Economics (9214) | Distribution of income

💰 Distribution of Income: Sharing the Economic Pie

Hello future Economists! Welcome to a crucial chapter: Distribution of Income. This topic is central to the "Government Objectives" section because governments around the world are constantly trying to decide how fair and equal the economy should be.

Imagine the economy is a giant cake. Production is baking the cake, but distribution is deciding how to cut and share the slices. This chapter looks at how evenly (or unevenly!) that 'income cake' is shared among the population, why it matters, and what the government can do about it.

Don't worry if this seems tricky at first! We will break down the graphs and numbers step-by-step.

1. Understanding Income and Wealth

Before we talk about distribution, we must know what we are distributing. Students often confuse income and wealth.

a) Income (The Flow)

• Definition: Income is a flow of money earned over a period of time (e.g., weekly, monthly, annually).
• Sources: Wages (from labor), rent (from property), interest (from savings/capital), and profit (from enterprise).
• Analogy: Income is like the water flowing into your bathtub from the tap every hour.

b) Wealth (The Stock)

• Definition: Wealth is the total value of assets owned at a specific point in time. It is a stock.
• Examples: Houses, land, savings, shares, expensive collectibles.
• Analogy: Wealth is the total amount of water already collected in the bathtub.

Key takeaway: Inequality in wealth is usually much greater than inequality in income, but the government policies we discuss primarily focus on income distribution.

2. Measuring Income Inequality

How do we actually know if an economy has a fair distribution? Economists use two main tools: the Lorenz Curve and the Gini Coefficient.

a) The Lorenz Curve (Visual Tool)

The Lorenz Curve is a graph that visually shows how income is distributed among the population.

Step-by-step interpretation:

1. The Axes: The vertical axis measures the cumulative percentage of total income (from 0% to 100%). The horizontal axis measures the cumulative percentage of the population (from 0% to 100%).
2. The Line of Absolute Equality: This is a 45-degree straight line running from the bottom left corner to the top right corner. This line shows a perfectly equal distribution (e.g., 20% of the population earns 20% of the income; 80% of the population earns 80% of the income).
3. The Lorenz Curve: This curve shows the actual distribution in the country. It always starts at (0,0) and ends at (100,100).

Interpreting Inequality: The further the Lorenz Curve bows away from the 45-degree line (the line of absolute equality), the greater the income inequality.

Example: If the Lorenz Curve passes through the point (20%, 5%), it means the poorest 20% of the population only earn 5% of the total national income. This shows high inequality.

b) The Gini Coefficient (Numerical Tool)

While the Lorenz Curve is visual, the Gini Coefficient provides a single number to summarise the inequality. It is based on the area between the Lorenz Curve and the Line of Absolute Equality.

The Gini Coefficient (G) is calculated using the following general concept (don't worry about memorizing the complex formula, focus on the result):

\( G = \frac{\text{Area between Line of Equality and Lorenz Curve}}{\text{Total area under the Line of Equality}} \)

Interpreting the Gini Score:

• 0 (or 0%): Represents perfect equality (everyone earns the same amount).
• 1 (or 100%): Represents perfect inequality (one person earns all the income).

Most countries have a Gini coefficient between 0.25 and 0.55. A country with a Gini score of 0.3 is generally considered to have less income inequality than a country with a score of 0.5.

Memory Aid: Gini is easy to remember—it gives you a Grade (a score) on Income Neutrality Index!

3. Causes of Income Inequality

Why do some people earn much more than others? Inequality isn't random; it stems from structural differences in the economy.

Key Factors Influencing Income:

1. Skills, Education, and Training (Human Capital):
   • Highly skilled jobs (like surgeons or engineers) require long training and are scarce. Demand is high, but supply is low, leading to high wages.
   • Unskilled labor is abundant, which keeps wages low.
   The higher your human capital, the higher your earning potential generally is.
2. Inheritance of Wealth: People who inherit assets (land, shares) automatically receive income from them (rent, interest, dividends) without having to work.
3. Bargaining Power: Strong trade unions or individuals in high demand (like professional athletes) can negotiate much higher salaries than those with weak bargaining power.
4. Risk and Enterprise: Entrepreneurs who take large financial risks and succeed (like starting a successful tech company) earn large profits, significantly increasing their income and wealth.
5. Discrimination: Sadly, differences in income often arise due to discrimination based on gender, ethnicity, or age, which limits opportunities for certain groups.

Did you know? Even geographical location affects income! Someone doing the exact same job in a large global city usually earns more than someone in a rural area due to differences in living costs and productivity levels.

4. Government Policies to Redistribute Income

Redistribution is a core objective of many governments, aiming to move income from those who have more to those who have less, thus promoting equity (fairness).

Governments use three main tools:

a) Taxation Policies

Taxation is the primary way governments raise funds for redistribution. The way taxes are structured has a massive impact on inequality.

• Progressive Taxes: The tax rate increases as the taxpayer’s income increases.
  • Effect: These taxes reduce income inequality because higher earners pay a larger percentage of their income in tax.
  • Example: Income tax (in most countries).
• Regressive Taxes: The tax rate decreases as the taxpayer’s income increases (the proportion of income paid in tax falls).
  • Effect: These taxes increase income inequality because they take up a larger proportion of a poor person's income.
  • Example: Sales tax (VAT/GST) on essential goods. A fixed percentage tax on a loaf of bread hits a low-income family harder than a millionaire.

b) Transfer Payments (Social Security and Welfare)

These are payments made by the government to individuals for which no direct good or service is provided in return. They are funded by taxes.

• Examples: Unemployment benefits, pensions, child allowances, disability payments.
• Effect: Transfer payments are targeted at low-income groups and drastically increase their disposable income (income after tax and transfers), reducing poverty and inequality.

c) Provision of Merit and Public Goods

By providing essential services free or heavily subsidised, the government effectively raises the real income of the poor.

• Examples: Public education, state healthcare, subsidized housing.
• Effect: If everyone has access to good schooling, regardless of their parents' income, it increases the long-term human capital of the poor, allowing them to earn more in the future. It provides equal opportunity.

5. The Equity vs. Efficiency Trade-Off

While reducing inequality sounds universally good, government redistribution policies face a major problem: the trade-off between equity (fairness) and economic efficiency (productivity and growth).

a) The Argument for Equity (Fairness)

• Reducing inequality promotes social cohesion and reduces crime.
• It reduces poverty and improves the overall standard of living for the poorest.
• Increased consumption from lower-income households can boost overall economic demand.

b) The Conflict with Efficiency (Productivity)

Policies designed to take from the rich and give to the poor can create disincentives.

1. Disincentive to Work (for the poor): If unemployment benefits are too generous, people might choose not to seek employment, leading to lower productivity and higher long-term government costs.
2. Disincentive to Earn/Invest (for the rich): Very high progressive taxes (e.g., 70% income tax rate) can discourage high earners from working extra hours, taking risks, or investing. Why work harder if most of the extra income goes to the government? This slows economic growth.

The "Leaky Bucket" Analogy:

Imagine the government is trying to move income from the rich (Bucket A) to the poor (Bucket B). The policy tools (taxation, welfare administration) are the bucket used to carry the money. If the bucket is leaky (due to administrative waste, disincentives, and evasion), not all the money taken from Bucket A reaches Bucket B. The economy as a whole loses output and efficiency.

Economists’ Challenge: Governments must find the sweet spot—enough redistribution to maintain social fairness (equity) without crippling productivity and investment (efficiency).