Equity in the distribution of income IB Economics

Unequal distribution  One of the characteristics of a free market is unequal distribution of income  Some people will earn more than others and therefore be in a position to consume/demand more  There is an argument to say that large inequalities are unfair  People on low incomes will experience relatively low living standards and will have fewer opportunities  In developing countries they may live in absolute poverty  In developed countries they may live in relative poverty Absolute poverty – not having the access to basic necessities needed to sustain life Relative poverty – poverty which is defined relative to existing living standards for the average individual (in the UK this is any family that is earning lower than 60% of the median income

Reasons for low income  Incomes may be low and people may live in poverty because  They were born into a household where income is low  They may have received poor, or no, education  They may have had poor health care and malnutrition  They may have had to go out to work before completing an education  The consequences of poverty include  Low living standards  Lack of access to sufficient health care  Low levels of education  The consequences lead to low levels of human capital  This is cyclical – people continue to be poor  If people have poor education and health care they will find it difficult to find work or it may be low paid

Economic incentives  Unequal distribution of income is seen as unfair but…  People need an incentive to work hard  They will work harder to gain higher incomes  If the incentive was not there people may not work hard in school and in work  Human capital would not improve having huge implications on the supply side of the economy  How much inequality is allowed is a value/normative judgement  Governments try to bring about equity rather than equality so that they do not destroy the incentive to work harder. Equity – fairness Equality - everyone receives the same income

Measuring the distribution of income  A method of measuring and illustrating the degree of inequality in the distribution of income and wealth is the Lorenz curve  The horizontal axis measures the cumulative percentage of the population  The vertical axis measures cumulative percentage of income  The 45 degree line is the line of perfect equality (50% of the population would have 50% of the income)  The actual share of income is shown by the curve (the Lorenz curve)  The greater the decree of inequality the further the curve will be from the 45 degree line  Country X is more unevenly distributed than country Y

Measuring the distribution of income  A statistical measure of the degree of inequality shown on a Lorenz curve is known as the Gini Coefficient  It is the ratio of the area between the line and the curve and the total area beneath the 45 degree line (a/(a+b))  Perfect equality would give a ratio of zero and perfect inequality would give 1  The closer to 1 the more unequal the distribution of income Examiner’s tip – know how to interpret Lorenz curves and Gini coefficients

The causes of income inequality between households  Impact of the state  A pure free market system would lead to large inequalities  Government intervention should narrow inequalities  Wealth inequality  Wealthier households will be able to earn more income such as dividends and interest from their asset holdings  Household composition  Individual households will contain different numbers in employment  Levels of skills and qualifications  Individuals with skills or qualifications that are in high demand will tend to earn more  Lifetime earnings of graduate are often considerably higher than those of non graduates  Differences in earnings  Full time earns more than part time  workers with opportunities to work overtime will earn more

Evaluation  It is important to be careful when using the Gini index numbers to evaluate a country’s development progress  Although low income countries tend to have higher levels of inequality than high income countries there is no hard and fast correlation between the level of development (measured using the HDI) and its Gini index  It is also not correct to assume that having more equality will raise living standards  If poorest 20% of the population earns 3% of the national income and the national income rises and the income distribution remains the same – the poorest will receive a larger amount (the cake got bigger but their percentage share remained)

Improving inequality of income with taxation  Tax can be used to improve income inequality  There are 2 different types of tax  Direct taxes – most of this tax is taken by your employer before you are paid but some could be taken using an annual tax return  Theoretically these taxes are unavoidable because individuals and firms have to declare their full income  Indirect taxes – The consumer pays the tax to the producer who then pays the government  These are possibly avoidable – you can choose not to buy the goods or services  An example in the UK is VAT – the standard rate is 20% but some things like electricity is charge with a reduced rate of 5% and other things like children’s clothes have 0% VAT Direct taxes – taxes imposed on people’s income or wealth and on firm’s profit e.g. income tax and corporation tax Indirect taxes – a tax on expenditure which is added to the selling price of a good or service

Taxation systems  There are 3 different types of taxation systems  Progressive taxes  Many countries use this system to redistribute income from high income earners to low income earners  There is normally a certain amount that is not subject to tax  Tax is then paid at different percentages for different levels (brackets)  This is a hypothetical example where there are 4 tax brackets Progressive taxation – a system of direct taxation where tax is levied at an increasing rate for successive bands of income. The marginal tax rate is higher than the average tax rate Taxable income ($)% to be paid as tax 0-10, , % 25,001 – 50,00040% 50,001 and higher50% If someone earns $56,000 they will pay the following tax For the first 10,000 = 0 For the next 15k = 4.5k (15x0.3) For the next 25k = 10k (25x0.4) For the next 6k = 3k (6x0.5) In total they would pay = 17.5k On average they would be paying 31% tax (17.5/56)

Taxation systems  How much tax would they pay and what is their average tax rate if they earned a)$7,000 b)$14,000 c)$28,000 d)$77,000 Taxable income ($)% to be paid as tax 0-10, , % 25,001 – 50,00040% 50,001 and higher50%  This tax structure is very simple  In reality they are much more complicated  Tax reductions allow people to reduce their taxable income  E.g. payments to charities in the US  Things that are considered to be tax deductions are different from country to country

Tax calculations – HL only  There are two types of calculations you could be asked to perform  The average tax rate = total tax paid divided by income x 100  The marginal tax rate = change in total tax paid divided by change in income x 100 Taxable income ($)% to be paid as tax 0-10, , % 25,001 – 50,00040% 50,001 and higher50%  Using the same scale  A person earning $56k paid an average tax rate of 31%  If that same person’s salary went up to $63k the total tax paid would be = 21k  Originally they paid $17.5k  The marginal tax rate = ( )/(63-56) = 50%

Taxation systems  Regressive taxes  Indirect taxes are a regressive tax  Consider this example  There is a $1 tax on a litre of petrol  Everyone spends $50 per month on petrol taxes  For a person earning $500 per month they are paying 10% of their income  For a person earning $2,500 per month they are paying 2% of their income  The tax is regressive because the person on the lower income is paying a higher proportion of their income  Regressive taxes like VAT may be a good source of government revenue and might discourage the consumption of demerit goods but they can worsen income inequality Regressive taxation – a system of taxation in which tax is levied at a decreasing average rate as income rises. This takes a greater proportion from the low-income taxpayer

Taxation systems  Proportional taxes  Many countries are now promoting the idea of proportional direct taxes or flat taxes  The same percentage of tax is paid at all levels of income  Because tax systems are complex governments may earn less revenue and people may find ways to avoid tax  This system is simpler  The second reason they are becoming popular is due to the disincentive effects of taxes on working  It can be argued that high rates of tax discourage people from working harder, moving into higher paid jobs and taking risks as they will lose their gains to higher taxes  Proportional taxes could be viewed as a supply side policy to raise labour supply Proportional taxation – a system of taxation in which tax is levied at a constant rate as income rises

Using tax revenues  Transfer payments  Governments can use transfer payments to redistribute income and help improve living standards  Examples are child support, pensions, unemployment benefits, payments to disabled people and subsidies to producers  To provide essential goods and services  Government can use taxation revenue to directly provide or subsidise goods and services that are seen as socially desirable  These goods have positive externalities of consumption  E.g. healthcare, education, sanitation, and water supplies  Provision is carried out to ensure that the poorer members of the economy have access to essential goods and services  This may lead to economic development

Evaluation of redistribution of income policies  Economists that support a new classical point of view tend to argue against government intervention  This is because it interferes with market forces and results in inefficiencies  They argue that…..  If firms have to pay insurance and social security costs for workers they will hire fewer workers thus contributing to unemployment  Higher taxes may discourage entrepreneurial activity and possibly lead to entrepreneurs leaving (flight of human capital)  Lower taxes encourage economic activity leading to an overall increase in output

Evaluation of redistribution of income policies  They talk about the trickle down effect – if the rich earn more they will consume more, firms will produce more and employment will increase  If the economy grows lower income earners will have the same percentage of the cake but the cake will be larger!  They argue that tax revenue should be used to finance the obligations of the government not redistribution

Time for you to do some work!!  All – P257 1a & b  HL – Exam Qs P257/258 see answers answers Perfect 10! Definition Diagram Analysis Example Perfect 15! New Definition More developed diagram/s Argument for and against with evidence Judgement