Income Distribution and Welfare

Updated: Apr 11

Key Terms:

Income: Money one earns by working or by capitalising on the work of others.

Wealth: A great amount of valuable assets or material possessions.

Income Distribution: Covers how a country’s total GDP is distributed amongst its population.

Wealth Distribution: This is a comparison of the wealth of various members or groups in a society.

Lorenz Curve: A graph that shows the proportion of overall income or wealth of the bottom percentage of people, often used to represent economic inequality.

Gini coefficient: A measure of the inequality of a statistical distribution, ranging from 0 (total equality) to 1 (maximal inequality), used in various disciplines but especially in economics to compare incomes or wealth.

Absolute Poverty: The situation of a household's income is insufficient to purchase even the minimum need of goods and services needed for survival.

Relative Poverty: Low income relative to others in a country.

Headcount Ratio (HCR): Is a population proportion that exists, or lives, below the poverty threshold.

International Poverty Line: Is the minimum level of income deemed adequate in a particular country.

 

Distinction Between Wealth and Income Inequality:

Wealth is defined as a collection of assets such as a home, stocks, land, automobiles, and money. The unequal distribution of these assets is referred to as wealth inequality.


Income is money that is received on a consistent basis. It could be from work, welfare payments, interest, or dividends, for example. Income disparity exists when income is unevenly distributed across a country.


A key distinction to keep in mind is that income is a flow of active earnings, whilst wealth is accumulated stock, however, one must keep in mind that even wealth can generate a flow of income: e.g., rent, dividends, and interest.


The Distribution of Wealth and Income:

In a country income is distributed among its population however, this income is not distributed evenly resulting in some inequality in the income distribution. Similar can be said about wealth distribution, as a matter-of-fact wealth is even more unevenly distributed than income. Income and wealth distribution also depends on countries. Certain countries have a more even distribution in comparison to other countries.


Multiple factors contribute to this uneven distribution, ranging from microeconomics factors such as differences in productivity which may lead to differences in income. Whilst for wealth inheritances play a significant role in the uneven distribution with wealth stores staying in the family and getting passed down.


Due to these reasons, there will always be inequality in society, as some people will have greater control over resources than others.


Measuring Inequality in Society:

The fact that GDP (or GNI) per capita is an average measure of living standards means that it does not offer information about how income is allocated among groups in society.

Inequality exists in all civilizations and will continue to do so in the future. The degree of inequality, on the other hand, differs from country to country. It is vital to be able to characterise and measure inequality before studying the causes of inequality and the strategies that might be employed to change how income and wealth are distributed within society. This is necessary in order to compare comparable living conditions in different countries or time periods.


One way to display data on this topic is to rank households according to their earnings, then determine the percentage of total household income that goes to the poorest 10%, 20%, and so on.


Deciles are used to describe groups that are divided into tenths in this way. The first decile is made up of the lowest 10% of the population, the second decile is made up of the next 10%, and so on. Similarly, the first quintile is made up of the poorest 20% of the population. The first quartile is made up of the poorest 25% of the population. This is helpful in determining the pattern of income distribution since it quantifies the difference in income between low- and high-income families.


To calculate a ratio, you should divide the top quintile (or whichever you wish) by the first quintile.


 

Measurements of Income Inequality:

The Lorenz curve is a graph that shows the proportion of overall income or wealth of the bottom percentage of people, often used to represent economic inequality. Max O. Lorenz created it in 1905 to show inequality in wealth distribution. The perfect equality line depicts the income distribution when the richest x percent of the population owns x percent of the total income, showing an ideally perfectly equal society.


The Lorenz curve depicts the actual income and wealth distribution. The one depicted in the diagram has a high level of inequality. The richest 20% of the population own a bigger percentage of the total income than the poorest 20%.


To construct a Lorenz, curve the values in the income distribution table need to be converted into cumulative percentages. (E.g., the lowest quintile for Denmark receives 9.1% of total household income, now to work out the poorest 40% you need to add the first quintile with the second one i.e., 9.1% + 13.7%= 22.8% and so on,) These cumulative percentages can then be plotted on the Lorenz curve.


The Gini coefficient is derived from the Lorenz curve and provides a numerical value for inequality. It is calculated by the areas:


A number of 0 denotes perfect equality, implying that everyone earns and owns the same amount of money. A score of 1 indicates perfect inequality, meaning that all of the country's wealth is concentrated in the hands of a single person or household.

 

Absolute and Relative Poverty

Poverty and inequality are two separate terms. In a society where there are rich and poor the level of ‘poor’ differs from poor to poorest and this must be kept in mind when measuring inequality hence we need to understand and regard these people as being ‘in poverty’.


An approach taken to calculate poverty is through a basket of goods and services that are required as vital, and the minimum required to live on. Households that have an income falling under the required price of purchasing this ‘basket’ are regarded as being in absolute poverty.


A simple way to measure poverty rate in a country is to estimate the percentage of population living under the poverty, known as the headcount ration. To allow comparison between countries poverty levels the World Bank introduced an international poverty line, which is $1.90 per person per day (PPP). The line has to be re-set every couple of years in order to keep up with the changing prices.


However, for more developed countries like the UK and Demark the absolute poverty line does not help much as very few people actually fall below it. This results in the use of a different type of poverty know as relative poverty. Relative poverty is defined as having low income relative to others in a country.


In the European Union relative poverty is measured by regular surveys conducted on households living below a certain threshold such as the UK’s £12,567 (set in 2015 as the threshold for poverty).


The Difference Between Equality and Equity Regarding the Distribution of Income and Wealth:

Equality refers to the allocation of wealth and income in society in such a way that everyone has the same amount of money. Fairness, or what is deemed an appropriate distribution of income and wealth in society, is referred to as equity. This could be a personal preference.

 

Causes of Income and Wealth Inequality Within Countries:

Income and wealth inequality can be found globally and is caused by a variety of factors such as:

  • The Uneven Distribution of Wealth

  • Wage Inequality

  • Employment (Labour Market)

  • Demographic

  • Government Policies/Intervention/Taxation & Benefits

  • Inequality Between Countries

The Uneven Distribution of Wealth:

Wealth is unevenly distributed within countries, with some families and individuals having greater control/influence over assets and material possessions that are then passed down via inheritance over time. Wealth then accumulates further causing greater inequality with the rich getting richer. Furthermore, wealth is a result of generations of passing down assets hence does not arise or relate to the current state of the economy (for example a diamond ring is still a diamond ring regardless of if there is a recession taking place).


Whilst wealth and income are not exactly the same thing, wealth can create an active flow of earnings through payments such as dividends and interest which, in turn, can lead to income inequality. In the UK over the last years, there has been a significant trend with house prices going up but the number of first-time home buyers going down.



In less developed countries wealth is even more unevenly distributed, with land being a key factor as well as weak financial markets.


Wage Inequality

Difference in wages also leads to income inequality, however, a key factor that needs to be considered is the inequality in wages between various demographics. This can particularly be seen between people with degrees and those without, people with university degrees tend to earn significantly more than those without.


Additionally, there has been an increase in popularity and the amount of part-time, temporary, and zero-hour contracts in comparison to the classical full-time. These greatly reduce individuals earning potential and their financial stability as they can be laid off relatively easily.


Another point worth considering is that on average males earn more than women, this is a clear example of wage inequality. Whilst in the UK and in more developed countries this is illegal it is still an issue (however slowly closing) resulting in income inequality.


Workers may also be discriminated against due to age, disabilities, gender, and race despite laws and legislation against it.


Employment (Labour Markets)

Employment and labour market conditions are also factors that cause income inequality, this can commonly be seen with demand and supply conditions within the labour markets (a recent example of this, is with HGV drivers in the UK). Furthermore, differences in economic rent and transfer earnings between different occupations also give rise to inequality in income.


Additionally, economic situations may impact the labour market, which in turn may lead to lower-paid jobs and lower social welfare as can be seen during a recession or times of high inflation. Labour mobility may also be an issue in some countries, where high-paying jobs are centred around main cities leaving those in the rural side of the country in lower-paying jobs. Labour forces may not be able to be flexible and move to the cities causing inequality.


Demographic

A country's demographic may also lead to income inequalities. Due to advancing technology and healthcare people now live longer, leading to an increase in the percentage of elderly within a country. Some countries also face lower fertility rates which puts significant pressure on the provision of pensions, social welfare, and healthcare provision which in a healthy economy is funded by those in active labour.


Government Policies/ Intervention/ Taxation & Benefits

Income inequalities can also occur due to government policies/interventions such as the minimum wage legislation, which was intended to reduce wage inequalities and protect the poor. Even though they are index-linked to inflation, state pensions and welfare payments tend to rise less than wages. This means that individuals on benefits have a smaller real rise in income than those working. This exacerbates inequality. Tax in the UK may also lead to income disparity with the top income bracket tax being reduced from 83% to 40% in 1988 and staying there as well as the reduction in the basic income tax rate from 33% to 22%.


Furthermore, sometimes assistance benefits get reduced. Although this may inspire some people to look for work, many people may be unable to work, lowering their income even further. Some taxes in the United Kingdom are regressive, which means that individuals with lower earnings suffer a greater weight of the tax. This may exacerbate inequality.


Inequality Between Countries

Some countries are more economically developed than others which leads to inequality, furthermore, some inequality has risen from the exclusion and marginalisation of certain social groups based on race, gender, sexual orientation, and impairments. Whilst some countries have been hampered by wars, droughts, famines, and earthquakes, leaving their citizens impoverished.


Differences in healthcare and standard of living are also visible, people born in different countries have different opportunities/chances depending on where they were born.

 

Consequences and Impacts of Economic Change and Development on Inequality and Poverty:

According to Kuznets' hypothesis, as civilization progresses from agriculture to industry, inequality within society grows, because industrial employees' earnings rise quicker than farmers. The Kuznets curve is depicted below:



Then, through government transfers and education, wealth is redistributed. He essentially maintained that disparity in underdeveloped countries is really a transitional phase and that as nations become more economically developed inequality decreases. In 2014, Thomas Piketty publicly debunked this idea by claiming that inequality is unavoidable in a capitalist free-market society. The percentage of as the rate of return on capital rises, the rich become richer due to better profits on their investments. Inequality rises as a result of investment.


The Hypothetical Benefits and Costs of More Equal and More Unequal Distributions:

  • Workers are motivated to gain new skills and work hard when there is inequality. In a capitalist system, a greater wage represents higher productivity, resulting in wage inequality.

  • Monopolies can exploit their customers by charging higher prices with lesser pay. This allows them to make even more money.

  • Because inheritance is passed down through generations, money is frequently concentrated in the hands of a small number of families Those that inherit a lot of money have more money. They are capable also have access to the best education and, as a result, the best jobs, which others do not have people with less means. As a result, there is a disparity in opportunity and income. Wealth can increase revenue for the wealthy, widening inequality.

  • Government intervention can result in income redistribution and wage equality. For example, inheritance taxes imply that wealthy families cannot keep their entire fortune. Furthermore, state education means that everyone has access to education, and monopoly corporations are regulated.

  • Inequality may discourage and demotivate lower-income people from participating in society. Inequitable distribution can result in negative externalities such as social unrest.

  • In a market economy, an individual's ability to consume goods and services is determined by their income and wealth, and an unequal distribution of income and wealth is likely to result in resource misallocation and hence market failure. Some customers may be unable to purchase goods and services at all.


Policy Objectives to Ensure a more Even Distribution

If the gap between the rich and poor becomes too big and there is excessive inequality this could pose a significant threat to the welfare of society and especially those from a lower socio-economics background that are more vulnerable. In the UK governments can affect the distribution of income through the taxation and transfer payments that can help the more vulnerable with an increase in income. However, one must keep in mind that taxing the poor too much in order to try diverting resources may result in demotivation of high earners as their incentives have been affected.


Furthermore, there may be a link between the degree of inequality and economic growth making this an issue at a macroeconomic level. This is important as it has a significant impact on less developed countries (LDCs) that may be trying to increase their economic growth and have to address concerns on poverty. Countries need to ensure that they don’t face a Catch-22 situation in which economic growth is impeded by existence of poverty however poverty cannot be tackled until economic growth has taken place, this leads to the government having to face difficult choices.


However, inequality is an issue in more advanced countries as well. As there can be inequality between various groups, or between regions such at the North and South in the UK. These issues need to try being addressed in-order to try reducing demotivation and social unrest among the population as well as increase social welfare and standard of living.

 

Sources/Further Reading:

Income – Wikipedia - https://en.wiktionary.org/wiki/income

Wealth – Wikipedia - https://en.wiktionary.org/wiki/wealth

Income Distribution – Wikipedia - https://en.wikipedia.org/wiki/Income_distribution

Wealth Distribution – Wikipedia - https://en.wikipedia.org/wiki/Distribution_of_wealth

Lorenz Curve – Wikipedia - https://en.wikipedia.org/wiki/Lorenz_curve

Lorenz, M. O. (1905). "Methods of measuring the concentration of wealth".

Gini Coefficient – Wikipedia - https://en.wikipedia.org/wiki/Gini_coefficient

Gini, Corrado (1936). "On the Measure of Concentration with Special Reference to Income and Statistics"

Absolute Poverty – Wikipedia - https://en.wikipedia.org/wiki/Extreme_poverty

Relative Poverty – Wikipedia - https://en.wikipedia.org/wiki/Poverty_threshold#Relative_poverty

Head Count Ration (HCR) – Wikipedia - https://en.wikipedia.org/wiki/Head_count_ratio

Kuznets Curve – Wikipedia - https://en.wikipedia.org/wiki/Kuznets_curve

The World Bank - https://databank.worldbank.org/source/world-development-indicators#

Poverty and Shared Prosperity 2018 – The World Bank - https://www.worldbank.org/en/publication/poverty-and-shared-prosperity-2018#:~:text=needs%20across%20countries.-,It%20introduces%20a%20multi%2Ddimensional%20poverty%20measure%20that%20is%20anchored,to%20education%20and%20basic%20infrastructure.

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