Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 17 The Distribution of Income

17-2 Chapter Objectives Basics of income distribution Measures of inequality Changing income inequality Reasons for rising inequality Poverty Debate over inequality Taxes and redistribution

17-3 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.

17-4 The Distribution of Income in the United States, 2006

17-5 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.

17-6 The Quintiles of Household Income, 2006 $0Bottom quintile $20,035Second quintile $37,774Third quintile $60,000Fourth quintile $97,032Top quintile $174,012 Top 5% Lower limitQuintiles

17-7 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.

17-8 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.

17-9 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.

17-10 The Rising 80/20 Ratio

17-11 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.

17-12 Share of Income Going to Top 1% of Taxpayers

17-13 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.

17-14 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.

17-15 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.

17-16 The Poverty Rate

17-17 Poverty Rate by Age Data: Census Bureau Percent below poverty line Under 18 years old years old 65 and over

17-18 Global Poverty

17-19 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.

17-20 The Pros and Cons of Government Intervention The income distribution statistics overstate inequality, because they fail to take economic mobility into account. The income distribution statistics understate inequality, because they miss the really high income house. Statistics 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

17-21 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.

17-22 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.

17-23 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 the income which is not taxed.

17-24 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 –The effective tax rate on high income individuals is essentially unchanged, but the effective tax rate for the poor has gone down.

17-25 Effective Federal Tax Rate for the Top 1% of Individuals

17-26 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 characteristics. –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.

17-27 Earnings Differences By Gender and Race for US, 2007

17-28 Women’s Median Weekly Earnings as a Percentage of Men’s