3.4.

1 Measuring Inequality &

Poverty
Inequality & Poverty Terminology

• Equality describes situations where economic outcomes are similar for different
people or different social groups
o Income equality would mean everyone, irrespective of their job, is paid the
same
o Inequality in the distribution of income is one cause of absolute and relative
poverty

• Equity refers to the idea of fairness and is a normative concept

o Equity in the distribution of income means that there is fairness in the wage
differentials that exist in society e.g. those with higher qualifications or skills
are paid more than those with less
o The size of acceptable wage differentials is a matter of much debate

• Income and wealth inequality are two different concepts

o Income inequality refers to the unequal distribution (flow) of income to
households i.e rent, wages, interest and profit
o Wealth inequality refers to differences in the amount of assets that
households own

• Absolute poverty is a situation where individuals cannot afford to acquire the basic
necessities for a healthy and safe existence
o These necessities include shelter, water, nutrition, clothing and healthcare
o In 2022, the World Bank defined absolute poverty as anyone who was living
on less than $1.90 a day (the so called international poverty line)

o Absolute poverty is more prevalent in developing countries than in

developed ones

• Relative poverty is a situation where household income is a certain percentage less

than the median household income in the economy
o Poverty in a household is considered relative to income levels in other
households
o Households that are living with less than 50% of the median household
income are considered to be in relative poverty
o Relative poverty is the main form of poverty that occurs
in developed countries
 Measuring Inequality - the Lorenz Curve & Gini Coefficient

• The two main measures of income inequality are the Lorenz Curve and the Gini
coefficient

The Lorenz Curve

• The Lorenz Curve is a visual representation of the income inequality that

exists between households in an economy

• Data is commonly presented in quintiles (population divided into 5 groups i.e 20%)
or deciles (population divided into 10 groups i.e 10%)
o E.g. in 2020, 49% of the income flow in Bolivia went to the top 20% of
households while only 4% went to the bottom 20%

• Perfect income distribution is not the goal (20 % of the population gets 20% of the
income; 40% gets 40% percent of the income etc.)
o That would equate to socialism and completely remove incentives for
work as everyone would be paid equally

• More equal income distribution is desired as it reduces poverty and social unrest
o What constitutes acceptable income equality is a normative economic issue
 An illustration of Income Inequality for Bolivia (blue line) and Sweden (red line) and the
UK (yellow line) using a Lorenz Curve Model. The income distribution in Bolivia is more
unequal than that of Sweden

Diagram Analysis

• The line of equality represents perfect income distribution (not desirable)

• In Bolivia the bottom 20% of households receive 4% of the income flow while in
Sweden they receive 9% of the income flow
• In the UK the top 10% of households receive 45% of the income flow while in
Sweden they receive 25%
• Sweden has a more equal distribution of income than the UK

The Gini Coefficient

• The Lorenz curve can be used to calculate the Gini Coefficient

 The Gini Coefficient is calculated using the area beneath the line of equality

Diagram Analysis

• GINI=A/A+B
• A represents the area between the line of equality and Bolivia's Lorenz curve
• B represents the area under the Lorenz curve
• A value of 0 represents absolute equality (socialism) and 1 represents perfect
inequality
• In 2017, Estonia's coefficient was 0.3 as compared with a value of 0.62 in South Africa
o The distribution of income in Estonia was more equitable than in South Africa
• Governments use progressive taxation and transfer payments to shift the Gini
coefficient closer to zero

Worked example
Using a Lorenz curve diagram, explain what happened to income inequality in Bolivia
between 2008 and 2016 [4]

Income Gini Coefficient Data for Bolivia

Income Gini Coefficient 2008 0.51

Income Gini Coefficient 2016 0.43

Step 1: Determine if inequality has improved or worsened

The closer to zero, the closer the country is moving to perfect equality.
The situation in Bolivia has improved so the Lorenz curve is moving closer to the line of
perfect equality

Step 2: Draw and label the Lorenz Curve for each year

(2 marks for a correctly labelled diagram with a shift inwards of the Lorenz curve)

Step 3: With reference to your diagram, explain what has happened to the income
inequality between the two time periods

The closer the Gini coefficient is to zero, the more equal the distribution of income in a
country. [1 mark] Bolivia's Gini coefficient has moved closer to zero indicating that there is
less income inequality in 2016 than there was in 2008 and this is illustrated by an inward shift
of the Lorenz curve towards the line of perfect equality [1 mark]

Constructing a Lorenz Curve from Quintile Data

• The Lorenz Curve plots the percentage of a nation’s total income against the
percentage of the nation’s population, and thereby shows how much each quintile
(or one fifth) of the population earns of the total income
% of Population Poorest 20% 2nd 20% 3rd 20% 4th 20% 5th 20% Gini Index
Bangladesh 8.6% 12.4% 16.2% 21.4% 41.4% 32.4
Canada 7.4% 12.6% 17% 23% 40% 32.5
South Africa 2.3% 4.8% 8.2% 16.5% 68.2% 63.00
Vietnam 6.6% 11.5% 15.9% 22.1% 43.9% 36.8
Source: World Bank

• The country with a Gini Index closest to zero has the most income equality
o Bangladesh has the best income equality and South Africa has the worst
• The Lorenz curve for Bangladesh will be closest to the line of perfect equality and
furthest away for South Africa

Worked example
Using information from the table above, construct a Lorenz Curve diagram which shows the
distribution of income for the country with the highest inequality and the country with the
lowest inequality [4]

Step 1: Identify the countries with the best and worst income inequality

South Africa has the worst and Bangladesh has the best [1 mark]

Step 2: Change the income data so that it is cumulative from quintile to quintile
[1mark]

% of Population Poorest 20% 2nd 20% 3rd 20% 4th 20% 5th 20% Gini Index
Bangladesh 8.6% 21% 37.2% 58.6% 100% 32.4
South Africa 2.3% 7.1% 15.3% 31.8% 100% 63.00

Step 3: Draw the Lorenz Curve diagram

[2 marks]

Measuring Poverty

• There are many single indicators of economic development. These can be used to
compare the relative standing of countries at any point in time. They also serve to
provide targets for improving the lives of citizens. Examples include

o Energy consumption per person

o The proportion of the population with access to clean water
o Number of girls completing primary education

• Another single indicator is the International Poverty Line (IPL)

o This is the absolute minimum level of income that a person must receive in
order to meet the basic needs required for human survival - currently $1.90 a
day

• The Minimum Income Standard (MIS) is another useful indicator

o The Minimum Income Standard (MIS) identifies the lowest amount of
income needed for what society views as an acceptable standard of living in
the country
o The value differs from region to region as adjustments are made for those
living in urban versus rural areas due to the different costs of living
associated with each

• A composite indicator can provide more meaningful data for comparisons between
countries
 o One useful composite indicator is the Multi-dimensional Poverty Index (MPI)

Characteristics of the MPI

1. Launched in 2010 by the Oxford Poverty and Human Development Initiative at the
University of Oxford
2. The MPI uses a survey to measure the complexities of poor people’s lives,
individually and collectively, each year
3. The MPI tracks deprivation across three dimensions and 10 indicators
o Health (child mortality, nutrition)
o Education (years of schooling, enrolment)
o Living standards (water, sanitation, electricity, cooking fuel, housing, assets)

4. The survey first identifies which of these 10 deprivations each household

experiences
5. Households are then categorised as poor if they suffer deprivations across 1/3 or
more of the weighted indicators
6. The MPI can focus in on regions, ethnicities and also any of the three dimensions
7. This adaptability makes it a useful tool for policymakers and non-government
organisation (NGOs) working to reduce poverty

Difficulties in Measuring Poverty

• Poverty is multi-dimensional concept and difficult to quantify

• Poverty is usually measured through self reported surveys and this gives rise to
multiple discrepancies in - and between - countries
• Households who identify as poor may exhibit very different characteristics from each
other
• Urban households may have very different ideas of their poverty level compared
to rural households
• Urban areas tend to have higher immigrant households whose status can change
relatively quickly as they seize opportunities
• Rural households may remain in long-term poverty
• Poverty data for different ages, gender and disabilities is not easily available
3.4.2 Causes Of Inequality &
Poverty
The Causes of Inequality & Poverty
Causes of Poverty

• There are many causes of poverty. However, poor countries have several common
characteristics which can be summarised in a poverty cycle diagram

Poverty is caused by a lack of both economic growth and human development

• Low wages represent the intersection of economic growth and human development
and are the major cause of poverty
o Low wages are usually the result of unemployment, informal employment, a
lack of skills, or a primary sector based economy

• Education and healthcare cost money and with lower wage levels these are not
accessible, resulting in poor human capital
o People find it harder to stay well or to recover from illness resulting in lower
productivity and shorter life expectancy

• Low productivity results in low wages and the cycle continues

• Populations with a large number of dependents (old people and children) for each
working household tend to experience higher levels of poverty
 Table 3.Causes of Wealth & Income Inequality

Cause Explanation
Differences in human capital • The higher the skill level the higher the level of income
• A country with a poor education system will see greater inequality
than one with a good education system

Inequality of opportunity • Access to education and health can vary significantly within
communities and between different regions
• Inequality in education and healthcare leads to inequality of
opportunity in the job market

Different levels of resource ownership • Assets generate income

• The more equal the asset ownership in an economy the less the
inequality in income distribution

Discrimination • Gender, race - or any other discrimination increases income inequality

in an economy

Unequal status and power • Countries with strong trade union membership provide workers with
more power and higher levels of income
• With low trade union membership, the exploitation of workers
through low wages is easier and income inequality is worse

Government tax and benefits policies • Countries that provide a range of benefits (such as unemployment,
pension, disability, child support, housing support etc) raise the
income of the lowest 20% of the population resulting in more equal
distribution
• Progressive tax systems allow all income earners to contribute
to public revenue according to their ability
• Decreasing taxes on the lower end and increasing it on the upper end
would mean that the system is more progressive and there would be
a more equal distribution of income

Globalisation and technological change • Globalisation is the economic integration of different countries
through increasing freedoms in the cross-border movement of people,
goods/services, technology and finance
• This integration of global economies has impacted national cultures,
spread ideas, speeded up industrialisation in developing nations and
led to de-industrialisation in developed nations
• Countries which are more isolated will experience higher levels of
wealth and income inequality
Market based supply-side policies • Supply-side policies such as deregulation, privatisation and trade
liberalisation can provide great opportunities but also increase
inequality
• E.g. Privatisation of state owned assets often allows a few people to
get rich (those who buy the asset) and the service provided by the
newly privatised firm may become more expensive to access

The Costs of Income & Wealth Inequality

• Capitalism is at the heart of free market economics

• Under Capitalism, inequality is inevitable
o Workers with higher skills receive higher wages
o Workers with little to no skills receive little to no wage
o Individuals with higher income will acquire more assets leading to higher
levels of income
▪ In turn, they can keep on acquiring assets
o Individuals with lower income will find it hard to acquire assets

• The principles of capitalism are considered important as the incentive to acquire

income raises productivity and output

• However, the long-term outcome of capitalism is that the factors of

production become concentrated in ownership with relatively few individuals
developing extreme wealth, at the expense of many who lose out

The costs of inequality

1. Impact on economic growth

o At some point, increasing levels of inequality becomes a disincentive for
workers to work and be productive
o This means that some resources (labour) in the economy are not being used
efficiently. National output falls and economic growth slows
o Government unemployment payments and welfare benefits may increase

o Government tax revenues may decrease with increasing inequality

2. Impact on living standards

o If the inequality gap grows, the rich get richer and the poor, relatively poorer
o Over time, this will reduce the standard of living
o The wealthier will access better education and healthcare creating even less
opportunity for poorer households in the future
3. Impact on social stability

o More equal societies tend to be more stable, tolerant and considerate with
lower levels of crime and better standards of living
o Less equal societies tend to be characterised by political instability, strife,
social unrest - and in extreme cases this can lead to revolutions
3.4.3 Using Taxation to Reduce
Inequality & Poverty
The Role of Taxation

• The main source of government revenue is taxation

• Taxation is used to redistribute income so as to reduce income inequality in a nation

Types of taxes

• Direct taxes are taxes imposed on income and profits

o They are paid directly to the government by the individual or firm
o E.g. Income tax, corporation tax, capital gains tax, national insurance
contributions, inheritance tax

• Indirect taxes are imposed on spending

o The less a consumer spends the less indirect tax they pay
o Examples of indirect tax include Value Added Tax (19% VAT rate in the
European Union in 2022), taxes on demerit goods such as excise duties on
fuel or cigarettes

Types of tax systems

• Tax systems can be classified as progressive, regressive or proportional

• Most countries have a mix of progressive (direct taxation) and regressive (indirect
taxation) taxes in place
 System Explanation Diagram
Progressive • As income
rises, a larger
percentage of
income is paid
in tax (called the
marginal tax
rate)
• In the diagram,
when
personal income
rises from Y1 to
Y2, the tax rate
rises from TR1 to
TR2

Regressive • As income
rises, a smaller
percentage of
income is paid
in tax
• In the diagram,
when
personal income
rises from Y1 to
Y2, the tax rate
falls from TR1 to
TR2
• All indirect taxes
are regressive
• In the
USA, Federal
income tax is
progressive but
almost all State
taxes are
regressive (the
bottom 20% of
income earners
pay as much as
6x the % of their
income than the
top 20%)

Proportional • As income
rises, the same
percentage of
income is paid
in tax
 • In the diagram,
when
personal income
rises from Y1 to
Y2, the tax rate
remains
constant at 20%
• In 2022, Bolivia
was using this
system with
a proportional
tax rate of 13%

The link Between Taxation & the Reduction of Income Inequality & Poverty

Progressive taxation • A progressive tax system redistributes from Higher redistribution → better
those with higher income to those with lower education/healthcare → better
income and reduces income inequality human capital → better
• Redistribution often starts with the provision productivity → higher income
of free education and healthcare
• Many governments use tax revenues to provide
multiple levels of financial support to poor
households including disability payments,
heating subsidies, travel subsidies etc.
• Sometimes the benefits of a good progressive
tax system are eradicated by the penalties
imposed through multiple regressive (indirect)
taxes

Direct & Indirect tax rate Calculations

• Indirect tax rate calculations focus on calculating the taxes paid by consumers on
expenditure
o Indirect taxes usually have to be identified from a table, before the
calculations are made

• Direct tax rate calculations usually focus on the calculation of marginal and average
tax rates from a set of data provided
o Marginal tax rates represent the amount of additional tax paid for every
additional dollar earned as income
o Marginal tax rates increase as income increases
 o Average tax rates are calculated using the following formula

Worked example
Using information from the table below, calculate the average tax rate paid by an employee
who earns $25,000 a year [4]

Income ($ per year) Rate of Income Tax

1 - 10,000 5%
10,001 - 18,000 10%
18,001 - 35,000 20%
35,001 and over 30%
Step 1: Calculate the tax paid on the first $10,000

5% x 10,000 = $500

Step 2: Calculate the tax paid on income between $10,001 - $18,000

10% x $7,999 = $799.90

Step 3: Calculate the tax paid on income between $18,001 and $25,000 (the employees
income)

20% x 6,999 = $1,399.80 [1 mark]

Step 4: Add the marginal tax paid together to obtain the total tax bill for the employee

$500 + $799.90 + $1,399.80 = $2,699.70 [1 mark]

Step 5: Calculate the average rate of tax for the employee

Step 6: Present your answer rounded to two decimal places

Average tax rate = 10.80% [1 mark]

 3.4.4 Other Policies to Reduce
Inequality & Poverty
Other Policies

Policy
Explanation Impact on Poverty Cycle
Investing in human capital • Investing in this supply-side Higher education/skill levels → higher
e.g. education policy increases the potential output of human capital → increased productivity
the country (shifts the production → higher output → higher income
possibility frontier outwards)

More generous transfer • Transfer payments are usually given to More benefits → higher wages → better
payments the poorest and most education/healthcare → better human
vulnerable people in society capital → better productivity → higher
• Transfer payments wages
include unemployment and disability
payments, pension payments, heating
discounts, public transport subsidies
etc.

Establishment/increase of • Minimum wages are set above the free Higher wages → better
national minimum wage market rate education/healthcare → better human
• Firms are not allowed to pay anyone capital → better productivity → higher
less than the legal rate wages

Establishing a universal • A universal basic income (UBI) is a Minimum income for all → better
basic income guaranteed minimum income level - education/healthcare → better human
and when necessary, paid by the capital → improved labour offer →
government to each individual in decreasing unemployment
society

Targeted government • This can be aimed at the greatest Higher education/skill levels → higher
spending on goods/services needs in society human capital → increased productivity
• E.g. Providing more schools, teachers or → higher output → higher income
hospitals

Policies to reduce • Discrimination occurs in many different Less discrimination → better productivity
discrimination forms (age, ethnicity, gender, disability → higher wages
etc) and in each case results in social
exclusion leading to inequalities of
opportunity and income
 • Reducing discrimination reduces
inequality

• Policies used to alleviate poverty include promoting economic growth,

improving education, providing more generous state benefits, progressive
taxation, and the establishment/increase of a national minimum wage

Policies which help to improve any factor in the diagram will help to alleviate
poverty