Unequal income distribution

Markets may result in a very wide distribution of income, such that some individuals may receive no income at all.

Incomes are earned in a market when individuals sell or hire out their factor of production to others.

Factor incomes include:

Wages
Rents
Interest
Profits

However, these incomes can vary considerably, and some individuals cannot earn even a moderate income. In a free market it may be difficult for some individuals to earn an income at all, leaving them unable to buy goods and services.

Income distribution in the UK

Who are most likely to have the least income?

Those who are likely to receive less than ‘average incomes’ include:

The unemployed
The underemployed
The sick and disabled
Those with poor qualifications or low skills
The elderly
Those working in the unofficial labour market where pay is below the legal minimum

Remedies

Progressive taxes

Governments can intervene in the labour market by altering personal disposable income via the tax and benefits system. This means employing a progressive tax system. Progressive taxes take proportionately more tax at higher incomes and proportionately less tax at lower incomes.

If this is accompanied by welfare payments to those on lower incomes, any gap between high and low income earners can be reduced.

Income tax in the UK is mildly progressive and helps to redistribute income. This is because:

Individuals on low incomes pay no income tax. In 2014 the tax-free ‘personal’ allowance was £10,000.
Beyond this, income earners pay tax at the ‘basic rate’, which is currently 20%.
Those on ‘higher incomes’ pay tax on some of their income at a higher tax rate, which is 40%.
A higher rate of 45% for those earning over £150,000 of taxable income.

These tax bands help narrow the income gap and so help reduce inequality.

Regressive taxes

Regressive taxes are those where the tax paid, as a percentage of income, falls the higher the level of income, and hence where the burden of the tax is largely on the poor.

Example of a regressive tax

VAT, currently at the standard rate of 20%, is a regressive tax as it takes no account of an individual’s income. For example, consider three different drivers, all of whom drive the same distance each year, but each earn a different incomes.

Mr Brown earns £10,000 per year
Mrs Green earns £50,000
Miss Black earns £200,000

If it is assumed that they all drive to work and buy 3000 litres of petrol per year at £1 per litre, of which 20% is VAT (hence they pay 20p VAT per litre, and pay £600 per year), then it can be seen that there is a considerable difference in terms of the proportion of their income that goes to the government in VAT:

Mr Brown earns £10,000 per year, and pays 6% of his income in petrol taxes
Mrs Green earns £50,000, and pays 1.2%, and
Miss Black earns £200,000, and pays 0.3%

If we include other excise duties on petrol, then the degree of regressiveness becomes even more extreme.

Welfare benefits

Not all individuals have the opportunity or ability to sell their labour in the labour market. To help provide a basic level of personal income a government may also provide transfer benefits, such as:

Unemployment benefit (Job Seekers Allowance – JSA)
Income support (IS)
Housing benefit
Old age pension
Child benefit
Sick benefit
Disability benefit
Child tax credit and working tax credit.

Many of these individual benefits will be incorpoated into a single universal benefit (Universal Credit), introduced in 2013.

More on Universal Benefit….

Criticisms

These benefits may compensate for the failure of labour markets to provide sufficient rewards, but such intervention can be criticised because:

It may create a disincentive effect, which occurs when individuals are discouraged from working hard, because they pay more taxes.
It may create moral hazard, where some individuals may not make an effort to find ways to improve their own position because the state provides insurance against poverty, unemployment and disability.