Inequality and Poverty CHAPTER20

C H A P T E R C H E C K L I S T

When you have completed your study of this chapter, you will be able to

1 Describe the economic inequality and poverty in the United States.

2 Explain how economic inequality and poverty arise.

3 Explain why governments redistribute income and describe the effects of redistribution on economic inequality and poverty.

We measure economic inequality by looking at the distributions of income and wealth.

Market income is a household’s wages, interest, rent, and profit earned from the markets for factors of production before paying income taxes.

Money income is market income plus cash benefits paid by the government.

A household’s wealth is the value of the things that it owns at a point in time.

Table 20.1 shows these distributions in the United States in 2006.

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Lorenz Curves

A Lorenz curve is a curve that graphs the cumulative percentage of income (or wealth) against the cumulative percentage of households.

Figure 20.1 on the next slide shows the Lorenz curves for the U.S. income in 2006 and U.S. wealth in 1998.

These Lorenz curves are based on Table 20.1

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The cumulative percentages of income and wealth are graphed against the cumulative percentage of households.

1. If each 20 percent of households received 20 percent of total income, there would be no rich and poor—there would be equality as shown by the Line of equality.

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2. The distribution of income shows that the poorest 20 percent of households received 3.4 percent of total income, and the richest 20 percent received 49.4 percent.

3. The distribution of wealth shows that the poorest 40 percent of households owned 0.2 percent of total wealth, and the richest 1 percent owned 38.1 percent.

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The farther the Lorenz curve is from the Line of equality, the greater is the inequality.

The distribution of wealth is much more unequal than the distribution of income.

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Inequality over Time

U.S. income inequality has increased the past few decades.

The highest incomes have increased much faster than the lower incomes.

The gap between rich and poor has widened.

Figure 20.2(a) on the next slide shows how the distribution of income changed from 1967 to 2006.

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The average income of the lowest quintile increased from $7,900 to $11,400—an increase of 43 percent.

The average income of three middle quintiles increased by 42 percent.

The average income of highest quintile increased by 91 percent.

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Economic Mobility

Economic mobility is the movement of a family up or down the income ladder and through the income quintiles.

If there were no economic mobility, a family would be stuck at a given point in the income distribution—persistently rich to persistently poor.

How much economic mobility has there been?.

Figure 20.2(b) shows the percentage of families that moved by one quintile or more over a ten-year period.

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The figure shows quite a lot of economic mobility.

About 30 percent of families move up a quintile or more in a decade;

A similar percentage move down by a quintile or more;

Between 35 and 40 percent remain in the same quintile.

Mobility decreased over the 1980s and 1990s.

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Who Are the Rich and the Poor?

The lowest-income household in the United States today is likely to be a black woman over 65 years of age who lives alone somewhere in the South and has fewer than nine years of elementary school education.

The highest-income household in the United States today is likely to be a college-educated white married couple between 45 and 54 years of age living together with two children somewhere in the Northeast or the West.

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The median income in 2005 was $46,326.

Education is the single biggest factor affecting household income distribution.

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Size of household, marital status, and age of householder are

also important.

Race and region are the least important.

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Poverty

Poverty is a state in which a household’s income is too low to be able to buy the quantities of food, shelter, and clothing that are deemed necessary.

In 2005, the poverty level for a household with 2 adults and 2 children was an income of $19,806.

In 2006, 36 million Americans lived below the poverty level.

Figure 20.4 on the next slide shows the distribution of poverty by race in 2006.

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Part (a) shows the distribution of poverty in 2006: 56 percent of white families

20 percent of black families

21 percent of Hispanic families

3 percent of Asian families

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Poverty Incidence and Trends

To measure the incidence of poverty, we look at the poverty rate.

The poverty rate is the percentage of families living in poverty.

In 2006, the poverty rate was 12.3 percent.

Figure 20.4(b) on the next slide shows the poverty rates and their trends for whites, blacks, and Hispanic families from 1996 to 2006.

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The white poverty rate has been fairly steady.

The black poverty rate fell during the 1960s and the 1990s.

Poverty rates for blacks and Hispanics are double that for whites.

The Hispanic poverty rate fell in the 1990s.

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Poverty Duration

Another measure of poverty is duration.

Duration of poverty is an important indicator of the hardship poverty brings.

Figure 20.5 on the next slide shows the duration of poverty in the United States from 1996 to 1999.

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More than 50 percent of poverty last for between 2 and 4 months.

But almost 30 percent of poverty lasts for more than 9 months. These families experience chronic poverty.

20.2 HOW INEQUALITY AND POVERTY ARISE

Economic inequality and poverty arise from five key factors

• Human capital• Discrimination• Financial and physical capital• Entrepreneurial ability• Personal and family characteristics

We look at each in turn.

20.2 HOW INEQUALITY AND POVERTY ARISE

Human Capital

High-skilled workers have a higher value of marginal product than low-skilled workers.

Figure 20.6(a) on the next slide illustrates the demand for high-skilled and low-skilled labor.

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High-skilled labor has a higher VMP than low-skilled labor and a greater demand.

The demand curve for high-skilled labor, DH, lies above the demand curve for low-skilled labor, DL, by the VMP of skill.

Demand for High-Skilled and Low-Skilled Labor

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The Supply of High-Skilled and Low-Skilled Labor

Skills are costly to acquire, and a worker pays the cost of acquiring a skill before benefiting from a higher wage.

Figure 20.6(b) on the next slide illustrates the supply of high-skilled and low-skilled labor

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High-skilled labor bears the cost of acquiring skill.

The supply curve of high-skilled labor, SH, lies above the supply curve of low-skilled labor, SL, by the compensation for the cost of acquiring skill.

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Wage Rates of High-Skilled and Low-Skilled Labor

The combined effects of skill on the demand for and supply of labor generate a higher wage for high-skilled labor than for low-skilled labor.

Figure 20.6(c) on the next slide illustrates the skilled wage differential.

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The demand for low-skilled labor, DL, and the supply of low-

skilled labor, SL, determine the

wage rate of low-skilled labor—in this example at $10 an hour.

The demand for high-skilled labor, DH, and the supply of high-

skilled labor, SH, determine the

wage rate of high-skilled labor—in this example at $20 an hour.

20.2 HOW INEQUALITY AND POVERTY ARISE

Discrimination

Human capital differences explain much of the income inequality that exists.

Economists are not sure whether and by how much discrimination adds to income inequality.

One line of argument is that competition prevents discrimination. But race and sex income differences do persist.

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Financial and Physical Capital

People with high incomes are usually those who own large amounts of financial capital and physical capital.

They receive income in form of interest, dividends, and capital gains.

Families with a lot of capital tend to become even more wealthy because

• They bequeath wealth to their children.

• Rich people marry rich people (on average).

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Saving and wealth accumulation is not inevitably a source of inequality.

When a family saves to redistribute an uneven income over the life cycle, it enjoys more equal consumption.

If a lucky generation that has a high income saves and makes a bequest to an unlucky generation, this saving decreases economic inequality.

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Entrepreneurial Ability

Some people become extremely rich through a combination of hard work, good luck, and outstanding entrepreneurial ability.

But others who borrow to create a business, work hard, and have bad luck become extremely poor.

Personal and Family Characteristics

Personal and family characteristics play a crucial role, for good or evil, in influencing economic well-being.

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How Governments Redistribute Income

Three main ways in which governments in the United States redistribute income are

• Income taxes• Income maintenance programs• Subsidized services

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Income Taxes

Income taxes may be progressive, regressive, or proportional.

• A progressive taxOne that taxes income at an average rate that increases with the level of income.

• A regressive taxOne that taxes income at an average rate that decreases with the level of income.

• A proportional taxOne that taxes income at a constant rate, regardless of income.

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Income Maintenance Programs

Three main types of program are• Social Security programs• Unemployment compensation• Welfare programs

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Social Security Programs

OASDHI or Old age, Survivors, Disability, and Health Insurance

Medicare, which provides hospital and health insurance for the elderly and disabled.

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Unemployment Compensation

To provide an income to unemployed workers.

A tax is paid based on the income of each covered worker.

Each worker receives a benefit when he or she becomes unemployed.

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Welfare Programs

1. Supplementary Security Income (SSI), designed to help the neediest elderly, disabled, and blind people.

2. Temporary Assistance for Needy Families (TANF) program, designed to help households that have inadequate income.

3. Food Stamp program, designed to help the poorest households obtain a basic diet.

4. Medicaid, designed to cover the costs of medical care for households receiving help under the SSI and TANF programs.

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Subsidized Services

Services provided by the government at prices far below the cost of production. The most important of these are

• Education• Health care

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The Scale of Income Redistribution

Market income is the income that a household earns in factor markets with no redistribution.

Money income is the market income plus cash benefits paid by the government.

Disposable income is market income plus cash benefits paid by the government minus taxes.

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The Scale of Income Redistribution

Market income is the income that a household earns in factor markets with no redistribution.

Disposable income is market income plus cash benefits paid by the government minus taxes.

We can measure the scale of income redistribution by calculating the percentage of market income paid in taxes minus the percentage received in benefits at each income level.

Figure 20.7 shows income redistribution in 2005.

In part (a), the Lorenz curve for the distribution of money income is closer to the line of equality than the distribution of market income.

The distribution of disposable income is even closer to the line of equality.

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Part (b) shows the amount of redistribution in 2005.

The quintile with the lowest incomes received net benefits that increased their share of total income by 2.9 percent.

The quintile with the highest incomes paid taxes that decreased their share of total income by 6.5 percent of total income.

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Why We Redistribute Income

Two approaches:• Normative approach

Discusses why we should compel everyone to help the poor and looks for principles to guide in the appropriate scale of redistribution.

• Positive approachSeeks reasons why we do compel everyone to help the poor and tries to explain the actual scale of redistribution.

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Normative Theories of Income Redistribution

Utilitarianism points to the ideal distribution being one of equality. But efficiency is also desirable.

Greater equality can be achieved only at the cost of inefficiency—the big tradeoff.

John Rawls proposed the principle that income should be redistributed to the point at which the poorest person’s share is maximized.

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Libertarian philosophers, such as Robert Nozick, say that any redistribution is wrong because it violates the sanctity of private property and voluntary exchange.

Modern political parties stand in the center of these extremes—some favor a bit more redistribution than others, but the major parties are basically happy with the current scale of redistribution.

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Positive Theories of Income Redistribution

There is no good positive theory, but economists have a promising idea called the median voter theory.

Median voter theory is a theory that government pursues policies that make the median voter as well off as possible.

In the majority voting system, the voter whose views carry most weight is the one in the middle—the median voter.

Political parties will deliver the scale of redistribution that the median voter prefers.

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The Major Welfare Challenge

The poorest people in the United States are young women who have not completed high school, have a child (or children), live without a partner, and are more likely to be black or Hispanic than white.

These young women and their children present the major welfare challenge:

• The long-term solution involves education and job training.

• The short-term solution is welfare.

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Welfare must be designed to strengthen the incentive to pursue the long-term solution while giving support in the short term.

The Current Approach: TANF

TANF is a block grant paid to the states to administer payments to individuals.

An adult member of a household receiving assistance must work or perform community service. Assistance is limited to 5 years.

Some economists suggest a negative income tax.

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Negative Income Tax

A negative income tax is a tax and redistribution scheme that provides every household with a guaranteed minimum annual income and taxes all earned income above the guaranteed minimum at a fixed rate.

A negative income tax does not remove the burden of the tax but it does improve the incentives to work and save at all levels of income.