Addressing income and wealth inequality

Economics AS · Government microeconomy intervention. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

Income is a flow: money received over a period of time, such as wages, rent, interest and profit. Wealth is a stock: the value of assets owned at one point in time, such as property, shares and savings.

Inequality is measured by the Gini coefficient, which runs from 0 (perfect equality) to 1 (perfect inequality). On a Lorenz curve diagram, the further the curve lies from the 45° line of equality, the greater the inequality.

Incomes differ because of skills, education, the demand for different types of labour and the ownership of assets. Governments redistribute through a minimum wage, transfer payments, progressive taxes, taxes on inheritance and capital, and state provision of essential services.

Rules to remember

Income is a flow (per week, month or year); wealth is a stock (at a point in time)
Gini coefficient = area between the line of equality and the Lorenz curve ÷ total area under the line of equality
Gini coefficient of 0 = perfect equality; 1 = perfect inequality; a rise means more inequality
Progressive tax: takes a larger percentage of income as income rises
Transfer payment: money paid by the government with no good or service given in return, e.g. pensions, unemployment benefit
Inheritance and capital taxes reduce inequality of wealth; income tax reduces inequality of income
Wealth is usually distributed more unequally than income, because it builds up over time and is passed on

Common mistake

Students think a tax is progressive just because richer people pay more dollars. It is progressive only if the percentage of income taken in tax rises as income rises.

Worked example

The first $8,000 of income is tax free and income above $8,000 is taxed at 25%. Asad earns $16,000 and Noor earns $40,000. Show that the tax is progressive.

Asad: tax = 25% × ($16,000 − $8,000) = $2,000, which is 2,000 ÷ 16,000 × 100 = 12.5% of his income.
Noor: tax = 25% × ($40,000 − $8,000) = $8,000, which is 8,000 ÷ 40,000 × 100 = 20% of her income.
The higher earner pays a larger percentage of income in tax.

Answer: The average rate of tax rises from 12.5% to 20% as income rises, so the tax is progressive.

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