Transcript 20 Distribution of Income

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.
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
Examiner’s tip
– know how to
interpret Lorenz
curves and Gini
coefficients
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
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
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
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)
If someone earns $56,000 they will
This is a hypothetical example where
pay the following tax
there are 4 tax brackets
For the first 10,000 = 0
Taxable income ($)
% to be paid as tax
For the next 15k = 4.5k (15x0.3)
0-10,000
0
For the next 25k = 10k (25x0.4)
10,001-25000
30%
For the next 6k = 3k (6x0.5)
25,001 – 50,000
40%
In total they would pay = 17.5k
50,001 and higher
50%
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)
b)
c)
d)
$7,000
$14,000
$28,000
$77,000
Taxable income ($)
% to be paid as tax
0-10,000
0
10,001-25000
30%
25,001 – 50,000
40%
50,001 and higher
50%
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
0-10,000
0
10,001-25000
30%
25,001 – 50,000
40%
50,001 and higher
50%
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
0+4.5+10+6.5 = 21k
Originally they paid $17.5k
The marginal tax rate = (2117.5)/(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
Regressive taxation – a
Everyone spends $50 per month on petrol taxes
system of taxation in which tax
is levied at a decreasing
For a person earning $500 per month
average rate as income rises.
they are paying 10% of their income
This takes a greater proportion
For a person earning $2,500 per month
from the low-income taxpayer
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
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