Equity in the

Distribution of
Income
Why does
inequality exist
in a free market
economy?

2
Why is equality important in a
free market economic system?
How might the government
1.
achieve equity in a free market
economy?
Equal vs. Fair
Equity vs. Equality
▪
Governments are not aiming for equality, since higher
incomes act as an incentive for people to work
harder

▪
Equity = Governments attempt to redistribute income
more ‘fairly’ through redistribution of tax revenue

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Equity vs. Equality
▪

▪
Inequality of opportunity: when the education or type
of job or level of income are not based on effort
or achievements but on their circumstances at
birth.
▪
In the last decade, income inequality has increased in
nearly all regions of the world (WID)

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Measuring
Income
Inequality...
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Lorenz Curve
The Lorenz curve shows what percentage of the population owns
what percentage of the total income of the economy.

It is calculated in cumulative terms.

The further the curve is from the 45 degree line of absolute equality,
the more unequal is the distribution of income.

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Lorenz Curve

The Lorenz Curve is an economic model useful to compare eithr two

or more countries in terms of income distribution or the change in
income distribution for a single country over time.

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 Income distribution for
Brazil and Hungary
Lowest Highest
Country 2nd 20% 3rd 20% 4th 20%
20% 20%

Brazil 2.4 5.9 10.4 18.1 63.2

Hungary 9.5 13.9 17.6 22.4 36.6

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 The Lorenz curve:
100
RED = Hungary
90
BLUE = Brazil
80
Cumulative 70
percentage 60 t e -
The further away the curve is from
of total income 50 s olu
f ab the line of absolute equality, the
o
40 n e l it y
i
L ua more unequal is the distribution
30 eq
20 of income.
10 -
Income is less equally distributed in
0 20 40 60 80 100 Brazil compared to Hungary.
Cumulative percentage of
total population
Gini Coefficient
A coefficient (index) that measures the ratio
of the area between a Lorenz curve and the
line of absolute equality to the total area under
the line of equality.

The higher the figure, the more unequal is the

distribution of income.

It basically provides a value for the ‘‘distance’’ of the

curve from the line of perfect equality.

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Gini coefficient :
100
90
80
Cumulative 70 Gini coefficient (index)
e
percentage 60 lut
o
of total income 50 a bs A
e of
40 n ty
30 Li uali A A+B
eq
20
B
10 The larger the answer, the
0 20 40 60 80 100 more unequal is the
distribution.
Cumulative percentage of
total population
Using the Gini Index
Consider the following countries:

◦
Gini index = 0.30

◦
Gini index = 0.41
Where would you rather live?
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Using the Gini Index
Consider the following countries:

◦
Gini index = 0.30 = Ethiopia

◦
Gini index = 0.41 = USA

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 Evaluate
Use Gini index numbers with caution when evaluating a country’s development.

Generally, low-income countries (low HDI) will have higher levels of inequality (high Gini index), but not
always.

⚫
Ethiopia: Gini index = 0.30 ; HDI = 0.41 (Ranked 171)

⚫
USA: Gini index = 0.41 ; HDI = 0.95 (Ranked 13)

It’s a measure of the distribution of income and NOT poverty levels.

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 Evaluate
A country with a high Gini coefficient (large inequality) could have a generally high standard
of living in low income groups…

Whilst a country with a low Gini index may face widespread poverty in most income groups.

Consider national income increasing…and income distribution remains the same – the poorest
are getting the same proportion of a larger amount.

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POVERTY 17
 Poverty
Absolute vs Relative poverty:
◦
Absolute = no access to basic necessities needed to live.
◦
Relative = living standards are below the ‘average’ in an economy.
●
Possible causes:
◦
Low incomes, Poor or no education, Unemployment, Poor healthcare /
malnutrition etc.
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Purchasing Power Parity (PPP) Exchange rate

▪
A popular macroeconomic analysis metric used to compare economic
productivity and standards of living between countries.
▪
PPP involves an economic theory that compares different countries' currencies
through a "basket of goods" approach. That is, PPP is the exchange rate at
which one nation's currency would be converted into another to purchase
the same and same amounts of a large group of products
▪
According to this concept, two currencies are in equilibrium—their currencies
are at par—when a basket of goods is priced the same in both countries,
taking into account the exchange rates.

▪
Purchasing Power Parity (PPP) Exchange rate (cont):

§
Some countries adjust their gross domestic product (GDP)
figures to reflect PPP.
§
Some feel that PPP does not reflect reality due to differences
in local costs, taxes, tariffs, and competition
▪
 Poverty: Multidimensional Poverty Index
A person is considered to be
multidimensionally
poor if they experience
deprivation in at least
1/3 of these weighted indicators

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Causes of Poverty
The causes of inequality and poverty are complex. It´s now your turn to list the most
relevant ones to all countries.

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 Consequences of Poverty

Let´s do the same with the consequences!!

A clue may help you!!

https://www.youtube.com/watch?v=CnS1HY7wWJs

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 Taxation to promote equity

We have discussed how governments use taxes to:

a) Fund government spending

b) Steer the economy using fiscal policies;
c) Discourage production and consumption of goods yielding negative externalities.
d) Fund spending to increase the production/consumption of goods having positive
externalities.

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 Taxation to promote equity
Direct taxes: Taxation imposed on people’s income or wealth, and on firms’
profits. In theory, such taxes are unavoidable (eg, income tax).

Indirect taxes: A tax on expenditure or consumption that is ‘hidden’. It

increases the firm’s costs and is added to the selling price of a good or service.
It is also known as an avoidable tax (eg, VAT and GST).

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 Direct Taxation
Associated with two main economic effects:
a) Redistribution effect:
◦
Tax is collected and redistributed to others.
◦
Money, health care, education, roads etc.
b) Disincentive effect:
◦
Increased taxes may discourage some from working, or at least from
working harder.
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Categories of taxation:
●
Our two types of taxes can now be placed into three
different categories:

◦
Progressive taxes

◦
Proportional taxes

◦
Regressive taxes 27
# 1 Progressive Taxes
A system of direct taxation where tax is levied at an increasing
rate for successive ‘brackets’ of income. So as an individual’s
income rises, the individual pays a higher proportion of their
income in taxes. The marginal tax rate (rate of tax paid on the
additional income earned) is higher than the average tax rate.

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Calculate
Consider the table below:

Calculate the amount of tax paid by a person earning $35 000 per annum.
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# 2 Proportional Taxes
A tax is a proportional tax if the proportion of income paid in tax is constant for all
income levels. (i.e. 10% tax)

A simpler system to understand than a progressive system.

This could make it more difficult for people to avoid paying taxes.

Also, it reduces the disincentive effects of taxes.

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# 3 Regressive Taxes
A system of taxation in which tax is levied at a decreasing average rate as
income rises. This form of taxation takes a greater proportion of tax from
the low-income earner than from the high-income earner.

●
Indirect taxes are regressive taxes. i.e: consider an example of a $1 tax on a litre of
diesel and assume that people end up spending $50 per month in petrol taxes. For a person
earning $500 per month. this represents 10% of their income. For a person earning $2,500 per
month, only takes a 2%.

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Evaluate (regressive tax)
Regressive taxes…
●
a good source of government revenue
●
discourages the consumption of demerit goods
●
but they can worsen income inequality
●

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Other redistribution methods
Direct Provision and Subsidization
Government expenditure can also be used to promote equity
by providing directly or giving subsidies to socially desirable
G&S like healthcare, education, infrastructure like sanitation
and clean water supplies.

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Other redistribution methods
Transfer payment:

A payment received for which no good or service is exchanged, eg,

unemployment benefits, child support assistance or a pension etc.

Basically, governments using tax revenues to redistribute income and

assist groups in the economy to improve their living standards.
Examples: Pensions, unemployment benefits etc.
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Overall Evaluation
●
We know that new classical economists would argue against the role of the
government .
●
High taxes discourage entrepreneurial activity and entrepreneurs may seek more
‘favorable’ tax countries.
●
Economic growth is negatively affected due to the disincentive effect.
●
On the other hand, lower taxes → encourages economic activity → increase in
output → benefits all people.

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Conclusion
Taxes are necessary but….

●
Free market economists might say that taxes should be used by government to
provide an effective security and judicial system, to reduce the effects of
market failure etc, but should not be used to primarily redistribute income.

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