Income inequality and poverty

Income – reward for the services of a factor of production. For labor income is paid in wages, salaries and bonuses.
For other factors it can take forms of rent, interests and profits.

It is a flow concept – this is because the return to the various factors of production are variable over any given
period of time.

Wealth – describes the stock of assets someone has built up over time, for example businesses, property, shares,
gold and antiques. These assets are there to provide security and in some cases, an income stream for the future.

Income and wealth inequality are two different concepts

- Income inequality refers to the unequal distribution (flow) of income to households i.e rent, wages, interest
and profit
- Wealth inequality refers to differences in the amount of assets that households own

Absolute poverty is a situation where individuals cannot afford to acquire the basic necessities for a healthy and
safe existence. These necessities include shelter, water, nutrition, clothing and healthcare. In 2022, the World Bank
defined absolute poverty as anyone who was living on less than $1.90 a day (the so called international poverty
line) Absolute poverty is more prevalent in developing countries than in developed ones.

Relative poverty is a situation where household income is a certain percentage less than the median household
income in the economy. Poverty in a household is considered relative to income levels in other households.
Households that are living with less than 50% of the median household income are considered to be in relative
poverty. Relative poverty is the main form of poverty that occurs in developed countries

Measuring income and wealth inequality:

The Gini coefficient is a numerical measure of the extent of income inequality in an economy. If the income
distribution in an economy is equal, the Gini coefficient will have a value of 0. At the other extreme, if all the
income accrues to just one person, then the Gini coefficient will be 1. Both extremes do not occur in the real
world.

The norm is for Gini coefficients to be somewhere between the values of 0 and 1. A Gini coefficient of 0.3
therefore indicates a more equal distribution of income than a coefficient of 0.5.

Low wages represent the intersection of economic

growth and human development and are the major
cause of poverty. Low wages are usually the result of
unemployment, informal employment, a lack of
skills, or a primary sector based economy

Education and healthcare cost money and with lower

wage levels these are not accessible, resulting in
poor human capital. People find it harder to stay well
or to recover from illness resulting in lower
productivity and shorter life expectancy

Low productivity results in low wages and the cycle continues. Populations with a large number of dependents (old
people and children) for each working household tend to experience higher levels of poverty

Causes of inequality:
Differences in human capital: The higher the skill level the higher the level of income. A country with a poor
education system will see greater inequality than one with a good education system

Poor vocational training: local industries cannot obtain the labor needed to maintain a viable operation in national
and international markets

Lack of formal employment opportunities: particular for young people, but also for those with professional skills

Inequality of opportunity: Access to education and health can vary significantly within communities and between
different regions. Inequality in education and healthcare leads to inequality of opportunity in the job market

Different levels of resource ownership: Assets generate income. The more equal the asset ownership in an
economy the less the inequality in income distribution

Discrimination: Gender, race - or any other discrimination increases income inequality in an economy

Unequal status and power: Countries with strong trade union membership provide workers with more power and
higher levels of income. With low trade union membership, the exploitation of workers through low wages is
easier and income inequality is worse.

Government tax and benefits policies: Countries that provide a range of benefits (such as unemployment,
pension, disability, child support, housing support etc) raise the income of the lowest 20% of the population
resulting in more equal distribution. Progressive tax systems allow all income earners to contribute to public
revenue according to their ability. Decreasing taxes on the lower end and increasing it on the upper end would
mean that the system is more progressive and there would be a more equal distribution of income

Globalisation and technological change: Globalisation is the economic integration of different countries through
increasing freedoms in the cross-border movement of people, goods/services, technology and finance. This
integration of global economies has impacted national cultures, spread ideas, speeded up industrialisation in
developing nations and led to de-industrialisation in developed nations. Countries which are more isolated will
experience higher levels of wealth and income inequality

Inability of people to obtain credit: unable to fund small business and improved personal education

Market based supply-side policies: Supply-side policies such as deregulation, privatisation and trade liberalisation
can provide great opportunities but also increase inequality. E.g. Privatisation of state owned assets often allows a
few people to get rich (those who buy the asset) and the service provided by the newly privatised firm may
become more expensive to access.

Positives of income inequality:

- Inequality provides incentives for people to work harder and earn more — so rewarding hard work increases
productivity
- It encourages enterprise by those who have the funds available to start businesses
- It also encourages people to work instead of claiming benefits
- It may create a trickle-down effect — some economists argue that if there’s inequality and greater economic
growth, the rich will become even richer and spend more on goods and services, providing more income for
the poor. This is known as the trickle-down effect. As a result, relative poverty may increase, but absolute
poverty will decrease

Costs of inequality:

1. Impact on economic growth

At some point, increasing levels of inequality becomes a disincentive for workers to work and be productive. This
means that some resources (labour) in the economy are not being used efficiently. National output falls and
economic growth slow. Government unemployment payments and welfare benefits may increase. Government tax
revenues may decrease with increasing inequality

2. Impact on living standards

If the inequality gap grows, the rich get richer and the poor, relatively poorer. Over time, this will reduce the
standard of living. The wealthier will access better education and healthcare creating even less opportunity for
poorer households in the future

3. Impact on social stability

More equal societies tend to be more stable, tolerant and considerate with lower levels of crime and better
standards of living. Less equal societies tend to be characterized by political instability, strife, social unrest - and in
extreme cases this can lead to revolutions

4. Current account deficit

As incomes rise even higher, people generally spend more on imports, so this money would leave the circular flow.

Using Taxation to Reduce Inequality & Poverty

- The main source of government revenue is taxation
- Taxation is used to redistribute income so as to reduce income inequality in a nation

Types of taxes
- Direct taxes are taxes imposed on income and profits. They are paid directly to the government by the
individual or firm. E.g. Income tax, corporation tax, capital gains tax, national insurance contributions,
inheritance tax
- Indirect taxes are imposed on spending. The less a consumer spends the less indirect tax they pay. Examples
of indirect tax include Value Added Tax (19% VAT rate in the European Union in 2022), taxes on demerit goods
such as excise duties on fuel or cigarettes
- Taxes can also be imposed to reduce wealth inequalities. One example is inheritance tax. Individuals who
inherit more than a certain amount of wealth have to pay some of the value of that wealth in tax to the
government. Another similar example is that of capital tax, whereby a tax is payable on the financial gain a
person may have made in the time that an asset, such as property or a financial portfolio, has been owned.
The overall impact of such measures is relatively small.

The link Between Taxation & the Reduction of Income Inequality & Poverty

Progressive taxation - A progressive tax system redistributes from those with higher income to those with lower
income and reduces income inequality. Redistribution often starts with the provision of free education and
healthcare. Many governments use tax revenues to provide multiple levels of financial support to poor households
including disability payments, heating subsidies, travel subsidies etc.

Higher redistribution → better education/healthcare → better human capital → better productivity → higher
income

However,
- Sometimes the benefits of a good progressive tax system are eradicated by the penalties imposed through
multiple regressive (indirect) taxes.
- Moreover, the collection of taxes causes serious difficulties in most low-income countries and many middle-
income countries where the informal economy is huge with only a small percentage of population paying
direct taxes.
- Corruption and tax evasion are also commonplace. This hinders the government’s ability to successfully
implement policies that redistribute income and wealth.
- For some poeple it might be a disincentive to work. For tax reasons, they may seek to move to a country that
has a more favorable tax regime.

How Different Policies Alleviate Poverty

1. Investing in human capital e.g. education - Investing in this supply-side policy increases the potential output
of the country (shifts the production possibility frontier outwards)

Higher education/skill levels → higher human capital → increased productivity → higher output → higher
income

2. More generous transfer payments - A transfer payment is a payment from tax revenue that is received by
certain members of the community. These payments are not made through the market, as no production
takes place. Their function is to provide a more equitable distribution of income. The main recipients are
vulnerable groups such as the elderly, the disabled, the unemployed and those on the lowest incomes.
Payments tend to transfer income from those able to work and pay taxes to those unable to work or in need
of assistance. E.g. old age pensions, unemployment benefits, housing allowances, food coupons and child
benefits.

More benefits → higher wages → better education/healthcare → better human capital → better productivity →
higher wages

However, the extent to which transfer payments can be paid is dependent on how much tax is collected and how
many people have paid tax. In low-income and lower middle-income countries, this is affected by all sorts of
problems. For example, Pakistan has a growing elderly population, yet it has a low tax base. Pension and social
security coverage is limited to the formal sector and therefore only covers a small percentage of the population.
Those who work or who have worked in the informal sector are not covered by these schemes. Similar
arrangements apply in India although a higher proportion of the population is eligible for help.

The effect of transfer payments on the market is a controversial issue. It is clear that in most cases they are
necessary to protect the most vulnerable groups in the community. Transfer payments result in less poverty and
provide for a more equitable distribution of income. The opposing argument is that unemployment benefits and
benefits to those on the lowest incomes can act as a disincentive to accepting work, so increasing the
unemployment rate. As a consequence, output in the economy is less than it might be and there is a form of
inefficiency.

3. Establishment/increase of national minimum wage. Minimum wages are set above the free market rate.
Firms are not allowed to pay anyone less than the legal rate. It is a rate before tax and social security
deductions are made. A national minimum wage, if it’s set at a sensible level, will reduce poverty among the
lowest paid workers. It will provide an incentive to work, and will help those on low incomes to afford a
reasonable standard of living.

Higher wages → better education/healthcare → better human capital → better productivity → higher wages

However, the problem with most middle income and low income countries is that the legislation might only apply
to a minority of poorly paid workers. This is because the legislation would not have an impact in the large informal
sectors that are prevalent in these economies. Also, a minimum wage rate has no relevance where workers are
self-employed or run small businesses staffed by family members.

In 2019, South Africa introduced a minimum wage rate of R20 per hour, reduced to R18 for farm workers and R15
for domestic workers. It was estimated that 47% of workers were being paid below this threshold.

It may also lead to unemployment as shown in the diagram below:

The equilibrium wage rate is w. Introducing a minimum wage rate increases the wage rate to W1. At this higher
wage rate, employers will only employ Q1 workers yet Q2 workers are willing to work. Those who are employed
will get more pay but at the cost of fewer jobs being available. This unemployment is shown by Q1 to Q2.

4. Targeted government spending on goods/services. This can be aimed at the greatest needs in society. E.g.
providing more schools, teachers or hospitals. State-provided services, such as health care and education, help
to reduce inequalities caused by differences in income — e.g. someone on a low income can receive the same
health care as someone on a high income. State-provided services also redistribute income because most of
the money to pay for them comes from taxing people with higher incomes. The view is that everyone should
have access to a certain level of health care and education regardless of income and wealth. Therefore, these
services are provided universally free: they are the material equivalent of monetary universal benefits.

Higher education/skill levels → higher human capital → increased productivity → higher output → higher
income

5. Policies to reduce discrimination - Discrimination occurs in many different forms (age, ethnicity, gender,
disability etc) and in each case results in social exclusion leading to inequalities of opportunity and income.
Reducing discrimination reduces inequality

Less discrimination → better productivity → higher wages

6. Economic Growth - Perhaps the most effective way of reducing poverty is through economic growth. This will
mean jobs are created and unemployment will be reduced. It also tends to lead to higher wages, meaning the
government will gain more tax revenue, which it can use to provide services.

Governments use fiscal policy to Tackle Poverty

- Fiscal policy can be used to reduce poverty in a country. Three key ways a government can do this is through
benefits, provision of certain goods and services, and progressive taxation.
- Government spending on benefits, e.g. JSA, pensions and disability benefits, is a way of helping those who are
unemployed or unable to work, and reducing absolute poverty.
- A government can also spend its tax revenue to provide goods and services, such as free health care or
education, to enable those who are suffering from poverty to have access to these things.
- Furthermore, by providing some goods and services to poorer members of society, a government will be
investing in the improvement of its country’s human capital — i.e. this spending may make labour (one of the
factors of production) much more productive.
- Progressive taxation may reduce relative poverty by narrowing the gaps between people’s disposable income,
and the revenue raised can pay for benefits and the state provision of goods and services. On top of this,
governments could provide tax cuts and discounts for the poor.
- Finally, if fiscal policy creates growth, then this may reduce both relative and absolute poverty. Greater
economic growth will mean more jobs, higher incomes and a better standard of living