2.3.Equity in the distribution of income

Introduction to Income Inequality

The meaning of equity in the distribution of income

Explain the difference between equity in the distribution of income and equality in the distribution of income.

Equity in economics is a concept meaning ‘fairness’ and ‘justice’, for example, that everybody should have the same right to work, own property and start a company – regardless of gender, ethnicity etc. There would then be fairness in the distribution of output, e.g. a just proportion of wealth to each and every citizen. Equality, on the other hand, would mean that everyone would have the same ability to work, own property and start a company – all would get equal portions of the wealth created.

Definition: “equity”

The concept of equity in economics deals with the highly normative concept of fairness in the distribution of wealth and income. Most countries have customs, laws and traditions aimed at giving disadvantaged members of society ‘fair shares’.

Definition: “equality”

Equality deals with spreading wealth and income equally, regardless of position or income in society.

The concept of equity is naturally highly normative and will therefore vary greatly over time and between cultures. There different moral and ethical bases in societies. In line with these differences, governments attempt to create equity, which is to say ‘everybody should have the same chance of bettering his or her situation’. Economics must often deal with the questions of equity:

 _Should the rich be taxed proportionately more than the poor and middle-classed? Should they pay more for university education?

 _Is it better to tax consumption (value-added taxes, VAT, for example) or income (taxes on profits and dividends)?

 _To what extent should the socially/economically disadvantaged be given additional resources at the expense of the economically advantaged – i.e. transfers of income and wealth aimed at evening-out income disparities?

 _What about the viewpoint of the wealthy; is it not an economic fact that the goods and services we desire are better furthered by self-interest and the profit motives of firms? Is it more economically efficient to increase output rather than re-distribute it? Should not governments try to create a favourable environment for firms and a framework for enterprise in order to increase the cake from which all subsequent taxes and income transfers will be sliced? Wouldn’t society ultimately gain if the incentives to produce (say via low corporate taxes) were enhanced?

Explain that due to unequal ownership of factors of production, the market system may not result in an equitable distribution of income.

Failure of market system

The above examples are but a small portion of a reoccurring debate within both economics and politics, dealing with the desirability and efficiency of government intervention in matters of equity. We have returned to the issues outlined in production possibility curves earlier, but now with a slightly more ideological and thus political flavour. The appealing simplicity of ‘invest now in order to produce more in the future’ must be appended by realism: it is not at all certain that any part of ‘more’ will be distributed equitably or evenly. Our basic economic problem is not so basic after all. If output were to grow by 50% and go to 0.1% of the population then we would certainly face some sort of sharp societal reaction – from protest lists to burning tyres in front of parliament. Most countries will have a redistribution system built into government policy, which evens out income differentials to a certain extent. Governments can redistribute income in three basic ways; taxation, transfer payments and goods and services in kind. (See further on.)

Source - http://goodbadecon.com/uploads/3/1/1/6/3116093/ch_55_-_equity_and_distr_of_income_-_2.3.pdf

Poverty

Distinguish between absolute poverty and relative poverty.

There are two ways to define poverty:

Absolute poverty

Defining absolute poverty means trying to agree a general definition of poverty which is valid at all times and for all economies – this is difficult to do.

The simplest definition of being poor is ‘…being unable to subsist…that is, being unable to eat, drink, have shelter and clothing. A common monetary measure of absolute poverty is ‘..receiving less than $1 a day…’’. (In 2008, the World Bank revised this figure to $1.25 a day, and then again to $1.90 a day in 2015.)

It is also possible to establish an international poverty line, at, say at $700 per capita per year, and then compare countries, by estimating the purchasing power equivalent of that sum in terms of the countries own currency.

Relative poverty

It can be argued that poverty is best understood in a relative way – what is poor in New York is not the same as what is poor in Mumbai (where over 50% of the population live in slums.)

Many relative definitions of poverty conclude that it is the inability to reach a minimum accepted standard of living in a particular society.

Another approach is to look at deprivation, the poor being defined as those who are deprived from the benefits of a modern economy.

Definitions of relative poverty vary considerably, but the definition of the UK government is typical for developed countries – this states that the poor are those living on ‘..less than 60% of median income..’.

If we take the international poverty line as a guide, then, as a region, Asia has the highest numbers of its population who are poor.

However, as a region of the world, Sub-Saharan Africa has the highest level of poverty as a proportion of total population, at over 60%. The second poorest region is Latin America, with 35% of its population poor.

Source - http://www.economicsonline.co.uk/Global_economics/Poverty.html

Explain possible causes of poverty, including low incomes, unemployment and lack of human capital.

Factors that cause poverty in developed countries

Some people imagine that in a rich region like the EU no one can be poor or if they are it must be the result of some personal failings or problems. However, this is not the case. The overall persistent high level of poverty in the EU suggest that poverty is primarily the consequence of the way society is organized and resources are allocated, whether these are financial or other resources such as access to housing, health and social services, education and other economic, social and cultural services. Indeed, the fact that there are very different levels of poverty in different Member States demonstrates clearly that different approaches to allocating resources and opportunities leads to different outcomes. The least unequal societies in Europe tend to have the lowest levels of poverty. This is primarily because these Governments chooses to give priority to ensuring adequate minimum income levels and ensuring good access to services, through the social protection system and through guaranteeing minimum wage levels. They are usually the most effective at redistributing wealth through the tax and other systems. This means that the decisions over how to eradicate poverty in the end are political choices about the kind of society we want.

Key factors

In terms of individuals, some key factors are seen as making a person more at risk of being in poverty such as:

• unemployment or having a poor quality (i.e. low paid or precarious) job as this limits access to a decent income and cuts people off from social networks;
• low levels of education and skills because this limits people's ability to access decent jobs to develop themselves and participate fully in society;
• the size and type of family i.e. large families and lone parent families tend to be at greater risk of poverty because they have higher costs, lower incomes and more difficulty in gaining well paid employment;
• gender - women are generally at higher risk of poverty than men as they are less likely to be in paid employment, tend to have lower pensions, are more involved in unpaid caring responsibilities and when they are in work, are frequently paid less ;
• disability or ill-health because this limits ability to access employment and also leads to increased day to day costs;
• being a member of minority ethnic groups such as the Roma and immigrants/undocumented migrants as they suffer particularly from discrimination and racism and thus have less chance to access employment, often are forced to live in worse physical environments and have poorer access to essential services;
• living in a remote or very disadvantaged community where access to services is worse.

All these factors create additional barriers and difficulties, but should be seen within the overall structural context of how a particular country chooses to distribute wealth and tackle inequality.

Source - http://www.poverty.org.uk/summary/eapn.shtml

Factors that cause poverty in developing countries

1. Income inequality

Research shows that when a country grows economically, overall poverty reduces. If the national income is not equally distributed among all communities in the country, there is a risk that poorer communities will end up poorer, and individuals will feel it most.

2. Conflicts and Unrests

About 33% of communities in absolute poverty live in places of conflict. In the past, countries like Rwanda and Sri-Lanka have suffered poverty as a result of years of tribal and civil wars. In recent years, Afghanistan, Iraq and the like are all going through difficult times and poverty is rife in these areas. Unrests result in massive loss of human live, diseases, hunger and violence, destruction of property and infrastructure, economic investments and quality labour. It is also a put-off for foreign investments. Wealth can never be created in such an environment.

3. Location, adverse ecology and location

Location of countries, as well as communities within the country can make people poor. Geographic and ecological factors such as mountains, swamps, deserts and the like have also made life conditions unbearable in many places. This is why some rural areas are poorer than others, even in the same country. For example, poverty in the Andes, Peru is six times higher than communities in the Amazonian region.

In other instances, some communities are cut off from the main economic centers of the country. They find themselves located so far from roads, markets, health services, schools and economic facilities. This makes it just impossible for the locals to access support and assistance, and also makes it discouraging for economic investors to consider investing there. In Bangladesh for example, poverty is severe in areas of physical remoteness, as indicated by the fact that seven rural districts are home to half of the country’s severely stunted children.

4. Natural disasters

Droughts, floods, hurricanes and other unexpected natural events cause deaths, illness and loss of income. In Ethiopia alone, there were 15 droughts (and famines) between 1978 and 1998 that led to the displacement, injury, or death of more than 1 million people. In better connected communities, families are able to come out of poverty and get on with their lives, but other remote and less accessible communities suffer for longer periods.

5. Ill Health and Disability

Poverty can also get worse if communities are affected with diseases such as Malaria and HIV aids. Diseases cause many deaths and children are left with no parents or care givers. Household wealth can also drain quickly with disable members. In many communities, disabled members are looked down upon and not allowed to inherit assets. They are considered a stigma and excluded from public events and exposure. This mentality can adversely affect the well-being of families. For example, the incidence of poverty is 15-44% higher in households with a disabled head or adult.

6. Inheritance of Poverty

Families that have had a lifetime of poverty tend to pass on the situation to their children. They cannot afford education for their children and children grow with no skills. Children work on the same family farms, and marry into families with similar conditions as they turn adults. They in turn pass on the tradition to their children.

7. Education, Training and skills

People who are educated or had some training or skills are in a better position to apply ideas and knowledge into fixing basic problems and enhancing their livelihoods. They are able to plan, follow instructions and get reach out to access information, tools and support that can improve their livelihoods. In the absence of training, skills or education, people cannot help themselves. They cannot prevent diseases, and cannot apply new ways of doing things. The result is that their poverty situation is worse of and are even more vulnerable than before.

8. Gender discrimination

In many African communities, girls were not allowed to be in school. Families preferred to invest in boys’ education than in girls. Women were also not allowed to do major economic activity and had less ownership of lands and assets. This idea negatively impacts on the well-being of women, and the development of their children is also impacted negatively.

Source - http://www.eschooltoday.com/poverty-in-the-world/causes-of-poverty.html

Explain possible consequences of poverty, including low living standards, and lack of access to health care and education in developed countries

The effects of poverty are intricately and deeply connected. However, it is helpful to individually identify its numerous effects before observing them in relation to one another. This, in turn, will provide insight as to the causes of poverty well as how to alleviate poverty entirely. Here are just five effects of poverty:

1. Education

Only 14 percent of the variation in a child’s performance can be attributed to school quality, according to Donald Hirsch, advisor to the Joseph Rowntree Foundation. This means that a child’s background has a significant effect on their performance in school. Children who come from low-income families are far less likely to perform well in school. According to Department for Education statistics, by the end of primary school, pupils in need of free school meals are estimated to be almost three terms behind their more affluent peers.

2. Child Development

Children living in poverty are more likely to learn poor health behaviors and are more susceptible to mental illness as they grow older. Children living in constant poverty also show the worst cognitive development, compared to children from higher socio-economic backgrounds. Children who are poor are often unable to participate in social, leisure and celebratory activities, which can negatively impact their self-esteem and friendships. They may feel less able to take advantage of learning opportunities in school, which can eventually hurt their future employment prospects.

3. Crime

The Edinburgh Study of Youth Transitions and Crime found that poverty had a significant and direct effect on young people’s likelihood to engage in violence at age 15. Young people living in a family where the head of the household was unemployed were also more likely to participate in criminal behavior. Even poor individuals with “low risk” backgrounds were more likely to engage in violence. This means that for certain types of young people, living in a poor household increases their risk of engaging in violence beyond what one would expect.

4. Low Social Mobility

Children born into poverty are also more likely to grow up to be poor. For example, poor teenagers in Britain in the 1970s are twice as likely to be poor as adults, while poor teenagers in the 1980s are four times as likely to remain poor. When parents cannot find stable work, they are unable to provide their children with necessary attention and resources. This ultimately makes it more difficult for them to build a better life for their children in the future.

5. Extra Social Spending

When adults are unable to meet their full potential in society, they contribute less productively to the economy. They often receive payment benefits and reduced tax revenues, which necessitates extra social spending. The Joseph Rowntree Foundation estimates that child poverty costs the United Kingdom at least £25 billion a year. This includes £12 billion a year on public spending on services that alleviate the immediate effects of poverty. The remaining £13 billion accounts for the annual costs of below average employment rates.

The key to alleviating poverty is to coordinate humanitarian efforts between these many factors. Once we understand the effects of poverty and their many dimensions, we can take the necessary steps to eradicate the issue altogether.

– Liliana Rehorn

Source - https://borgenproject.org/5-effects-poverty/

Calculate the marginal rate of tax and the average rate of tax from a set of data (HL only)

Average rate of Tax (ART)

The average tax rate is the tax rate you pay when you add all sources of taxable income and divide that number into the amount of taxes you owe. In other words, you can calculate your average tax rate by dividing your total tax obligation by your total taxable income.

Formula: Tax payable/Taxable income x 100

For example, if you earn $50,000 in salary for one year, and you must pay $10,000 in taxes, then the applicable income tax rate/average tax rate is 20% i.e. which is 20% of the value of your annual income.

Source - http://study.com/academy/lesson/average-tax-rate-definition-formula-quiz.html

Marginal rate of Tax (MRT)

Your marginal tax rate is the extra taxes you pay on each additional dollar of income you make. The marginal rate is calculated by taking the change in total tax paid divided by the change in income, times 100; (ΔT/Δy) x 100.

For example, imagine that you are a couple whose taxable income equals $50,000. You wish to calculate the marginal tax rate on a new venture that will earn you $35,000. The tax authorities will charge you 15 percent on the first $18,000 of that $35,000 and will charge you 25 percent on the remaining $17,000.

Step 1: Multiply each portion of the new income by its tax rate: 0.15 × $18,000 = $2,700; 0.25 × 17,000 = $4,250.

Step 2: Add these results together: $2,700 + $4,250 = $6,950.

Step 3: Divide this new sum by the income whose rate you're calculating: $6,950 ÷ $35,000 = 0.198571429.

Step 4: Multiply this answer by 100: 0.198571429 × 100 = 19.8571429.

Step 5: Round this result to a level that suits your needs. 19.8571429 is approximately 19.86, so this is the marginal tax rate on the additional income.

Source - http://thefinancebase.com/calculate-marginal-tax-rate-economics-4244.html

Task 16: Tax Systems and Income Distribution

Introduction: The government of Country X currently collects taxes on individuals’ income at rates represented in the 2014 column in the following table. The government is considering the implementation of an expansionary fiscal policy in 2015 involving an across the board reduction in tax rates as represented in the 2015 column. Study the table then answer the questions that follow:

I. Calculate the amount of tax paid in 2014 by an individual in country X earning

a. $32,000

b. $60,000

II. Calculate the amount of tax paid in 2015 by the same individuals (assuming their incomes remained the same as in 2014).

c. $32,000

d. $60,000

III. Calculate the average tax rates in 2015 faced by the individual earning

e. $32,000

f. $60,000

IV. Explain why the average tax rate differs from each individual’s marginal tax rate.

V. How will a decrease in the income tax rate affect the value of the spending multiplier in Country X?

VI. The Lorenz Curve below represents the distribution of family income in Country X.

I. An alternative plan for fiscal stimulus being discussed by the government of Country X involves reducing the value added tax (VAT), an indirect tax on consumption, from 15% to 8%.

a. Explain how a reduction in the VAT will affect aggregate demand in Country X.

b. On the Lorenz Curve diagram above, show the effect a reduction in the VAT will have on the level of income distribution in Country X. Label the new Lorenz Curve “2015b”

c. Explain how a reduction in the VAT affects income distribution.

II. Supporters of the proposed income tax rate reduction argue that it will increase productivity and efficiency in the economy. Why might this argument be justified?

III. Opponents of the proposed income tax rate reduction argue that it will decrease equity in Country X. Why might this argument be justified?

IV. Explain how a fiscal stimulus that combines the proposed income tax cuts and an simultaneously increases the provision of public goods and transfer payments could address the concerns of the opponents to the income tax cut. Why is such a compromise harmful to the government’s budget balance?

Explain the term transfer payments, and provide examples, including old age pensions, unemployment benefits and child allowances

Societies often find it necessary and prudent to provide benefits for certain groups of citizens. Social (welfare) benefit systems which redistribute income via cash transfer payments exist in most countries in some form. Students will receive grants and soft loans; retired people receive pensions and additional health care monies; low income households and single parents (far too often one and the same) receive supplemental housing allowance and welfare payments; and unemployed people receive unemployment benefits and perhaps travel contributions for job seeking.

Definition: “transfer payments”

Any government monies granted to households – without some form of corresponding output – is a transfer payment. Unemployment benefits, housing allowances for low income families and social benefits are examples of transfer payments.

Explain that governments undertake expenditures to provide directly, or to subsidize, a variety of socially desirable goods and services (including health care services, education, and infrastructure that includes sanitation and clean water supplies), thereby making them available to those on low incomes.

The other main form of societal redistribution is services in kind; merit goods such as health care and education. Since these goods would be both underprovided and thus under-consumed on a free market, it would be the poorer groups who would suffer the most. By using government (tax) monies to provide these goods on a general basis of not-for-profit, total economic welfare is increased.

Definition: “services in kind”

Under-provided and under-consumed goods such as public transport, education and health care are services often provided directly or indirectly (subsidies) by governments. These services in kind have highly positive regressive effects as they benefit poorer households proportionally more than wealthier

Source - http://goodbadecon.com/uploads/3/1/1/6/3116093/ch_55_-_equity_and_distr_of_income_-_2.3.pdf

Relationship between equity and efficiency

Evaluate government policies to promote equity (taxation, government expenditure and transfer payments) in terms of their potential positive or negative effects on efficiency in the allocation of resources.

All taxes will in some way lead to market distortions, since they lead to a decrease in supply and concomitant decrease in quantity demanded. Taxes on labour lead to higher costs for firms and an increase in unemployment; indirect taxes lead to less goods being consumed; corporate taxes lead to fewer new firms and less investment; and capital gains tax reduces incentives and lowers economic activity. However, the economic argument in favour of enduring these distortions is that the allocative losses can be made up for by the overall redistribution gains to society in terms of public and merit goods. Governments use tax receipts to provide goods which are beneficial to all of society. For example, the efficiency loss in firms due to labour taxes are offset by productivity gains arising from a well-educated work force, and the relatively small decrease in consumption arising due to high marginal taxes on the richest 1% can be offset by welfare gains when the taxes are redistributed to poorer groups.

It gets trickier when governments have to decide which tax creates the ‘fairest’ outcome. Indirect taxes have the advantage of being simple and easy to collect, but have the disadvantage of levying a heavier burden on the poor than the rich. For example, a unit tax of €2 per litre of alcoholic beverage will have a far greater real income effect on Otto Normalverbraucher14 purchasing a €3 six-pack of beer than it will have on Countess Antoinette du la Monet15 buying a €150 bottle of 1966 Chateau Neuf du Pape. In effect, a flat-rate tax expenditure tax will have strong regressive tax effects on poorer groups.

As for income taxes, where is it written that higher income must lead to higher proportion of tax – when in fact a proportional tax already means that higher income leads to more tax payments?! The argument for progressive income taxes (‘higher income = higher percentage tax’) is highly normative, in that there is an evening-out effect of incomes which is ‘fair’ to society in general. Increased income equality also has economic benefits, such as lower crime rates and inner city regeneration which, of course, benefits everyone. Quite naturally, the well-off point out that between one third and half of all income tax receipts in developed countries come from the top 5% income earners – the implication being that this is “more than their fair share”. Another common argument put forward by the affluent is that progressive taxes are a major disincentive for people to push themselves, being in fact a ‘punitive tax’ on achievement, hard work and entrepreneurial spirit.

Redistributing income has a double-edged price tag of administrative costs to government and allocative losses to society. Redistribution has been likened to attempting to transfer water from one bucket to another.16 A portion of the water – income – will invariably be lost in the process, i.e. there will be costs associated with administration and economic efficiency. The taxes on economic endeavours such as labour and investment also render opportunity costs in the form of forgone…labour and investment. This argument thus puts forward that attempting to improve social welfare by increasing equity will render a social cost in terms of greater inefficiency in the use of resources which leads to a loss of income.

The basic question here is whether the costs to society of trying to increase equity are counterproductive in terms of economic growth. The trade-off, according to this line of reasoning, is between growth in total income and growth in income equality. In the final analysis, a good many studies show that there is indeed a trade-off – increased income inequality is ‘pro-growth’. However, a good many studies show the reverse, i.e. that greater inequality leads to lower growth! And for my final trick; a recent study by the OECD showed “…no evidence that the level of income inequality affects GDP one way or another.”

Source - http://goodbadecon.com/uploads/3/1/1/6/3116093/ch_55_-_equity_and_distr_of_income_-_2.3.pdf

Questions on evaluation of government policies to promote equity

Task 17: If the incidence of poverty decreases during periods when the economy is growing and increases during periods when the economy is in recession, what government policies might be used to reduce poverty most effectively?

Task 18: Some economists argue that we should use more progressive taxes, while others claim that we should adopt a flat tax. List some reasons for and against using progressive taxes.

Task 19: Suppose the government is trying to decide between putting a sales tax on luxuries, which usually have very high demand elasticities, or on petrol. Answer the following with diagrams:

a) Which tax will have a larger effect on the market price?

b) Which tax will cause the quantity traded in the market to decline more?

Files to download