ECON 405 Notes

TOPIC 5: INCOME DISTRIBUTION AND CHOICE OF PUBLIC POLICY

Introduction and Meaning of Income Inequality

Income inequality is an extreme disparity of income distributions with a high concentration of

income usually in the hands of small percentage of the population.

When income inequality occurs, there is a large gap between the wealth of one population
segment compared to another.

Evidence Measurement

Economists use various metrics to measure the extent of income inequality. The most commonly
used measures are:

 Lorenz Curve
 Gini Coefficient
 Decile Ratio
 Palma Ratio
 Thail Index

Lorenz Curve

The Lorenz curve is a common graphical method of representing the degree of income inequality
in a country. The Lorenz curve is a way of showing the distribution of income (or wealth) within
an economy. The Lorenz curve was developed by an American economist, Max O. Lorenz, in
1905 as a graphical representation of income inequality and is an important concept in
Economics because it is one of the simplest ways to illustrate the level of economic inequality in
society. The Lorenz curve shows the cumulative share of income from different sections of the
population.

The Lorenz curve provides a method of displaying the distribution of income or wealth within an
economy. One of the macroeconomic objectives of the government is ‘equal distribution of
income and wealth’. In order to use any policy to achieve this objective, the government must
first measure the level of inequality in income or wealth distribution. The Lorenz curve is used to
measure the inequality of income or wealth distribution in a country.
It is a graph on which the cumulative percentage of total national income (or some other
variable) is plotted against a cumulative percentage of a corresponding population (ranked in
increasing size of share). The extent to which the curve sags below the straight diagonal line
indicates the degree of income inequality.

The closer the Lorenz Curve is to the line of equality, the lesser the inequality in the
economy/society and the further away the Lorenz Curve is from the line of equality, the more
serious/adverse the inequality is in the economy/society.

The Graph of the Lorenz Curve

The Lorenz curve displays the cumulative share of income from various sections of the
population. The Lorenz curves graph the percentiles of the population against cumulative income
or wealth of people at or below that percentile. The following table for constructing the Lorenz
curve.

Data table for the Lorenz curve.

In the above table, the poorest 20% of households only have 5% of the total income of the
nation. Meanwhile, the poorest 80% hold 50% of the total income, leaving the richest 10% with
50% of the total income.

In order to plot the graph of the Lorenz curve, we take the cumulative % of households on the X-
axis (the horizontal axis) and the cumulative % of income on the Y-axis (the vertical axis). The
45-degree line (the line of equality or the line of perfect equality) is drawn as a straight diagonal
line to show the perfectly equal distribution of income. If perfect equality were to exist (if
everyone had the same salary), the poorest 20% of the population would then gain 20% of the
total income. Meanwhile, the poorest 60% of the population would receive 60% of the income.
The line of equality is used to compare with the Lorenz curve to find the extent of inequality in
the income distribution.

The graph above illustrates the Lorenz curve.

The shape of the Lorenz curve is convex. If the Lorenz curve is away from 45-degree line, it
shows higher inequality in income distribution. Area ‘A’ shows income inequality. The greater
the area ‘A’, the greater the inequality in the distribution of income in a country. The smaller the
area ‘B’, the greater the inequality in the distribution of income in a country.

Diagram of Lorenz curve

In the Lorenz curve above, the poorest 20% of households have 5% of the nation’s total income.

The poorest 90% of the population holds 55% of the total income.

That means the richest 10% of income earners gain 45% of total income.
Comparing the Income Distribution of a Country Over Time

The Lorenz curve can be used to compare income inequality within a country over the period of
time. Consider the following diagram, which shows two Lorenz curves.

The graph above illustrates income inequality in a country over time.

The initial Lorenz curve for country X is (LC)1 which is closer to 45-degree line and hence it
which shows lower inequality in the distribution of income in country X.

The final Lorenz curve (after the shift) for country X is (LC)2 which is away from 45-degree line
and hence it shows higher inequality in the distribution of income in country X.
Over the period of time (may be due to economic growth), LC is shifted away from 45-degree
line leading to higher income inequality in country X.

In the example above, an increase in inequality has taken place. The Lorenz curve has moved
and is now away from the line of equality. This shows an increase in the income inequality.

Comparing the Income Distribution between Countries

The Lorenz curve can be used to compare income inequality between countries. Consider the
following diagram.

The graph above illustrates the comparison of income inequality between countries. The Lorenz
curve for country X i.e. (LC)x is closer to 45-degree line which shows lower inequality in the
distribution of income in country X. The Lorenz curve for country Y i.e. (LC)y is away from 45-
degree line which shows higher inequality in the distribution of income in country Y.

Shift in the Lorenz Curve

In this example, there has been a reduction in inequality – the Lorenz curve has moved closer to
the line of equality.

The poorest 20% of the population now gain 9% of total income.

The richest 10% of the population used to gain 45% of total income but now only get 25% of
total income.
Limitations of Lorenz Curve

(a) If the higher income households are able to use their income more efficiently than the
lower income households, then the degree/extent of inequality would be understated
hence misleading.
(b) When comparing two Lorenz Curves, it is not possible to determine which distribution
has more inequality since the two curves are likely to intersect.
(c) An individual’s income varies over his/her lifetime and this variation is usually not
considered (taken into consideration) when analyzing the inequality i.e. Lorenz Curve
ignores the lifecycle effects.
(d) It is graphical representation and hence cannot be used to compare income distribution
between many countries.
(e) It cannot be used to compare income distribution over the period of many years.
(f) The magnitude of difference between inequality of distribution cannot be compared by
using the Lorenz curve.
(g) Government cannot have numeric target for re-distribution of income on the basis of the
Lorenz curve only.

The Lorenz Curve and Gini Coefficient

The Lorenz Curve can be used to calculate the Gini coefficient which is also another measure of
inequality. The Gini Coefficient is the ratio of the area between the line of perfect equality and
the observed Lorenz Curve to the area. Gini coefficient is a number which is used to measure
income inequality in a country and is also called Gini Ratio or Gini Index.

Gini Coefficient = (Area Between 45-degree line and LC) / (Area below 45-degree line)

Gini Coefficient = (Area A) / (Area A + Area B)

Values of Gini Coefficient can be from 0 to 1. 0 and 1 are ideal values and in real life, values of
the Gini Coefficient are between 0 and 1. If income distribution is equal, Area A will be zero and
Gini coefficient will have a value of 0. If all income is with one person, Area B will be zero and
Gini coefficient will be 1. Higher value of Gini Coefficient shows higher income inequality.
Area A becomes smaller the closer the Lorenz curve is to the line of equality. The Gini
Coefficient will be low in this situation. But if there’s a high degree of inequality, area A will
take up a larger percentage of the total area. When the Gini Coefficient rises, it shows a rise in
inequality. It shows that the Lorenz curve is further from the line of equality. A Gini coefficient
of 0.35 indicates a more equal distribution of income than a coefficient of 0.65.

The trend in Gini Coefficient is important as it indicates whether income distribution is

becoming more equal or unequal over time.

Government can set target in terms of Gini Coefficient (say 0.25).

 Area A
Gini Coefficient =
Area A + Area B

The closer the Lorenz curve is to the line of equality; the smaller area A is. And the Gini
coefficient will be low. If there is a high degree of inequality, then area A will be a bigger
percentage of the total area. A rise in the Gini coefficient shows a rise in inequality – it shows the
Lorenz curve is further away from the line of equality.

If the Gini Coefficient is equal to zero (G.C = 0), then there is a perfect equality in the economy.

If the Gini Coefficient is less than one or 100%, then there is less inequality in the economy.
If the Gini Coefficient is equal to one or 100%, then there is maximum inequality in the economy
i.e. only one person has all the income and all others have none.

Limitations of the Gini Coefficient

(a) Sample bias – the validity of the Gini Coefficient calculation can be dependent on the
sample size e.g. less developed countries or countries with less economic activities
frequently tend to show low Gini Coefficient while developed countries with many
economic activities tend to have a large (high) Gini Coefficient.
(b) Problem of data inaccuracy – the Gini Coefficient is prone to systematic and random data
errors thus inaccurate data can distort the validity of the Gini Coefficient.
(c) It does not reflect the structural changes in a population.
(d) Extensive data may be needed to calculated Gini Coefficient.
(e) Two countries with different income distributions may have the same Gini coefficient.

The Lorenz Curve and Wealth

The Lorenz curve shows the cumulative wealth of each wealth decile.

It shows that the lowest 38% of individuals have zero property wealth.

The top 10% own nearly 50% of property wealth.

With financial wealth, inequality is even greater with 60% of the population in debt and negative
wealth.

The top 10% have 80% of the nation’s financial wealth.

In the Lorenz Curve, you can see the cumulative wealth of each of the wealth deciles.

For example, it shows that the lowest 38% of people have zero property wealth.

The top 10%, however, own almost 50% of the property wealth.

When you look at financial wealth, the inequality is even greater. 60% of the population is in
debt and has negative wealth.

At the same time, the top 10% has 80% of the nation’s financial wealth.
Poverty, Income Inequality and Economic Growth

Economic growth means an increase in national income, but does economic growth actually help
to reduce relative poverty and income inequality – or can economic growth exacerbate existing
income inequalities?

There are two types of poverty:

Relative poverty: This is when income is a certain percentage less than the average income. For
example, in the UK, relative poverty is defined as income 50% less than average incomes.
Therefore, a rise in economic growth and average incomes will cause a change in what
constitutes relative poverty. In 1920, relative poverty may have been an income of less than £800
a year. In 2017, relative poverty may be income of less than £12,000 a year. Economic growth
may or may not reduce relative poverty; it depends on the income distribution of the growth.
Absolute Poverty: This is an income below a certain level necessary to maintain a minimum
standard of living. (e.g. enough money to buy the basic necessities of food, shelter and heat.
Therefore, economic growth should reduce absolute poverty, so long as the poorest can gain
some increase in living standards from the nation’s growth.

Does Economic Growth reduce Relative Poverty?

Economic growth will reduce income inequality if:

(1) Wages of the lowest paid rise faster than the average wage.
(2) Government benefits, such as; unemployment benefits, sickness benefits and pensions are
increased in line with average wages.
(3) Economic growth creates job opportunities which reduce the level of unemployment.
Unemployment and lack of employment are one of the biggest causes of relative poverty.
(4) Minimum wages are increased in line with average earnings.
(5) Progressive taxes redistribute income. Progressive taxes such as higher rates of income
tax will take a higher percentage of income from the rich; this can be used to fund social
spending, such as health care, education and welfare benefits which help to reduce
income inequality.

Why economic growth may not reduce income inequality

(1) Economic growth often creates the best opportunities for those who are highly skilled and
educated. For example, in recent years, UK have seen faster wage growth for highly paid
jobs than unskilled jobs.
(2) Modern economies are creating an increased number of part-time/flexible service sector
jobs. In these sectors, wages have been lagging behind average earnings.
(3) In many countries, government benefits have been indexed linked. This means increased
in line with inflation. This means that benefit incomes have fallen behind average
earnings.
(4) Interest-bearing wealth. The wealthy gain interest and dividends from their assets. This
rent, interest and dividends can be used to re-invest in increasing their wealth. For the
wealthy, it is a wealth creating cycle – which increases their share of income. The
 economist Thomas Piketty argued that without government intervention the rate of return
from wealth would lead to widening income and wealth inequality.

Economic growth will not necessarily solve unemployment. For example, growth cannot solve
structural and frictional unemployment; this is unemployment caused by lack of skills and
geographical immobilities.

Causes of Inequality

A range of global and domestic factors — which may reinforce each other — have been
proposed in the theory and empirical literature to account for the income inequality trends. The
key forces include the following:

(a) Participation rate in economic activities – Some individuals are willing to participate
more in economic activities than others hence leading to inequality in the society.
(b) Illegal activities such as corruption, money laundering, smuggling, theft, robbery etc. can
bring about inequality.
(c) Difference in natural abilities and talents – People do not have same talents. Some are
more gifted than others. For example, individuals endowed with better intelligence, good
physique, and greater capacity of hard work are likely to surpass others in the race of life.
(d) Institutional structures – There can be a situation whereby some institutions or employers
more than others hence inequality in terms of incomes earned by employees.
(e) Different education levels – Highly educated individuals are likely to be paid more
compared to individuals who are less educated thus leading to inequality.
(f) Global factors, such as technological progress, globalization, and commodity price
cycles, play an important role. For instance, technological advancement has contributed
to the skill premium, because individuals with higher education have a comparative
advantage in using new technologies (Card and DiNardo, 2002). In Western Europe and
the United States, technological progress has also translated into a hollowing out of
middle-class jobs, a phenomenon known as job polarization (Goos and Manning, 2007).
(g) Country-specific factors, such as those related to economic developments and economic
stability as well as to domestic policies — including financial integration, redistributive
fiscal policies, and liberalization and deregulation of labour and product markets — also
play an important role in explaining inequality trends within countries.
Consequences of Inequality

While some inequality is inevitable in a market-based economic system as a result of differences

in talent, effort, and luck, excessive inequality could erode social cohesion, lead to political
polarization, and ultimately lower economic growth (Berg and Ostry, 2011; Rodrik 1999).

But when is inequality excessive? There is no easy answer, but it will depend on several country-
specific factors, including the growth context in which inequality arises, along with societal
preferences.

The following are some of the consequences of inequality:

(a) Class Conflict

Inequality creates two classes in the society i.e. the haves and the have nots which are
ever in the war path and this has resulted in social tensions and instabilities.
(b) Political Domination
The rich dominate the political field and machinery and they use it to promote their own
self interests. This results in corruption and social injustice in the society.
(c) Emergence of Monopolies
Unequal incomes promote monopolies. These powerful monopoly firms gang up and
charge unfair prices and put barriers that prevent entry of new firms into the industry.
(d) Suppression of Talents
Due to inequality in the society, it might not be easy for the low-income earners to make
it in life however brilliant they may be.
(e) Exploitation
The high-income earners might exploit the low-income earners and the consequence of
this exploitation is political awakening, agitation and mass revolution. Thus, inequality is
a major cause of social and political instability.

Policies or Measures to Address Inequality in the Society

(a) Taxation
A progressive tax policy ought to be implemented. A progressive tax policy is a tax that
takes a larger percentage of income from high-income groups than from low-income
groups.
 (b) Education
Education is an equalizer in that it provides everyone with equal opportunities. The
government should, therefore, put in place measures to ensure equal access by all citizens
to education opportunities.
(c) Promoting Growth in Rural Areas
The residents of rural areas in many LDCs are generally low-income earners thus the
government should come up with policies that are aimed at promoting growth in rural
areas.
(d) Regulating Monopolies
The government should implement measures aimed at controlling excess power of
monopoly firms. This will help remove entry barriers in the industry such that new small
firms are able to enter the industry to get a market share too.
(e) Tapping and Promoting Talents
The government should come up with programs aimed at tapping and promoting talents
in the country e.g. Talanta Hela Progam run by the Ministry of Youth Affairs, Creative
Economy and Sports.
(f) Democracy
The government should promote democratic activities in the country since democracy
gives everyone an opportunity to be elected/lead thus a chance to change a bad regime.
(g) Price Controls
The government can introduce price controls to ensure that low-income earners are not
exploited.
(h) Universal Access to Health Care Services by All
The government should put in place measures aimed at ensuring universal access to
health care services by all citizens in the country. With good health, everyone has an
equal chance of engaging in economic activities hence be in a position to earn income.

Important Facts to note About Income Inequality

Global inequality has been declining fast since 1990s. During the nineteenth and most of the
twentieth centuries, global inequality increased dramatically, reflecting widening disparities
between countries’ per capita income as advanced economies took off sharply compared with the
rest of the world. The revival in global economic cooperation in the middle twentieth century
ushered in an era of growth and development. Subsequently, per capita GDP growth rates
accelerated in least developed countries (LDCs), particularly in Asia, resulting in convergence in
income levels across countries (Bourguignon, 2015). Millions of households were lifted out of
poverty. As a result, the global income inequality first stabilized and then started to rapidly
decline over the last three decades. However, it should be noted that not all regions of the world
experience income convergences with more developed countries. In Sub-Saharan Africa, for
instance, income growth on average was more modest than in Asia. Some gains in the reduction
of global inequality are likely to be reversed as a result of the COVID-19 crisis. It will likely
deteriorate global inequality because advanced economies, in general, have more resources to
deal with the fallout from the pandemic and the ensuing recovery effort.

Within-country inequality has risen in most countries. While the progress in the reduction of
global inequality over the last thirty years has been remarkable, within country inequalities have
increased, especially in advanced economies. Over the past three decades, more than half of the
countries and close to 90 percent of advanced economies have seen an increase in income
inequality, with some countries recording an increase in their Gini coefficients exceeding two
points. Some of key factors behind the increase in within-country income inequality noted in the
literature include technological progress, globalization, commodity price cycles, and domestic
economic policies such as redistributive fiscal policies, labor and product market policies.

Rising social spending has been used to combat inequality. Fiscal policy is a key policy
instrument available to governments to achieve their distributional objectives. In advanced
economies, taxes and transfers decrease income inequality by one-third, with most of this being
achieved via public social spending (such as pensions and family benefits) Paulus et al., 2009).
The extent of fiscal redistribution is even higher if the redistributive impact of in-kind spending
(such as education and health) is included (Paulus et al., 2009). Thus, it is important to ensure
that social spending is adequate, effective and sustainable. Progressive income taxes also play an
important redistributive function in some countries. The lower redistributive impact of fiscal
policy in developing economies is also a key factor behind their high levels of inequality.