Chapter 17 The Distribution of Income McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 17Chapter 17

The Distribution of Income

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning ObjectivesLearning Objectives

• Summarize the basics of income distribution.• Identify some reasons why income inequality

and poverty have risen in recent years.• List and discuss the arguments for and against

government action to reduce inequality.• Explain how the tax system can be used to

redistribute income.• Give examples of labor market discrimination.

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Basics of Income DistributionBasics of Income Distribution

• Data on the nation’s income distribution is produced each year by the Census Bureau.

• Each year, the Census surveys households about how much money they received from various sources.

• There seems to be a growing gap between the people at the top of the income distribution and everyone else.

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QuintilesQuintiles

• Economists look at income distribution in terms of quintiles.

• A quintile represents 20% of households.

• Thus, the bottom quintile is the 20% of families with the lowest income.

• The table on the following slide shows the minimum income needed to get into each quintile.

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The Quintiles of Household The Quintiles of Household Income, 2009Income, 2009

$0Bottom quintile

$20,450Second quintile

$38,530Third quintile

$61,800Fourth quintile

$100,000Top quintile

$180,000Top 5%

Lower limitQuintiles

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Measures of InequalityMeasures of Inequality

• The income level that marks the dividing line between the bottom quintile and the second quintile is called the 20th percentile because 20% of households fall below that level.

• The income level that marks the dividing line between the top quintile and everyone else is called the 80th percentile because 80% of households have incomes below that level.

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Measures of InequalityMeasures of Inequality

• The 80/20 ratio (the 80th percentile divided by the 20th percentile) measures the spread between high-income and low-income households.

• In 2009, the 80th percentile was equal to $100,000.

• In 2009, the 20th percentile was equal to $20,450.

• Thus, the 80/20 ratio is $100,000/$20,450, which equals 4.89.

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Changing Income InequalityChanging Income Inequality

• Most economists believe that the distribution of income has widened over the past twenty-five years.

• But there is no consensus about whether the increase in inequality has been large or small.

• It depends on which data source you look at and which measure of inequality you use. – The 80/20 ratio shows a slow and gradual

rise.

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The Rising 80/20 RatioThe Rising 80/20 Ratio

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Changing Income InequalityChanging Income Inequality

• An alternative measure of income inequality is obtained by examining tax return data from the Internal Revenue Service.

• Look at the share of income going to the top 1% of taxpayers.– A growing share of income going to this

group suggests an increase in inequality.– The top 1% garnered 21% of total income

in 2008 compared to around 9% in 1975.

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Reasons for Rising InequalityReasons for Rising Inequality

• The increase in inequality is attributed to a number of factors.– First, rapid technological change tends to

favor highly educated workers.– Another factor is foreign trade.

• The labor-pool effect of globalization has caused wages for low-skilled workers to fall.

• At the same time, the market expansion impact of globalization has benefitted high-skilled workers.

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Reasons for Rising InequalityReasons for Rising Inequality

– Another cause of inequality is the shift to what is called the superstar economy.

• As the economy evolves from local to national and even global markets, companies are reaching out to the very best talent they can find. This means that the top people in any field do well.

– Finally, there has been a lack of government action.

• The minimum wage has not kept up with inflation.

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PovertyPoverty

• Another measure of the distribution of income is the poverty rate.

• The poverty rate measures the percent of people living in households with incomes below the poverty line. – In 2006 the poverty line for a family of

four was $19,971.

• One problem with the poverty rate is that it excludes in-kind transfers such as food stamps and Medicaid payments.

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The Poverty RateThe Poverty Rate

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Are Emerging Economies Are Emerging Economies Catching Up?Catching Up?

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The Debate over InequalityThe Debate over Inequality

• There is considerable debate among economists about the causes of inequality and the role of government intervention.

• There are two competing notions of fairness:– Some argue that an economy with wide

gaps between rich and poor is inherently unfair and immoral, so there is a need for government programs.

– Others argue that taking money from those who earned it is unfair and immoral.

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The Pros and Cons of The Pros and Cons of Government InterventionGovernment Intervention

The income distribution statistics overstate inequality because they do not include noncash benefits and fail to take economic mobility into account.

The income distribution statistics understate inequality because they undercount high-income households.

Data

A policy devoted to reducing inequality eventually leads to political control of the economy and rent-seeking behavior.

Big income differences cause political strife and eventually undermine support for a market economy.

Politics

Allowing big rewards to go to the most successful performers helps motivate creativity, innovation, and hard work.

More equal societies experience stronger growth.

Growth

Taking money away from individuals who have earned it is unfair and immoral.

A wide gap between rich and poor is unfair and immoral.

Fairness

Arguments against government intervention to reduce inequality

Arguments in favor of government intervention to reduce inequality

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Taxes and RedistributionTaxes and Redistribution

• The most common form of government intervention is through the use of the tax system.

• Redistribution transfers money from high-income to low-income households.

• Progressive taxes make the distribution of income more equal. – With a progressive tax, the after-tax

income distribution is more equal than the pre-tax income distribution.

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Taxes and RedistributionTaxes and Redistribution

• We call the share of income a household pays in taxes the effective tax rate.

• An income tax is progressive if high-income households pay a higher share of their income in taxes than low-income households– That is, high-income households have a

higher effective tax rate. – The higher effective tax rate tends to

narrow the income distribution.17-19

Taxes and RedistributionTaxes and Redistribution

• A tax is regressive if low-income households pay a bigger share of their income than high-income households.

• An example of a regressive tax is the sales tax.– Under the sales tax, only the portion of income

consumed is taxed, with savings not taxed.– Low-income households consume virtually their

entire income, so they pay a high percentage of their income in taxes.

– In contrast, high-income households save a high percentage of their income which is not taxed.

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Taxes and RedistributionTaxes and Redistribution

• It is difficult to determine whether the US tax system is progressive or regressive overall since individuals pay a number of different types of taxes.

• The federal tax system is only slightly more progressive than in 1981.– The effective tax rate on high income

individuals is essentially unchanged, but the effective tax rate for the poor has gone down.

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An Example of a Progressive An Example of a Progressive Income TaxIncome Tax

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How a Regressive Sales Tax How a Regressive Sales Tax WorksWorks

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Effective Federal Tax Rate for Effective Federal Tax Rate for the Top 1% of Taxpayersthe Top 1% of Taxpayers

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Earnings and DiscriminationEarnings and Discrimination

• Discrimination occurs when one person is paid less or treated worse on the job than an equally qualified person because of his or her race, gender, or some other characteristic. – The role of government is to enforce

antidiscrimination laws.– Despite the laws, some groups – notably

women, blacks, and Hispanics – consistently earn less, on average, than others.

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