Distribution of Income

Distribution of Income

• The fifth macroeconomical goals to ensure that income distribution is equitable. Equitable means fair, but fairness is an elusive concept and it means different things to different people.
• A more equitable distribution may help to accelerate growth and promote human and economic development in many ways:
• The propensity to consume of the poor is higher than that of the rich so redistribution will increase aggregate demand especially for basic goods and services.
• Social tensions are lower and thus governments can more easily undertake important economic reforms which require a high degree of consensus within the population. If people feel that they enjoy the fruits of economic growth then they will be willing to work harder and sacrifice more now in order for them or their children to enjoy more at a later date. They will be willing and able to save more, permitting higher rates of investment and thus growth. Fewer social tensions decrease uncertainty and risks for domestic and foreign investors.
• The very poor will be able to afford access to crucial resources such as education so the amount and quality of productive resources available to a country increases.
• Trust increases among the population so the cost of economic transactions decreases. More economic activity will take place thus accelerating growth.
• However, an excessively equal income distribution could lower economic efficiency. It could lower the incentives for hard work and for risk taking. Growth may be undermined.

Direct and indirect taxes

Direct taxes are taxes on incomes, on profits and on wealth. The burden of a direct tax cannot be shifted onto another entity.

Indirect taxes include taxes on goods and on expenditures. The burden of an indirect tax can be shifted onto a different entity.

Progressive, proportional and regressive taxation

The marginal tax rate is the percentage taken by the government on the last pound earned. It is the extra tax paid as a result of an extra pound earned.

The average tax rates it the ratio of the tax collected over income earned or more generally the ratio of the tax collected over the tax base.

A progressive tax system is one in which higher-income individuals pay proportionately more so the average tax rate rises as income rises. In a progressive income tax system the marginal tax rate is greater than the average tax rate.

A proportional tax system is one in which all the individuals pay the same proportion of their income independently of the level of their income. In a proportional tax system the average tax rate remains constant as income rises so the marginal tax rate is equal to the average tax rate. A flat-rate (proportional) income tax presents many advantages over the progressive tax systems that most countries have. Disincentives are lower, administrative costs are lower, it is simple and thus more transparent and it is potentially even fairer as loopholes do not exist which usually higher-income households take advantage of.

A regressive tax system is one in which poorer individuals pay a greater proportion of their income. In a regressive tax system the average tax rate decreases as income rises so the marginal tax rate is less than the average tax rate. Indirect taxes are proportional with respect to expenditure but regressive with respect to income. This is why indirect taxation on food and basic goods is lower or zero.

Short-run solutions

Usually governments resort to a mixture of progressive income taxes coupled with a system of transfer payments. Transfer payments include pensions, unemployment benefits, disability benefits, subsidies. By taxing higher income households more heavily than lower income households and spending more on transfer payments, national income may be redistributed in a n attempt to satisfy the equity goal.

Long-run solutions

In the long run the most effective route to a more equitable income distribution is by improving the quality and access to education and health services for the most deprived income groups. Job creation policies are also of utmost significance. Lastly, lower corruption and a fair judicial system are also important.

The Laffer Curve
The Laffer Curve is a theory built on the incentive effects of lower taxation which suggests that total tax revenue coming into the government may increase at a lower tax rate. As the tax rate further increases, the marginal revenue from lower taxes may tend to fall at an increasing rate up to optimal tax revenues, at tax rate X. After this point, any increase in the tax rate prompts people to work less, or to do more to avoid the tax, thereby reducing total revenue as the opportunity cost of paying the tax rises. Hypothetically at a 100 percent tax rate, nobody would have any incentive to work at all, since the Government collects everything people earn. Laffer’s ultimate prediction is if you cut taxes you can increase tax revenues and create a virtuous circle.