How do Income Sources Affect Income Inequality?

Abstract

How individual income sources affect income inequality has long been important for interpreting economic trends and for making public policy. Whether the issue is changes in budget and tax policies, in social security benefits, or in the treatment of a form of property income, a major part of the debate is over the distributional impact of the policies that raise or lower particular income sources. Our understanding of economic inequality partly turns on our estimates of the impacts of the rising share of women in the paid labor force, of the increasing returns to human capital, and of the changing distribution and levels of net worth. Until the late 1970s, the problem for the analyst appeared straightforward. To estimate how a tax or transfer program affected inequality, one could simply calculate an inequality index both before the tax or transfer (say IB) and after the tax or transfer (IA) and then tabulate the percentage change in I. Studies of the US tax and transfer system typically utilize this approach (see, for examples, Smolensky and Reynolds, 1977; Pechmanand Okner 1974; Danziger, 1977; and, more recently, Barthold, Nunns and Toder, 1995). Researchers recognize that these before-after tabulations rarely took account of behavioral impacts induced by the tax or transfer, but viewed the problem of determining the changes in each individual's net income as analytically distinct from the problem of calculating the inequality impact of the combination of individual income changes.