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IB Diploma Economics:
Equity and the distribution of income
equity in income distribution
In the circular flow model of income and expenditure, income is a payment made to households by firms for the use of resources (factors of production) that households provide.
Payments for the factors of production are:
The income distribution that is considered fair is referred to as equity of income. People’s views on what is a fair distribution of income differ, as people make value judgements about what is fair. Some individuals consider that everyone should receive exactly the same level of income (equality of income). Others consider that others should get what they earn and therefore accept the income distribution that comes from the free market. This, however, means that those unable to work because of age, ill health or because they cannot get work would miss out on receiving an income. Other people might argue that equitable (or fair) distribution of income is to accept the free market outcome but provide a safety net for those unable to earn an income.
It is impossible to prove that one particular view on what is a fair distribution of income is correct, because it involves a value judgement about what is fair.
Income equality: People earn the same amount of income regardless of the work performed.
Market income: People earn only what the market provides.
Income equity: People earn a fair income which is proportional to the skills and demands of the work, and the risks associated with it (e.g., an entrepreneur takes risks, but will profit handsomely if her business venture succeeds).
factors of production
Unequal ownership of factors of production can lead to an unequal and inequitable distribution of income in the market system.
The ownership of the factors of production are not distributed equally (or equitably) in society:
Inequality in america
Horizontal and vertical equity
Disposable income is the amount of net income a household or individual has available to invest, save, or spend after income taxes have been paid.
Horizontal equity implies that we give the same treatment to people in an identical situation. For example, if two people earn £15,000 they should both pay the same amount of income tax. Therefore, horizontal equity makes sure there is no discrimination on the grounds such as race, gender and type of work being performed.
Vertical Equity implies that people with higher incomes should pay more tax. Vertical equity seeks to tax income in a proportional or progressive way – i.e., people with more ability to pay should pay more tax. Vertical equity is important for redistributing income within society, and is the basis for progressive tax systems.
A progressive tax is a tax in which the tax rate increases as the taxable amount increases. Progressive taxes are imposed in an attempt to reduce the tax incidence of people with a lower ability to pay, as such taxes shift the incidence increasingly to those with a higher ability-to-pay.
A progressive income tax is one in which people with lower income pay a lower percentage of that income in tax than do those with higher income.
Horizontal equity is an important starting point for any tax system. Horizontal equity can be consistent with also achieving vertical equity. Horizontal equity is the equal treatment of equals and this is a means for achieving a distribution of tax burdens that is vertically equitable.
Margaret Thatcher’s ill-fated Poll Tax was an example of a tax that had horizontal equity (everyone would have paid a lump sum of £500 a year). Mrs Thatcher’s theory was that as everyone had the same access to council services everyone should pay the same tax.
However, the poll tax does not meet the criteria for vertical equity. For those on low incomes, the poll tax was a high percentage of their disposable income. For those on high incomes and more ability to pay it was a low percentage – i.e., it disproportionally disadvantaged those on low incomes.
Income and wealth inequality
Analysing inequality with data
The Lorenz Curve (the actual distribution of income curve), a graphical distribution of wealth showing the proportion of income earned by any given percentage of the population. The line at the 45º angle shows perfectly equal income distribution, while the other line shows the actual distribution of income.
The further away from the diagonal, the more unequal the size of distribution of income.
In the above example, economy 1 has more evenly distributed income in its population than does economy 2, where income inequality is more pronounced. The further the Lorenz curve for an economy is from the line of perfect income equality, the more unequal income distribution is, with less of the population controlling relatively more of the total income.
The two Lorenz Curves above, which represents the actual distribution of income in two countries, shows how the poorest 40% of the population in country 1 earns about 27% of the national income in this population. Whereas, there is increased income inequality in country 2 where the poorest 40% of the population account for just under 10% of the country’s aggregate income.
While in a case of perfect equality, the poorest 40% of the population would earn 40% of the income. The more bowed out a Lorenz Curve, the greater is the inequality of income in the country.
The Lorenz curve explained
The Gini coefficient
The Gini coefficient provides an index to measure inequality. It is a way of comparing how distribution of income in a society compares with a similar society in which everyone earned exactly the same amount. Inequality on the Gini scale is measured between 0, where everybody is equal, and 1, where all the country's income is earned by a single person.
It summarises the information contained in the Lorenz Curve. Looking at the Lorenz curve below, country 1, where income distribution is less unequal, would have a lower Gini coefficient then country 2, where income inequality is greater.
The higher the Gini coefficient, the less equally income is distributed.
The gini coeffcient explained
Quantifying income inequality I
QUANTIFYING INCOME INEQUALITY II
Absolute and relative poverty
Absolute poverty refers to a set standard which is the same in all countries and which does not change over time. An income-related example would be living on less than $X per day.
Relative poverty refers to a standard which is defined in terms of the society in which an individual lives and which therefore differs between countries and over time. An income-related example would be living on less than X% of the average UK income.
Absolute poverty and relative poverty are both valid concepts. The concept of absolute poverty is that there are minimum standards below which no one anywhere in the world should ever fall.
The concept of relative poverty is that, in a rich country such as the UK, there are higher minimum standards below which no one should fall, and that these standards should rise if and as the country becomes richer.
Clearly, where both absolute and relative poverty are prevalent, it is absolute poverty which is (by far) the more serious issue. This is the case in much of the developing world, where the focus is therefore on fixed income thresholds (typically $1 or $2 a day, on the grounds that this is the minimum needed for mere survival). But in a developed economy, such thresholds have no importance: no one in the UK for example lives on incomes anywhere near this low.
So, logically, either one concludes that there is no absolute poverty in the UK or that a much higher threshold of absolute poverty than $1 or $2 per day should be used.
The view that there is no absolute poverty in the UK is a perfectly valid position to take.
The view that there should be an absolute poverty threshold but that it should be much higher than $1 or $2 per day begs the question about how such a threshold should be defined and on what basis.
In the UK, the main efforts to define such thresholds have been undertaken under the general heading of 'minimum income standards', which basically estimate the level of income required to purchase a given basket of goods and services. But the key point about such initiatives is that the basket of goods and services is defined according to the norms of the day and, as such, are inherently relative rather than absolute in nature. So, for example, there would be many items in the 'today's basket' that would not have been in the basket 50 years ago. In other words, 'minimum income standards' relate to relative poverty rather than to absolute poverty.
America's poor kids
The view that relative poverty is not important is a perfectly valid position to take – it is just not the view that most poverty researchers, the EU, the UK government, and politicians of all hues across the political spectrum take. So, for example, a government's target of halving child poverty by 2010 is defined in terms of relative poverty.
The reason that relative poverty is important is because no one should live with resources that are so seriously below those commanded by the average individual or family that they are, in effect, excluded from ordinary living patterns, customs and activities. In other words, in a rich country such as the UK, there should be certain minimum standards below which no one should fall. And, as society becomes richer, so norms change and the levels of income and resources that are considered to be adequate rises. Unless the poorest can keep up with growth in average incomes, they will progressively become more excluded from the opportunities that the rest of society enjoys.
If substantial numbers of people do fall below such minimum standards then, not only are they excluded from ordinary living patterns, but it demeans the rest of us and reduces overall social cohesion in our society. It is also needless.
If one accepts that relative poverty is important in principle, then the obvious issue arises of what thresholds to use and on what basis. The answer is that it does not matter, so long as the thresholds are defined in relation to contemporary average (median) income and are for households rather than individuals. But, for reasons of consistency and clarity, there has to be a 'headline' threshold and, for this, this different governments and NGOs use different thresholds. For example, both the UK government and the EU, use a household income of less than 60% of contemporary median household income.
Some people criticise the concept of relative poverty on the grounds that it is to do with 'inequality' rather than 'poverty'. At one level, this is simply an issue of semantics – because of the potential confusion between absolute poverty in the third world and 'relative poverty in a developed economy, thus many stakeholders are not very comfortable with the phrase 'relative poverty' and this is why we some choose to use the more descriptive term 'in low-income households'.
But at another level, the criticism is simply confused: whilst 'inequality' is about differences in income across the whole of the income distribution, 'relative poverty' is about the number of people who have incomes a long way below those of people in the middle of the income distribution. These two things are very different. For example, whilst there will inevitably always be inequality, there is no logical or numeric reason why there should always be people in relative poverty.
Subsidised or direct provision of merit goods
Direct government provision
Traditionally in Western Europe the overwhelming majority of health care and education is still paid for out of general taxation and provided free at the point of contact by the government – for most people, when they visit their doctor, go to hospital, school or college, no direct charge is levied upon them; the private sector still only accounts for a relatively small proportion of all health and education provision. Apart from generating substantial positive externalities and overcoming the problems arising from unequal income distribution, lack of current and future information and potential private monopoly power, direct government provision may also give rise to large economies of scale, and may thus be productively efficient; for example, when a service such as health care is provided to the population as a whole, greater scale economies are likely to arise in terms of capital and labour costs than could be expected to accrue to the private health care sector, whose scale of operations is necessarily much smaller than that of the NHS.
However, the idea of universal provision for all on the basis of need, with prices and profits playing no role, is one which sits very uneasily with the philosophy of market economics, and has thus in recent years come under fierce attack from right-wing, market-oriented economists. They have argued that government provision of health and education has led to an undesirable situation of state monopoly power in these areas and that to increase consumer choice, lower costs and raise the level of efficiency, greater competition is required.
The growth in income inequality
The cost of inequality
Subsidies may be used to increase the output of merit goods, provided both by the private and public sectors, to the socially optimum level.
For example, the theatre is usually provided by the private sector, and is often regarded as a merit good on account of the educative and civilising benefits that it confers on society. The government might take the view that without state assistance to the arts, there would be an unacceptably small number of theatres able to survive. The figure illustrates how the subsidy would operate.
Essential statement: A subsidy increases the quantity demanded by decreasing the price paid by consumers, which increases the consumer surplus. A subsidy increases the quantity supplied by increasing the price received by producers, which increases producer revenues and profitability, and the producer surplus
In the diagram, the free market price of health services (e.g., a visit to the GP) is established by the intersection of the curves D and S at P1, with the equilibrium quantity at Q1. A government subsidy, equivalent to the vertical distance between S1 and S2, would have the effect of shifting the supply curve to the right, causing the market price to fall to PC and the quantity of health services demanded and supplied to increase to QSUB.
Consumers' expenditure on health services increases. Firms in the market (e.g., GPs) receive a higher price for their services (PP) and sell an increased quantity of output, also at QSUB. The difference between PP and PC (the cost per unit of the subsidy) and the total quantity supplied and consumed in the market represents the total amount that the government spends on the subsidy.
In the case of health care in several West European countries, the majority of it is provided free to the user out of general taxation, although charges may be levied for prescriptions and optical and dental treatment. In these cases the prices charged have been made cheaper than they would otherwise be, with patients only paying part of the cost of treatment and the government making up the difference through the payment of subsidies to suppliers. In the case of housing, owner occupiers receive a subsidy through the receipt of tax relief on mortgage interest repayments, which is not available to those people who rent their accommodation. State education like health care, may be provided without direct charges being made, although education vouchers represent an alternative form of market-based, subsidised provision which has been proposed.
Taxation to redistribute income and reduce inequality
Direct and indirect taxes
Direct and indirect taxes include all the different types of taxes levied by the government. Direct taxes include the taxes that cannot be transferred or shifted to another person, for instance the income tax an individual pays directly to the government. In this case, the burden of the tax falls flatly on the individual who earns a taxable income and cannot shift the tax to others.
Indirect taxes, on the other hand, are taxes which can be shifted to another person. An example would be the Value Added Tax (VAT) that is included in the bill of goods and services that you procure from others. The initial tax is levied on the manufacturer or service provider, who then shifts this tax burden to the consumers by charging higher prices for the commodity by including taxes in the final price.
Both direct and indirect taxes are critical components of governmental revenue and consequently the economy.
Direct taxes: Direct taxes are paid directly to the government by the individual taxpayer – usually through “pay as you earn”. The tax liability cannot be passed onto someone else.
Indirect taxes: Indirect taxes – include GST, VAT, sales taxes and excise duties. The supplier can pass on the burden of an indirect tax to the final consumer – depending on the price elasticity of demand and supply for the product.
Major types of direct tax include:
Some types of indirect taxes are:
Arguments for using indirect taxation:
Arguments against using indirect taxation:
Marginal tax rates - investopedia
Average (effective) tax rates
Regressive, proportional, and progressive taxes
Taxes can be categorised as either regressive, proportional, or progressive, and the distinction has to do with the behaviour of the tax as the taxable base (such as a household's income or a business' profit) changes:
For example, an excise tax on petrol is likely to be a regressive tax since lower-income households spend a greater fraction of their income on petrol and, thus, on the tax on petrol. Lower-income households also tend to spend larger fractions of their incomes on necessities such as food and clothing, so a sales tax on such items would also be quite regressive. (This is why it is not unusual for unprepared foods to be exempt from sales taxes, and in some cases, clothing may be exempt from sales tax as well.)
A taxpayer’s average tax rate (or effective tax rate) is the share of income that he or she pays in taxes.
By contrast, a taxpayer’s marginal tax rate is the tax rate imposed on his or her last dollar of income.
An example of a progressive tax system – the United States:
It achieves this by applying higher marginal tax rates to higher levels of income. For example, the first portion of any taxpayer’s taxable income is taxed at a 10 percent rate, the next portion is taxed at a 15 percent rate, and so on, up to a top marginal rate of 39.6 percent.
The average tax rate is generally much lower than marginal rate. As an example, the graph below shows a married couple with two children earning a combined salary of $110,000. They face a top marginal tax rate of 25 percent, so they would commonly be referred to as “being in the 25 percent bracket.” But their average tax rate — the share of their salary that they pay in taxes — is only 9.0 percent, as explained below.
An individual’s average tax rate tends to be much lower than his or her marginal tax rate for three main reasons:
1. Because of exemptions and deductions, not all income is subject to taxation.
In the example above, the couple can claim exemptions and deductions for tax year 2015 totalling $28,600 (a $4,000 personal exemption for each family member and a $12,600 standard deduction). Subtracting that $28,600 from the couple’s $110,000 salary leaves them with $81,400 in taxable income — the amount of income subject to federal income taxes.
2. The top marginal tax rate applies only to a portion of taxable income.
As the graph shows, the first $18,450 of the couple’s taxable income is taxed at a 10 percent rate; the next $56,450 is taxed at 15 percent. Only the last $6,500 of their income faces their top marginal rate of 25 percent.
The couple’s resulting tax liability — before credits are taken into account — is $11,938.
3. Credits directly reduce the amount of taxes a filer owes.
Taxpayers subtract their credits from the tax they would otherwise owe to determine their final tax liability. In our example, the couple can claim the Child Tax Credit for both children, further reducing their tax by $2,000.
Our example couple is left with a final tax liability of $9,938. Dividing that amount by the couple’s total income ($110,000) results in an effective tax rate of 9.0 percent.
Calculating tax RATES HL
Gross income is income earned before income tax is paid to the government. Net income or disposable income is the income an individual is left with after income tax has been paid to the government.
Table 1 above shows the marginal income tax rates for country A.
1. Calculating the average tax rates for a worker earning $35,000 pa.
→ $10,000 taxed at 0% = $0
→ $10,000 taxed at 10% = $1,000
→ $15,000 taxed at 20% = $3,000
→ Total income tax paid = $4,000
2. Calculating the average tax rates for a worker earning $125,000 pa.
→ $10,000 taxed at 0% = $0
→ $10,000 taxed at 10% = $1,000
→ $20,000 taxed at 20% = $4,000
→ $40,000 taxed at 30% = $12,000
→ $45,000 taxed at 50% = $22,500
→ Total income tax paid = $39,500
3. Calculating the marginal tax rates for a worker earning $35,000 per annum and has found a new job paying $45,000 pa.
At $35,000 the tax paid was:
→ $10,000 taxed at 0% = $0
→ $10,000 taxed at 10% = $1,000
→ $15,000 taxed at 20% = $3,000
→ Total income tax paid = $4,000
At $45,000 the tax paid is:
→ $10,000 taxed at 0% = $0
→ $10,000 taxed at 10% = $1,000
→ $20,000 taxed at 20% = $4,000
→ $5,000 taxed at 30% = $1,500
→ Total income tax paid = $6,500
→ Income tax paid increases from $4,000 to $6,500 as income earned increases from $35,000 to $45,000.
Direct taxes may be used to redistribute income
Tax systems can play an important role in determining how income is distributed in a society. A progressive tax system can be used to redistribute income towards low income earners by taking money away from high income earners.
Tax revenues can be used to finance transfer payments to low income individuals and families.
A transfer payment is a payment made or income received in which no goods or services are being paid for, such as a benefit payment or subsidy.
Transfer payments can be used to increase the incomes of the unemployed (unemployment benefits), the sick and/or disabled (sickness and disability benefits), and the old (pensions), as well as other low income individuals and families (income support payments).
Redistributing income from high income earners to those on low incomes reduces inequality in society. Scandinavian countries such as Sweden, Norway and Denmark tend to have the lowest income inequality scores (as measured through the Gini coefficient) because they have the highest marginal tax rates in the world.
The effect of this can be seen below.
Essential statement: Progressive taxation considers the ability of the individual (or entity) to pay the tax. A shift from a regressive to a progressive tax system should lead to less inequality in the distribution of income in society
Equality and redistribution
The trade-off between incentives and income equality
The trade-off between incentives and economic equality. Figure 1: Society faces a trade-off where any attempt to move toward greater equality, like moving from choice A to B, involves a reduction in economic output. Figure 2: Situations can arise like point C, where it is possible both to increase equality and also to increase economic output, to a choice like D. It may also be possible to increase equality with little impact on economic output. However, at some point, too aggressive a push for equality will tend to reduce economic output, as in the shift from D to E.
Government policies to reduce poverty or to encourage economic equality, if carried to extremes, can injure incentives for economic output. The poverty trap, for example, defines a situation where guaranteeing a certain level of income can eliminate or reduce the incentive to work. An extremely high degree of redistribution, with very high taxes on the rich, would be likely to discourage work and entrepreneurship. Thus, it is common to draw the trade-off between economic output and equality, as shown below. In this formulation, if society wishes a high level of economic output, such as is achieved at point A, it must also accept a high degree of inequality. Conversely, if society wants a high level of equality, such as is achieved point B, it must accept a lower level of economic output because of reduced incentives for production.
Is income inequality inevitable?
Does income inequality matter?
The top 1%
Inequality for all?
This view of the trade-off between economic output and equality may be too pessimistic, and the figure below presents an alternate vision. Here, the trade-off between economic output and equality first slopes up, in the vicinity of choice C, suggesting that certain programs might increase both output and economic equality. For example, the policy of providing free public education has an element of redistribution, since the value of the public schooling received by children of low-income families is clearly higher than what low-income families pay in taxes. A well-educated population, however, is also an enormously powerful factor in providing the skilled workers of tomorrow and helping the economy to grow and expand. In this case, equality and economic growth may complement each other.
Figure 1 above shows an inverted downward slope with points A and B. Figure 2 above a more severe inverted downward slope with points C, D and E.
Moreover, policies to diminish inequality and soften the hardship of poverty may sustain political support for a market economy. After all, if society does not make some effort toward reducing inequality and poverty, the alternative might be that people would rebel against market forces. Citizens might seek economic security by demanding that their legislators pass laws forbidding employers from ever laying off workers or reducing wages, or laws that would impose price floors and price ceilings and shut off international trade. From this viewpoint, policies to reduce inequality may help economic output by building social support for allowing markets to operate.
The trade-off in Figure 1 then flattens out in the area at the top of the curve, which reflects the pattern that a number of countries that provide similar levels of income to their citizens – the United States, Canada, and the nations of the European Union, Japan, and Australia – have different levels of inequality. The pattern suggests that countries in this range could choose a greater or a lesser degree of inequality without much impact on economic output. Only if these countries push for a much higher level of equality, like at point E, will they experience the diminished incentives that lead to lower levels of economic output. In this view, while a danger always exists that an agenda to reduce poverty or inequality can be poorly designed or pushed too far, it is also possible to discover and design policies that improve equality and do not injure incentives for economic output by very much – or even improve such incentives.
Essential statement: The incentive to take entrepreneurial risk-taking may be reduced by increasing tax rates which, in turn, may have a negative impact of future GDP
Essential statement: The incentive to invest in a foreign country may be reduced by increasing the corporate tax rate, and foreign direct investment and thus, national output and incomes may be reduced the higher the corporate tax rate. Similarly, a high rate of domestic corporate tax may incentivise domestic firms to move production and/or headquarters abroad
Essential statement: In line with the law of diminishing marginal utility, the total utility within a country will be boosted by redistributing income from those on high incomes to those on low incomes
Essential statement: It is difficult to design a tax system that is both equitable and provides adequate incentives for individuals to work hard, improve their human capital and take entrepreneurial risks
The Laffer curve
Increasing tax rates to improve income inequality may decrease total tax revenues.
The Laffer curve is a representation of the relationship between rates of taxation and the resulting levels of government revenue. Proponents of the Laffer curve claim that it illustrates the concept of taxable income elasticity – i.e., taxable income changes in response to changes in the rate of taxation.
The Laffer curve assumes that no tax revenue is raised at the extreme tax rates of 0% and 100%, and thus there must be a rate between 0% and 100% that maximises government taxation revenue. The Laffer curve is typically represented as a graph that starts at 0% tax with zero revenue, rises to a maximum rate of revenue at an intermediate rate of taxation, and then falls again to zero revenue at a 100% tax rate. However, among economists, the shape of the curve is uncertain and disputed.
One implication of the Laffer curve is that increasing tax rates beyond a certain point is counter-productive for raising further tax revenue.
lower taxes increase revenue?
Note: This video was produced by a right-wing think tank!
THE LAFFER CURVE EXPLAINED
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