Income Inequality: Policies, Measurement, and Economic Impact

Understanding Income Inequality

Definition of Income Inequality

Income inequality refers to the phenomenon where households earn different shares of income within an economy.

Key Characteristics of Income Distribution

• Income is typically unequally distributed within economies.
• Inequality can provide incentives and rewards for productivity and innovation.

Measuring Income Inequality

The Lorenz Curve

The Lorenz curve illustrates the proportion of a nation’s income earned by a given percentage of the population. It typically lies below the line of complete equality because, for instance, the poorest 20% of the population will own less than 20% of the national income. The more curved the line, the greater the degree of inequality.

The Gini Coefficient

The Gini coefficient provides a numerical measure of the degree of inequality. A higher number indicates greater inequality, calculated as A/(A+B) where A and B refer to areas on the Lorenz curve diagram.

Policies to Mitigate Income Disparities

Governments often implement various policies to reduce income inequality, though these can sometimes lead to trade-offs with economic efficiency.

1. Progressive Tax Systems

A progressive tax system is characterized by tax rates that increase as income rises, meaning higher-income households pay a relatively larger share of their earnings in taxes. For example, Hong Kong's income tax ranges from 0% to 15%, while the U.S. system can go from 0% to 45%. This approach aims to increase the disposable income for lower-income households and redistribute wealth from the affluent to the less fortunate.

Potential Efficiency Concerns: Progressive taxation may reduce the incentive to work or invest for higher earners. In extreme cases, high-income individuals might consider leaving the country, potentially reducing the overall labor force and shifting the Production Possibility Curve (PPC) inward.

2. Transfer Payments

Transfer payments are grants provided by the government to individuals without the exchange of goods or services. An example is social assistance programs in Hong Kong. These payments directly increase the disposable income for lower-income households.

Potential Efficiency Concerns: Transfer payments can sometimes reduce the incentive to work, leading to a reliance on government support and a potential reduction in the labor force.

3. Provision of Socially Desirable Goods and Services

This policy involves the government providing essential goods and services, such as public education or healthcare. By offering these necessities at a reduced cost or for free, lower-income households pay less, leaving them with more income to consume other goods and services.

Potential Efficiency Concerns: Government spending on these provisions incurs an opportunity cost, as the money could have been allocated elsewhere. However, this policy also has the potential to enhance efficiency.

Balancing Equity and Economic Efficiency

While some policies designed to reduce inequality may pose efficiency trade-offs, others can actually enhance overall productivity and economic output.

• Investment in Human Capital: Investments in public education and healthcare, for instance, can significantly increase the productivity of the workforce, potentially shifting the Production Possibility Curve (PPC) outwards. In such cases, there is no conflict between equity and efficiency; rather, they are complementary.
• Degree of Progressivity: The extent to which a policy reduces efficiency often depends on its degree of progressivity. For example, Hong Kong's 0-15% income tax system may have a less significant impact on reducing work incentives compared to the U.S. system, which can reach 45%.
• Productivity Gains from Support: Transfer payments, when effectively managed, can facilitate spending and improve the living standards of lower-income households, which in turn can increase their productivity.
• Targeted Subsidies: Specific types of subsidies, such as transportation subsidies, can encourage workers to take jobs further from home, reducing concerns about commuting distance and potentially increasing labor force participation and efficiency. However, the positive impact of such policies is often effective only to a certain extent.