Taxation and Inequality: A Time-Exposure Perspective

Conclusions about inequality based on cross-sectional snapshots of annual income can give a misleading picture of the inequality of a more permanent notion of income, due to the mobility of individuals across annual income classes. This paper reassesses some of the issues about taxation and inequality using two longitudinal tax return data bases. Replacing annual income with "time-exposure" income, defined as average real income over the period, does not significantly reduce the measured degree of inequality in the 1979-1985 period, although the fraction of income received by the lowest increase substantially. The procedure does, though, reduce the contribution to inequality of certain sources of income such as capital gains and increase the contribution of other sources such as interest and dividends. There is no systematic evidence that the comparison of snapshots between the 1967-1973 and 1979-1985 periods overstates the growth in inequality of a more permanent notion of income. The inequality of pre-tax income has been increasing steadily in the past two decades. Changes in income taxation have neither stemmed nor contributed significantly to this trend; since 1980 the contribution of the income tax to decreasing inequality has declined slightly.