1) Income inequality concept
a) Is inequality increasing?
2) Mechanisms that have led to inequality
a) Market Factors
i) Globalisation
ii) Education
b) Government policies
i) Regressive taxation
ii) Taxation on income and capital
c) Political situation
i) Decline of trade unions
ii) Immigration
3) Multiplier effect
a) Theory of the effect
b) Evidence of its effect
4) Scale of inequality
a) Local inequality
b) National inequality
c) Global inequality
5) Possible policies to reduce inequality
a) Progressive taxation
b) Trade Unions
c) Education funding
d) Transfer payments
6) China’s polices to reduce income inequality
a) Social welfare
b) Labour mobility
1) Concept of Income Inequality
a) Is Inequality Increasing?
The question assumes that inequality is increasing. As researched by the OECD, inequality is increasing in almost all of the countries that the organization includes (OECD, 2011), which is the majority of the developed, westernized nations.
Figure 4 Increasing Income Inequality
Clearly, it is a growing dilemma in this type of demographic, and also contradicts the Kuznets’ hypothesis (Ganaie & Kamaiah, 2015) of decreasing inequality once countries have become developed.
Developing countries such as China, India and Indonesia are also exhibiting the same characteristics as many Western and English speaking countries, with inequality falling throughout the 20th century until around 1980, where almost all countries displayed (in this particular data set), a rise in inequality, (Alvaredo, 2011). In addition, this data is not completely reliable as it is the result of the rise in income inequality over an entire century. The data, especially from less economically developed nations at the beginning of the 20th century is unlikely to be completely reliable.
Figure 5 Income Inequality in Developed Countries
2) Mechanisms that have led to inequality
a) Market Factors
Market forces lead to inequality because incomes are allocated one the basis of production, as a result, there is a large market failure because there is an inequality of incomes. Without government intervention, it can be that the poorest members of society, may have a worse standard of living.
i) Globalization
It is suggested by this dissertation that inequality has increased due to globalization. Inequality has been increasing while globalization occurs. According to (Berger & Bank, 2014), this can happen in two scenarios, that lead to inequality becoming worse, with two varying degrees.
Some countries conduct policies on the principle that inequality is a necessary side effect of economic growth, therefore it should be tolerated if growth should continue. As a result, Ricardo’s theories of comparative advantage, which means countries specialize in goods and services that they have a competitive advantage in, will benefit the whole economy. However, depending on the good or service, it could lead to an increase in wages in certain sectors and not others.
Globalization leads to inequality because the production of goods, is now spread out over many countries. As a result, the higher-skilled workers in developing countries, have the opportunity to match with foreign, even higher-skilled workers, from developed countries. This sometimes leaves those less-skilled workers out of the production process, so they cannot experience the rise in wages that higher skilled workers are obtaining. As a result, their wages may begin to fall while others rise.
Maskin does suggest that raising the skills of low skilled workers, may also reduce inequality as they would be able to find opportunities in the international market.
On the other hand, as mentioned in (The Economist, 2014), globalization could lead to a decrease in inequality. In developing countries, lower skilled workers are more in demand from other countries that want to manufacture there. As a result, wages rise in these sectors of lower-skilled workers as they are in more demand than their high-skilled counterparts. Therefore, inequality is decreasing.
However, current data suggests that inequality is increasing in developing countries, disproving these theories. For example, China’s GINI Index has increased by 34% in the twenty years (The Economist, 2014). Multinationals tend to also employ higher-skilled workers and also pay higher wages than local companies. Furthermore, the opportunities that higher-skilled workers get from working with multinationals also further improve their skills, increasing the inequality of income as wider disparities of skills emerge.
Overall, the evidence suggests that globalization has led to a rise in inequality, especially in developing countries when low-skilled workers may be left behind as the rest of the country accelerates.
ii) Education
It is suggested that educational inequality has also lead to the worsening of income inequality. Of course, educational inequality does arise from income inequality and regional inequality. However, this ought not to be the case because the differences between the private and state education should not be so vast. As well as this, educational inequality seriously reduces the literacy rates of leavers from worse off backgrounds and makes them less desirable in the work place.
Education gaps definitely do lead to inequality as the graph from the Tax Foundation (Hodge, 2012). That argues that inequality has arisen from educational differences, rather than the more popular belief that it has come from unfair taxation by a free market government. Many suggest that income inequality arising from having a being educated until obtaining a degree is acceptable because they are more skilled. Society does need better skilled and poorer skilled workers in order to work at full production possibility capacity. People need to be incentivized with higher wages, in order to attract the most talented workers to that field and perform the more challenging jobs.
Figure 6 Education Income Gap
However, it is the equality of opportunity that is important. Disadvantaged pupils ought to have the same start to life and the same opportunities as pupils from richer backgrounds. (Chalabi, 2014) states, “In 2012/13, 64.8% of pupils not eligible for a free school meal obtained at least 5 A*-C grades including Maths and English. But that percentage drops dramatically to just 38.1% among pupils who are eligible for free school meals.” This suggests that people whose household income is lower, achieved much lower qualifications, decreasing their likelihood of going to university and obtaining a degree. The problem is not with the inequality of these skills leading to higher ages, but the inequality of opportunity, for example, a worse school, that has led to lower qualifications and therefore a lower income.
In conclusion, inequality arising from being a more skilled worker is acceptable, however, the inequality of opportunity arising from a poorer schooling background, leads to disadvantaged pupils (who may also have the potential to be successful) not having the opportunity to receive further education because of their poor educational background earlier on in life, eventually leading to them working in a worse paid and poor-skilled job, that they could have surpassed with the right opportunities.
b) Government Policies
Inequality is sometimes exacerbated by government policies, despite their attempts to try and reduce market failures. These examples are explored in this section.
i) Regressive taxation
Includes any taxation that taxes a larger proportion of people on lower incomes, and therefore means that income inequality is increased. Examples of regressive taxation include taxes such as VAT and excise duty, as those with lower incomes pay a larger proportion when they buy products.
However, excise duty is a necessary part of correcting market failure as it encourages the decreased consumption in demerit goods and therefore reduces the total negative externalities in the country. Without it, there would be serious impacts on harmful effects on the environment and people’s health.
On the other hand, it can be argued that VAT itself is not a regressive tax because with higher incomes are likely to spend more money on certain goods anyway. As a result, they are still paying a larger proportion of their income to the government through VAT and excise duties. Furthermore, VAT is imposed more on ‘luxury’ item, basic goods. have no tax. As a result, people on lower incomes are further prevented from their current having a higher standard of living.
Currently, the richest fifth of UK households pay 15% of their disposable income to indirect tax, whereas the poorest fifth pay 29.7% of their disposable income. This clearly suggests that indirect taxation is a regressive tax as they end up paying a much larger proportion of their income. This increases income inequality as they end up spending less money on goods and services as they would have been able to without the tax.
ii) Taxation on income and capital
Taxation of income is one of the main tools that the government uses to redistribute income, as well as being the largest generator for the Exchequer. However, some claim that the income tax is not high enough to reduce after tax-income in the richer percentiles and therefore does not do enough to reduce income inequality.
Furthermore, it is suggested that having a progressive taxation in income tax is not enough to reduce income inequality. The Netherlands is given as the example as it has very similar policies for income tax as the UK and the US have, however, it has much lower income inequality, suggesting that there are many other factors that lead to having a more equal society and therefore, raising the top bracket of tax as suggested by left wing parties in many parts of the world, may not be the solution and have little impact on overall equalization as this evidence suggests.
Figure 7 Netherlands Tax Rate
Taxable Income
Tax Rate
$0—$9,275
10%
$9,276—$37,650
$927.50 plus 15% of the amount over $9,275
$37,651—$91,150
$5,183.75 plus 25% of the amount over $37,650
$91,151—$190,150
$18,558.75 plus 28% of the amount over $91,150
$190,151—$ 413,350
$46,278.75 plus 33% of the amount over $190,150
$413,351—$415,050
$119,934.75 plus 35% of the amount over $413,350
$415,051 or more
$120,529.75 plus 39.6% of the amount over $415,050
Figure 8 Netherlands Tax Rate
Overall, as this table shows, income tax is progressive, however, due to regressive indirect taxes, the tax in total in the Netherlands is a flat tax. VAT in The Netherlands is 21%, whereas the US does not have an any VAT, it does have sales tax but this is considerably lower. This could point to the solution that the impact of taxes is not as large as it could previously be argued. This is made clear by the fact the Netherlands has a Gini index of 0.29, while the US has a Gini index of 0.38.
Although, as the US doesn’t have an income tax system which is as progressive as the Netherlands, it would suggest that maybe income tax does play a role. However, as the Netherlands has a much higher VAT than America, it could suggest that having higher regressive taxes, like there are in many European countries, does not hamper reductions in inequality as many European countries have very low levels of inequality. Therefore, it is a suggestion of the fault of the government at not in the necessary regressive taxation of goods and services, but rather its reluctance to increase income tax brackets in at the highest levels.
The reasons for why progressive taxes appear not to be as effective as many proposed could be due to the fact the income is relatively easy to hide – if you have the influence. This means that those with the income and wealth that they want to hide will often have the ability to do so. The recent Panama scandal that revealed there to be many high profile individuals hiding money in Panama to avoid taxation.
However, according to what makes a good tax, income tax fulfills almost all of the qualities being efficient, generating a large income, cheap to collect and it supposedly adds a bit of restoration to society’s inequality, however this is debatable.
As Thomas Piketty has famously suggested, to reduce inequality what is needed is a wealth tax, in other words a tax on capital. Piketty’s main idea is that r > g. With r being the rate of return of capital and g being the rate of economic growth. When economic growth is low, having capital is more important, while when economic growth is high, wealth has a lower importance. Piketty used historical trends to work on this theory. It is significant because it suggests that as long as wealth keeps accumulating, i.e. inequality remains high, then economic growth will not continue as highly and the future lead to very high inequality and low rates of growth.
Wealth tax is already present in a selection of very few countries including Argentina, France, Spain, India, Norway, Switzerland and Italy. These countries are all very different levels of wealth tax and thresholds therefore making it very difficult to judge the affect that this has on inequality. Furthermore, no conclusive answer can be drawn from this because they all have very different Gini Coefficients with Norway the lowest at 0.27 and Argentina the highest 0.46.
c) Political Situation
i) Decline of Trade Unions
Trade unions are organisations that are made up of members who are all workers in a particular industry. The main job of trade unions is to protect the rights of the workers and fight for their interests through collective bargaining. It gives workers a much stronger place in the market and they are less likely to lose their job unfairly and will have better pay and better hours. As a result, trade unions have been praised as having a large impact inequality because they increase workers’ power as they are a group rather than an individual. This means that can strike against changes or unanswered difficulties they face in the workplace such as anti-social hours or poor pay.
However, like Margaret Thatcher and her Conservative Government, some people see Trade Unions as a barrier to growth because they can damage industries during strikes, like Margaret Thatcher experienced during her time as Prime minister as she tried to prevent their continuous strikes which severely damaged industries forcing some to move overseas for production or in some cases they are replaced by machines, like the dock workers in the UK. Furthermore, people argue that they also drain the economy in areas such as education and healthcare because the government has to spend more money in abiding by the negotiations with trade unions that may include certain things such as pensions or working less hours. Therefore, it is argued that it has contributed to large budget deficits seen in many countries today.
As a result, successive governments over the last 30 years, the period in which inequality in many OECD countries has slowly begun to increase, have continued to introduce anti-Trade Union laws and in the UK in 2015, came another bout of restrictions, including allowing the government to fine trade unions and unlawful picketing could become a criminal offence.
Another reason for the decline of the trade unions is the movement from a more manufacturing based economy as many OECD countries used to be, to a more service based economy. Many manufacturing workers are exactly the type of workers who would have joined a Trade Union. As the manufacturing sector decreases, the necessity of it to the marketplace also decreases meaning that the Trade Union power is also diminished. Along with drops in workers in this sector, it seriously reduces the power and size of Trade Unions.
This decline of Trade Unions has an impact on inequality as the majority of people in trade unions are low or middle class earners and therefore are more likely to have poorer job security. A decrease in job security will reduce an individual’s consumer confidence so they are less likely to spend their disposable income as well. Therefore, trade unions do not just reduce income inequality as they limit low pay, but also, they allow for low income earners to have higher consumer confidence and therefore reduce the stresses of living on a lower income.
As seen in the graph below, since the late 1950s, union membership in the USA has been falling. From a peak of 33.4% in 1945, to the 2012 rate of 11.2%, the union membership has been decreasing. This shows a clear correlation between the share of income going to the top 10% and union membership. As union membership has decreased inequality has also begun to increase. It suggests that trade unions could help to resolve income inequality as the percent of income going to the top 10% was the lowest in the 20th century while the union membership was at its highest. It may also suggest that even union membership of only 33.4% could have spill over benefits for those not in unions, hence the fall in inequality.
There is a selection of reasons as to why trade union membership has declined and as to why their strength has also done so.
Overall, the demise of trade unions has seen a dramatic effect on the increase in inequality that we have seen over the last half century.
ii) Immigration
The effect of immigration on income inequality depends on which country being observed. For example, in the US, immigration would have a larger effect on income inequality because a smaller percentage of the immigrants have a degree (only 27%). On the other hand, 35% of UK immigrants have a degree, this is compared with only 26% of the UK born population.
Having immigrants that have lower qualifications can lead to inequality for two reasons. Firstly, it creates a larger pool of lower skilled workers. This means that the labour supply for these jobs has increased, allowing companies to maybe even lower the wages and still have applicants for the job. Overall, these depressed wages lead to a rise in income inequality.
Another reason that income inequality increases with immigration is that immigrants have less access to government welfare funded schemes. Therefore, they have an even more reduced income in comparison to US or UK born citizens who may also be low income earners. This creates even more disparity between incomes in these countries leading to increases in income inequality figures. This has been even more pronounced lately because of the rises of immigration seen by many Western nations that also correlates with rising income inequality. This is shown in the graph below in which the Gini Coefficient is higher with immigrants than without immigrants showing that they increase income inequality.
Figure 10 Effect of Immigration
This is why immigration increases inequality less in the UK compared with the US because it experiences higher level of qualified immigrants. These immigrants will have access to higher paid jobs because of their qualifications and will therefore have little effect on income inequality.
3) Can be found in appendix
4) Can be found in appendix
5) Possible Policies to Reduce Inequality
Choosing policies to reduce income inequality is difficult because in each country, different factors may have led to income inequality. As a result, countries must first find the cause of the inequality before they begin to use policies to solve it. Furthermore, there also needs to be a balance between how equitable society is and how efficient it is. Many who are against income equality argue that it slows growth down, and as a result such extensive policies should not be used. However, there is no reason that equality should be at the expense of growth.
a) Progressive Taxation
Progressive taxation is when a government taxes a higher proportion of income or wealth for higher earners than lower earners. It is already in place in some form in many economies worldwide. However, if it is already in place, then why has inequality still been rising throughout the past 40 years? It is true that tax rates for the rich have been falling in both income tax and corporation tax, with the amount the wealthiest have to pay decreasing. The graph below shows how the highest % of tax paid has decreased, making it less progressive. Furthermore, the top tax bracket has also decreased which could damage the middle-class more than the wealthy as they are now in the top income bracket. Furthermore, any income above, for example, $1.5 million is taxed the same as amount as income at 500,000 despite it being so much higher. Overall, the tax system has clearly become much less progressive which is one reason for the growing income inequality.
Figure 11 Progressive Taxation
However, progressive taxation systems are in place. In theory, they should lower inequality as the rich have more money taken away than those who cannot afford to. As a result, in many more mixed economies, this money is then given to the poorer members of society in the form of welfare benefits, jobseekers’ allowance or pensions. Although, it is not guaranteed that the money that the government brings in from this taxation will go into welfare.
Overall, there is a suggestion that the reason that progressive taxes are effective as throughout the second half of the 20th century, they were much higher that current levels, for example at 90% between 1950 and 1962. This was a much more progressive system and at the same time, inequality was much lower (see figure), suggesting that this is effective. Of course, there are other arguments as to why inequality during this period was lower. More recently, Thomas Piketty suggested that the dramatic fall in assets and therefore wealth of the richest individuals during the second world war, resulted in a large reduction in inequality as their assets were now unable to generate as much income. This low period of inequality coincided with when tax rates were very high and progressive making it difficult to distinguish which factor actually lead to this long term low inequality.
Furthermore, during this period, worldwide economic growth was not slow, despite many European and North American countries being more equal, contradicting the argument that equality can reduce growth. As can be seen in the graph below, the average growth rate has actually very slightly decreased between the 1950s and today.
Figure 12 US GDP Growth Rate
Overall, one of the reasons for high levels of inequality is the not-so-progressive taxation in many countries all over the world. If it truly is to be reduced, more tax breaks ought to be provided at the bottom of the taxation scale and the top marginal rate of tax should be increased with higher tax brackets too. (Roser M. , 2015)
b) Trade Unions
I have already discussed the fall of trade unions in many countries and how many governments are trading them for increased efficiency and flexibility in the work place. Having already discussed the reason for their decline, it is also important to stress how they reduce income inequality and increase workers’ rights. They are more important as lower-skilled and therefore poorer workers are the ones who truly require them.
Many agree that trade unions do reduce inequality, however, China has a union density of 90%, the highest in the world and it still has high income inequality across the entire country. Of course, this could be due to restriction on how much power trade unions have that have been enforced by the government. For example, in 2002, there were 140,000 deaths that were caused by accidents at work and 250,000 other injuries or lost body parts. This suggests that trade unions in China do little to try and improve workers’ rights in the workplace as they are clearly still so poor. As a result, little is also done by the trade unions in anything else, such as improving wages and therefore lowering income inequality. In fact, lots of companies in China like to use performance-related pay to motivate their workers to be more productive during working hours. This further creates harsh working conditions and can limit the extent of improving income inequality in China. Therefore, it is obvious that it’s not just trade unions that need to be in place but the extent of their power also has to be enforced by the law and not quashed by it.
Government policies over the last few decades have been against trade unions, nothing has been done to improve the state of trade unions, despite keeping to other promises such as improving working conditions and introducing a minimum wage. As a result, weak trade unions have not had a big enough impact to actually begin to lower inequality. If regulations of trade unions continue, it may even increase income inequality even further.
c) Education Funding
I have already discussed how those with higher education are more likely to go on to higher earning jobs. However, I earlier concluded that this was needed to provide incentives for people to become better trained. However, the problems lie in the fact that those who are poorer often end up going to worse schools, either because the house prices near the worse schools are lower, or they cannot afford to go to private school, which in many countries are often higher achieving that state schools.
A prime example of this is the type of professions that privately educated pupils go into are often much higher paid. This is a problem as only 7% of UK students are educated privately. This lack of diversity in these types of professions could be down to social immobility, where a poorer individual may feel like they can’t do a certain job because they feel that it is too ‘posh’ for them. This is also a market failure because it means that the market loses out on these skills that these individuals have but feel that they cannot use.
Figure 13 Educational Inequality
Many people see funding education as one of the best policies to reduce inequality as unlike other policies that people claim at the same time they can reduce growth, better education should improve long-term growth because the future workforce will be more efficient and productive, creating a higher output and boosting the economy. Therefore, increasing schooling has often been a key factor when nations (and the world) consider lowering inequality. Primary education for all was a millennium development goal. It is also difficult in developing countries however, as private schools pull away from state ones in the quality of their education, it needs to be understood why that is happening and what solutions are there for the government to increase the quality of state schools to bring them to the level of the private ones.
One of the problems that state schools have is that poor quality teachers are kept on without dismissal. For example, in the last 10 years, only 17 out of 400,000 teachers were dismissed due to incompetence. This figure surely should be higher if teachers were truly dismissed due to incompetence.
Nowadays, some people also suggest that once state educated students get to university however, they outperform their privately educated counterparts by achieving better degree results when they leave university. For example, students that achieved ABB at a-level from independent schools, 69% of them went on to achieve a 2:1 degree. However, 77% of state school pupils who had the same A-level results, also achieved a 2:1 degree from university.
However, it is widely recognised that students who grow up in an environment where their parents are poorer, will struggle to do well in school. This is because their parents are more likely to suffer from mental illnesses like depression and anxiety as well as more likely to alcoholics or drug users. When a child is developing at an early age in this type of environment, parents are less likely to focus on their child’s wellbeing and therefore will affect their ability to do well once they go to school. This therefore suggests that the children falling behind at school begins before they are even eligible to go to school if they come from a poor family.
Many solutions have been put forward in order to try and limit and even close this gap between the levels of schools. The UK could increase the amount of money they spend in the education, however, it is also emphasised that this has to be effective spending. For example, the primary school teachers in the UK are paid above the OECD average, but it is questionable about whether these teachers actually also deliver better results. The balance is difficult to strike however. If the pay is too low, no good teachers will want to work in state primary schools. Overall, increasing funding to schools so they have the ability to have more teachers and have higher salaries would be the best outcome.
Other solutions that were suggested by the OECD to Sweden after its school standards began to slip were things such as harsher entry requirements to become a teacher and better integration
Current policies such as pupil premium where the government pays schools more depending on how many disadvantaged pupils they have in order to improve their school achievements. Ofsted has concluded that at the moment it is too close to confirm that this scheme has made a difference. However, they say so far it has been most effective in schools that has better governance and a way of tracking pupil’s progress regularly and effectively.
d) Transfer Payments
Transfer payments include things such subsidies and benefits because it refers to anything that is not being paid for. Benefits are the main section of transfer payments that are aimed at reducing income inequality. According to the OECD, transfers reduce inequality more than taxes do with three quarter of the reduction in inequality between market and disposable income due to transfers and the rest is due to taxes. Therefore, transfer payments are very important in reducing inequality, more than that of taxes which so far are not affective enough.
However, benefits do not do anything to reduce before tax inequality and therefore have a limited effect in reducing actual inequality. Furthermore, they are argued to reduce motivation to work harder or get a job because economically it makes more sense to do nothing and get free money than go out and get a job. This means that they may only be beneficial to ease serious income inequality in the short run and help people to ensure they have enough money to have a decent standard of living, but still aware that there are better options open if they were willing to work.
Overall, transfer payments are a very short term solution for most people and do not solve the actual problem of income inequality, which might be why income inequality is still rising in the UK despite paying welfare benefits.
6) A short case study about China’s income inequality can be found in the appendix.
Conclusion
To conclude, I believe that many of the policies I have suggested, in many cases are already in place in some form. However, I think that the trouble lies in the extent and the effectiveness of their implementation. For example, the progressive taxation system would be much more effective if the highest marginal rate of taxation was higher than it currently is and closer to what it used to be. In terms of education, the money must be put to a more effective use in order to ensure maximum social mobility.
I found the research quite hard as there was so much to cover, I found it really difficult to ensure that the whole thing was written in a cohesive and comprehensive way. Although, I do feel that I found a wide range of sources and that my research that I used is almost always from a respectable source. I was lucky in the sense that the topic is so large that there was a lot of information available for me to use. However, this could also be viewed as hindering my research as it was almost as though I was overloaded with possible papers and articles to read on the subject.
The process was also a challenge as I found that I often wrote my project in short intense sessions followed my long breaks of doing relatively little. This sometimes helped me to work well as I was able to easily maintain an understanding of the topic and the structure of the writing was able to flow more easily. However, it also meant that returning to the writing was difficult as it was often problematic to recall the thought process from previous occasions. Despite this, I found it enjoyable to do in-depth research a topic I am interested in.
To improve, I would have chosen a narrower and more specific question at the beginning in order to make writing the piece more cohesive and easier to form a well-structured answer to. The question was too broad to be able to fully cover the answer in under the word count. Furthermore, it may have improved my project if I had done some primary research, such as sending a survey out to my local community and ask them about what they thought about current government policies to reduce income inequality.