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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 of inequality 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 of income 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. 586January 8, 2007
� 
 
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 in America 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
The Economist 
cited the same study and concluded:“The one truly continuous trend over the past25 yearshas 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
 Financial Times,
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 (thenumerator) and what is counted as totalincome for the nation (the denominator). By adopting the broadest conceivable measure of income 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 are just 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 toIndividual Income
The Economist 
has depicted the apparentrise in the top 1 percent’s share as a “truly continuous trend.”
8
But that is not what the
2
Seven majorfactors have seri-ously distortedmeasurements of income inequality in 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
corporate
income 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 by Emmanuel Saez and others show that when
3
The reportedincome share of the top 1 percenthas changedsharply in peri-ods when taxrules havechanged.
FactorMain Effect of Factor
 Business Income.
Shifting of business Great expansion of reported income at the top.from corporate tax returns to individualtax returns after individual tax rates fell.
 Personal Savings.
Large expansion inReduced reported investment income amongthe use of tax-favored savings vehiclesmiddle-income taxpayers, which raised theincluding 401(k)s and IRAs.top’s apparent income share.
Transfer Payments.
Large growth inReduced the total income denominator transfer payments for low-incomeof income distribution in estimatesfamilies—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 changescapital gains realizations and stock and stock market trends between twooption exercises as a result of tax rate.atypical years need not represent sustainedtrends.
Stock Options.
Change in stock optionsIncreased top incomes in comparison of for executives and workers from a type capital gains and ordinary income withtaxed as capital gains to a type taxed as the 1970s in those studies that excludesalary in response to changes in tax rates.capital gains.
Tax Rate Changes.
Marginal tax rates Marginal tax rate changes may have largechanged in 1981, 1986, 1990, 1993, effects on reported income at the top, in2001, and 2003. Income reported by situations where actual income may nothigh-income taxpayers is highly have changed very much.responsive to such rate changes due to changesin avoidance, evasion, and other behaviors.
 AGI Gap.
The AGI gap of unreportedMay have exaggerated the apparentincome on tax returns has grown growth of top incomes due to greater since 1988.underreporting of other incomes.
Table 1Factors Affecting Estimates of Income from Individual Tax Returns
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