Equity in the Distribution of Income

Equity in the Distribution of Income IB Economics Ms. Villarreal

Macroeconomic Goals of Government • Economic growth: a steady rate of increase of national output • Employment: a low level of unemployment • Price stability: a low and stable rate of inflation • Income distribution: An equitable distribution of income

Equitable Distribution of Income One of the characteristics associated with free market economies is an unequal distribution of income. People with low incomes will experience relatively low living standards and fewer opportunities than people with high incomes. • Absolute poverty: do not have access to the basic necessities needed to sustain life; • Relative poverty: Living standards are well below an observed “average” in an economy.

Equitable Distribution of Income Reasons people may live in poverty Consequences of poverty Low living standards Lack of access to sufficient healthcare Low levels of education • Born into households where incomes are low • Received poor, or no, education • May have suffered in terms of poor health and malnutrition • May have needed to find work before completing an education

Poverty trap For these reasons, poverty tends to be cyclical (you’ll look at this in greater depth in the Development unit).

Equitable Distribution of Income You and your partner will be given a picture representing a person in poverty. Determine: • Why you think this person is experiencing poverty • Is this person living in absolute or relative poverty? Why do you think so? • The consequences to this person of living in poverty • The consequences to the economy of this person living in poverty • The consequences to society of this person living in poverty

Equitable Distribution of Income Using what you’ve learned in this lesson and the class discussion, refer back to your picture and with your partner, answer the following question: To what extent do you feel it is the government’s obligation to reduce this person’s income inequality? Why?

Measuring Income Inequality The most common representation of inequality is the Lorenz Curve. Households are ranked in ascending order of income levels and the share of total income going to groups of households is calculated. We will now draw a Lorenz Curve for Bolivia using the data from page 252.

Measuring Income Inequality We can use the data from a Lorenz curve to calculate a Gini Index, which is a ratio of the area between the line of equality and the Lorenz curve (a) to the total area under the line of equality (a)+(b). Let’s look at the Gini Index for Bolivia based on the Lorenz Curve we’ve drawn on the board.

Correcting Income Inequity Governments at all levels impose a huge array of taxes for a range of reasons, but in this section we are only looking at the way in which taxation is used to change the distribution of income. This can happen in two ways: • Direct taxes • Indirect taxes

Correcting Income Inequity Direct taxes are taxes on income, wealth, or a firm’s profits Theoretically, such taxes are unavoidable because households and firms are obliged to declare their full income to governments and pay taxes on it accordingly.

Correcting Income Inequity Indirect taxes are taxes on expenditure or consumption Consumers who buy goods pay the tax to the seller, or producer, who then pays the tax to the government. These taxes are seen as avoidable, as consumers have the choice as to whether to buy the good or not. Examples: • VAT (value added tax)

Correcting Income Inequity Direct and Indirect taxes can be placed into three different categories: • Progressive Tax • Regressive Tax • Proportional Tax Each category differs in the effect that they have in terms of changing people’s incomes.

Progressive Tax As incomes rise, people pay a higher proportion of this income in taxes. The chart below represents progressive tax “brackets”.

He-Man earns $15,000 a year. We can use the above tax bracket to determine the tax he pays on his income. According to the bracket He-Man would pay no taxes on the first $10,000 of his income. This leaves on $5,000 to be taxed. To determine his tax, we multiply the amount of taxable income by the applicable tax rate, or 30%. $5,000 (taxable income) * 30% (tax rate) = $1500. Given the numbers, we can say that He-Man pays an average tax of 10%

She-Ra earns double the income of He-Man, or $30,000. Use the above tax bracket to calculate the tax She-Ra would pay on her income. We’ll check your answer together in three minutes. Break it down: Tax on first 10,000- 0 Tax on next 15,000 =15000*30%= $4500 Tax on Remaining 5,000= $5,000*40%= $2000 Income tax for Person B = $6500 $6500 represents an average tax rate of 22% for She-Ra. Recall He-Man had an average tax rate of only 10% what accounts for this difference? Because average tax rate rises as incomes rises, the above is an example of a progressive tax.

Check your understanding of this concept by completing student workpoint 20.5 on page 254. • Using the tax structure given above, calculate the total tax paid and the average tax paid for a person earning each of the following incomes: • $7000 • 14,000 • $28,000 • $56,000 • You have 10 minutes to complete this task.

Regressive Tax A tax is known as a regressive tax if the proportion of the income paid in tax (the average rate of tax) falls as income rises. Indirect taxes, such as VATs, are examples of indirect taxes because higher earners pay a lower percentage of their income toward the tax than lower income earners.

Regressive tax Consider a $1.00 tax on a litre of petrol and assume people end up spending $50 per month in petrol taxes. What percentage of income is paid toward the tax if Skeletor is earning $500/month? What percentage of income is paid toward the tax if Skeletor is earning $2500/month? How is this an example of a regressive tax?

Proportional Tax 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, of flat taxes, whereby the same percentage of tax is paid at all levels of income, for example 10% of income.

Reasons for Proportional Taxes • Flat taxes are simple to calculate and apply, whereas tax code in many countries is very complex • Many tax loopholes exists, causing governments to earn less revenue than they otherwise could • Progressive taxes could lead to disincentives for work.

How do governments use tax revenue? • Transfer payments: redistribution of income to provide for different types of assistance to groups in the economy to improve their living standards Examples: • Child support assistance • Pensions • Unemployment benefits • Disability • Subsidies to producers

How do governments use tax revenue? Government expenditure to provide essential goods and services: use of tax revenue to provide merit goods or goods/services that have positive externalities of consumption, such as education, healthcare, sanitation, and water supplies. The provision of these goods and services is carried out to ensure that the poorer members of the economy have access to essential goods and services.

Assessment Check your understanding of today’s lecture by completing the high level examination question on pages 257-258 Your completed response is due on Friday, April 12

Equity in the Distribution of Income