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IB DP Economics Study Notes

2.12.1 Income Inequality

Income inequality, a significant concern in modern economies, refers to the uneven distribution of income among different segments of the population. A higher level of income inequality can negatively affect societal cohesion and hinder economic growth.

An diagram illustrating income inequality

Image courtesy of wallstreetmojo

Causes of Income Inequality

A multitude of factors can contribute to rising income disparities:

1. Globalisation

  • Skill-based Demand: As countries integrate more into the global economy, there's a pronounced demand for skilled labour. This typically results in higher wages for those with the necessary skills.
  • Wage Compression: Conversely, those without these skills, particularly in manufacturing roles, may see stagnant or even decreasing wages due to increased competition from cheaper overseas labour.

2. Technological Advancements

  • Skilled vs. Unskilled Labour: Technological progress often disproportionately benefits skilled over unskilled workers. As automation and digital tools become more prevalent, routine jobs are at higher risk of being replaced.
  • Digital Economy: The rise of the digital economy can create "superstar" effects, where top players in industries (e.g., software developers, tech entrepreneurs) command enormous incomes.

3. Educational Disparities

  • Access and Quality: Not everyone has equal access to quality education. This inequality in educational opportunities translates to disparities in income in adulthood. To understand more about how demand for different levels of education affects incomes, see our page on Income Elasticity of Demand (YED).
  • Skills Gap: The modern economy often demands skills that outdated educational systems don't provide, leading to a skills gap and further income disparities.

4. Labour Market Policies

  • Union Power: A decline in union power in many countries has resulted in less bargaining power for workers, leading to suppressed wages. Effective labour market reforms could help address this issue.
  • Contractual Work: The rise of temporary and contract work, often with less job security and benefits, can also contribute to income inequality.

5. Tax Policies

  • Regressive Taxes: When wealthier individuals pay a smaller proportion of their incomes as tax compared to the less affluent, it exacerbates net income inequality. Learn more about how different taxation policies can influence income inequality.
  • Capital Gains: In some jurisdictions, income from capital gains is taxed less than income from work, benefiting the wealthy who are more likely to have significant investments.

6. Rent-seeking

  • Lobbying: Wealthy individuals and corporations might use their resources to lobby for policies that further their interests, often at the public's expense.
  • Monopolies: Firms with monopolistic power can charge higher prices, leading to higher profits and further income disparities.

7. Cultural and Social Norms

  • Discrimination: Discrimination based on gender, race, or ethnicity can restrict opportunities and thus potential incomes for certain groups.
  • Networking: Often, higher-paying jobs are secured through networks which might be more accessible to certain societal groups.

Measurements of Income Inequality

Quantifying income inequality is crucial for effective policy-making. For a deeper understanding of how income inequality is measured, visit our page on measures of inequality.

1. Gini Coefficient

  • Represents the distribution of income or consumption expenditure. A value of 0 indicates perfect equality, and 1 signifies maximum inequality.
Graphs illustrating different values of gini coefficient

Image courtesy of imf

2. Percentile Measures

  • Contrasting income percentiles, such as the income of the top 10% to the bottom 10%, offers a clear picture of disparity.

3. Palma Ratio

  • This ratio compares the richest 10% of the population's share of gross national income to the poorest 40%'s share.
An image illustrating the palma ratio

Image courtesy of earthbound

4. Atkinson Index

  • Offers more flexibility than the Gini coefficient. It allows policymakers to weigh income levels differently and is particularly useful when comparing inequality across different societal groups.

Solutions to Income Inequality

Combating income inequality often necessitates a blend of social, economic, and political strategies:

1. Progressive Taxation

  • Taxing higher incomes at steeper rates can reduce post-tax income inequality. Additionally, closing tax loopholes and ensuring that the wealthy cannot avoid their tax obligations can also help.

2. Education

  • Quality Education: Governments can invest in quality education for all, ensuring that everyone has the skills needed for modern jobs.
  • Vocational Training: Not everyone needs a university degree. Vocational and technical training can provide skills for well-paying jobs.

3. Labour Market Reforms

  • Reinvigorating trade unions and ensuring workers have the right to collective bargaining can help in raising wages.

4. Redistribution Policies

  • Governments can use tools like social security, pensions, and unemployment benefits to redistribute wealth and reduce income inequality.

5. Minimum Wage Policies

  • A robust minimum wage ensures that workers earn a living wage, reducing poverty and income inequality.

6. Corporate Governance Reforms

  • Regulations can ensure companies consider workers' wages when deciding executive pay, helping reduce disparities within organisations.

7. Social Cohesion Policies

  • Initiatives to reduce gender and racial discrimination, both in society at large and the workplace specifically, can help reduce income disparities based on these factors.

8. Inclusive Growth Strategies

  • Policymakers can focus on sectors that employ a significant portion of the lower and middle classes, ensuring these sectors benefit from economic growth policies.

To explore how externalities influence economic decisions and policies that can impact income inequality, further information is available.

Efforts to mitigate income inequality should be balanced to ensure they don't unintentionally hamper economic growth or stifle individual enterprise and motivation.

FAQ

Trade unions are instrumental in bargaining for better wages and working conditions for their members. By doing so, they can counteract tendencies for wages to stagnate or decline, especially for lower and middle-income workers. In economies where trade unions are strong and have substantial representation, wage disparities tend to be lower. This is because unions work to reduce the wage gap between skilled and unskilled workers, and between executives and average employees. However, in places where union membership is on the decline or their influence is waning, the protective barrier against widening wage disparities may be compromised, potentially exacerbating income inequality.

The division of income between capital (returns on investments, property) and labour (wages) has significant implications for income inequality. Historically, labour's share of income has been relatively stable. However, recent trends indicate a declining share for labour in many countries. As capital becomes a larger contributor to income, and given that capital ownership is typically concentrated among the wealthier segments of the population, this shift can heighten inequality. Essentially, the rich, who receive more income from capital, get richer, while wage earners see a smaller proportion of the economic pie, widening income disparities.

Globalisation is a double-edged sword in the context of income inequality. On the positive side, it can open up markets, leading to job creation, especially in export-oriented sectors in developing countries, potentially lifting many out of poverty. Furthermore, the diffusion of technology and knowledge can improve productivity and wages in less developed regions. However, globalisation can also intensify competition, especially in low-skilled sectors, leading to job losses or wage suppression in certain industries. Additionally, it can lead to a 'race to the bottom' in labour standards if countries compromise on worker rights to attract investment. In essence, while globalisation has the potential to equalise incomes across countries, within countries, it can sometimes magnify disparities.

Education plays a cardinal role in shaping income distribution. It is an equalising force when accessible to all, as it improves the human capital of the workforce, enhancing productivity and potential income. However, when quality education is disproportionately available to the affluent, it perpetuates income disparities. Those with better education tend to command higher wages, leading to wage premiums associated with higher educational attainment. Moreover, in a technologically advancing world, the demand for skilled labour increases, exacerbating wage differentials. If education is not democratised, it can inadvertently widen the chasm between the haves and have-nots.

Income inequality can influence economic growth in several nuanced ways. On one hand, if the rich reinvest their wealth effectively, it can stimulate growth. However, excessive inequality can lead to a myriad of negative outcomes. It might curtail the potential of individuals from lower socio-economic backgrounds, thereby underutilising human capital. Moreover, high inequality can lead to lower consumer demand, as a larger proportion of the population may not have sufficient purchasing power. Furthermore, pronounced disparities can breed social unrest and instability, detracting from a conducive environment for investment and growth. Essentially, while some level of inequality might be growth-enhancing, beyond a threshold, it can stifle long-term economic prosperity.

Practice Questions

Discuss the impact of globalisation and technological advancements on income inequality.

Globalisation and technological advancements have both played pivotal roles in exacerbating income inequality. Globalisation, by intensifying international trade and integration, has led to increased demand for skilled labour, thereby elevating their wages. In contrast, those in lower-skilled roles have seen wage stagnation due to competition from cheaper overseas labour. Simultaneously, technological advancements, particularly automation, have benefited skilled workers, often at the expense of routine, low-skilled jobs. The rise of the digital economy can also create 'superstar' effects, where top industry players command vast incomes, widening the income gap. Collectively, these forces have reshaped income distribution in many economies.

Evaluate the effectiveness of progressive taxation as a solution to reduce income inequality.

Progressive taxation, where higher income brackets are taxed at increasing rates, serves as a powerful tool in mitigating post-tax income inequality. By placing a higher tax burden on the wealthy, it narrows the income gap and can generate revenue for public welfare programmes. This revenue can be redirected to services like education and health, which further help in reducing pre-tax income disparities. However, its effectiveness hinges on robust implementation. If the wealthy exploit tax loopholes or there's significant tax evasion, the desired equalising effect can be diluted. Thus, while progressive taxation has potential, its efficacy largely depends on stringent enforcement and complementary fiscal policies.

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