Estimating Inequality with Tax Data: The Problem of Pass-Through Income

In recent decades, a growing share of U.S. business income has been taxed on a pass-through basis. When taxed on a pass-through basis, business income is attributed to a firm’s owners and taxed to them as individual income, rather than being subject to a separate entity-level tax. Among its many implications, the growth of pass-through taxation complicates our ability to estimate historical trends in income inequality. Prominent studies of income inequality use data from individual income tax returns to measure changes in the distribution of income over time yet fail to control for the increasing amounts of business income reflected in this data. Accordingly, to the extent that pass-through income flows to high-income individuals, such studies may overestimate the recent growth in income inequality. This paper explores the effect of pass-through income taxation at the high-end of the income distribution. Using data from the World Top Incomes Database, it shows that the growth of passthrough income has been concentrated among the top 0.5 percent of taxpayers. The trend towards taxing business income on a pass-through basis may thus be responsible for some of the growth in income inequality that researchers have observed