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We analyze household budget survey data to examine income inequality in Hungary between 1987 and 1996. Inequality did not increase significantly between 1987 and 1991. However, after 1991, the increase was substantial. Falling real incomes and taxes and state transfers may have held back inequality in the early transition. However, growth in earnings inequality, and increasing diversity in sources of household incomes, interacted to increase inequality between 1991 and 1996. This was exacerbated by an emerging polarization in state transfers, i.e., between earnings-related pensions and other benefits. In the context of sustained economic growth, the increase in inequality could accelerate. J. Comp. Econ., March 2001 29(1), pp. 40–65. Department of Applied Economics and Corpus Christi College, University of Cambridge, Cambridge CB3 9DE, United Kingdom; Social Policy Research Center, The …