🏙️Public Economics Unit 5 – Income Distribution and Redistribution

Key Concepts and Definitions

• Income inequality refers to the uneven distribution of income among individuals or households within an economy
• Gini coefficient is a statistical measure of income inequality, ranging from 0 (perfect equality) to 1 (perfect inequality)
  • Calculated using the Lorenz curve, which plots the cumulative share of income against the cumulative share of the population
• Poverty is a state of lacking sufficient financial resources to meet basic needs, such as food, shelter, and healthcare
  • Poverty line is the minimum level of income deemed necessary to achieve an adequate standard of living
• Progressive taxation system imposes higher tax rates on higher income levels, while regressive taxation imposes higher rates on lower income levels
• Transfer payments are government-provided benefits (unemployment insurance, welfare) that redistribute income to those in need
• Human capital refers to the skills, knowledge, and experience possessed by an individual that contribute to their economic value
• Intergenerational mobility measures the extent to which an individual's economic status is determined by their parents' status

Measures of Income Inequality

• Gini coefficient is the most widely used measure of income inequality, providing a summary statistic of the income distribution
• Theil index is another measure of inequality that can be decomposed into within-group and between-group components
• Atkinson index incorporates a parameter that represents society's aversion to inequality, allowing for different value judgments
• Income quintiles or deciles divide the population into equal-sized groups based on income, enabling comparisons between groups
  • For example, the income share of the top 20% compared to the bottom 20%
• Palma ratio compares the income share of the top 10% to that of the bottom 40%, focusing on the tails of the distribution
• 90/10 ratio compares the income at the 90th percentile to the income at the 10th percentile, measuring the gap between the rich and poor
• Top income shares measure the concentration of income among the highest earners (top 1%, 0.1%, etc.)

Causes of Income Inequality

• Skill-biased technological change favors high-skilled workers, leading to higher wage premiums for education and experience
• Globalization and trade can lead to job displacement and downward pressure on wages for low-skilled workers in developed countries
• Decline of unions and collective bargaining power has reduced the ability of workers to negotiate for higher wages and benefits
• Changes in family structure, such as the rise of single-parent households, can contribute to household income inequality
  • Assortative mating, where high-earning individuals marry each other, can also amplify inequality
• Differences in human capital, such as education and health, can lead to disparities in productivity and earnings
• Institutional factors, such as minimum wage laws and tax policies, can affect the distribution of income
• Wealth inequality, which is typically higher than income inequality, can perpetuate income disparities through capital income and intergenerational transfers

Economic Impacts of Income Inequality

• High levels of inequality can reduce economic growth by limiting human capital investment and aggregate demand
  • Lower-income households have a higher marginal propensity to consume, so redistribution can boost overall spending
• Inequality can lead to social and political instability, as well as reduced trust and cohesion within society
• Unequal access to education and healthcare can perpetuate intergenerational poverty and limit social mobility
• Concentration of economic power among the wealthy can lead to rent-seeking behavior and the diversion of resources away from productive activities
• Inequality can affect the transmission of monetary policy, as wealthy households are less sensitive to changes in interest rates
• Excessive inequality can undermine the legitimacy of economic and political institutions, leading to populist backlash
• Some argue that inequality can incentivize innovation and entrepreneurship, but empirical evidence is mixed

Redistribution Policies and Mechanisms

• Progressive taxation, where higher income levels are subject to higher tax rates, is a key tool for redistribution
  • This includes income taxes, capital gains taxes, and wealth taxes
• Transfer payments, such as welfare benefits, unemployment insurance, and social security, provide direct support to low-income households
• In-kind benefits, such as public housing, food stamps, and subsidized healthcare, redistribute resources without direct cash transfers
• Public provision of goods and services, like education and infrastructure, can promote equality of opportunity
• Labor market policies, such as minimum wage laws and job training programs, can boost incomes for low-wage workers
• Land reform and property redistribution can address wealth inequality, particularly in developing countries
• Policies promoting financial inclusion and access to credit can help low-income households build assets and escape poverty

Taxation and Transfer Systems

• Design of tax systems involves trade-offs between efficiency, equity, and simplicity
  • Progressive tax systems can reduce inequality but may distort incentives and be complex to administer
• Optimal taxation theory seeks to balance redistributive goals with minimizing deadweight loss from taxation
  • Mirrlees model suggests that marginal tax rates should be higher for low and high incomes, and lower for middle incomes
• Negative income tax provides a guaranteed minimum income through the tax system, with benefits phasing out as income rises
• Earned income tax credit (EITC) supplements the earnings of low-income workers, encouraging labor force participation
• Value-added taxes (VATs) are often regressive, but can be combined with transfers to mitigate distributional impacts
• Means-tested transfers target benefits to those below a certain income threshold, while universal transfers provide benefits to all
• Social insurance programs, like unemployment insurance and disability insurance, provide protection against income shocks

Challenges in Implementing Redistribution

• Political economy considerations, such as the influence of special interest groups and voter preferences, can shape redistributive policies
  • Median voter theorem suggests that policies will cater to the preferences of the median voter
• Behavioral responses to redistribution, such as changes in labor supply or tax avoidance, can reduce the effectiveness of policies
• Informational constraints and administrative costs can limit the ability to target transfers effectively
  • Means-testing can create poverty traps, where individuals face high marginal tax rates when benefits are phased out
• Globalization and tax competition can limit the ability of countries to maintain progressive tax systems
  • Capital mobility and the rise of digital economies pose challenges for tax collection
• Intergenerational equity concerns arise when considering the long-term impacts of redistribution on future generations
• Public attitudes towards redistribution, including perceptions of fairness and deservingness, can influence policy design
• Trade-offs between equality and efficiency, as well as short-term and long-term goals, must be navigated in policy design

Case Studies and Real-World Examples

• The Nordic model, exemplified by countries like Sweden and Denmark, combines high levels of redistribution with strong economic performance
  • Key features include progressive taxation, generous social benefits, and active labor market policies
• The United States has experienced a significant rise in income inequality in recent decades, driven in part by skill-biased technological change and declining union power
  • Policies like the EITC and Affordable Care Act have aimed to address inequality, but political gridlock has limited further action
• Brazil's Bolsa Família program, a conditional cash transfer targeting low-income households, has been credited with reducing poverty and inequality
  • Transfers are conditioned on children's school attendance and health check-ups
• South Africa's post-apartheid redistribution efforts have included affirmative action policies, land reform, and social grants
  • However, high levels of inequality persist, driven by factors such as unemployment and spatial segregation
• The COVID-19 pandemic has highlighted the importance of redistributive policies, with many countries expanding social protection measures
  • Debates have emerged over the design and duration of these policies, as well as their long-term fiscal implications