Welcome to Equity and Redistribution: Sharing the Economic Pie!
Hello future economists! This chapter, Equity and Redistribution of Income and Wealth, might sound a bit technical, but it’s actually about one of the most critical and often debated topics in all of Economics: fairness.
You’ve learned how markets work efficiently, but efficient outcomes aren't always fair. Here, we investigate *why* inequality exists, *how* we measure it, and *what* governments can do to make the system more equitable, while dealing with the inevitable trade-offs. Don't worry if the concepts seem challenging; we’ll break down the jargon into simple steps!
Key Takeaway from the Introduction:
This chapter explores the challenges governments face when balancing efficiency (making the economic pie as big as possible) and equity (dividing the pie fairly).
1. Income vs. Wealth: Knowing the Difference
Before we talk about sharing, we must distinguish between two fundamental concepts often confused in everyday conversation: Income and Wealth. (This links back to your AS concepts, 3.3.1.)
Income (A Flow Concept)
Definition: Income is a flow of money (or goods and services) received by an individual or household over a period of time (e.g., weekly, monthly, annually).
- Examples: Wages/salary, rent received from property, interest on savings, profits from a business, or state benefits (like unemployment pay).
Wealth (A Stock Concept)
Definition: Wealth is a stock of assets owned by an individual or household at a particular point in time.
- Examples: Physical assets (property, cars, jewelry) and financial assets (stocks, bonds, money in the bank).
Analogy: Think of a bathtub.
The amount of water flowing from the tap *into* the tub each minute is Income (a flow).
The total amount of water *already* in the tub at any given moment is Wealth (a stock).
Did You Know? Wealth is usually distributed much more unequally than income. People with high wealth can generate high income (e.g., through investments), which increases their wealth further—a cycle that drives extreme inequality.
2. Equity vs. Equality (8.2.1)
These two words sound similar but have very different meanings in Economics, especially when discussing policy objectives.
Equality
Definition: Equality means treating everyone exactly the same, giving everyone the same amount, or ensuring that outcomes are identical.
- Example: If a government insists that every person in the country must receive an identical salary, regardless of their job, effort, or skill, that is equality of income.
Equity
Definition: Equity means fairness or justice. It implies that outcomes should be adjusted according to need or contribution.
- Example: A progressive tax system, where higher earners pay a larger *proportion* of their income in tax, is an attempt to achieve equity, even though it results in unequal tax payments.
Memory Aid: Think of the word 'Equitable'—it means fair.
EQUALITY = Everyone gets the same.
EQUITY = Everyone gets what is fair, based on their situation.
3. Measuring Inequality (Gini Coefficient and Lorenz Curve) (3.3.2)
To know if redistribution policies are working, economists need tools to measure income and wealth distribution.
The Lorenz Curve
This is a diagrammatic representation of income or wealth distribution.
- It plots the cumulative percentage of the population (on the horizontal axis) against the cumulative percentage of total income (on the vertical axis).
- A Line of Absolute Equality (a 45-degree diagonal line) shows a hypothetical situation where 20% of the population earns 20% of the income, 50% earns 50%, and so on.
- The further the Lorenz Curve bows away from the Line of Absolute Equality, the greater the degree of inequality.
The Gini Coefficient
The Gini Coefficient is a single number derived from the Lorenz Curve that summarises the degree of income inequality.
It is calculated as: \(Gini = A / (A + B)\)
Where A is the area between the Lorenz Curve and the Line of Absolute Equality, and B is the area under the Lorenz Curve.
- The Gini Coefficient ranges from 0 to 1 (or 0% to 100%).
- 0 (or 0%): Represents perfect equality (the Lorenz curve lies exactly on the 45-degree line).
- 1 (or 100%): Represents perfect inequality (one person has all the income).
Quick Review Box:
- Lorenz Curve: A visual way to show inequality (a bowed line).
- Gini Coefficient: A numerical measure (0 to 1). High Gini = High inequality.
4. Understanding Poverty (8.2.3)
Inequality is about the *gap* between the richest and the poorest. Poverty is about whether the poorest can meet their needs.
Absolute Poverty
Definition: Absolute Poverty occurs when people do not have sufficient income to afford the basic necessities of life, such as food, shelter, and clothing.
- It is often defined by an international standard, like the World Bank’s measure of living on less than $2.15 a day (adjusted for purchasing power parity).
- Crucially: If a country gets richer, fewer people should be in absolute poverty, as this standard doesn't change with the country's average income.
Relative Poverty
Definition: Relative Poverty is defined in relation to the average standards of living within a specific society or country. People are considered poor if their income falls below a certain percentage of the country's median income (e.g., less than 60% of median income).
- Crucially: Relative poverty can persist even in rich countries because as the overall standard of living rises, the median income also rises, meaning the definition of 'poor' adjusts upwards.
Common Mistake to Avoid: Don't confuse rising national income (GDP) with reduced poverty. Economic growth may reduce *absolute* poverty, but if the richest benefit disproportionately, *relative* poverty may increase.
5. The Equity-Efficiency Trade-Off (8.2.2)
This is one of the most important concepts for essay writing and evaluation. Government intervention to achieve greater equity often reduces economic efficiency.
What is Efficiency in this Context?
Efficiency generally means resources are being used optimally to maximise output (productive efficiency) and overall social welfare (allocative efficiency).
Why the Trade-Off Exists (The Conflict)
- Taxes Reduce Incentives: Policies aimed at redistribution (like high progressive income taxes on high earners) reduce the marginal benefit of working extra hours or taking risks. If a doctor must pay 60% of their extra earnings in tax, they might choose to work less, reducing overall labour productivity.
- Opportunity Cost of Spending: Transfer payments (money given to the poor) are funded by taxes. This money could otherwise have been used for investment, R&D, or infrastructure—activities that boost long-run efficiency and growth.
- The Poverty Trap: Poorly designed benefit systems can directly lead to inefficiency by disincentivising work (see Section 6).
Analogy: Imagine a team trying to win a football match (efficiency) while ensuring every player gets equal credit (equity). If insisting on equity means you have to constantly pass the ball to the weak players, you might lose the game (reduced efficiency). A perfect economic policy seeks the best balance between these two goals.
6. Policies for Redistribution and the Poverty Trap
Governments use various tools (3.3.4, 8.2.5) to try and achieve greater equity.
A. Traditional Redistribution Policies (Review)
- Progressive Income Taxes: Tax rates increase as income increases. This automatically reduces income inequality (equity).
- Transfer Payments: Payments made by the government for which no goods or services are currently provided in return (e.g., unemployment benefits, pensions, child support).
- Minimum Wage: A legally mandated lowest wage rate, designed to boost the income of low-skilled workers.
- State Provision of Essential Goods/Services: Providing goods like education and healthcare for free or heavily subsidised. This increases the real income of the poor.
B. The Poverty Trap (8.2.4)
This is a major issue arising from traditional transfer payment systems.
Definition: The Poverty Trap occurs when an individual or family gains little or no increase in net income (income after tax and benefits) when they take on extra work or receive a pay rise. This happens because higher earnings lead to:
- Higher Income Tax and National Insurance contributions.
- A withdrawal (loss) of means-tested state benefits.
The result is a very high Marginal Rate of Tax (MRT)—sometimes over 80%—making the incentive to work harder disappear.
Example: A person earning $100 works an extra hour for $10. But because of the pay rise, they lose $5 in housing benefits and pay $3 in tax. Their net gain is only $2. They decide working that extra hour isn't worth the effort (an efficiency loss).
C. Targeted vs. Universal Benefits (8.2.5)
Means-Tested Benefits
Definition: Benefits provided only to people whose income and/or wealth (their 'means') falls below a certain level.
- Advantage: Cost-effective; targets those truly in need.
- Disadvantage: Creates the poverty trap; high administrative costs; can cause stigma for recipients.
Universal Benefits
Definition: Benefits paid to everyone, regardless of their income or wealth (means).
- Advantage: Low administrative cost; avoids the poverty trap; promotes social cohesion.
- Disadvantage: Very expensive; many payments go to people who do not need them (poor targeting).
D. Advanced Policy Options (8.2.5)
Governments often look at radical reforms to solve the efficiency losses caused by complexity.
1. Negative Income Tax (NIT)
Definition: A proposed system where the tax and benefit systems are merged into one streamlined process.
How it works:
- Below a certain income level, the government pays the citizen a subsidy (the 'negative tax').
- Above that level (the break-even point), the citizen pays tax at a constant rate.
- Benefit: Since benefits are not withdrawn suddenly, the marginal tax rate remains moderate, significantly reducing the incentive problem of the poverty trap.
2. Universal Basic Income (UBI)
Definition: A regular, unconditional cash payment delivered to every individual citizen in a community, regardless of income, employment status, or means.
Key Features:
- Universal: Everyone gets it.
- Unconditional: No requirement to work or look for work.
Evaluation Points:
- Pro-Equity: Eliminates absolute poverty and provides a safety net.
- Pro-Efficiency: Abolishes the poverty trap and bureaucracy associated with complex benefits.
- Anti-Efficiency/Cost: Extremely high cost; potential moral hazard (people might choose not to work, reducing aggregate supply).
Encouragement: The key to success in this topic is using strong evaluation. Whenever you discuss a redistribution policy, ask yourself: Does this policy improve equity, and what is the resulting cost to efficiency?
Key Takeaway from Policy:
Traditional means-tested benefits create the poverty trap (high Marginal Rate of Tax). Policies like Negative Income Tax and Universal Basic Income are proposed as modern solutions to maintain equity while improving work incentives (efficiency).