Income Inequality went Up 12 Percent under Clinton, Zero under Bush

January 20, 2012

It is a good rule to question every study on income inequality by asking, “Why those years?”

The latest version is from the Congressional Research Service (CRS), and the author concludes:

“Changes in income from capital gains and dividends were the single largest contributor to rising income inequality between 1996 and 2006. Changes in tax policy also made a significant contribution to the increase in income inequality, but even in the absence of tax policy changes income inequality would likely have increased.”

And about those years:

“The years 1996 and 2006 are examined for several reasons. First, both years were at approximately similar points of the business-cycle with moderate inflation (about 3%), a modest unemployment rate (about 5%), and moderate economic growth (3.7% in 1996 and 2.7% in 2006). Second, 2006 was the year before the August 2007 liquidity crunch and the onset of the severe 2007-2009 recession. Third, there were major tax policy changes between these two years. Fourth, both 1996 and 2006 were three years after the enactment of tax legislation that affected tax rates and are unlikely to be affected by short-run behavioral responses to these changes.”

In fact, 1996 and 2006 are not even close to similar points in the business cycle: 1996 was at the beginning of an economic expansion that lasted another four years, while 2006 was at the end of an economic expansion that ended the following year.

It is deeply misleading to talk about income inequality without properly taking into account the business cycle. The financial crisis of 2008 and ensuing recession has devastated personal incomes to a degree not seen since the Great Depression. The most dramatic collapse has been in high incomes, as can be seen with the most recent IRS data. For example, since 2007 the number of millionaires has dropped 60 percent, while income reported by millionaires has dropped in half.

Much of this volatility is due to the collapse of capital gains, as the charts below indicate. Based on IRS data, as a share of income, capital gains went from 9.5 percent in 2006 to 3.0 percent in 2009, and this while the tax rate on capital gains remained 15 percent. The second chart shows capital gains in dollar terms and compares it to the S&P 500. First, capital gains track the stock market – that should be obvious. Second, capital gains realizations went from $771 billion in 2006, peaked at $896 billion in 2007, and then collapsed to $231 billion by 2009 – a drop of 74 percent in two years.

Why is this important? The CRS acknowledges that capital gains mainly accrue to high-income earners, and this too can be seen from IRS data. In 2009, it is in fact the largest source of income for those making $10 million or more. Thus, the collapse of this income since 2007, as well as other sources of income such as business income, completely disrupts the story that income inequality has increased since 1996.

Lastly, the third chart below shows a standard measure of income inequality, the Gini coefficient, for the years 1986 to 2009, again based on the most recent IRS data.

It shows just how much measures of income inequality depend on the business cycle, and why 2006 or 2007 are terribly unrepresentative years. They are in fact the two peak years for the Gini coefficient over this time period, at 0.567 in 2006 and 0.574 in 2007. From there, the Gini coefficient falls 7 percent to 0.535 in 2009. This is not quite as low as it was in the 2002 recession, but then we haven’t seen 2010 data yet. From the trajectory it seems likely that 2010 will be still lower. As it is, the Gini coefficient in 2009 is lower than it was in 1998, and close to where it was in 1997.

It must be acknowledged that the Gini coefficient has an underlying upward trend between 1986 and 2000. The steepest increase follows the 1986 tax reform, which dramatically lowered the top marginal rate on ordinary income (see the last chart below), and began a long trend of business income moving from the corporate code to the personal code in the form of pass-through entities such as partnerships and S-corporations. This alone might explain much of the measured increase in income inequality over this period. However, Clinton raised the top marginal rate in 1993 to 39.6 percent, and this also ushered in a long period of increasing income inequality. The Gini coefficient went from 0.498 in 1993 to 0.555 in 2000 – an increase of 12 percent.

In contrast, the period since 2000 has exhibited no underlying trend in income inequality, but rather dramatic fluctuations resulting from the business cycle. The CRS is right to connect this to capital gains, which have likewise cycled up and down, but wrong to conclude this represents an underlying trend. Income inequality at the beginning and end of the Bush years was virtually unchanged, with the Gini coefficient going from 0.555 in 2000 to 0.557 in 2008. In 2009 the Gini coefficient fell further, to 0.535, for a 4 percent drop since 2000. There is therefore no evidence that the Bush tax cuts in either the top marginal rate or capital gains rate had any long term effect on inequality.

It may be the case that lowering the tax rate on capital gains created more volatility in the stock market and thus capital gains realizations and personal incomes. More likely, the stock market moves for many reasons more important than the tax rate on capital gains, such as the internet revolution, war, monetary policy, demographics, and the housing bubble.

Here is our earlier critique of a CBO study that claims income inequality increased between 1979 and 2007.

Follow William McBride on Twitter @EconoWill

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