This post describes the difference between income and wealth. It outlines basic problems of unfair and unequal distribution of income.
It also differentiates between Absolute Poverty, Relative Poverty and lack horizontal equity. In the second half of this story, The Trickle Down Effect is explained in details. Finally, the way of measuring the distribution of income and wealth using The Lorenz Curve is introduced.
The article also analyzes government policy and the cost of distribution as well as evaluates the different policies to redistribute income.
Income and wealth
Income is the current earnings of an economic agent over time.
This income can be used to invest in property. Buying property increases your wealth and can be used to increase income. Therefore wealth is the accumulation of property, savings and other belongings.
Redistribution of income and wealth
The free market is likely to lead to a situation where income and wealth are not distributed evenly amongst the population.
This inequitable distribution of income and wealth may be described by governments as market failure, as is the widening of this gap. It can create little incentive for poor groups to work, especially if there are welfare payments from the government. Poor people may not have access to goods considered normal in society. These problems can cause crime, civil unrest or exploitation of the poor.
A. Absolute Poverty. Absolute poverty exists when an individual does not have the resources to be able to live e.g. they do not have access to sufficient food, water, clothing, shelter, basic health care etc. People suffering from absolute poverty may be homeless, uneducated or may be malnourished by lack food and water. It is important to realize that in a developed society, such problems can be avoided. In extreme cases some people living in absolute poverty may die as a result of their living standards, indicating clear inequality, as others have far more comfortable lives.
B. Relative Poverty. A person is considered to living in relative poverty if their living standard is below the average standard of living in their country or region. Therefore, what is considered to be relative poverty can be very different from country to country. If the gap between the rich and the poor is too great it creates social problems, so it is important to have an understanding of what is ‘normal’ for society. Relative poverty is often measured using material items e.g. the number of TV in a home, whether or not a family owns a car. Relative poverty may exist because of a lack of horizontal equity.
C. Lack of horizontal equity. When people at the same level in society are not treated as equal, some are discriminated against. Sexual discrimination is an example, women paid less than men for precisely the same work, or for a job of the same ‘level’ of work. However, discrimination can be applied to many other groups in society. Discrimination can occur because of race, age, religion, class and many other reasons where there is a real or perceived difference.
Economic efficiency
Some people believe that the opportunity of earning a much higher salary than others can drive people to work harder. Therefore differences in income levels may motivate people to work or get a higher level of education. The competition creates a greater level of efficiency in the economy.
Not all people see the wealth gap as posing a real problem for society. Hence, The Trickle Down Effect. The Trickle Down Effect is the idea that the income and wealth of the richer members of society will move downwards (be invested back into) to the poorer members of society.
For example, the rich groups in society eat in restaurant regularly, this means they pay the owner of the restaurant, who in turn pays for the employment of staff such as waiters, chefs and suppliers, etc. If society was more equitable, perhaps this situation could not exist.
Famous supporters of the trickle down effect were former British Prime Minister Margaret Thatcher and former President of the United States Ronald Reagan. They believed that cutting Income TAX of richer groups allows them to invest more. This will create growth, indirectly redistributing wealth to lower income groups as employment levels grow.
Measuring the distribution of income and wealth
It is possible to graphically plot the cumulative % of income within the economy against the cumulative % of households that exist to determine how even or unfair income is spread. This information presented graphically is called The Lorenz Curve.
1. THE SOCIETY WITH EQUAL INCOME AND WEALTH
An example of an even society exists below.
Imagine that everybody in society is earning the same amount, as seen in the table below. The poorest 80% of households in the society have 80% of the income and wealth. While the richest 20% of households in the society have 20% of the income and wealth.
2. THE SOCIETY WITH UNEQUAL INCOME AND WEALTH
To make a comparison to the previous chart consider the following data. If income is not evenly distributed (like in reality) we will see a graph which does not have a 45° line.
An example of an uneven society exists below.
Imagine that everybody in society is not earning the same amount, as seen in the table below. The poorest 80% of households in the society have 60% of the income and wealth. While the richest 20% of households in the society have 40% of the income and wealth.
The further to the right the curve is, the greater the level of inequality that exists in society.
How is redistribution of income and wealth accomplished?
The government can take an active role in redistributing wealth in society by using:
- Government expenditure.
- TAXation.
- Legislation.
1. Government expenditure
The government can make society more equal through direct spending, government expenditure, in the form of welfare payments. Examples include TAX credits designed to increase the income of lower income groups and unemployment benefits (now called job seekers allowance in the UK).
Welfare payments put money in the hand of the underprivileged, but the government is also able to provide more specific forms of spending, such as spending on children’s clothes, food coupons for the poor and housing in areas dominated by low income groups.
When the government provides good and services that are a benefit to society (merit goods) such as the provision of free health care and education, it also a means of providing welfare.
2. TAXation
Governments can organize TAXation, the TAX system, so that different people in society are charged different amounts. A proportional system would have no effect in the wealth gap. However, a regressive system would charge poor groups a greater percentage of their income which would produce an even less equal society.
Therefore, a government wishing to reduce the wealth gap in society would opt to use a progressive system as this would reduce the wealth gap and cause The Lorenz Curve to move towards the line of perfect equality.
3. Legislation
The government can create laws that can force companies to adopt equal opportunity policies, so they pay equally, creating horizontal equity.
Another method of redistributing income is to set a minimum wage level to increase the income of the lowest earners.
Finally, they are able to make certain benefits compulsory e.g. pension and sick pay.
The costs of redistribution of income and wealth
TAXes mean that individuals lose the freedom over how they spend a percentage of their income. This can be more severe if the government uses a progressive system to make society more equitable.
Some economists (namely classical economists) are against redistributing income because it reduces the benefits of the free market system. They argue that such measures make the economy less efficient.
Furthermore, opponents to the redistribution of income believe it can have a negative effect on employment levels and investment:
- Higher TAXation acts as a disincentive to work, entrepreneurs may wish to invest elsewhere, as may foreign firms.
- Higher TAXes may make skilled people seek employment overseas (brain drain).
- Higher costs caused by minimum wages and forced benefits may increase the unemployment rate, so again, less output for the economy.
- Paying benefits may discourage low income groups from seeking work, therefore reducing output produced in the economy.
The wealth gap can cause huge problems for government, if it becomes too great. The wealth gap can be calculated using The Lorenz Curve.
Government may force better salaries for poorer people or even provide money themselves in the form of benefits. However, this can cause problems itself if employment and investment levels fall
