Unit VIII

Income Inequality

In this chapter, look for the answers to these questions:

How much inequality and poverty exist in our society?

What are the problems measuring inequality?

What are some of the leading philosophies on the proper role of government in altering the distribution of income?

What policies are used to fight poverty? What are the problems with these policies?

Introduction

Recap of the previous chapters:• equilibrium wages equal the value of workers’

marginal products• differences in equilibrium wages result from

differences in –worker characteristics:

education, experience, talent, effort

– job characteristics: extent to which a job is pleasant and safe

• some earnings differences due to discrimination

Introduction

• Even in the absence of discrimination, the income distribution in a market economy may not be equitable or otherwise desirable.

• In this chapter, we examine– indicators of inequality and poverty– philosophies about income redistribution– policies designed to help the poor

The U.S. Income Distribution: 2008

Group Annual family income

Bottom fifth Under $20,712

Second fifth $20,712 – $42,057

Middle fifth $42,057 – $65,000

Fourth fifth $65,000 – $100,250

Top fifth $100,250 and over

Top 5 percent $180,000 and over

Inequality Around the World

Income share of the top 20% divided by income share of the bottom 20%

Income Inequality

• Lorenz Curves– A Lorenz curve is a curve that graphs the cumulative

percentage of income (or wealth) against the cumulative percentage of households.

– The figure on the next slide shows the Lorenz curves for the United States in 2004.

Income Inequality• 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.

Income Inequality2. The distribution of income shows that the poorest 20% of households received 3.5% of total income, and the richest 20 percent received 50.1 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.

Income Inequality–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.

Gini Coefficient

• Gini coefficient is a measure of statistical dispersion, commonly used as a measure of inequality of income distribution or inequality of wealth distribution– defined as a ratio with values between 0 and 1:– low Gini coefficient indicates more equal income or

wealth distribution, while a high Gini coefficient indicates more unequal distribution

– 0 corresponds to perfect equality (everyone having exactly the same income) and 1 corresponds to perfect inequality (where one person has all the income, while everyone else has zero income)

– Gini coefficient requires that no one have a negative net income or wealth

Economic Inequality

• Inequality over Time– U.S. income and wealth have become more unequal over the

past few decades– highest incomes have increased much faster than the lower

incomes– gap between rich and poor has widened– figure on the next slide shows how the distribution of income

has changed

Economic Inequality

The average income of the lowest 20 percent group increased from $7,700 to $10,300—an increase of 34 percent.

The average income of three middle groups also increased by 34 percent.

The average income of highest 20 percent increased by 77 percent.

How Inequality and Poverty Arise

• Economic inequality and poverty arise from six key factors

– Human capital– Discrimination– Financial and physical capital– Entrepreneurial ability– Personal and family characteristics– Luck

Poverty• Poverty line: an absolute level of income

set by the govt for each family size below which a family is deemed to be in poverty

• Poverty rate: the percentage of the population whose family income falls below the poverty line

• In 2008 in the U.S.,– median family income = $52,029– poverty line for family of four = $21,200– poverty rate = 13.2%

U.S. Poverty Over Time

Percent of the population below poverty line

U.S. Poverty Rate by Group, 2008

Group Poverty Rate

All persons 13.2%

White, not Hispanic 8.2

Black 24.4

Hispanic 22.5

Asian, Pacific Islander 11.8

Children 17.6

Elderly 10.2

Married-couple families 5.4

Female household, no spouse present

28.0

Policies to Reduce Poverty• Poor families more likely to experience

– homelessness– drug dependence– health problems– teen pregnancy– illiteracy– unemployment

• Most people believe govt should provide a “safety net.”

Income Redistribution

• How Government Redistributes Income– Three main ways in which governments in

the United States redistribute income are• Income taxes• Income maintenance programs• Subsidized services

Income Redistribution

Income Taxes– Income taxes may be progressive, regressive, or

proportional.• A progressive tax

– One that taxes income at an average rate that increases with the level of income.

• A regressive tax– One that taxes income at an average rate that

decreases with the level of income.• A proportional tax

– One that taxes income at a constant rate, regardless of income.

Income Redistribution

This slide shows income redistribution.

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

In part (b), the three lowest income groups gain and the two highest income groups lose.

Income Redistribution

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.

Income Tax• The Personal Income Tax

– In 2008, the personal income tax raised:• More than $1 trillion for the federal government• About $300 billion for state and local governments

– The amount of income tax that a person pays depends on her or his taxable income and on the tax rates.

– Taxable income– Total income minus a personal exemption and a

standard deduction (or other allowable deductions).

Income Tax

• Marginal tax rate– The percentage of an additional dollar of

income that is paid in tax.

– Marginal Tax Rate = (∆ taxes due) / (∆ taxable income)

– Example:• If my income rises by $100 and the taxes that I owe

the government rise by 25%, the marginal tax rate is 25% on the additional $100.

Income Tax

• Average tax rate– The percentage of income that is paid in tax.– Average Tax Rate = (total taxes due) / (total

taxable income)

– Example:• If my monthly taxable income is $1000 and $200 is

deducted for taxes, my average tax rate is 20 percent.

Income Tax (Tax Fairness)

• Whenever political leaders debate tax issues, it is fairness, not efficiency, that looms above all other considerations.

• There are two conflicting principles of fairness of taxes:– The benefits principle– The ability-to-pay principle

Income Tax (Tax Fairness)• The Benefits Principle

– Benefits principle– The proposition that people should pay taxes

equal to the benefits they receive from public goods and services.

– This arrangement is fair because it means that those who benefit most pay the most.

– But to implement it, we would need an objective way of measuring each person’s marginal benefit from public goods and services.

Income Tax (Tax Fairness)

• The Ability-to-Pay Principle– Ability-to-pay principle– The proposition that people should pay

taxes according to how easily they can bear the burden.

– A rich person can more easily bear the burden of providing public goods than a poor person can, so the rich should pay higher taxes than the poor.

Income Tax (Tax Fairness)

• April 12, 2012

Tax Freedom Day in Minnesota

(8th longest in the United States)

Conclusion• Poverty is one of society’s most serious

problems.• Public policy can help reduce poverty and

inequality.

CHAPTER SUMMARY• Data on income distribution show a wide disparity

in our society. The richest 20% of families earn about ten times as much as the poorest 20%.

• Problems in measuring inequality arise from in-kind transfers, the economic life cycle, transitory income, and economic mobility. When these factors are taken into account, the distribution of well-being is probably less unequal than the distribution of annual income.

CHAPTER SUMMARY• Political philosophers differ in their views

of the proper role of government in altering the income distribution. Utilitarians believe that income distribution should maximize the sum of everyone’s utility. Liberals believe the government should aim to maximize the well-being of the worst-off person in society. Libertarians believe the government should aim for equality of opportunity, not equality of income.

CHAPTER SUMMARY• Policies such as welfare, minimum-wage

laws, negative income taxes, and in-kind transfers can help the poor.

• Since financial assistance falls as income rises, the poor face high effective marginal tax rates, discouraging them from escaping poverty on their own.

• THAT IS ALL!