15.5Government Policies to Reduce Income Inequality

making it more possible to learn about and coordinate economic interactions all around the world. In turn, the rising impact of foreign trade in the U.S. economy has opened up greater opportunities for high-skilled workers to sell their services around the world, and lower-skilled workers have to compete with a larger supply of similarly skilled workers around the globe. We can view the market for high-skilled labor as a race between forces of supply and demand. Additional education and on-the-job training will tend to increase the high-skilled labor supply and to hold down its relative wage. Conversely, new technology and other economic trends like globalization tend to increase the demand for high-skilled labor and push up its relative wage. We can view the greater inequality of wages as a sign that demand for skilled labor is increasing faster than supply. Alternatively, if the supply of lower skilled workers exceeds the demand, then average wages in the lower quintiles of the income distribution will decrease. The combination of forces in the high-skilled and low-skilled labor markets leads to increased income disparity.

15.5 Government Policies to Reduce Income Inequality

LEARNING OBJECTIVES By the end of this section, you will be able to:

• Explain the arguments for and against government intervention in a market economy
• Identify beneficial ways to reduce the economic inequality in a society
• Show the tradeoff between incentives and income equality

No society should expect or desire complete equality of income at a given point in time, for a number of reasons. First, most workers receive relatively low earnings in their first few jobs, higher earnings as they reach middle age, and then lower earnings after retirement. Thus, a society with people of varying ages will have a certain amount of income inequality. Second, people’s preferences and desires differ. Some are willing to work long hours to have income for large houses, fast cars and computers, luxury vacations, and the ability to support children and grandchildren. These factors all imply that a snapshot of inequality in a given year does not provide an accurate picture of how people’s incomes rise and fall over time. Even if we expect some degree of economic inequality at any point in time, how much inequality should there be? There is also the difference between income and wealth, as the following Clear It Up feature explains. CLEAR IT UP How do you measure wealth versus income inequality? Income is a flow of money received, often measured on a monthly or an annual basis. Wealth is the sum of the value of all assets, including money in bank accounts, financial investments, a pension fund, and the value of a home. In calculating wealth, one must subtract all debts, such as debt owed on a home mortgage and on credit cards. A retired person, for example, may have relatively little income in a given year, other than a pension or Social Security. However, if that person has saved and invested over time, the person’s accumulated wealth can be quite substantial. In the United States, the wealth distribution is more unequal than the income distribution, because differences in income can accumulate over time to make even larger differences in wealth. However, we can measure the degree of inequality in the wealth distribution with the same tools we use to measure the inequality in the income distribution, like quintile measurements. Once every three years the Federal Reserve Bank publishes the Survey of Consumer Finance which reports a collection of data on wealth. Even if they cannot answer the question of how much inequality is too much, economists can still play an important role in spelling out policy options and tradeoffs. If a society decides to reduce the level of economic inequality, it has three main sets of tools: redistribution from those with high incomes to those with low incomes; trying to assure that a ladder of opportunity is widely available; and a tax on inheritance.

Redistribution

Redistribution means taking income from those with higher incomes and providing income to those with lower incomes. Earlier in this chapter, we considered some of the key government policies that provide support for people experiencing poverty: the welfare program TANF, the earned income tax credit, SNAP, and Medicaid. If a reduction in inequality is desired, these programs could receive additional funding. The federal income tax, which is a progressive tax system designed in such a way that the rich pay a higher percent in income taxes than the poor, funds the programs. Data from household income tax returns in 2018 shows that the top 1% of households had an average income of $1,679,000 per year in pre-tax income and paid an average federal tax rate of 25.4%. The effective income tax, which is total taxes paid divided by total income (all sources of income such as wages, profits, interest, rental income, and government transfers such as veterans’ benefits), was much lower. The effective tax paid by that top 1% of householders paid was 20.4%, while the bottom two quintiles actually paid negative effective income taxes, because of provisions like the earned income tax credit. News stories occasionally report on a high-income person who has managed to pay very little in taxes, but while such individual cases exist, according to the Congressional Budget Office, the typical pattern is that people with higher incomes pay a higher average share of their income in federal income taxes. Of course, the fact that some degree of redistribution occurs now through the federal income tax and government antipoverty programs does not settle the questions of how much redistribution is appropriate, and whether more redistribution should occur.

The Ladder of Opportunity

Economic inequality is perhaps most troubling when it is not the result of effort or talent, but instead is determined by the circumstances under which a child grows up. One child attends a well-run grade school and high school and heads on to college, while parents help out by supporting education and other interests, paying for college, a first car, and a first house, and offering work connections that lead to internships and jobs. Another child attends a poorly run grade school, barely makes it through a low-quality high school, does not go to college, and lacks family and peer support. These two children may be similar in their underlying talents and in the effort they put forth, but their economic outcomes are likely to be quite different. Public policy can attempt to build a ladder of opportunities so that, even though all children will never come from identical families and attend identical schools, each child has a reasonable opportunity to attain an economic niche in society based on their interests, desires, talents, and efforts. Table 15.8 shows some of those initiatives. Children College Level Adults

• Improved day care
• Widespread loans and grants for those in financial need
• Opportunities for retraining and acquiring new skills
• Enrichment programs for preschoolers
• Public support for a range of institutions from two-year community colleges to large research universities
• Prohibiting discrimination in job markets and housing on the basis of race, gender, age, and disability
• Improved public schools

- - TABLE 15.8Public Policy Initiatives Children College Level Adults

• After school and community activities

- -

• Internships and apprenticeships

- - TABLE 15.8Public Policy Initiatives Some have called the United States a land of opportunity. Although the general idea of a ladder of opportunity for all citizens continues to exert a powerful attraction, specifics are often quite controversial. Society can experiment with a wide variety of proposals for building a ladder of opportunity, especially for those who otherwise seem likely to start their lives in a disadvantaged position. The government needs to carry out such policy experiments in a spirit of open-mindedness, because some will succeed while others will not show positive results or will cost too much to enact on a widespread basis.

Inheritance Taxes

There is always a debate about inheritance taxes. It goes like this: Why should people who have worked hard all their lives and saved up a substantial nest egg not be able to give their money and possessions to their children and grandchildren? In particular, it would seem un-American if children were unable to inherit a family business or a family home. Alternatively, many Americans are far more comfortable with inequality resulting from high-income people who earned their money by starting innovative new companies than they are with inequality resulting from high-income people who have inherited money from rich parents. The United States does have an estate tax—that is, a tax imposed on the value of an inheritance—which suggests a willingness to limit how much wealth one can pass on as an inheritance. However, in 2022 the estate tax applied only to those leaving inheritances of more than $12.06 million and thus applies to only a tiny percentage of those with high levels of wealth.

The Tradeoff between Incentives and Income Equality

Government policies to reduce poverty or to encourage economic equality, if carried to extremes, can injure incentives for economic output. The poverty trap, for example, defines a situation where guaranteeing a certain level of income can eliminate or reduce the incentive to work. An extremely high degree of redistribution, with very high taxes on the rich, would be likely to discourage work and entrepreneurship. Thus, it is common to draw the tradeoff between economic output and equality, as Figure 15.10 (a) shows. In this formulation, if society wishes a high level of economic output, like point A, it must also accept a high degree of inequality. Conversely, if society wants a high level of equality, like point B, it must accept a lower level of economic output because of reduced incentives for production. This view of the tradeoff between economic output and equality may be too pessimistic, and Figure 15.10 (b) presents an alternate vision. Here, the tradeoff between economic output and equality first slopes up, in the vicinity of choice C, suggesting that certain programs might increase both output and economic equality. For example, the policy of providing free public education has an element of redistribution, since the value of the public schooling received by children of low-income families is clearly higher than what low-income families pay in taxes. A well-educated population, however, is also an enormously powerful factor in providing the skilled workers of tomorrow and helping the economy to grow and expand. In this case, equality and economic growth may complement each other. Moreover, policies to diminish inequality and soften the hardship of poverty may sustain political support for a market economy. After all, if society does not make some effort toward reducing inequality and poverty, the alternative might be that people would rebel against market forces. Citizens might seek economic security by demanding that their legislators pass laws forbidding employers from ever laying off workers or reducing wages, or laws that would impose price floors and price ceilings and shut off international trade. From this viewpoint, policies to reduce inequality may help economic output by building social support for allowing markets to operate.

FIGURE 15.10The Tradeoff between Incentives and Economic Equality(a) Society faces a trade-off where any attempt to move toward greater equality, like moving from choice A to B, involves a reduction in economic output. (b) Situations can arise like point C, where it is possible both to increase equality and also to increase economic output, to a choice like D. It may also be possible to increase equality with little impact on economic output, like the movement from choice D to E. However, at some point, too aggressive a push for equality will tend to reduce economic output, as in the shift from E to F. The tradeoff in Figure 15.10 (b) then flattens out in the area between points D and E, which reflects the pattern that a number of countries that provide similar levels of income to their citizens—the United States, Canada, European Union nations, Japan, and Australia—have different levels of inequality. The pattern suggests that countries in this range could choose a greater or a lesser degree of inequality without much impact on economic output. Only if these countries push for a much higher level of equality, like at point F, will they experience the diminished incentives that lead to lower levels of economic output. In this view, while a danger always exists that an agenda to reduce poverty or inequality can be poorly designed or pushed too far, it is also possible to discover and design policies that improve equality and do not injure incentives for economic output by very much—or even improve such incentives. BRING IT HOME Occupy Wall Street The Occupy movement took on a life of its own over the last few months of 2011, bringing to light issues that many people faced on the lower end of the income distribution. The contents of this chapter indicate that there is a significant amount of income inequality in the United States. The question is: What should be done about it? The 2008-2009 Great Recession caused unemployment to rise and incomes to fall. Many people attribute the recession to mismanagement of the financial system by bankers and financial managers—those in the 1% of the income distribution—but those in lower quintiles bore the greater burden of the recession through unemployment. This seemed to present the picture of inequality in a different light: the group that seemed responsible for the recession was not the group that seemed to bear the burden of the decline in output. A burden shared can bring a society closer together. A burden pushed off onto others can polarize it. On one level, the problem with trying to reduce income inequality comes down to whether you still believe in the American Dream. If you believe that one day you will have your American Dream—a large income, large house, happy family, or whatever else you would like to have in life—then you do not necessarily want to prevent anyone else from living out their dream. You certainly would not want to run the risk that someone would want to take part of your dream away from you. Thus, there is some reluctance to engage in a redistributive policy to reduce inequality. However, when those for whom the likelihood of living the American Dream is very small are considered, there are sound arguments in favor of trying to create greater balance. As the text indicated, a little more income equality, gained through long-term programs like increased education and job training, can increase overall economic output. Then everyone is made better off, and the 1% will not seem like such a small group any more.

Key Terms

earned income tax credit (EITC) a method of assisting the working poor through the tax system effective income tax percentage of total taxes paid divided by total income estate tax a tax imposed on the value of an inheritance income a flow of money received, often measured on a monthly or an annual basis income inequality when one group receives a disproportionate share of total income or wealth than others Lorenz curve a graph that compares the cumulative income actually received to a perfectly equal distribution of income; it shows the share of population on the horizontal axis and the cumulative percentage of total income received on the vertical axis Medicaid a federal–state joint program enacted in 1965 that provides medical insurance for certain (not all) people with a low-income, including those near the poverty line as well as those below the poverty line, and focusing on low-income families with children, the low-income elderly, and people with disabilities poverty the situation of being below a certain level of income one needs for a basic standard of living poverty line the specific amount of income one requires for a basic standard of living poverty rate percentage of the population living below the poverty line poverty trap antipoverty programs set up so that government benefits decline substantially as people earn more income—as a result, working provides little financial gain progressive tax system a tax system in which the rich pay a higher percentage of their income in taxes, rather than a higher absolute amount quintile dividing a group into fifths, a method economists often use to look at distribution of income redistribution taking income from those with higher incomes and providing income to those with lower incomes safety net the group of government programs that provide assistance to people at or near the poverty line Supplemental Nutrition Assistance Program (SNAP) a federally funded program, started in 1964, in which each month poor people receive SNAP cards they can use to buy food wealth the sum of the value of all assets, including money in bank accounts, financial investments, a pension fund, and the value of a home

Key Concepts and Summary

15.1 Drawing the Poverty Line

Wages are influenced by Supply and demand in labor markets influence wages. This can lead to very low incomes for some people and very high incomes for others. Poverty and income inequality are not the same thing. Poverty applies to the condition of people who cannot afford the necessities of life. Income inequality refers to the disparity between those with higher and lower incomes. The poverty rate is what percentage of the population lives below the poverty line, which the amount of income that it takes to purchase the necessities of life determines. Choosing a poverty line will always be somewhat controversial.

15.2 The Poverty Trap

A poverty trap occurs when government-support payments decline as the recipients earn more income. As a result, the recipients do not end up with much more income when they work, because the loss of government support largely or completely offsets any income that one earns by working. Phasing out government benefits more slowly, as well as imposing requirements for work as a condition of receiving benefits and a time limit on benefits can reduce the harshness of the poverty trap.

15.3 The Safety Net

We call the group of government programs that address poverty the safety net. In the United States, prominent safety net programs include Temporary Assistance to Needy Families (TANF), the Supplemental Nutrition Assistance Program (SNAP), the earned income tax credit (EITC), Medicaid, and the Special Supplemental Food Program for Women, Infants, and Children (WIC).

Simpler explanation — Cambridge AS & A Level Economics

wealth Governments may use a range of policies to reduce inequality in the distribution of income and wealth. Most governments seek to reduce income inequality; there may also be policies to redistribute wealth. Many of the policies depend on funds generated from tax revenue for their implementation and regulation. The collection of taxes causes serious difficulties in most low-income countries and many middle-income countries, where the informal economy is huge with only a very small percentage of the population paying direct as opposed to indirect taxes. Corruption and tax evasion (where people deliberately do not pay tax) are also commonplace.

This hinders the ability of governments to successfully implement policies that redistribute income and wealth. KEY CONCEPT LINK Regulation, equality and equity: There are various ways in which governments can reduce inequality in the distribution of income; the problem is that choice is largely determined by the limited resources available. Minimum wage rates A minimum wage rate is a legal requirement of what employers must pay an employee per hour. It is a rate before tax and any social security deductions are made. It is now widely applied in many economies (see can be fined or face other forms of penalty.

in 2018 $, PPP) Introducing a minimum wage can reduce poverty in all economies. The problem for most low-income and lower middle-income countries is that the legislation might only apply to a minority of poorly paid workers. This is because the legislation would not have any impact in the large informal sectors that are prevalent in these economies. Also, a minimum wage rate has no relevance where workers are self-employed or run small businesses staffed by family members. In 2019, South Africa introduced a minimum wage rate of R20 per hour, reduced to R18 for farm workers and to R15 for domestic workers.