Introduction
One of the characteristics associated with free market economies is an unequal distribution of income. Inequality obviously occurs to different extents in different countries. The reasons for difference in income and the consequences of inequality are many and complex they can form massive debates among economists. A main complaint against inequality is that it’s unfair, people with low income will experience relatively low living standards and fewer opportunities than people with higher incomes. On the other hand, many economists believe that inequality is necessary to avoid economic stagnation and market enterprise as it creates an incentive to work harder, without it there would be huge implications, creating lower overall level of economic activity. This paper discusses the question to which extent government intervention to aid economic inequality is necessary.
Firstly, this paper illustrates the extent of economic inequality on the world as a whole, secondly it will analyze the advantages and disadvantages of economic inequality through government policies and interventions.
Economic Inequality and How it is Measured
Economic inequality can be defined as the disparity in the distribution of income and wealth (assets) among individuals in a population, often many use it solemnly to compare individual groups within a society but it as our world is becoming more integrates one can also denote inequality between countries. Inequality can be traced as far back as possible and can vary through different societies, historic periods and economic systems of structures. One can date it back to the 18th century. The most common representation of inequality comes in the form of a Lorenz curve. One can refer to Figure 1 below to see a depiction of the model.
This takes national monitored surveys and presents them graphically. The x-axis shows the cumulative percentage of the total population whilst the y-axis shows the cumulative percentage of total income earned. In the middle, there is a 45-degree line touching both the y and x-axis known as the Line of absolute Equality where there is a perfectly equal distribution of income. Each country then has its own Lorenz curve based on their income data. The farther away a country’s curve is from the line of absolute equality, the more unequal is the distribution of income.
To summarize the information displayed on the Lorenz Curve there is a specific indicator knows as the Gini index. The Gini index can be derived from the Lorenz curve and is a ratio of the area between the line of equality and a country’s Lorenz curve this can be illustrated by the equation (Area A )/((Area A+Area B)) using Figure 1. The higher the index the more unequal the distribution of income. Although reducing inequality is an important objective for future development one must be careful when using the Gini index when evaluating a country’s development process. While low income countries tent to have higher levels of inequality than high income countries, there is no hard correlation between the level of development of a country and its Gini Index. For example, there are countries with high human development such as the United States, that have a relative high Gini Index of 40.8 compared to a country with a low level of human development such as Ethiopia with a much lower Gini value of 29.8.
Government Policies on Redistributing Income
There are various reasons for why incomes may be low and people live in poverty such as being born into a household with a low income, one may have received poor or no education, healthcare and may have found it necessary to work before completing an education. The consequences of poverty lead to low levels of human capital and it creates a cycle of poverty which is hard to get out of, this is illustrated in Figure 2. Thus, the government feels compelled to introduce policies and regulations in order to redistribute income.
Many countries use a progressive tax as the main way to redistribute income from higher income earners to low income earners. A progressive tax means that, as income rises, people pay a higher proportion of this income in taxes. Usually a certain amount of income is non-taxed so a person earning a low income might pay no taxes at all however, when the income gets to a minimum then a certain percentage of it must be paid to the government. Then as income rises further, a progressive tax would take larger percentages at higher incomes. With progressive taxes however, complications like tax deductions arise. Tax deductions allow people to reduce their taxable income in result from spending on certain things. The governments motif to do so is because this might encourage people to find work and lower unemployment but, what is considered a tax deduction varies from country to country.
Another government policy is the regressive tax, which is when the proportion of income paid in tax falls as income rises. This is a form of indirect tax (expenditure or consumption taxes) and it is regressive because a higher proportion if income is paid at lower levels of income. Regressive taxes may be a good source of revenue for the government but then they might also discourage the consumption of demerit goods and overall worsen inequality.
Proportional taxes are another form of government intervention. It is when the proportion of income paid in tax is constant for all income levels, many countries are currently promoting this as taxation is extremely complicated. This taxation system may result in governments earning less revenue than expected as people find ways to avoid paying taxes. One may argue, that high rates of taxes discourage people from working harder, moving into higher paid jobs and taking risks, as they will be reluctant to lose their own gains to higher taxes.
Transfer payments allow governments to use tax revenues to redistribute income and they provide different types of assistance to groups in the economy in order to increase living standards. Whilst they are not included as income, because they do not represent payment for the production of a good or service, transfer payments are made to increase the income of particular groups within an economy. Examples of these are child support assistance, pensions, unemployment benefits and etc.
Lastly there is government expenditure. Governments use large amounts of their taxation revenue to provide directly, or to subsidize a number of goods and services that are desirable. These tend to be good and services that have positive externalities of consumption like health care, education… to ensure that the poorer member of the economy have access to essential goods and services leading to economic development.
Evaluating Redistribution of Income Policies
Governments have many diverse policies in order to decrease income inequality but not always do these have the best effect on a country. While many agree that it is a governments obligation to ensure each citizen has a reasonable standard of living many question what that constitutes. Some economists tend to argue against the active role of the government for the simple reason that it interferes with market forces and results in inefficiencies. This view argues that the optimal allocation of resources occurs in free markets and so government taxation must be kept to a minimum.
They discuss how if firms have to pay insurance and social security costs for workers, then this will encourage firms to hire fewer workers, thus contributing to unemployment. High taxes in a country might discourage entrepreneurial activity and even encourage entrepreneurs to leave a country in search or more favorable tax climates. High taxes also have negative effects on overall growth in the economy due to disincentive effect mention earlier, lower taxes encourage to economic activity leading to an overall increase in output that will be benefit to all people.
Free market economists do not believe that there is no role for the government in an economy and no reasons for taxes to be collected however, taxes should be used to finance the obligations of the government to ensure property right, reduce market failure and its effects but taxation should not be sued to redistribute income.