Chapter 18 Economic Inequality and Redistribution Mc Taggart

Objectives After studying this chapter, you will be able to: § Describe the inequality in income and wealth in Australia § Explain the features of the labour market that contribute to economic inequality § Describe the scale of income redistribution by governments and the effects of taxes and benefits on economic inequality Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -2

Rags and Riches § In Australia some people are incredible rich while others are abjectly poor. § Can governments redistribute incomes and wealth to moderate the amount of poverty in Australia. § This chapter deals with the distribution of income and economic inequality in Australia Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -3

Measuring Economic Inequality § The Australian Bureau of Statistics defines as gross income the households receive from market activity plus cash benefits from the government § Gross income equals wages, interest, rent, and profit earned in factor markets before paying income taxes plus government cash benefits Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -4

Australian Income Distribution Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18

Australian Quintile Shares Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18

Measuring Economic Inequality § The Income Lorenz Curve § The income Lorenz curve graphs the cumulative percentage of income earned against the cumulative percentage of households. § Figure 18. 3 shows the income Lorenz curve for the income shares in Australia. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -7

Lorenz Curves for Income and Wealth Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson

Cumulative % of income & wealth The Income Lorenz Curve 100 Figure 18. 3 80 60 40 Line of equality Income Lorenz curve 20 0 20 40 60 80 100 Cumulative % of households Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -9

Measuring Economic Inequality § The Distribution of Wealth § Wealth is the value of all the things that are owned by a household at a given point in time. § The distribution of wealth is another way of examining the degree of economic inequality. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -10

Lorenz Curve for Wealth Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia

Measuring Economic Inequality § Wealth Versus Income § Wealth is distributed more unequally than income § Wealth excludes human capital which generates labour income § Wealth is less comprehensive than income, and the distribution of income is a more accurate measure of economic inequality Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -12

Measuring Economic Inequality § Annual or Lifetime Income and Wealth? § A household’s income and wealth change over time. § Household income start out low, grow to a peak when the household’s workers reach retirement age, and then fall after retirement. § Much of the inequality in annual income and wealth arises from the life-cycle effect Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -13

Measuring Economic Inequality § Poverty § There are two concepts of poverty § Absolute poverty is a situation in which a household’s income is too low to function effectively in our society § Relative poverty is a situation in which a household’s income is too low relative to the average Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -14

Measuring Economic Inequality § Poverty § Using the relative definition of poverty, 11 per cent of Australian households had income below the poverty line in 2001. § The unemployed and those not in the labour force, such as retired persons, have the greatest incidence of poverty accounting for 58 per cent of the poor in Australia Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -15

Poverty Rates in Australia Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia

The Sources of Economic Inequality § Inequality arises from unequal labour market outcomes and from unequal ownership of capital. § Two significant features of labour markets create income differences among individuals: § Human capital § Discrimination Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -17

The Sources of Economic Inequality § Human Capital § The more human capital a person possesses, the more income that person likely earns, other things remaining the same. § High-skilled workers generate a larger marginal revenue product than low-skilled workers. § Firms are willing to pay a higher wage rate for high-skilled labour. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -18

The Sources of Economic Inequality § The demand for high-skilled and low-skilled labour § High-skilled workers can perform tasks that low-skilled labour would perform badly or cannot perform at all § The supply of high-skilled and low-skilled labour § High-skilled labour contains more human capital than lowskilled labour, and human capital is costly to acquire Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -19

Skill Differentials Figure 18. 6 Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education

The Sources of Economic Inequality § Inequality Explained by Human Capital Differences § High-income households tend to be better educated and middle aged § Education contributes directly to human capital, and age contributes indirectly because older workers have more experience § Human capital differences also explain some of the inequality associated with sex Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -21

The Sources of Economic Inequality § Wage Rates of High-skilled and Low-skilled Labour § The higher the marginal revenue product of the skill and the more costly it is to acquire, the larger is the wage differential between high-skilled and low-skilled labour § Do Education and Training Pay? § Returns to education in Australia are significant ranging from 20 per cent for science graduates to 16 per cent in law and engineering Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -22

The Sources of Economic Inequality § Human Capital Trends and Inequality § Human capital differences are a possible source of shifts in income inequality § The demand for high-skilled labour increases the number of high-skilled jobs and raises the wage rate of high-skilled workers Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -24

The Sources of Economic Inequality § Discrimination § Another possible source of inequality is discrimination. § Discrimination occurs when the levels of marginal revenue product of one race or one sex are perceived to be higher than that of another race or another sex. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -26

The Sources of Economic Inequality § Counteracting Forces § Economists disagree about whether prejudice actually causes wage differentials, and one line of reasoning implies that it does not § Only firms which do not discriminate survive in a competitive industry § Differences in the degree of specialisation Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -29

The Sources of Economic Inequality § Ownership of Capital § Income inequality is increased by the unequal distribution of wealth. § Unequal wealth results from savings and wealth transfers between generations. § There are two significant aspects of intergenerational wealth transfers that increase economic inequality: § Debt cannot be inherited § Marriage and wealth concentration Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -30

Income Redistribution § Four main ways governments use to redistribute income are: § Direct taxes § Indirect taxes § Direct benefits § Indirect benefits Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -31

Income Redistribution § Direct Taxes § Direct taxes are taxes on incomes –personal income tax and company profits taxes § Taxes can be progressive, regressive or proportional. § A progressive income taxes household incomes at an average rate that rises with income. § The Australian income tax system is a progressive tax system. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -32

Income Redistribution § Direct Taxes § A regressive income taxes income at average rates that fall with income. § A proportional income tax (also called a flat-rate income tax) taxes income at a constant average rate for all income levels. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -33

Income Redistribution § Indirect Taxes § Indirect taxes are taxes on expenditure or other activities, like the GST § The GST is a regressive tax. The percentage of income paid in GST falls as income rises § Other indirect taxes are probably progressive because they fall on items largely consumed by the higher income groups Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -34

Income Redistribution § Direct Benefits § These are cash payments by the government to individuals to the aged, unemployed, the disabled, the sick, sole parents, and families with children. § All these payments are means-tested on the basis of income and assets § The largest payments are to retired old aged people. § Direct benefits are an important means for redistributing income from high income to low income groups Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -35

Income Redistribution § Indirect Benefits § Indirect benefits (also called in-kind benefits) are benefits of services that people receive from government expenditures § Main indirect benefits from government are from expenditures on education and health Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -36

Income Redistribution § The Scale of Income Redistribution § A household’s market income is called its private income. § A household’s final income equals its private income minus direct and indirect taxes, plus direct and indirect benefits. § The difference between the two determine the scale of income redistribution. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -37

Income Redistribution Figure 18. 9 Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education

Income Redistribution § The Big Tradeoff § All redistribution involves a tradeoff between equity and efficiency § Governments can redistribute income only by taxing the richer people to pay for benefits to poorer people § Taxes on the rich reduce their incentives to work and save, while benefits to the poor reduce their incentives to work and save. Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -39

Income Redistribution § The Benefit Trap § A situation in which a person is better off not working and receiving benefits than he or she would be working (or working longer hours) § Two main types of benefit trap: § Unemployment trap § Poverty trap Mc. Taggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 18 -40