DISTRIBUTION OF INCOME

Economics – a Course Companion. Blink & Dorton, 2007. p238-243

Introduction to Income Distribution

• One of the characteristics associated with free market economics is an unequal distribution of income.

• Inequality occurs to different extents in different countries.

• The reasons for difference in income and the consequences of inequality are many and complex.

• The can form the basis of considerable debate among economists, politicians, sociologists, parents, and students.

Income Inequality is Unfair

• One argument suggests that huge inequalities in income are unfair.

• People with low incomes will experience relatively low living standards, and fewer opportunities than people with high incomes

• They may live in a state of absolute poverty whereby they do not have access to basic necessities needed to sustain life.

• Or they may live in relative poverty whereby their living standards are well below the observed “average” in an economy.

REASONS FOR INCOME INEQUALITYBorn into Poverty

• Incomes may be low because they themselves were born into a household where incomes were low and they experience little opportunity to break out from the conditions associated with poverty such as poor education, malnutrition, and perhaps the necessity to find work before completing an education.

REASONS FOR INCOME INEQUALITYHuman Capital

• Incomes may be low because human capital keeps some people in low paying jobs.

REASONS FOR INCOME INEQUALITYUnemployment

• Income may be low due to unemployment.• The reason the person is unemployed and

their time without employment will be key issues.

Higher Incomes are Incentive to Worker Harder

• Even though unequal distribution of income is unfair, economic reasoning will show that higher incomes act as an incentive for people to work harder.

• If people did not believe that their hard work in school or at work would allow them to raise their human capital and provide them with an opportunity to earn higher incomes, then this would have huge implications for the supply side of an economy, resulting in a lower level of economic activity.

What level of income inequality is acceptable?

• Purely economic analysis will not lead to an answer as to exactly how much inequality is acceptable or appropriate.

• This is very much a normative issue. • What can be agreed upon is the fact that

market economies do result in inequality of income.

REDISTRIBUTION OF INCOME IN AN ECONOMY: TAXATION

• Governments at all levels (municipal, provincial, state, national) impose a huge array of taxes for a range of reasons.

• In this section, we are looking at the way taxation is used to change the distribution of income.

TYPES OF TAXES

There are many different types of taxes Including:• Direct Taxes• Indirect Taxes• Progressive Taxes• Regressive Taxes• Proportional Taxes

Direct Taxes

• Direct taxes are imposed on peoples’ income or wealth, and the profits of firms.

• The income from households comes in various forms such as employment income and interest on savings and dividends from the ownership of shares.

• Some of the income is taxed directly by employers, while some is charged based on the annual “tax return” form that people are usually obliged to fill out.

• Theoretically such taxes are unavoidable, because households and firms are obliged to declare their full income to governments and pay taxes accordingly.

Indirect Taxes or Expenditures Taxes or Consumption Based Taxes

• Indirect taxes are also known as expenditure taxes or consumption taxes and have different names in different countries.

• Canada and Australia have a “goods and services tax” (GST)

• The UK has a “value added tax” (VAT) and so does Austria (Mehrwertsteur)

• In this case, consumers who buy the goods pay the tax to the seller or producer who then pays the tax to the government.

Indirect Taxes or Expenditures Taxes or Consumption Based Taxes

• In a sense these taxes are avoidable, as consumers have the choice as to whether to buy the goods or not and in what quantities.

• Governments may vary the rate of indirect tax they charge on different goods and services, with necessity and valued goods such as food in supermarkets, being charged at a lower tax rate than luxuries, such as food in restaurants.

• Alternatively, they may treat all goods the same.

Direct Taxes and Indirect TaxesFurther Classification

There are three different categories into which we can place direct and indirect taxes. • Progressive Taxes• Regressive Taxes • Proportional Taxes

Progressive Taxes

• Many countries use a progressive tax as the main way to redistribute income from higher income earners to lower income earners.

• A progressive tax means that as incomes rise, people pay a higher proportion of this income in taxes.

• Usually there is a certain amount of income that is not taxed at all.

• However, when the income moves beyond the minimum, then a certain percentage of the income will have to be paid to the government.

• Then as income rises further, a progressive tax would take a larger percentage at higher incomes.

Progressive Income Tax ExampleTaxable Income % to be paid as tax

0 - $10,000 0

10,001-25,000 30

25,0001-50,000 40

50,001 and higher 50

If a person were to earn $15,000, then they would pay no taxes on the first $10,000 and 30% on the next $5000 so they would pay $1500 in taxes. This represents an average tax of 10%. As we can see from this table, the average tax rises as income rises, making it a progressive tax.

Tax Deductions

• It important to note that the previous example represents a very simplified tax structure.

• In reality most countries tax structures are infinitely more complicated.

• The biggest complication comes in the form of tax deductions and the calculation of taxable income.

• Tax deductions allow people to reduce their “taxable income” as result of spending of items that relate directly to their work.

Example of Tax Deductions

• For example, if a worker must travel a long distance to work and this costs $1000 a month, the government might allow the person to deduct this spending from her taxable income, thus reducing the amount of tax that she pays.

• The government might do this because it feels that this will encourage people to find work and lower unemployment.

• What is considered to be a tax deduction is different from country to country

Regressive Taxes

• A tax is known as a regressive tax if the proportion of income paid in tax (the average rate of tax) falls as income rises.

• Indirect taxes are regressive taxes. • GST or Sales taxe are regressive taxes.

Regressive Tax - Example

• Assume there is a $1.00 tax on every litre of petrol.• The average commuter spends about $50 per

month in petrol taxes.• For a person earning $500 per month, the tax will

take 10% of their income. • For a person earning $2500 per month, the tax will

represent 2% of their income. • The tax is regressive because a higher proportion

of income is paid at lower levels of income.

Regressive Taxes exacerbate income inequality

• Regressive Taxes may be a good source of government revenue and they might discourage the consumption of demerit goods, BUT THEY CAN WORSEN INCOME INEQUALITY.

Proportional Taxes

• A tax is proportional, if the proportion of income paid in tax is constant for all income levels.

• Many countries are now promoting the idea of proportional direct taxes or flat taxes, whereby the same percentage of tax is paid at all levels of income.

Reasons for Proportional Taxes

The Tax System is too complex• A glance at the tax guide for most countries

will confirm that taxation is an incredibly complicated process, with ample room for error and manipulation.

• This may result in governments earning less revenue than expected as people find ways to avoid paying taxes.

Reasons for Proportional Taxes

Direct Taxes are Disincentive to work Harder • It might be argued that high rates of taxes

discourage people from working harder, moving into higher paid jobs and taking risks. WHY? They will be reluctant to loose their own gains to higher taxes.

• If taxes were to be constant, then this could be viewed as a supply-side policy to encourage greater incentives to work and therefore raise labour supply.

REDISTRIBUTION OF INCOMETransfer Payments

• Governments can use tax revenues to redistribute income and provide different types of assistance to groups in the economy to improve their standards of living.

• These are known as transfer payments.• Transfer payments are not included as income in

national income accounting. This is because they do not represent payment for the production of a good or service. They are payments made to increase the income of particular groups within the economy.

REDISTRIBUTION OF INCOMETransfer Payments

Examples of Transfer Payments• Child support assistance, pensions,

unemployment benefits, payments to disable people and subsidies to producers.

REDISTRIBUTION OF INCOMEOther policies

• A minimum wage policy is designed to ensure that workers are paid what is determined to be a “fair” wage.

• Governments may also legislate that firms pay social security benefits such as a designated minimum amount to cover medical insurance and or pensions for their workers.

• Both of these serve to redistribute income from firms to workers.

• It could be said that government sponsored training schemes are a way of helping workers find gainful employment and thus raise their living standards.

EVALUATION OF REDISTRIBUTION OF INCOME POLICIES

• While many would argue that it is a government’s obligation to ensure that its citizens enjoy a “reasonable” standard of living, this is a problematic issue for many reasons, not the least of which is the question of what constitutes a reasonable standard!.

Neo Classical Perspective Redistribution of Income

• As to be expected, economists who support a classical point of view tend to argue against the active role of government in redistributing income. They believe it interferes with market forces and results in inefficiencies.

• The neo classical view argues that the optimal allocation of resources occurs in free markets and so government taxation must be kept to a minimum.

Neo Classical Perspective Redistribution of Income

• If firms have to pay insurance and social security costs for workers, then this will encourage firms to hire few workers, thus contributing to unemployment.

• High taxes in a country might discourage entrepreneurial activity and even encourage entrepreneurs to leave a country in search of more “favourable” tax climates.

Neo Classical Perspective Redistribution of Income

• High taxes have negative effects on overall growth in the economy due to the disincentive effect.

• Lower taxes will encourage economic activity leading to an overall increase in output that will be to the benefit of all people.

Taxes and the Neo Classical Perspective

• Economists promoting a free market view might argue that taxes should be used to finance the obligations of the government to ensure property rights, reduce the effects of market failure, provide effective security and judicial system and promote competition.

• However taxation should not be used to redistribute income.

THE LAFFER CURVE(HL Concept)

• The view that higher direct taxes create a disincentive effect and ultimately a negative effect on government revenues became popular in the 1970s as a result of the work of American economist Arthur Laffer (Supply side free market economist)

• Laffer developed what is now known as the Laffer Curve to illustrate the relationship between direct taxes and government revenue.

DIRECT TAXES & THE LAFFER CURVE

If the direct tax is 0%, then the government would earn no money in tax revenues. If the direct tax rate is 100%, then there would be no incentive to work and thus there would be no income for the government to tax. The points in between reflect the view that ultimately higher direct taxes will cause people to work less hard, thus earning less income and paying less in taxes. According to the theory an increase in the direct tax rate from a% to b% will result in higher tax revenues. However, a further b% to c% would lead to a fall in tax revenue. It follows that if direct tax rates are above b%, (at c% for example), the government could increase tax revenue by reducing the direct tax rate, thus giving people an incentive to work harder.

The Laffer Curve & The Optimum Tax Rate

• The model would suggest that there is an optimal direct tax at which government revenue is maximized.

• Clearly this optimum tax level will vary from country to country, and would not necessarily be at the 50% implied by the diagram.

EXAMINATION QUESTIONSShort Response Questions (10 marks each)

1. Distinguish between a progressive tax system and a regressive tax system.

2. Using a diagram, explain the

concept of the Laffer curve

EXAMINATIONS QUESTIONS Essay Question

1a. Explain two ways that a government might redistribute income in an

economy from the more well-off to the less well-off.

1b. Evaluate the consequences of income redistribution policies on an

economy.