to measure broad changes in inequality.Larger Gini coefficients indicate increasedinequality. Despite the break in the data in1993, as noted, the Bureau’s Gini coefficient forafter-tax post-transfer household income (whichis the way most other countries measureinequality) has not increased—it was .409 in1986, .398 in 1993, and .394 in 2002–2003.59

Note that the post-tax, post-transferCensus Bureau Gini coefficients are based onmean income by quintile. But mean incomefor, say, the top 5–20 percent is always muchlarger than median income because, unlikeother income groups, top groups have noincome ceiling to exclude extreme outliers(such as a hedge fund manager earning a bil-lion dollars in one year). This makes it mis-leading to compare changes of mean incomebetween top income groups and other quin-tiles or deciles.

Table 4 compares real median income byincome group from the periodic Federal ReserveBoard’s Survey of Consumer Finances.60

Between 1989 to 2004 the increase in real medi-an income for the top two deciles was about 20percent—essentially identical to the increase forthe bottom two quintiles.

The common impression that the UnitedStates remains in the midst of a large and persis-

19

Countries thatcut top marginaltax rates in halfexperienced thelargest increasesin reported pre-tax incomeamong topincome groups.

tent 20-year increase in income inequality is alsoinconsistent with measures of consumption orwage inequality. A 2005 study published by theU.S. Bureau of Labor Statistics shows that theGini coefficient for a broad measure of consump-tion inequality was 0.283 in 1986, 0.293 in 1990,0.294 in 1994, 0.281 in 1999, and 0.280 in 2001.61

The most recent two figures show less inequalityof living standards (consumption) than in 1986.

Economists Wojciech Kopczuk andEmmanuel Saez examined the inequality ofwealth. They concluded that in the 1980s,“top wealth shares increased only to the lev-els prevailing prior to the recessions of the1970s. Furthermore, this increase took placein the early 1980s and top shares were stableduring the 1990s.”62

In another study, economists David Cardand John DiNardo found that wage inequalitydid not increase before 1980 and that 85 per-cent of the increase during the 1980s hap-pened before 1985, concluding that “none ofthe three series [measuring wage differences]. . . shows a noticeable change in inequalitybetween 1988 and 2000.” 63

Most measures do show some increase inthe inequality of income, wages, wealth, andconsumption between 1981 and 1986. But1981 was an atypical base year with acutestagflation and severely depressed stock andbond prices.

Conclusions

The many changes in U.S. tax rules since1980 have made a dramatic difference inwhat is reported as income on individual taxreturns. One result is that it is misleading, ifnot meaningless, to compare income report-ed on tax returns in the 1970s and 1980swith data reported in recent years.

The estimated ratio of top percentile U.S.incomes to total incomes has been distorted bytax-induced changes to both the numeratorand the denominator. The amount of businessincome reported on individual income taxreturns by the top 1 percent rose from 7.8 in1981 to 28.4 percent in 2004, following sharpreductions in individual income tax rates enact-

20

There is surpris-ingly little U.S.evidence of anysignificant and

sustained increasein inequality ofincome, wealth,

wages, or con-sumption since

the late 1980s.

0

5

10

15

20

25

30

35

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Piketty and Saez

Bureau of the Census

Figure 5

Estimates of the Top 5 Percent's Share of Income

Perc

enta

ge o

f T

otal

Inc

ome

Source: U.S. Bureau of the Census household income data, www.census.gov/hhes/www/income/histinc/

h03ar.html; and Thomas Piketty and Emmanuel Saez, “Income Inequality in the United States,” as updated at

http://emlab.berkeley.edu/users/saez.

ed in 1981 and 1986. Corporate executivesswitched from accepting stock options taxed ascapital gains to nonqualified stock optionsreported and taxed as salaries, and those newlypopular stock options were distributed to mil-lions of non-executives.

Estimates of the elasticity of taxable incomeamong high-income taxpayers range from 0.56to 1.0, implying that large increases in reportedincome should be observed when tax rates arecut. And that is what occurred in countries thatcut top tax rates in half, such as the UnitedStates, the United Kingdom, New Zealand, andIndia. Estimates of the elasticity of reportedincome from capital gains cluster near 0.9,implying large increases in reported incomefrom capital gains should have been observed(as they were) after the U.S. capital gains tax ratewas cut in the early 1980s, in 1997, and in 2003.

This paper estimates that simply includ-ing transfer payments in the denominator ofthe Piketty-Saez data reduces the top per-centile’s income share in 2004 from 16.1 per-cent to 13.1 percent. Just one form of incomeshifting—business income from corporate toindividual returns—added another three per-centage points to the share reported by thetop 1 percent. The adjusted estimates showno increase in the top 1 percent’s income

share between 1988 and 2003. The top 1 per-cent’s income share rose in 2004 based on thePiketty-Saez interpolated estimate, but thatappears to be partly explained by the neardoubling of dividend income reported afterthe sharp dividend tax cut of 2003.

There is still much to be uncovered withrespect to data on income shares, however.With respect to top percentile incomes, thispaper did not attempt to estimate the size oftax shifting between stock options taxed ascapital gains in the 1970s and those taxed assalary in the 1990s.

Most importantly, this paper just beginsto focus attention on the large magnitude ofshifting between taxable savings in the 1970sand tax-favored savings, such as in 401(k)s,today. Many new and expanded savings plansresulted in much of the dividends, interestincome, and capital gains of middle-incometaxpayers disappearing from tax returns,leaving only the investment income of afflu-ent investors visible in the data. This papermakes no effort to estimate the magnitude ofthis disappearance, yet it is clearly very largeand growing rapidly.

In sum, studies of changes in income dis-tribution based on tax return data providedistorted and misleading comparisons of

21

It is misleading,if not meaning-less, to compareincome reportedon tax returns inthe 1970s and1980s with datareported inrecent years.

Table 4

Real Pretax Median Household Income (in 2004 dollars)

Percentile Percent Change

of Income 1989 2004 1989–2004

0 to 20 9,173 11,100 21.0

20 to 40 21,439 25,700 19.9

40 to 60 38,292 43,200 12.8

60 to 80 59,731 68,100 14.0

80 to 90 87,250 104,700 20.0

90 to 100 153,168 184,800 20.7

Source: Federal Reserve Board, “Survey of Consumer Finances,” www.federalreserve.gov/pubs/oss/oss2/scfind

ex.html.

Note: The 1989 figures were converted to 2004 dollars using the CPI-U.

U.S. income shares because of dramaticchanges in tax laws in recent decades. Asidefrom changes in taxpayer reporting due tochanges in the tax laws, there is no clear evi-dence of a significant and sustained increasein the inequality of U.S. incomes, wages, con-sumption, or wealth since the late 1980s.

Notes1. “Dividing the Pie,” The Economist, February 2,2006, www.economist.com.

2. “The Rich, the Poor and the Growing Gapbetween Them,” The Economist, June 15, 2006.

3. Paul Krugman, “Whining over Discontent,”New York Times, September 8, 2006, p. A29.

4. For example, one study adds IRA rollovers andaccelerated depreciation to top incomes while exclud-ing Social Security and other transfers from thedenominator. See Michael Strudler, Tom Petska, andRyan Petska, “Further Analysis of the Distribution ofIncome and Taxes, 1979–2002,” Statistics of IncomeDivision, Internal Revenue Service, November 2004,www.irs.gov/pub/irs-soi/04asastr.pdf.

5. Thomas Piketty and Emmanuel Saez, “IncomeInequality in the United States, 1913–1998,”NBER Working Paper no. 8467, September 2001.See also Thomas Piketty and Emmanuel Saez,“Income Inequality in the United States,1913–2002,” November 2004, http://emlab.berkeley.edu/users/saez/piketty-saezOUP04US.pdf. The authors have updated their data athttp://emlab.berkeley.edu/users/saez.

6. Piketty and Saez, “Income Inequality in theUnited States, 1913–2002,” p. 31.

7. Piketty and Saez explain the interpolation tech-nique in the appendix to their November 2004paper. Note that Anthony B. Atkinson of OxfordUniversity cautions that “the Pareto distributionis at best an approximation.” See A. B. Atkinson,“Top Incomes in the United Kingdom over theTwentieth Century,” Nuffield College, OxfordUniversity, December 2003, www.nuff.ox.ac.uk/economics/people/atkinson.htm.

8. “The Rich, the Poor and the Growing Gap betweenThem.”

9. Piketty and Saez, “Income Inequality in theUnited States, 1913–1998,” p. 8.

10. In those series that include taxable capital

gains, such as the CBO figures, reductions in thecapital gains tax rate in 1997 and 2003 would beexpected to increase the amount of gains report-ed on tax returns, since the amount of gains real-ized is very sensitive to the tax rate.

11. Emmanuel Saez, “Reported Incomes andMarginal Tax Rates, 1960–2000: Evidence andPolicy Implications,” NBER Working Paper no.10273, January 2004, p. 21.

12. Saez, p. 27.

13. Ibid., p. 28.

14. David Hoffman, ed., Facts and Figures onGovernment Finance, 36th edition (Washington:Tax Foundation, 2002), Table C29.

15. Ibid., Table C34.

16. Kelly Luttrell, “S Corporation Returns, 2002,”SOI Bulletin, Spring 2005, p. 59, www.irs.gov/pub/irs-soi/02scorp.pdf.

17. Jagadeesh Sivadasan and Joel Slemrod, “TaxLaw Changes, Income Shifting and MeasuredWage Inequality: Evidence from India,” NBERWorking Paper no. 12240, May 2006.

18. These are a few exceptions, including intereston tax-exempt bonds and half of capital gains(60% after 1978).

19. Piketty and Saez, “Income Inequality in theUnited States, 1913–1998,” p. 16.

20. James M. Poterba, “Valuing Assets inRetirement Savings Accounts,” Center for Retire-ment Research, Boston College Working Paper2004-11, April 2004, www.bc.edu/centers/crr/papers/wp_2004-11.pdf.

21. Arthur B. Kennickel, “A Rolling Tide: Changes inthe Distribution of Wealth in the U.S., 1989–2001,”Federal Reserve Board, September 2003, Tables 10 and11, www.federalreserve.gov/pubs/oss/oss2/method.html.

22. Congressional Budget Office, “Tax-DeferredRetirement Savings in Long-Term RevenueProjections,” May 2004, p. 8.

23. Mark A. Ledbetter, “Comparisons of BEAEstimates of Personal Income and IRS Estimatesof Adjusted Gross Income,” Survey of CurrentBusiness, U.S. Bureau of Economic Analysis,November 2005, p. 30.

24. Paul Krugman, “For Richer,” New York TimesMagazine, October 20, 2002, p. 62.

22

25. Piketty and Saez, “Income Inequality in theUnited States, 1913–1998,” footnote to Figure A-1.

26. Bureau of Economic Analysis, National Incomeand Product Accounts, Table 2.1, www.bea.gov/bea/dn/nipaweb/SelectTable. asp?Selected=N.

27. Congressional Budget Office, “HistoricalEffective Federal Tax Rates: 1979 to 2003,”December 2005, Table 1C.

28. Transfer payments are added only to the measureof total income, on the uncontroversial assumptionthat the share of transfer payments received by thetop 1 percent is small enough to ignore.

29. The estimates for the top 1 percent’s share in2004 are a curiosity because the stock market didnot rise so dramatically. It will be interesting tosee if the Piketty-Saez interpolations (approxima-tions) turn out to be consistent with CBO esti-mates, which will be released in the future basedon data not publicly available. Judging by a recente-mail exchange with Saez, I believe we agree thatreported dividends may be a large part of the expla-nation—arguably a response to the new 15-per-cent dividend tax.

30. Krugman’s column of September 8, 2006(“Whining over Discontent”), switched to anentirely different set of Piketty-Saez estimates oftop income group’s share of combined incomeand estate taxes—a questionable concept that Icritiqued in a recent column. (Alan Reynolds,“The Top One-Hundredth of One Percent,” May17, 2006, www.cato.org/pub_display.php?pub_id=6394). Those estimates show the average tax ofthe middle 20 percent dropping by 63 percentfrom 1980 to 2005, from 8.9 percent to 3.3 per-cent, which hardly looks like a tax cut for the rich.

31. Congressional Budget Office, “HistoricalEffective Federal Tax Rates: 1979 to 2003,”December 2005, Table 1C.

32. Ibid. Footnotes to the CBO tables explain:“Comprehensive household income equals pretaxcash income plus income from other sources. Pretaxcash income is the sum of wages, salaries, self-employ-ment income, rents, taxable and nontaxable interest,dividends, realized capital gains, cash transfer pay-ments, and retirement benefitsplus taxes paid by busi-nesses (corporate income taxes and the employer’sshare of Social Security, Medicare, and federal unem-ployment insurance payroll taxes) and employees’ con-tributions to 401(k) retirement plans. Other sources ofincome include all in-kind benefits (Medicare,Medicaid, employer-paid health insurance premiums,food stamps, school lunches and breakfasts, housingassistance, and energy assistance). Households withnegative income are excluded from the lowest income

category but are included in the totals.”

33. For a critical survey of the evidence about elastic-ity of capital gains, see Alan Reynolds, “CapitalGains Tax: Analysis of Reform Options for Australia,Australian Stock Exchange Ltd,” July 1999, Chap. 4,www.asx. com.au/about/pdf/cgt. pdf.

34. John Karl Scholz, “Saez Comments,” on a panelentitled “Income and Wealth Concentration in aHistorical and International Perspective,” BerkeleySymposium on Poverty, The Distribution of Incomeand Public Policy, December 12–13, 2003,http://www.asx.com.au/about/shareholder/media_releases/R160799_AS3.htm.

35. Carola Frydman and Raven E. Saks, “HistoricalTrends in Executive Compensation 1936–2003,”University of Chicago Graduate School of Business,Applied Economics Workshop, November 15, 2005,http://gsb.uchicago.edu/research/workshops/AppliedEcon/archive/WebArchive20052006/FrydmanSecondPaper.pdf.

36. Ian Dew-Becker and Robert J. Gordon,“Where Did the Productivity Growth Go?Inflation Dynamics and the Distribution ofIncome,” NBER Working Paper no. 11842,December 2005. Dew-Becker and Gordon con-verted the distribution of total W-2 income into adistribution of hourly income since 1967 byassuming the greatly increased proportion oftwo-earner joint tax returns at the top of theincome distribution did not affect the distribu-tion of hours per tax return. Income-switchingbetween qualified and nonqualified stock optionsfurther complicates the Dew-Becker and Gordonconclusions.

37. Piketty and Saez, “Income Inequality in theUnited States, 1913–2002,” Table B-4.

38. Lucian Bebchuk and Yaniv Grinstein, “TheGrowth of Executive Pay,” Oxford Review of EconomicPolicy 21, no. 2 (2005): Table 1, www.law.harvard.edu/faculty/bebchuk/pdfs/Bebchuk-Grinstein.Growth-of-Pay.pdf.

39. Towers Perrin reports that CEOs in Francereceive a sizable 19 percent of their pay in theform of tax-favored benefits and perquisites andonly 41 percent as “variable” (risky) pay thatdepends on performance. CEOs in the U.S. andCanada received only 11 percent of pay as benefitand perks, with 62 percent of the total pay pack-age being variable in the U.S. and 51 percent inCanada. Towers Perrin, “Managing Global Payand Benefits, 2005–2006,” TP433-05, undated.

40. Martin Feldstein, “The Effect of Marginal TaxRates on Taxable Income: A Panel Study,” NBER

23

Working Paper no. 4496, October 1993. See alsoSteven J. Davis and Magnus Henrekson, “Tax Effectson Work Activity, Industry Mix and ShadowEconomy Size: Evidence from Rich CountryComparisons,” Stockholm School of EconomicsWorking Paper no. 560, June 2004, http://ideas.repec.org/p/hhs/hastef/ 0560.html. And seeEdward C. Prescott, “Why Do Americans Work SoMuch and Europeans So Little?” Federal ReserveBank of Minneapolis, July 2004, http://minneapolis-fed.org/research/common/pub_detail.cfm?pb_autonum_id=905.

41. Wojciech Kopczuk, “Tax Bases, Tax Rates andthe Elasticity of Reported Income,” NBERWorking Paper no. 10044, October 2003.

42. Adam Looney and Monica Singhal, “The Effect ofAnticipated Tax Changes on Intertemporal LaborSupply and the Realization of Taxable Income,”Federal Reserve Board Working Paper 2005-44, July2006, www.federalreserve.gov/pubs/feds/2005/ 200544/200544pap. pdf.

43. Jon Gruber and Emmanuel Saez, “The Elasticity ofTaxable Income: Evidence and Implications,” Journal ofPublic Economics 84, no. 1 (April 2002): 1–32.

44. Martin Feldstein, “The Effect of Taxes onEfficiency and Growth,” NBER Working Paper no.12201, May 2006.

45. Saez, p. 4.

46. Reynolds, “Capital Gains Tax.”

47. Raj Chetty and Emmanuel Saez, “The Effectsof the 2003 Dividend Tax Cut on CorporateBehavior: Interpreting the Evidence,” AmericanEconomic Review 96, no. 2 (May 2006): 124–129.

48. Internal Revenue Service, Statistics of IncomeDivision, “Individual Income Tax Returns,Selected Income and Tax Items for Selected Years,2000–2004,” www.irs.gov/taxstats/indtaxstats/article/0,,id=134951,00.html.

49. Thomas Piketty and Emmanuel Saez, “TheEvolution of Top Incomes: A Historical andInternational Perspective,” American EconomicReview 96, no. 2 (May 2006): 200–05.

50. The international evidence is examined inAlan Reynolds, “The Misuse of Tax Data toEstimate Income Distribution,” presented at theWestern Economics Association International81st Annual Conference, San Diego, July 1, 2006.

51. Krugman, “Whining Over Discontent.”

52. Paul Krugman, “The Death of Horatio Alger”The Nation, January 5, 2004, www.thenation.com/doc/20040105/krugman.

53. Piketty and Saez, “The Evolution of Top Incomes:A Historical and International Perspective.”

54. Piketty and Saez, “Income Inequality in theUnited States, 1913–1998,” Figure A-1.

55. Congressional Budget Office, “HistoricalEffective Federal Tax Rates: 1979 to 2003,”December 2005.

56. U.S. Bureau of the Census, “Historical IncomeTables—Households,” Table H-3, www.census.gov/hhes/www/income/histinc/h03ar.html.

57. Alan Reynolds, Income and Wealth (Westport,CT: Greenwood Press, 2006) Table 2.1, p. 38.

58. Lawrence Mishel, et. al., The State of WorkingAmerica 2004/2005 (Washington: Economic PolicyInstitute, January 2005), p. 67, www.epinet.org/content.cfm/books_swa2004.

59. This refers to the Census Bureau’s 14th definitionof income, which is quite inclusive. Unfortunately,when the Census Bureau properly accounts for taxesand transfer payments, they include capital gains thatare realized and taxable. See U.S. Bureau of the Census,“Percent Distribution of Households by SelectedCharacteristics within Income Quintile and Top 5Percent in 2004,” June 24, 2005, Table HINC-05,http://pubdb3.census.gov/macro/032005/hhinc/new05_000.htm.

60 Data is discussed in Reynolds, Income andWealth, Table 1.4, p. 20.

61. David Johnson et. al., “Economic Inequalitythrough the Prisms of Income and Consump-tion,” Monthly Labor Review, April 2005, www.bls.gov/opub/mlr/2005/04/art2abs.htm.

62. Wojciech Kopczuk and Emmanuel Saez, “TopWealth Shares in the United States, 1916–2000:Evidence from Estate Tax Returns,” National TaxJournal 57, no. 2, part 2 (June 2004), http://elsa.berkeley.edu/saez/estateshort.pdf.

63. David Card and John E. DiNardo, “Skill-Biased Technological Change and Rising WageInequality: Some Problems and Puzzles,” NBERWorking Paper no. 9769, February 2002.

24

OTHER STUDIES IN THE POLICY ANALYSIS SERIES

585. The Cato Education Market Index by Andrew J. Coulson with advisers JamesGwartney, Neal McCluskey, John Merrifield, David Salisbury, and RichardVedder (December 14, 2006)

584. Effective Counterterrorism and the Limited Role of Predictive Data Miningby Jeff Jonas and Jim Harper (December 11, 2006)

583. The Bottom Line on Iran: The Costs and Benefits of Preventive War versusDeterrence by Justin Logan (December 4, 2006)

582. Suicide Terrorism and Democracy: What We’ve Learned Since 9/11 by Robert A. Pape (November 1, 2006)

581. Fiscal Policy Report Card on America’s Governors: 2006 by Stephen Slivinski (October 24, 2006)

580. The Libertarian Vote by David Boaz and David Kirby (October 18, 2006)

579. Giving Kids the Chaff: How to Find and Keep the Teachers We Needby Marie Gryphon (September 25, 2006)

578. Iran’s Nuclear Program: America’s Policy Options by Ted Galen Carpenter(September 20, 2006)

577. The American Way of War: Cultural Barriers to Successful Counterinsurgency by Jeffrey Record (September 1, 2006)

576. Is the Sky Really Falling? A Review of Recent Global Warming Scare Stories by Patrick J. Michaels (August 23, 2006)

575. Toward Property Rights in Spectrum: The Difficult Policy Choices Ahead by Dale Hatfield and Phil Weiser (August 17, 2006)

574. Budgeting in Neverland: Irrational Policymaking in the U.S. Congress and What Can Be Done about It by James L. Payne (July 26, 2006)

573. Flirting with Disaster: The Inherent Problems with FEMA by Russell S. Sobel and Peter T. Leeson (July 19, 2006)

572. Vertical Integration and the Restructuring of the U.S. Electricity Industryby Robert J. Michaels (July 13, 2006)

571. Reappraising Nuclear Security Strategy by Rensselaer Lee (June 14, 2006)

570. The Federal Marriage Amendment: Unnecessary, Anti-Federalist, and Anti-Democratic by Dale Carpenter (June 1, 2006)

569. Health Savings Accounts: Do the Critics Have a Point? by Michael F. Cannon (May 30, 2006)

568. A Seismic Shift: How Canada’s Supreme Court Sparked a Patients’ Rights Revolution by Jacques Chaoulli (May 8, 2006)

567. Amateur-to-Amateur: The Rise of a New Creative Culture by F. Gregory Lastowka and Dan Hunter (April 26, 2006)

566. Two Normal Countries: Rethinking the U.S.-Japan Strategic Relationship by Christopher Preble (April 18, 2006)

565. Individual Mandates for Health Insurance: Slippery Slope to National Health Care by Michael Tanner (April 5, 2006)

564. Circumventing Competition: The Perverse Consequences of the Digital Millennium Copyright Act by Timothy B. Lee (March 21, 2006)

563. Against the New Paternalism: Internalities and the Economics of Self-Control by Glen Whitman (February 22, 2006)

562. KidSave: Real Problem, Wrong Solution by Jagadeesh Gokhale and Michael Tanner (January 24, 2006)

561. Economic Amnesia: The Case against Oil Price Controls and Windfall Profit Taxes by Jerry Taylor and Peter Van Doren (January 12, 2006)

560. Failed States and Flawed Logic: The Case against a Standing Nation-Building Office by Justin Logan and Christopher Preble (January 11, 2006)

559. A Desire Named Streetcar: How Federal Subsidies Encourage Wasteful Local Transit Systems by Randal O’Toole (January 5, 2006)

558. The Birth of the Property Rights Movement by Steven J. Eagle (December 15, 2005)

557. Trade Liberalization and Poverty Reduction in Sub-Saharan Africa by Marian L. Tupy (December 6, 2005)

556. Avoiding Medicare’s Pharmaceutical Trap by Doug Bandow (November 30,2005)

555. The Case against the Strategic Petroleum Reserve by Jerry Taylor and Peter Van Doren (November 21, 2005)

554. The Triumph of India’s Market Reforms: The Record of the 1980s and 1990s by Arvind Panagariya (November 7, 2005)

553. U.S.-China Relations in the Wake of CNOOC by James A. Dorn (November 2, 2005)

552. Don’t Resurrect the Law of the Sea Treaty by Doug Bandow (October 13, 2005)

551. Saving Money and Improving Education: How School Choice Can Help States Reduce Education Costs by David Salisbury (October 4, 2005)

550. The Personal Lockbox: A First Step on the Road to Social Security Reform by Michael Tanner (September 13, 2005)

549. Aging America’s Achilles’ Heel: Medicaid Long-Term Care by Stephen A. Moses (September 1, 2005)

548. Medicaid’s Unseen Costs by Michael F. Cannon (August 18, 2005)

547. Uncompetitive Elections and the American Political System by Patrick Basham and Dennis Polhill (June 30, 2005)

546. Controlling Unconstitutional Class Actions: A Blueprint for Future Lawsuit Reform by Mark Moller (June 30, 2005)

545. Treating Doctors as Drug Dealers: The DEA’s War on Prescription Painkillers by Ronald T. Libby (June 6, 2005)

544. No Child Left Behind: The Dangers of Centralized Education Policy by Lawrence A. Uzzell (May 31, 2005)

543. The Grand Old Spending Party: How Republicans Became Big Spendersby Stephen Slivinski (May 3, 2005)

542. Corruption in the Public Schools: The Market Is the Answer by Neal McCluskey (April 14, 2005)

541. Flying the Unfriendly Skies: Defending against the Threat of Shoulder-Fired Missiles by Chalres V. Peña (April 19, 2005)

540. The Affirmative Action Myth by Marie Gryphon (April 6, 2005)

539. $400 Billion Defense Budget Unnecessary to Fight War on Terrorism by Charles V. Peña (March 28, 2005)

538. Liberating the Roads: Reforming U.S. Highway Policy by Gabriel Roth (March 17, 2005)

537. Fiscal Policy Report Card on America’s Governors: 2004 by Stephen Moore and Stephen Slivinski (March 1, 2005)

536. Options for Tax Reform by Chris Edwards (February 24, 2005)

PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2PA Masthead.indd 2 2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PM2/9/06 2:08:35 PMUntitled-2 2 2/7/06 4:35:00 PM

535. Robin Hood in Reverse: The Case against Economic Development Takings by Ilya Somin (February 22, 2005)

534. Peer-to-Peer Networking and Digital Rights Management: How Market Tools Can Solve Copyright Problems by Michael A. Einhorn and Bill Rosenblatt (February 17, 2005)

533. Who Killed Telecom? Why the Official Story Is Wrong by Lawrence Gasman (February 7, 2005)

532. Health Care in a Free Society: Rebutting the Myths of National HealthInsurance by John C. Goodman (January 27, 2005)

531. Making College More Expensive: The Unintended Consequences ofFederal Tuition Aid by Gary Wolfram (January 25, 2005)

530. Rethinking Electricity Restructuring by Peter Van Doren and Jerry Taylor(November 30, 2004)

529. Implementing Welfare Reform: A State Report Card by Jenifer Zeigler (October 19, 2004)

528. Fannie Mae, Freddie Mac, and Housing Finance: Why True Privatization Is Good Public Policy by Lawrence J. White (October 7, 2004)

527. Health Care Regulation: A $169 Billion Hidden Tax by Christopher J. Conover (October 4, 2004)

526. Iraq’s Odious Debts by Patricia Adams (September 28, 2004)

525. When Ignorance Isn’t Bliss: How Political Ignorance Threatens Democracy by Ilya Somin (September 22, 2004)

524. Three Myths about Voter Turnout in the United States by John Samples (September 14, 2004)

523. How to Reduce the Cost of Federal Pension Insurance by Richard A. Ippolito (August 24, 2004)

522. Budget Reforms to Solve New York City’s High-Tax Crisis by Raymond J. Keating (August 17, 2004)

521. Drug Reimportation: The Free Market Solution by Roger Pilon (August 4, 2004)

520. Understanding Privacy—And the Real Threats to It by Jim Harper (August 4, 2004)