Academic journal article Brookings Papers on Economic Activity

Rising Inequality: Transitory or Persistent? New Evidence from a Panel of U.S. Tax Returns

Academic journal article Brookings Papers on Economic Activity

Rising Inequality: Transitory or Persistent? New Evidence from a Panel of U.S. Tax Returns

Article excerpt

ABSTRACT We use a new, large, and confidential panel of tax returns to study the persistent-versus-transitory nature of rising inequality in male labor earnings and in total household income, both before and after taxes, in the United States over the period 1987-2009. We apply various statistical decomposition methods that allow for different ways of characterizing persistent and transitory income components. For male labor earnings, we find that the entire increase in cross-sectional inequality over our sample period was driven by an increase in the dispersion of the persistent component of earnings. For total household income, we find that most of the increase in inequality reflects an increase in the dispersion of the persistent income component, but the transitory component also appears to have played some role. We also show that the tax system partly mitigated the increase in income inequality, but not sufficiently to alter its broadly increasing trend over the period.

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An extensive literature has documented a large increase in income inequality in the United States in recent decades. In this paper we ask to what extent this observed increase reflects an increase in persistent or in transitory inequality. By persistent inequality we mean long-run inequality, or the dispersion across the population in those components of income that are more or less stable over periods of more than a few years. By transitory inequality we mean the dispersion arising from short-run variability in incomes, as individuals move around within the income distribution at relatively short frequencies of one to a few years. (1)

The distinction between persistent and transitory inequality is important for various reasons. First, it is useful in evaluating proposed explanations for the documented increase in annual cross-sectional inequality. For example, if rising inequality reflects solely an increase in persistent inequality, then explanations consistent with this rise would include skill-biased technical change and long-lasting changes in employers' compensation policies. By contrast, an increase in transitory inequality could reflect increases in income mobility, driven perhaps by greater flexibility among workers to switch jobs. Second, the distinction is useful because it informs the welfare evaluation of changes in inequality. Lifetime income captures an individual's (or a household's) long-term available resources, and hence an increase in persistent inequality would reduce welfare according to most social welfare functions. By contrast, increasing transitory inequality would have less of an effect on welfare, especially in the absence of liquidity constraints restricting consumption smoothing.

One important aspect of our contribution is the use of a new and superior data source to shed new light on the decomposition of inequality and of changes in inequality into persistent and transitory components. We use a new, large, and confidential panel of tax returns from the Internal Revenue Service (IRS) to study the persistent-versus-transitory nature of rising inequality in individual male labor earnings and in total household income, both before and after taxes, in the United States over the period 19872009. (2) Our panel constitutes a 1-in-5,000 random sample of the population of U.S. taxpayers. It contains individual-level labor earnings information from W-2 forms as well as household-level income information from Form 1040. It also includes information on the age and sex of the primary and secondary tax filers from matched Social Security Administration (SSA) records. Our broadest sample consists of roughly 350,000 observations on 35,000 households and is therefore substantially larger than the publicly available, survey-based panels typically used to address related questions in the literature. In addition, our data are not subject to top-coding and are less likely than the survey data to be affected by measurement error. …

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