Inequality, poverty and redistribution
Key terms
Define each term.
Multiple choice
Circle the correct answer.
A country's economy grows and every household's real income doubles. What happens to poverty?
Which measure tackles a cause of poverty rather than relieving its symptoms?
A country's Gini coefficient falls from 0.42 to 0.35 after taxes and benefits are taken into account. What does this show?
Worked problems
Show your working.
Testing whether a tax system is progressive. In a country, a worker earning $20,000 pays $2,000 in total tax, while one earning $80,000 pays $20,000. A third earning $200,000 pays $44,000. Calculate the average tax rate for each and classify the system across the whole range.
Calculating an effective marginal rate and finding the poverty trap. A worker earning $12,000 receives a means-tested benefit of $5,000, withdrawn at 60 cents for every extra dollar earned. Income tax and social contributions take 32% of additional earnings. Calculate the effective marginal deduction rate on an extra $1,000 of earnings, and compare it with a top earner facing a 45% marginal income tax rate.
Chains of reasoning
The steps are in the wrong order. Write the letters in the order that makes a linked chain.
Why inequality can reduce long-run growth
- A Labour productivity growth is consequently lower than it could be, and long-run aggregate supply grows more slowly.
- B Both demand and capacity are weaker, so the economy grows more slowly than a more equal one with the same resources.
- C A large share of national income accrues to households at the top of the distribution.
- D Those households have a lower marginal propensity to consume than poorer households, so a greater share of income is saved rather than spent.
- E Aggregate demand is therefore weaker than it would be with the same income more evenly distributed.
- F Meanwhile poor households cannot afford education or healthcare, and cannot borrow against future earnings because they have no collateral.
- G Talented individuals from poor backgrounds do not develop their productive potential, so human capital formation is below what the population is capable of.
Diagrams
Draw a Lorenz curve diagram with cumulative percentage of population on the horizontal axis and cumulative percentage of income on the vertical axis. Draw the 45 degree line of perfect equality and a Lorenz curve below it. Shade the area used in the numerator of the Gini coefficient, then draw a second Lorenz curve showing the distribution after progressive taxes and transfers.
Extended answer
Plan your answer: list the points you would make in each paragraph.
Assess whether government policies to reduce income inequality necessarily reduce economic efficiency. (13 marks)
Answers
Absolute poverty: A situation in which a person's income is insufficient to afford the basic necessities of life, such as food, clean water, shelter, clothing and healthcare.
B. Doubling every income lifts households above a fixed subsistence threshold, so absolute poverty falls. But every income doubles including the median, so the proportion of households below any given fraction of the median is exactly as before. Relative poverty depends on the shape of the distribution, not its level.
B. Training raises earning capacity so that recipients can command higher wages, which addresses the cause. The other three raise the incomes of poor households, which relieves hardship but leaves the underlying position unchanged if the support is withdrawn. Both kinds of policy are needed, and saying so is the evaluative point.
B. A lower Gini means a distribution closer to equality. Comparing the pre-tax and post-tax figures isolates the redistributive effect of the system. It says nothing about the level of average income, about absolute poverty, or about wealth, which is measured separately and is always more unequal.
Step 1. Calculate the average rate for the lowest earner. Average tax rate = (tax paid / income) x 100 = (2,000 / 20,000) x 100 = 10%.
Step 2. Calculate it for the middle earner. (20,000 / 80,000) x 100 = 25%.
Step 3. Calculate it for the highest earner. (44,000 / 200,000) x 100 = 22%.
Step 4. Classify each section of the range. From $20,000 to $80,000 the average rate rises from 10% to 25%, so the system is progressive over that range. From $80,000 to $200,000 it falls from 25% to 22%, so it is regressive over that range.
Step 5. Interpret the pattern. The system redistributes from middle earners towards the poor but not from the very rich. That pattern typically arises where high earners receive income as capital gains or dividends taxed at lower rates than wages, or where reliefs and allowances are available only to those with substantial assets. A headline top rate of tax therefore tells you very little about how progressive a system actually is.
Always calculate the proportion, never compare the amounts. The highest earner pays much the largest sum in absolute terms and the smallest but one as a share of income, and it is the share that determines whether a tax is progressive.
Step 1. Calculate the benefit withdrawn on the extra earnings. 60% of $1,000 = $600 of benefit is lost.
Step 2. Calculate tax and contributions on the extra earnings. 32% of $1,000 = $320.
Step 3. Find the net gain and the effective marginal deduction rate. Total deduction = $600 + $320 = $920. The worker keeps $80 of the extra $1,000. Effective marginal deduction rate = (920 / 1,000) x 100 = 92%.
Step 4. Compare with the top earner. The top earner keeps $550 of an extra $1,000 and faces a 45% marginal rate. The low earner faces 92%, more than twice as high. The incentive to earn an extra pound is far weaker for the poor worker than for the rich one.
Step 5. State the policy conclusion. This is the poverty trap, and it arises from the interaction of the tax and benefit systems rather than from either alone. It is why debates about work incentives that focus solely on top rates of tax are looking in the wrong place, and why reforms such as tapering benefits more gently, or replacing means-tested benefits with universal ones, are proposed despite costing more.
This calculation reframes the incentive argument. The efficiency cost of redistribution falls most heavily on low earners through benefit withdrawal, not on high earners through income tax, and pointing that out is a strong evaluative move in any question about the equity and efficiency trade-off.
C, D, E, F, G, A, B
- A large share of national income accrues to households at the top of the distribution.
- Those households have a lower marginal propensity to consume than poorer households, so a greater share of income is saved rather than spent.
- Aggregate demand is therefore weaker than it would be with the same income more evenly distributed.
- Meanwhile poor households cannot afford education or healthcare, and cannot borrow against future earnings because they have no collateral.
- Talented individuals from poor backgrounds do not develop their productive potential, so human capital formation is below what the population is capable of.
- Labour productivity growth is consequently lower than it could be, and long-run aggregate supply grows more slowly.
- Both demand and capacity are weaker, so the economy grows more slowly than a more equal one with the same resources.
This chain is the counterweight to the standard efficiency argument for tolerating inequality, and it inverts the usual trade-off. Note the honest qualification: it is stronger where credit markets are underdeveloped and education is not publicly provided, which is why the effect is more pronounced in developing economies.
The post-redistribution curve lies closer to the line of equality, and the reduction in the shaded area is what redistribution achieves. This diagram is the standard way to show the effect of a policy on inequality, and it is far more convincing than asserting that a policy 'reduces the gap between rich and poor'.
Define and frame: Define income inequality, and define efficiency in both senses, allocative and productive, rather than leaving it vague. Distinguish equity from equality early. Identify 'necessarily' as the claim under test, and state that the answer depends on which instrument is used, how it is designed and over what time horizon.
Analysis: the case that it does: Run the incentive mechanisms properly. High marginal tax rates reduce the net return to work, investment and enterprise, so labour supply and risk-taking may fall. Benefit withdrawal creates the poverty trap, and the effective marginal rate calculation shows this bites hardest on the low paid. Add administrative costs, avoidance, evasion and capital flight where taxes on mobile assets are raised. Note that resources devoted to redistribution have an opportunity cost.
Analysis: the case that it need not: Attack 'necessarily' directly. Redistribution through education and healthcare raises human capital and therefore productivity, so it increases efficiency rather than reducing it. Poor households face credit constraints, so transferring income to them can fund investment in skills that the market would not finance. The inequality-and-growth chain shows weaker demand and lost human capital in a highly unequal economy. And under monopsony a minimum wage raises pay and employment together, which is a redistribution that improves allocative efficiency.
Evaluation: Weigh the conditions. The instrument matters most: education spending and marginal tax rises have opposite efficiency effects. Design matters, since a gently tapered benefit avoids the poverty trap that a sharply withdrawn one creates. Empirical magnitude matters, as measured labour supply responses to tax changes are small for most workers. The starting point matters, since the efficiency cost of redistribution rises with the level of redistribution already undertaken. And time horizon matters, because incentive effects appear quickly while human capital gains appear over a generation.
Judgement: Reject 'necessarily' and specify. Redistribution reduces efficiency where it relies on high marginal rates and sharply withdrawn means-tested benefits, and where existing redistribution is already extensive. It raises efficiency where it funds education, health and credit access for households that could not otherwise afford them, particularly where inequality is high and capital markets are weak. The defensible conclusion is that the trade-off is real but is a function of policy design rather than an inescapable law, which reframes the question from how much to redistribute to how.