U.S. Income Inequality: It's Not So Bad

By Garrett, Thomas A. | Regional Economist, October 2008 | Go to article overview

U.S. Income Inequality: It's Not So Bad


Garrett, Thomas A., Regional Economist


Each year, the U.S. Census Bureau releases data on the income levels of America's households. A comparison of these annual data over time reveals that the income for wealthier households has been growing faster than the income for poorer households- real income for the wealthiest 5 percent of households rose by 14 percent between 1996 and 2006, while the income for the poorest 20 percent of households rose by 6 percent. As a result of these differences in income growth, the income of the wealthiest 5 percent of households was 8.1 times that of the income of the poorest 20 percent of households in 1996 and increased to 8.7 times by 2006. By these figures, a common conclusion is that income inequality in the United States has increased.

The apparent increase in U.S. income inequality has not escaped the attention of policymakers and social activists who support public policies aimed at reducing income inequality. However, the common measures of income inequality that are derived from the census statistics exaggerate the degree of income inequality in the United States for several reasons. Furthermore, although income inequality is seen as a social ill by many people, it is important to understand that income inequality has many economic benefits and is the result of, and not a detriment to, a well-functioning economy.

An Inaccurate Picture

The Census Bureau essentially ranks all households by household income and then divides this distribution of households into quintiles of equal size.1 Finding the highest ranked household in each quintile then provides the upper income limit for each quintile. 2 Comparing changes in these income limits over time for different quintiles reveals that income for the wealthier households has been growing faster than the income for poorer households, thus giving the impression of an "increasing income gap" or "shrinking middle class."

One big problem with using the census income statistics to infer income inequality is that these statistics only provide a snapshot of the income distribution at a single point in time. The statistics do not consider the reality that the income for many households changes over time, i.e., incomes are mobile. The income of most people increases over time as they move from their first low-paying job in high school to a better paying job later in their lives. It is also true that some people lose income over time due to business cycle contractions, demotions, career changes, retirement, etc. The point is that individuals' incomes are not constant over time, which implies that the same households are not in the same income quintiles over time. Thus, comparing different income quintiles over time is the proverbial "comparing apples to oranges" because incomes of different people are being compared at different stages in their earnings profile.

The U.S. Treasury released a study in November 2007 that examined income mobility in the U.S. from 1996 to 2005.3 Using data from individual tax returns, the study documented a household's movement along the distribution of real income over the 10-year period. As shown in Figure 1A, the study found that nearly 58 percent of the households that were in the lowest income quintile (lowest 20 percent) in 1996 moved to a higher income quintile by 2005. Similarly, nearly 50 percent of the households in the second lowest quintile (20 percent to 40 percent) in 1996 moved to a higher income quintile by 2005. Even a significant number of households in the third and fourth income quintiles in 1996 moved to a higher quintile in 2005.

The Treasury study also documented falls in household income between 1996 and 2005. This is most interesting when considering the richest households. As shown in Figure 1B, more than 57 percent of the richest 1 percent of households in 1996 fell out of that category by 2005. Similarly, more than 45 percent of the households having the top 5 percent of income in 1996 fell out of that category by 2005. …

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