The major aims of this report are to explain why the distribution of income in the UK is so unequal; to suggest ways in which the distribution can be made more equal; and to assess the economics benefits and costs of the types of intervention, and state which forms of intervention are the most effective overall.
Firstly, let us define income and the distribution of income. Income is the sum of earned income and unearned income. Earned income is money earned through employment e.g. wages, salaries, commission, bonuses, net earnings (if self-employed). Unearned income is income received other than income received in return for services. These include interest, dividends, rent, and capital gains.
The distribution of income is how evenly the income is distributed, it is unlikely to be efficient or equitable in a free market economy and the vast differences can cause market failure. It will mean that some people will live in both absolute poverty and relative poverty. Fig. 1 shows the Lorenz curve, it shows the degree of inequality of income in a society. The further from the curve is from the 45� line, the greater the degree of inequality. For instance, the bottom 50% might only earn 20% of the total income, whereas the top 10% might earn 40% of the country's income.
There are several reasons why the distribution of income in the UK is very unequal some of which are described below:
The most obvious reason is that people have different jobs offering different salaries. A Brain Surgeon will be more skilled than a shelf-stacker and therefore will earn a higher overall salary. The wage rate of a given worker will fluctuate in accordance to the supply of workers for that particular occupation and the demand for workers for the occupation. If the demand for a job rises or the supply for a job falls or both, the wage rate will rise and vice-versa: this causes pay to differ and hence some people receive more original income than others. E.g. Brain Surgeons are very limited supply but highly demanded, whereas shelf-stackers are available in abundance but the demand is much lower.
The unequal distribution of wealth can have a big effect on the distribution of income. The wealthiest people in the population will have many assets which they can use to generate more income. These can include rent, interest, and dividends. This causes the rich people to become even richer and widens the gap between poor and rich. Some people will inherit assets which can then be used to accumulate incomes. Not everyone will inherit assets and this makes people's income differ, as unearned income is likely to be much greater for those will the assets.
If a family is without anyone who is in paid employment this could cause a serious problem as they would be relying on state-benefits; this once again causes inequalities as they will obviously receive lower incomes (on the whole) than those who work.
How incomes are measured can distort inequalities. Income can be measured per individual or per household. For instance, an individual earning a high salary may be in the low income bracket if he / she has a large family to support and is the only income generator as income per person in the household will be low. Whereas, if all of the family were to work and bring home a 'low pay' they would still not be classed as low paid because collectively they would achieve a high pay.
The amount of opportunities an individual receives can affect the distribution of income. For example, it has been proven that in many poor areas the percentage of students who decide to continue on to further education is very low. This is because at the time of consuming the good they are unaware how it can benefit them (merit good argument) and prefer to go straight into employment to facilitate their especial need for income to be bought into their family and this vicious cycle may lead to a lack of qualifications relative to the middle-class students and may seriously hamper them in finding a well paid job. Due to the fact they are poor they see income as more of a priority than education, of course they are oblivious to the fact that education itself could lead to better future prospects. This can lead to the rich continuing to be rich and the poor continuing to be poor.
Another factor that can lead to differences in income is wage discrimination in the workplace. Females have traditionally earned less than men. In the past, men have been given more educational opportunities than women, and this will have an empowering effect on the income. Some employers may be biased when deciding whether to employ a man or a woman, due to the reasoning that women take career breaks to start families.
Fig. 4 shows the differing demand for labour for men and women. Since the women are not demanded as much as the men (with a difference of Q to Q1) the wage rate drops for women from WM to WW. This could be a factor that affects the distribution of income for households in the UK.
Natural talents and aptitudes can have an effect on the distribution of income. Some people are academically gifted and this will enhance their chances of getting good qualifications and getting good qualification will allows them to enter a wider array of job markets and thus have a better chance of getting a higher income. People who are not as gifted may end up with little or no qualification which will seriously hamper their job prospects and chances of getting a well paid job.
This section of the coursework will suggest ways in which the distribution of income in the UK can be made considerably more equal. I will use 'table 1' to help show real life effects of taxes and benefits and analyse different methods of intervention. This piece of tax analysis secondary source was adapted from the ONS website.
The government uses different types of taxation in the UK. There are two types of taxes direct and indirect taxes. Direct taxes are the taxes that are levied on the income and resources of individuals whereas indirect taxes are the taxes on goods or services. Officially indirect taxes are taxes that are imposed on the producers put most of the time the burden of paying the tax is thrust upon the consumers. The extent of the burden will depend upon the price elasticity of demand and price elasticity of supply of the product.
Taxation can be also put into three categories with regard to redistribution effects. Progressive, Regressive or Proportionate tax; progressive taxation is taking a higher proportion of tax from higher income groups. Regressive tax is the opposite of progressive tax and involves taking a higher proportion of tax from lower income groups. Proportionate tax involves taking the same proportion from all income groups.
One would think that progressive taxation such as income taxes do help to redistribute income as the revenue from the taxation can be handed out as benefits to the poor people; these are known as transfer payments. However, free market economists believe that this method results in a loss of freedom and the government takes away what is rightly people's hard earned money. Other economists believe that 'the law of diminishing marginal utility' is the best way forward to increase the overall utility of the country. For instance an extra �10 per week to a poor family will go a lot further than �10 per week to a rich family. This implies that the gain from the poor family in benefits is far greater than the taxes lost from the rich family of the same value. Thus, it can be said that progressive measures can be given out to the poorer people via benefits and thus bridging the gap of living standards of people in Britain and can help to alleviate relative and absolute poverty. Fig. 6 shows income tax as a proportion of gross income of all the quintiles.
Regressive taxes do not help to redistribute income as well as progressive taxes as they take a higher proportion of tax revenue for the lower income groups. Most regressive taxation is a result of demerit goods. Fig. 7 shows duty of tobacco as a proportion. There must be some sort of tax on such demerit goods to deter people from consuming it, so one could argue it acts as a disincentive to consume tobacco. In some cases, regressive taxation can help redistribute income despite taking a larger proportion from the lower income groups. The rich are likely to spend a lot more money on certain items for instance wine and spirits. In 2005 / 2006 the bottom quintile spent �89 in indirect taxes on wines and spirits (0.9% of overall disposable income) whereas the top quintile spent �273 on the same (0.5% of disposable income). Although, the consumption of wines and spirits harmed the poorest people the most by taking away a bigger chunk of their disposable income the �273 generated in tax revenue by the rich people could find its ways into the poor people's pockets in the form of transfer payments.
Using direct taxation for redistribution will naturally negatively affect incentives to work. If an individual if faced with a rise in direct taxation he / she can react in two ways. Since the net reward for work has fallen he / she will choose to substitute work for leisure time; in this case the tax has proved to be a disincentive to the worker and a strong substitution effect is prevalent. Alternatively, the worker could work longer hours to maintain the post tax income; in this case the rise in direct taxation has acted as an incentive to work longer. There is a strong income effect here and this will improve output in the economy.
In practice the later is probably more apparent in the UK due to the vast majority of workers having to pay rents, mortgages, and other bills.
Should the substitution effect be stronger, the 'Laffer Curve' below shows how an increasing tax rate doesn't automatically lead to higher tax revenue.
Up to t% tax a rise in the rate of tax leads to a rise in revenue, however if the tax rates rise above t% then the tax revenue actually falls due a strong disincentive effect. So it can be concluded that just because the government raises tax rates it does not automatically lead to higher tax revenue. The factors which affect the revenue are the extent to which the substitution effect is prevalent and where in relation to t the tax rate is.
The redistribution of income via benefits and taxes can adversely affect the economy as the poor who are content on receiving benefits will not have any incentive to go and work longer hours, this is known as 'the poverty trap'. Although the poor people in question may gain extra income from working longer hours they will also lose benefits and thus this acts as a disincentive to find work. For instance, a worker may be given the opportunity to work an additional ten hours in a week for �50; however he / she might also have to pay additional income tax or national insurance and may also lose benefits. He /she might only end up with �20 for an extra 10 hours work. The poor people would much rather not work than be paid a measly �20 for 10 hours work. Similarly, the unemployment trap concerns the unemployed people. The unemployment trap occurs when workers calculate that because of lost benefits and extra tax they are no better off working and instead they choose to remain outside the workforce and that way they need not sacrifice forty hours of leisure time and still enjoy similar net income. The system is acting as a disincentive to work at all.
This will raise the rate of unemployment and can stem the level of output, and growth in the economy. This may cause poor people on benefits to partake in unofficial jobs; this is very bad for the economy as these people would be defrauding tax payers. Other people on benefits may get lazy and settle for the benefit payments, they might become excluded from the workforce; because they are unemployed for so long that they might become unemployable.
"30% of UK households receive at least half of their income from state benefits." Is the UK encouraging a dependency culture?
To try to solve this problem, the labour government introduced a 'Working Families Tax Credit'. This enabled working families to earn a guaranteed minimum income and also entitled to an exemption to income tax for wages below a threshold. Although this system appears to encourage work it may act as a disincentive to work full time, as part-time work could be equally as rewarding.
High direct taxation especially high marginal taxes rates can act as a massive disincentive to work extra. Workers will act in a variety of ways, for instance they may retire earlier to the extortionate rate of tax. Workers may be less likely to go for promotions and this in turn creates less mobility in labour markets as workers are less willing to move between jobs. There may be a lack of enterprise for new business people or existing small businesses. Saving money in the bank may be deterred by high income taxation on interest. If the income tax is at such a level whereby people think it is too much people will always try and find loopholes in the system and may employ specialist lawyers to bail them out of paying tax. Some entrepreneurs may fiddle the figures in the book and this will mean the government will gain less revenue than if is kept income tax to a minimal; other people may move to a different country to avoid tax laws. One possible solution to this problem is to clamp down on non-domiciles and close the loopholes. Non-domiciles pretend to live in foreign countries and have offshore accounts. Another better solution is to keep direct taxation to a minimal and maybe that way the government will actually gain higher revenue from tax as fewer people will bother to hide their incomes.
The inheritance tax is currently levied at a staggering 40% on all estates worth more than �300,000. Keeping the thresholds unmoved despite a housing boom has been a stealth ploy by the UK government. Since, the average house price in the UK is now around �300,000 a lot more people qualify to pay this proportion of tax. This means the average inheritance tax is around �120,000! This definitely helps to redistribute income as it effectively takes vast amounts of money from the rich people and hands it out to the poor people, but what are the consequences of this to the whole economy? If the threshold remains unchanged for too much longer it may act as a disincentive to save and a disincentive to move up the property ladder. It won't affect the very rich at all as they will be able to escape it so the middle-class and lower middle-class will be hit the most as they might be unable to escape it. Many feel that it is a form of double taxation as the estates were acquired for earned income which has been taxed itself. The government may want to look at preventing tax evasion and closing the loopholes that have cost them billions of pounds.
In the October 2007 pre-budget report the new chancellor Alistair Darling, showed his proposed views on the inheritance tax system. The threshold for married couples would double from �300,000 to �600,000. If this new system to be put into place it would certainly mean a lot less people would qualify to pay the inheritance tax. This might mean less taxation is generated from the rich in order to pay put to transfer payments. The lack of revenue generated by the government may put added pressure other forms of taxation. For instance, Darling also outlined plans to tax the tax the mega wealthy kings of private equity by raising the rate of capital gains tax from the current bottom level of 10% to 18%. This will hit also business though, regardless of the size and will reduce due to the rate of tax almost doubling it will no doubt reduce the fondness of starting a new business.
There are two types of benefits; universal and means tested. Universal benefits are available to everyone within a certain criteria, for example 'child benefits'. Means tested are available to people who can prove their income is below a given threshold, for example 'family credit'. There is an argument that child benefits should be targeted at the poor the most and then would certainly help to redistribute income better. Many of the means tested benefits require a lengthy process in applying for them and many of the people that are entitled to such benefits are not getting them especially the old people as they are not aware of them. Means tested benefits help the poor people the most whereas universal benefits help everyone. It is all well and good switching to means tested benefits but if people are not aware of there existence then it won't aid the redistribution process one little bit. Perhaps greater advertising of these benefits and concise, easy to follow application forms is the answer to this problem.
A controversial argument with regard to the inequalities in income is the trickle down effect and it is favoured by some supply-side economists. The theory is to let the free market work independently and cut the high rates of income tax and corporation tax. Thereby entrepreneurs are incentivized to expand and thus more employment opportunities will arise and the multiplier effect will allow the income to trickle down to the poor. There are flaws to this theory as not all poor people will have the adequate skills to do the jobs created and the poor people who cannot work will be hit the most, and some people will still suffer from absolute poverty.
Other economists believe that the government must intervene as it can cause problems with the lower income families including hampering their children's education prospects. The government has now introduced EMA, Education Maintenance allowance to all students who proceed to further education under a certain income threshold. This system gives students an incentive to go to school instead of entering employment. Despite being controversial many more students stay on to school and it increases the supply-side of the economy and more importantly gives the poor people an opportunity to succeed and improve their overall job prospects and thus pay prospects without having to worry too much about contributing to the household income. There is a flaw of this system as the EMA is also available for students who fail their GCSE's and return to post-16 education to retake them, is this a incentive for students to fail?
The government will also provide benefits in kind to everyone. The graph below shows the benefits in kind for education.
This progressive measure helps redistribute post-tax income as well as give the poorest a chance to get out of the trap of unemployment. Notice that the rich people do not get as much as the poor in benefits in kind due to very few rich people attending state schools. This is an example of 'government spending on merit goods' and such provision increases equality of opportunities and will help reduce poverty.
The national minimum wage legislation was introduced to redistribute incomes, but it may cause a loss of employment, as firms will want to employ fewer workers at that wage rate. A NMW can increase the incentives to work for the poorest people, it will help the low paid workers the most who stay in employment, but this does not necessarily mean all poor people will benefit from this service. In addition, the national minimum wage must be increase in line with earnings to have any real affect. For some low paid workers it will simply replace welfare benefits and will do little in the way of improving living standards, however it may mean that everyone is taxed less due the lessened need of welfare benefits. Some of the lowest paid workers aren't necessarily from the lowest income groups; they could be part-time workers or students from a high income family. Some of the poorest people could lose their jobs in favour of the middle-class people. This does not help to redistribute income. The NMW for 16-17 year olds in considerably lowers than older age groups. It is �3.40 for 16 and 17 year olds compared to �4.60 for 18-21 year olds. This system acts as a disincentive for students to leave school immediately and wait till they are 18 to enter employment. Along with EMA, this is an excellent ploy to lure the poor into staying at school for as long as possible and surely by doing so it will enhance long term job prospects.
Legislation is an example of redistribute income. They can be used in a variety of ways; a good one is Equal Pay Act and Sex Discrimination Act which aim to reduce differences in pay between genders, however this policy doesn't stop bias within the workplace.
Boosting employment is a poor area could seriously enhance the chances of the poor people to get jobs and move on financially. Enterprise Zones can also help, big investors can provide jobs for people in poor areas, and this also acts as an incentive for poor people to even start their own firm up. If the poor get more jobs then they will need less benefits and this will lesson the burden on UK taxpayers; so everyone is better off.
Looking back at the aims of this report they were not only to decide which measures make the unequal distribution of income more equal but which will benefit the economy the most.
Fig. 6 clearly shows that progressive taxation such as income tax helps to redistribute income by taking a higher revenue and higher proportion of income from the rich people. This can be used for transfer payments and effective give money that the rich have earned to the poor. We can further verify that this method of redistribution works by looking at the direct impact of progressive taxes as shown in the table below.
Income Before Tax
Income After Tax
Before this measure the rich earned about six and a half times more than the poor; after exclusively deducting income tax we can see a significant effect, the richest quintile now receive approximately five and a half times more than the bottom quintile. The overall difference between the top and bottom is also reduced from around �60, 000 to �47, 000, thus closing the gap between the living standards.
If the aim of this report was exclusively to find the most effective way to redistribute income then progressive taxation and benefit system would definitely come top, but what implication will this have of the economy as a whole?
In my opinion this will only create a dependency culture as the poor will sit back and take these benefits all day long! This may make the poor lazy. A high rate of progressive tax can lead to tax avoidance and evasion especially from the rich businessman. Plus, high marginal taxation acts as a huge disincentive to work longer hours, if to work at all. This can limit the amount the country grows. Non-domiciles escape proportional taxation via their privileged tax status and cost the government an estimated �1 billion, an obvious resolution to this problem is to tax these people heavily.
Regressive taxation takes away a higher proportion of the lower income groups' income and often widens the gap between the rich and the poor (as already shown in fig. 7). Having said that they do have a vital role to play in acting as a deterrent to consume demerit goods such as cars and cigarettes.
Clearly the nature of the benefits given will have a say in the redistribution of income, if more means-tested benefits are given out than universal it will target the poorest people and make the distribution of income more equal. But often it is not as simple as that as the lack of knowledge and awareness of these benefits count against the poor. The poor need to be told about the benefits and given easy to follow paperwork.
The Tory leader David Cameron outlined ways to alleviate the poverty and unemployment trap in a recent speech, his ideas will definitely help the redistribution of income and the improve state of the economy. The unemployed people who are on benefits would need to be actively looking for jobs. Searching for suitable jobs would be arranged with the help of the job centres. If the unemployed person was offered a job but he / she declined it for whatever reason then they would lose their benefits. This would put added pressure on them to find a job instead of sitting at home idly milking the tax-payers money! The working families' tax credit can be used to good effect by encouraging work albeit part-time. However, eyebrows can be raised as to whether this now acts as a disincentive to work full time as part time work can be equally rewarding.
Encouraging enterprise in the country can help provide jobs for the unemployed and reduce the need for as much taxation in the country as everyone will have jobs.
Overall, to round off this issue I believe that progressive taxation is the best ploy to make the distribution of income more equal along with means-tested benefits. It is very important however, to get these rights as too much in favour of the poor people will create disincentive effects. The most effective for the economy as a whole is creating job opportunities for poor people as it gives them the chance to get onto the career ladder and progress, they certainly cannot succeed financially by staying at home. The working families' tax credit also gives the incentive to poor people to work. The fewer unemployed people the better, taxes will be lower for all of us as there will not be an especial need to redistribute income, and it will lead to higher output, better living standards, higher growth and better levels of morale within the country (less areas of depression). Giving people from disadvantaged backgrounds the opportunity to students also provides opportunities for the poor to get out of poverty. Putting pressure on the poor people will force them to fight poverty.
I have only collected one main piece of secondary research. Although the quality of research is very good, perhaps more research would have given a better picture of the economy. Having said that doing a specialist topic such as the redistribution of income only one piece of information is vital and that is the table showing average incomes, taxes and benefits for the UK.
It is very difficult to find up to date information and the earliest I could find was the year 2005/2006. So perhaps I am dealing with data that is slightly out of date. Another possible flaw with my coursework is that the secondary research may be biased. Many businesses may be reluctant to reveal their true levels of profit for tax reasons. Some people may have unofficial jobs in which case their incomes won't be accounted for. Several factors may distort the data.
Heinemann Economics A2 for AQA - Susan Grant
Economics (Third Edition) - Alain Anderton
Economics Explained (Paperback) - Peter Maunde
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