1. Chapter 17 The Distribution of Income McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Learning Objectives Summarize the basics of income distribution. Identify some reasons why income inequality and poverty have risen in recent years. List and discuss the arguments for and against government action to reduce inequality. Explain how the tax system can be used to redistribute income. Give examples of labor market discrimination. 17-2

3. Basics of Income Distribution Data on the nation’s income distribution is produced each year by the Census Bureau. Each year, the Census surveys households about how much money they received from various sources. There seems to be a growing gap between the people at the top of the income distribution and everyone else. 17-3

4. Quintiles Economists look at income distribution in terms of quintiles. A quintile represents 20% of households. Thus, the bottom quintile is the 20% of families with the lowest income. The table on the following slide shows the minimum income needed to get into each quintile. 17-4

5. The Quintiles of Household Income, 2009 $0Bottom quintile $20,450Second quintile $38,530Third quintile $61,800Fourth quintile $100,000Top quintile $180,000 Top 5% Lower limitQuintiles 17-5

6. Measures of Inequality The income level that marks the dividing line between the bottom quintile and the second quintile is called the 20th percentile because 20% of households fall below that level. The income level that marks the dividing line between the top quintile and everyone else is called the 80th percentile because 80% of households have incomes below that level. 17-6

7. Measures of Inequality The 80/20 ratio (the 80th percentile divided by the 20th percentile) measures the spread between high-income and low-income households. In 2009, the 80 th percentile was equal to $100,000. In 2009, the 20 th percentile was equal to $20,450. Thus, the 80/20 ratio is $100,000/$20,450, which equals 4.89. 17-7

8. Changing Income Inequality Most economists believe that the distribution of income has widened over the past twenty- five years. But there is no consensus about whether the increase in inequality has been large or small. It depends on which data source you look at and which measure of inequality you use. –The 80/20 ratio shows a slow and gradual rise. 17-8

9. The Rising 80/20 Ratio 17-9

10. Changing Income Inequality An alternative measure of income inequality is obtained by examining tax return data from the Internal Revenue Service. Look at the share of income going to the top 1% of taxpayers. –A growing share of income going to this group suggests an increase in inequality. –The top 1% garnered 21% of total income in 2008 compared to around 9% in 1975. 17-10

11. Reasons for Rising Inequality The increase in inequality is attributed to a number of factors. –First, rapid technological change tends to favor highly educated workers. –Another factor is foreign trade. The labor-pool effect of globalization has caused wages for low-skilled workers to fall. At the same time, the market expansion impact of globalization has benefitted high- skilled workers. 17-11

12. Reasons for Rising Inequality –Another cause of inequality is the shift to what is called the superstar economy. As the economy evolves from local to national and even global markets, companies are reaching out to the very best talent they can find. This means that the top people in any field do well. –Finally, there has been a lack of government action. The minimum wage has not kept up with inflation. 17-12

13. Poverty Another measure of the distribution of income is the poverty rate. The poverty rate measures the percent of people living in households with incomes below the poverty line. –In 2006 the poverty line for a family of four was $19,971. One problem with the poverty rate is that it excludes in-kind transfers such as food stamps and Medicaid payments. 17-13

14. The Poverty Rate 17-14

15. Are Emerging Economies Catching Up? 17-15

16. The Debate over Inequality There is considerable debate among economists about the causes of inequality and the role of government intervention. There are two competing notions of fairness: –Some argue that an economy with wide gaps between rich and poor is inherently unfair and immoral, so there is a need for government programs. –Others argue that taking money from those who earned it is unfair and immoral. 17-16

17. The Pros and Cons of Government Intervention The income distribution statistics overstate inequality because they do not include noncash benefits and fail to take economic mobility into account. The income distribution statistics understate inequality because they undercount high-income households. Data A policy devoted to reducing inequality eventually leads to political control of the economy and rent-seeking behavior. Big income differences cause political strife and eventually undermine support for a market economy. Politics Allowing big rewards to go to the most successful performers helps motivate creativity, innovation, and hard work. More equal societies experience stronger growth. Growth Taking money away from individuals who have earned it is unfair and immoral. A wide gap between rich and poor is unfair and immoral. Fairness Arguments against government intervention to reduce inequality Arguments in favor of government intervention to reduce inequality 17-17

18. Taxes and Redistribution The most common form of government intervention is through the use of the tax system. Redistribution transfers money from high-income to low-income households. Progressive taxes make the distribution of income more equal. –With a progressive tax, the after-tax income distribution is more equal than the pre-tax income distribution. 17-18

19. Taxes and Redistribution We call the share of income a household pays in taxes the effective tax rate. An income tax is progressive if high- income households pay a higher share of their income in taxes than low-income households –That is, high-income households have a higher effective tax rate. –The higher effective tax rate tends to narrow the income distribution. 17-19

20. Taxes and Redistribution A tax is regressive if low-income households pay a bigger share of their income than high-income households. An example of a regressive tax is the sales tax. –Under the sales tax, only the portion of income consumed is taxed, with savings not taxed. –Low-income households consume virtually their entire income, so they pay a high percentage of their income in taxes. –In contrast, high-income households save a high percentage of their income which is not taxed. 17-20

21. Taxes and Redistribution It is difficult to determine whether the US tax system is progressive or regressive overall since individuals pay a number of different types of taxes. The federal tax system is only slightly more progressive than in 1981. –The effective tax rate on high income individuals is essentially unchanged, but the effective tax rate for the poor has gone down. 17-21

22. An Example of a Progressive Income Tax 17-22

23. How a Regressive Sales Tax Works 17-23

24. Effective Federal Tax Rate for the Top 1% of Taxpayers 17-24

25. Earnings and Discrimination Discrimination occurs when one person is paid less or treated worse on the job than an equally qualified person because of his or her race, gender, or some other characteristic. –The role of government is to enforce antidiscrimination laws. –Despite the laws, some groups – notably women, blacks, and Hispanics – consistently earn less, on average, than others. 17-25