C hapter 18 Income Distribution and Poverty © 2002 South-Western.

CChapter 18hapter 18

Income Distribution

and Poverty

© 2002 South-Western

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Economic PrinciplesEconomic Principles

•The Lorenz curve

•The Gini coefficient

•Rawls’s theory of justice

•Life cycle wealth

•The case for income equality

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Economic PrinciplesEconomic Principles

•The case for income inequality

•Poverty thresholds

•Negative income tax

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Income Distribution Income Distribution and Povertyand Poverty

Questions about the rich and the poor arise from the political, ethical, economic and religious foundations of our society.

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Questions include:

• Why are some people rich and others poor?

• Why does it seem there are so many more poor than rich?

• Can anything be done about the situation?

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These questions concerning income distribution haven’t changed much in the last 2,500 years.

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There is one difference, however. Today, it is commonly recognized that a person’s income seems to be connected to that person’s productive contribution in the market.

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Not Too Many Coal Not Too Many Coal Miners Are Miners Are MillionairesMillionaires

There are four forms of income:

• Wages.

• Interest.

• Rent.

• Profit.

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One can generally guess a person’s economic status by knowing the principal source of the person’s income.

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When there is a shift in either the supply curves or MRP curves of labor, capital, or land, the equilibrium wage rates, interest rates, and rents also change.

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People’s income increases or decreases as a result of these changes.

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Measuring Income Measuring Income DistributionDistribution

There are two principal ways to measure an economy’s income distribution:

• The Lorenz curve.

• The Gini coefficient.

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Lorenz curve

A curve depicting an economy’s income distribution. It records the percentage of total income that a specific part of the population -- typically represented by quintiles, ranging from the poorest to the richest -- receives.

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Lorenz curve

The percentage of population is measured along the horizontal axis and the percentage of total income is measured along the vertical axis.

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Perfect income equality is achieved when each percent of the population receives an equal percent of the economy’s total income. The perfect income equality curve on the Lorenz curve is a diagonal.

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For example, if 20 percent of the people receive 20 percent of the income, then there is perfect income equality.

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Perfect income inequality is achieved when one person receives all of the income and everyone else receives no income. The prefect income inequality curve on a Lorenz curve is formed by the two sides of a right angle.

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In reality all income distributions lie somewhere between perfect equality and perfect inequality.

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EXHIBIT 1LORENZ CURVES FOR THE COM- MUNITIES OF WASHTENAU, SPRINGFIELD, AND HOLMES

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Exhibit 1: Lorenz Curves Exhibit 1: Lorenz Curves for the Communities of for the Communities of Washtenau, Springfield, Washtenau, Springfield,

and Holmesand HolmesWhat percentage of total income do the poorest 20 percent of the population receive in Washtenau, Springfield and Holmes?

• They receive 20 percent of total income in Washtenau, 0 percent in Springfield and 4 percent in Holmes.

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EXHIBIT 2 LORENZ CURVES FOR SWEDEN, FRANCE, BRAZIL, AND THE UNITED STATES

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Exhibit 2: Lorenz Exhibit 2: Lorenz Curves for Sweden, Curves for Sweden,

France, Brazil and the France, Brazil and the United StatesUnited States

Which country in Exhibit 2 has the greatest income equality? The least?

• Sweden has the greatest income equality, while Brazil has the least.

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• The Lorenz curve is not perfect and is, at best, only a rough estimate of the underlying reality.

• For example, the distribution of government-provided goods such as national security, health care and transportation are impossible to account for in the Lorenz curve.

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Gini coefficient

A numerical measure of the degree of income inequality in an economy. It ranges from zero, depicting perfect equality, to one, depicting perfect inequality.

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The coefficient is a ratio of the two areas produced by the Lorenz curve. Area A lies between the diagonal and the economy’s Lorenz curve. Area B lies below the economy’s Lorenz curve.

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The coefficient (G) is calculated as

G = A/(A+B).

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EXHIBIT 3 THE GINI COEFFICIENT

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Exhibit 3: The Gini Exhibit 3: The Gini CoefficientCoefficient

As the area represented by A in Exhibit 3 becomes smaller, the Gini coefficient becomes:

i. Smaller.

ii. Larger.

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Exhibit 3: The Gini Exhibit 3: The Gini CoefficientCoefficient

As the area represented by A in Exhibit 3 becomes smaller, the Gini coefficient becomes:

i. Smaller.

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How Unequal is Our How Unequal is Our Income Distribution?Income Distribution?

An overall upward drift toward greater income inequality shows up in the Lorenz curve and Gini coefficient between 1970 and 1995 in the United States.

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EXHIBIT 4 SHARE OF AGGREGATE INCOME RECEIVED BY HOUSEHOLDS, BY QUINTILE AND TOP 5 PERCENT, AND GINI COEFFICIENT: 1970–99

Source: U.S. Bureau of the Census, Money Income in the United States: 1995, Current Population Reports, P60-193 (Washington, D.C.: U.S. Government Printing Office, 1996); and U.S. Bureau of the Census, Money Income in the United States: 1999, Current Population Reports, P60-220 (Washington, D.C.: U.S. Government Printing Office, 1999).

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Exhibit 4: Share of Exhibit 4: Share of Aggregate Income Received Aggregate Income Received by Households, By Quantile by Households, By Quantile

and Top 5 Percent, and and Top 5 Percent, and Gini Coefficient: 1970-1999Gini Coefficient: 1970-1999

How has the share of total income received by the top 5 percent changed in the US since 1970?

• The top 5 percent received about 16 percent of the total income in 1970. In 1995 the percentage had increased to 21 percent.

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EXHIBIT 5 PERCENTAGE CHANGE IN HOUSEHOLD GINI COEFFICIENT: 1967–99

Source: U.S. Bureau of the Census, Current Population Survey, March 1999.

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Exhibit 5: Percentage Exhibit 5: Percentage Change in Household Change in Household

Gini Coefficient: Gini Coefficient: 1967-991967-99

The curve in Exhibit 5 is upward sloping. Does this mean income is becoming more equal or less?

• Income is becoming less equal, since the cumulative percentage change is positive.

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How Unequal Is Our How Unequal Is Our Income Distribution?Income Distribution?

The increase in income inequality seen in the US is similar to the pattern in some developed countries, while other developed countries seem to be more egalitarian.

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In developing countries, income inequality is extreme. Many economists attribute the inequality to their agrarian economies. The prospect for breaking out depends on the creation of nonagricultural employment.

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EXHIBIT 6 INCOME DISTRIBUTION IN THE MID-1980s, SELECTED COUNTRIES, BY QUINTILE

Source: European Economy: 1996 Broad Economic Policy Guidelines, no. 62 (Brussels, 1996), and World Development Report, 1996 (Washington, D.C.: World Bank, 1996).

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Exhibit 6: Income Exhibit 6: Income Distribution in the Mid-Distribution in the Mid-

1980s, Selected 1980s, Selected Countries, By QuintileCountries, By Quintile

Which countries show similar patterns in income distribution in Exhibit 6?• Italy, France, United Kingdom and Canada all share a similar distribution while Japan, the Netherlands, Sweden and West Germany share a more egalitarian distribution.

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EXHIBIT 7 INCOME DISTRIBUTION IN LESS-DEVELOPED ECONOMIES, BY QUINTILE

Source: World Development Report, 1996 (Washington, D.C.: World Bank, 1996). The footnote to the table in the report reads: “These estimates should be treated with caution.”

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Exhibit 7: Income Exhibit 7: Income Distribution in Less-Distribution in Less-

Developed Economies, by Developed Economies, by QuintileQuintile

How does the percentage of wealth received by the top 20 percent in this exhibit compare to Exhibit 6?• The top 20 percent in the less-developed countries receive a much greater share of total income than the top 20 percent in developed countries.

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Wealth

The accumulated assets owned by individuals.

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Life-cycle wealth

Wealth in the form of nonmonetary assets, such as a house, automobiles, and clothing.

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• Wealth represents the accumulated assets of a lifetime, including inherited assets.

• Net wealth among population deciles tends to be far more unevenly distributed than income.

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EXHIBIT 8 DISTRIBUTION OF NET WEALTH OF U.S. FAMILIES (1774 AND 1973)

Source: Jones, A. H., Wealth of a Nation to Be—The American Colonies on the Eve of Revolution (New York: Columbia University Press, 1980); and Greenwood, D., “An Estimation of U.S. Family Wealth and Its Distribution from Macro Data, 1973,” The Review of Income and Wealth, Series 29, I, March 1983, pp. 23–44.

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Exhibit 8: Distribution Exhibit 8: Distribution of Net Wealth of US of Net Wealth of US

Families Families (1774 and 1973)(1774 and 1973)

How much of the nation’s wealth did the wealthiest decile hold in 1973? And the least wealthy 50 percent?• The wealthiest 10 percent of the population held 69.8 percent of the wealth while the least wealthy 50 percent held just 1 percent of the wealth.

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Is There an Optimal Is There an Optimal Income Distribution? Income Distribution? The Case for EqualityThe Case for Equality

Some argue that good fortune, as well as disaster, are distributed randomly. Income inequality, then, has no more justification than a lottery result.

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Harvard philosopher John Rawls agrees. He believes that people who look at income distribution alternatives objectively, would always choose less income inequality.

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Others, particularly Marxists, argue for income equality based on the idea that people are created equally. They believe that individuals come to own property by theft. The unequal distribution of property creates income inequality.

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Still others, particularly economist A.P. Lerner, make the case for equality based on the presumption that equality produces the greatest welfare for the greatest number of people.

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EXHIBIT 9 EQUALITY AND MAXIMUM UTILITY

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Exhibit 9: Equality Exhibit 9: Equality and Maximum Utilityand Maximum Utility

Where is combined total utility maximized in Exhibit 9?

• Combined total utility is maximized at equality – when each person has $10.

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Is There an Optimal Is There an Optimal Income Distribution? Income Distribution?

The Case for The Case for InequalityInequality

Other economists argue for income inequality by drawing on the connection between productive contribution and economic reward.

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The argument is that without the reward linkage, productive people would lack the incentive to contribute as much as they do. The economy’s output would be less than its productive potential.

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Even though total national income may fall as a result of redistributing wealth toward greater equality, however, the poor may still be better off.

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EXHIBIT 10 EFFECT OF INEQUALITY ON NATIONAL INCOME

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Exhibit 10: Effect of Exhibit 10: Effect of Inequality on Inequality on

National IncomeNational Income

1. How does national income change as the Gini coefficient moves from 0.45 to 0.35?

• National income declines from $900 billion to $700 billion as the Gini coefficient declines.

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Exhibit 10: Effect of Exhibit 10: Effect of Inequality on Inequality on

National IncomeNational Income

2. How does the income received by the poorest 60 percent change?

• Although national income declines, the income received by the poorest 60 percent increases from $300 billion to $350 billion.

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Income inequality may also lead to economic growth. The rich tend to do the country’s investing. The richer the rich, the greater the investment and the higher the rate of growth.

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The poor may even benefit from the inequality. Even though their share of national income is relatively small, as investments grow and the economy grows, the absolute size of their share will increase.

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EXHIBIT 11 INEQUALITY AND ECONOMIC GROWTH

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Exhibit 11: Inequality Exhibit 11: Inequality and Economic Growthand Economic Growth

What happens to the income received by the poorest 60 percent after 15 years in Exhibit 11?

• After 15 years, the income received by the poorest 60 percent in the more unequal society (G=0.45) surpasses that of the more equal society (G=0.35).

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Do We Have to Live Do We Have to Live with Poverty?with Poverty?

To many people, poverty is a relative concept. People are only poor relative to others. How many live in poverty, then, depends not on a person’s particular income, but upon the relationship between that income and the income of others.

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Median income

The midpoint of a society’s income distribution, above and below which an equal number of individuals (or families) belong.

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Poverty threshold

The level of income below which families are considered to be poor.

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Another way of identifying poverty is by describing some minimal acceptable physical standard of living that people ought to have.

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EXHIBIT 12 PERCENTAGE OF PERSONS BELOW THE POVERTY LEVEL, BY RACE, 1960-97

NA = not available* Refers to data for 1959Source: Bureau of the Census, Statistical Abstract of the United States, 1999 (Washington, D.C.; Department of Commerce, 1999), p. 483.

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Exhibit 12: Percentage Exhibit 12: Percentage of Persons Below the of Persons Below the

Poverty Level, by Race, Poverty Level, by Race, 1960-951960-95

How has the number of people living in poverty changed since 1960?• Between 1960 and 1970 the number of people living in poverty dropped dramatically from over 22 percent to about 12 percent. It has held fairly steady since then.

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EXHIBIT 13 FAMILIES IN POVERTY, BY SELECTED CHARACTERISTICS: 1997

* Refers to 1992† Refers to 1994Source: Statistical Abstract of the United States, 1999 (Washington, D.C.: Department of Commerce, 1999), p. 484.

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Exhibit 13: Persons and Exhibit 13: Persons and Families in Poverty, by Families in Poverty, by

Selected Selected Characteristics: 1997Characteristics: 1997

According to Exhibit 13, what characteristic was most associated with poverty in 1997?

• Within this list, families headed by a single mother were at the highest risk for living in poverty.

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Fighting the War Fighting the War on Povertyon Poverty

Cash assistance

Government assistance in the form of cash.

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Fighting the War Fighting the War on Povertyon Poverty

In-kind assistance

Government assistance in the form of direct goods and services, such as Medicaid or food stamps.

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EXHIBIT 14 CASH AND NONCASH BENEFITS FOR PERSONS WITH LIMITED INCOME: 1996

Source: Statistical Abstract of the United States, 1999 (Washington, D.C.: Department of Commerce, 1999), p. 389.

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Exhibit 14: Cash and Exhibit 14: Cash and Noncash Benefits for Noncash Benefits for Persons with Limited Persons with Limited

Income: 1994Income: 1994 What types of programs for the poor has the government funded?

• Medical care, food, housing, education, job training, energy assistance and cash aid are all programs supported by the government.

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EXHIBIT 15 POPULATION BELOW 50 PERCENT OF MEDIAN INCOME (LATEST OECD DATA)

Source: OECD Economic Surveys, Germany, 1996 (Paris: OECD, 1996), P. 90.

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Exhibit 15: Population Exhibit 15: Population Below 50 Percent of Below 50 Percent of

Median Income (Latest Median Income (Latest OECD Data)OECD Data)

Has government spending to assist the poor been effective at raising families out of poverty?• The effects of low-income assistance programs seem barely perceptible. While some countries have seen the numbers of poor drop by half, the US number have dropped by less than 1 percent.

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The Negative Income The Negative Income Tax AlternativeTax Alternative

Negative income tax

Government cash payments to the poor – an income tax in reverse – that is linked to the income levels of the poor. The cash payments decrease as income levels increase. The payments are designed to provide a minimum level of income to the poor.

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The Negative Income The Negative Income Tax AlternativeTax Alternative

Under this scheme, the poor are provided with enough money to maintain a minimum standard of living and are allowed to earn as much as possible without penalty. It creates an incentive to work.

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EXHIBIT 16 THE NEGATIVE INCOME TAX APPLIED (TAX = 50%)

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Exhibit 16: The Negative Exhibit 16: The Negative Income Tax Applied Income Tax Applied

(Tax=50%)(Tax=50%) If the government sets a minimum income level of $10,000 and incomes are taxed at 50 percent, what would be the after-tax income of a family earning $10,000?

• The family’s tax obligation would be ($10,000*50%) = $5,000.

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• This leaves an after-tax income independently derived of $5,000.

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• The family still receives the $10,000 negative income tax, so total after-tax income is $15,000.

C hapter 18 Income Distribution and Poverty © 2002 South-Western.

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