© 2005 Thomson C hapter 18 Income Distribution and Poverty

© 2005 Thomson 2 Gottheil - Principles of Economics, 4e Economic Principles The Lorenz curve The Gini coefficient Rawls’s theory of justice Life cycle wealth The case for income equality

© 2005 Thomson 3 Gottheil - Principles of Economics, 4e Economic Principles The case for income inequality Poverty thresholds Negative income tax

© 2005 Thomson 4 Gottheil - Principles of Economics, 4e Income Distribution and Poverty Questions about the rich and the poor arise from the political, ethical, economic and religious foundations of our society.

© 2005 Thomson 5 Gottheil - Principles of Economics, 4e Income Distribution and Poverty 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?

© 2005 Thomson 6 Gottheil - Principles of Economics, 4e Income Distribution and Poverty These questions concerning income distribution haven’t changed much in the last 2,500 years.

© 2005 Thomson 7 Gottheil - Principles of Economics, 4e Income Distribution and Poverty 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.

© 2005 Thomson 8 Gottheil - Principles of Economics, 4e Not Too Many Coal Miners Are Millionaires There are four forms of income: Wages Interest Rent Profit

© 2005 Thomson 9 Gottheil - Principles of Economics, 4e Not Too Many Coal Miners Are Millionaires One can generally guess a person’s economic status by knowing the principal source of the person’s income.

© 2005 Thomson 10 Gottheil - Principles of Economics, 4e Not Too Many Coal Miners Are Millionaires 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.

© 2005 Thomson 11 Gottheil - Principles of Economics, 4e Not Too Many Coal Miners Are Millionaires People’s income increases or decreases as a result of these changes.

© 2005 Thomson 12 Gottheil - Principles of Economics, 4e Measuring Income Distribution There are two principal ways to measure an economy’s income distribution: The Lorenz curve The Gini coefficient

© 2005 Thomson 13 Gottheil - Principles of Economics, 4e Measuring Income Distribution 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.

© 2005 Thomson 14 Gottheil - Principles of Economics, 4e Measuring Income Distribution Lorenz curve The percentage of population is measured along the horizontal axis and the percentage of total income is measured along the vertical axis.

© 2005 Thomson 15 Gottheil - Principles of Economics, 4e Measuring Income Distribution 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.

© 2005 Thomson 16 Gottheil - Principles of Economics, 4e Measuring Income Distribution For example, if 20 percent of the people receive 20 percent of the income, then there is perfect income equality.

© 2005 Thomson 17 Gottheil - Principles of Economics, 4e Measuring Income Distribution 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.

© 2005 Thomson 18 Gottheil - Principles of Economics, 4e Measuring Income Distribution In reality all income distributions lie somewhere between perfect equality and perfect inequality.

© 2005 Thomson 19 EXHIBIT 1 LORENZ CURVES FOR THE COM- MUNITIES OF WASHTENAU, SPRINGFIELD, AND HOLMES

© 2005 Thomson 20 Gottheil - Principles of Economics, 4e Exhibit 1: Lorenz Curves for the Communities of Washtenau, Springfield, and Holmes What 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.

© 2005 Thomson 21 EXHIBIT 2LORENZ CURVES FOR SWEDEN, FRANCE, BRAZIL, AND THE UNITED STATES

© 2005 Thomson 22 Gottheil - Principles of Economics, 4e Exhibit 2: Lorenz Curves for Sweden, France, Brazil and the United States Which country in Exhibit 2 has the greatest income equality? The least? Sweden has the greatest income equality, while Brazil has the least.

© 2005 Thomson 23 Gottheil - Principles of Economics, 4e Measuring Income Distribution 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.

© 2005 Thomson 24 Gottheil - Principles of Economics, 4e Measuring Income Distribution 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.

© 2005 Thomson 25 Gottheil - Principles of Economics, 4e Measuring Income Distribution 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.

© 2005 Thomson 26 Gottheil - Principles of Economics, 4e Measuring Income Distribution The coefficient (G) is calculated as G = A/(A + B).

© 2005 Thomson 27 EXHIBIT 3THE GINI COEFFICIENT

© 2005 Thomson 28 Gottheil - Principles of Economics, 4e Exhibit 3: The Gini Coefficient As the area represented by A in Exhibit 3 becomes smaller, the Gini coefficient becomes: i. Smaller ii. Larger

© 2005 Thomson 29 Gottheil - Principles of Economics, 4e Exhibit 3: The Gini Coefficient As the area represented by A in Exhibit 3 becomes smaller, the Gini coefficient becomes: i. Smaller ii. Larger

© 2005 Thomson 30 Gottheil - Principles of Economics, 4e How Unequal is Our 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.

© 2005 Thomson 31 Gottheil - Principles of Economics, 4e EXHIBIT 4SHARE OF AGGREGATE INCOME RECEIVED BY HOUSEHOLDS, BY QUINTILE AND TOP 5 PERCENT, AND GINI COEFFICIENT: 1970–2001 Source: U.S. Bureau of the Census, Money Income in the United States: 2001, Current Population Reports (Washington, D.C.: U.S. Government Printing Office, 2001).

© 2005 Thomson 32 Gottheil - Principles of Economics, 4e Exhibit 4: Share of Aggregate Income Received by Households, By Quantile and Top 5 Percent, and Gini Coefficient: How has the share of total income received by the top 5 percent changed in the U.S. since 1970? The top 5 percent received about 16 percent of the total income in In 2001 the percentage had increased to 21 percent.

© 2005 Thomson 33 Gottheil - Principles of Economics, 4e EXHIBIT 5PERCENTAGE CHANGE IN HOUSEHOLD GINI COEFFICIENT: 1967–99 Source: U.S. Bureau of the Census, Current Population Survey, March 1999.

© 2005 Thomson 34 Gottheil - Principles of Economics, 4e Exhibit 5: Percentage Change in Household Gini Coefficient: 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.

© 2005 Thomson 35 Gottheil - Principles of Economics, 4e How Unequal Is Our Income Distribution? The increase in income inequality seen in the U.S. is similar to the pattern in some developed countries, while other developed countries seem to be more egalitarian.

© 2005 Thomson 36 Gottheil - Principles of Economics, 4e How Unequal Is Our Income Distribution? 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.

© 2005 Thomson 37 Gottheil - Principles of Economics, 4e EXHIBIT 6INCOME DISTRIBUTION IN THE MID-1990s, SELECTED COUNTRIES, BY QUINTILE Source: European Economy: 1996 Broad Economic Policy Guidelines, no. 62 (Brussels, 1996), and World Development Report, 2000/2001 (Washington, D.C.: World Bank, 2000/2001).

© 2005 Thomson 38 Gottheil - Principles of Economics, 4e Exhibit 6: Income Distribution in the Mid-1990s, Selected Countries, By Quintile Which countries show similar patterns in income distribution in Exhibit 6? France, United Kingdom, and Canada all share a similar distribution while Japan, the Netherlands, and Sweden share a more egalitarian distribution.

© 2005 Thomson 39 Gottheil - Principles of Economics, 4e EXHIBIT 7INCOME 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.”

© 2005 Thomson 40 Gottheil - Principles of Economics, 4e Exhibit 7: Income Distribution in Less- Developed Economies, by Quintile 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.

© 2005 Thomson 41 Gottheil - Principles of Economics, 4e How Unequal Is Our Income Distribution? Wealth The accumulated assets owned by individuals.

© 2005 Thomson 42 Gottheil - Principles of Economics, 4e How Unequal Is Our Income Distribution? Life-cycle wealth Wealth in the form of nonmonetary assets, such as a house, automobiles, and clothing.

© 2005 Thomson 43 Gottheil - Principles of Economics, 4e How Unequal Is Our Income Distribution? 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.

© 2005 Thomson 44 Gottheil - Principles of Economics, 4e EXHIBIT 8DISTRIBUTION 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.

© 2005 Thomson 45 Gottheil - Principles of Economics, 4e Exhibit 8: Distribution of Net Wealth of U.S. Families (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.

© 2005 Thomson 46 Gottheil - Principles of Economics, 4e Is There an Optimal Income Distribution? The 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.

© 2005 Thomson 47 Gottheil - Principles of Economics, 4e Is There an Optimal Income Distribution? The Case for Equality Harvard philosopher John Rawls agrees. He believes that people who look at income distribution alternatives objectively, would always choose less income inequality.

© 2005 Thomson 48 Gottheil - Principles of Economics, 4e Is There an Optimal Income Distribution? The Case for Equality 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.

© 2005 Thomson 49 Gottheil - Principles of Economics, 4e Is There an Optimal Income Distribution? The Case for Equality 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.

© 2005 Thomson 50 EXHIBIT 9EQUALITY AND MAXIMUM UTILITY

© 2005 Thomson 51 Gottheil - Principles of Economics, 4e Exhibit 9: Equality and Maximum Utility Where is combined total utility maximized in Exhibit 9? Combined total utility is maximized at equality—when each person has $10.

© 2005 Thomson 52 Gottheil - Principles of Economics, 4e Is There an Optimal Income Distribution? The Case for Inequality Other economists argue for income inequality by drawing on the connection between productive contribution and economic reward.

© 2005 Thomson 53 Gottheil - Principles of Economics, 4e Is There an Optimal Income Distribution? The Case for Inequality 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.

© 2005 Thomson 54 Gottheil - Principles of Economics, 4e Is There an Optimal Income Distribution? The Case for Inequality Even though total national income may fall as a result of redistributing wealth toward greater equality, however, the poor may still be better off.

© 2005 Thomson 55 EXHIBIT 10EFFECT OF INEQUALITY ON NATIONAL INCOME

© 2005 Thomson 56 Gottheil - Principles of Economics, 4e Exhibit 10: Effect of Inequality on National 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.

© 2005 Thomson 57 Gottheil - Principles of Economics, 4e Exhibit 10: Effect of Inequality on National 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.

© 2005 Thomson 58 Gottheil - Principles of Economics, 4e Is There an Optimal Income Distribution? The Case for Inequality 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.

© 2005 Thomson 59 Gottheil - Principles of Economics, 4e Is There an Optimal Income Distribution? The Case for Inequality 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.

© 2005 Thomson 60 EXHIBIT 11INEQUALITY AND ECONOMIC GROWTH

© 2005 Thomson 61 Gottheil - Principles of Economics, 4e Exhibit 11: Inequality and 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).

© 2005 Thomson 62 Gottheil - Principles of Economics, 4e Do We Have to Live 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.

© 2005 Thomson 63 Gottheil - Principles of Economics, 4e Do We Have to Live with Poverty? Median income The midpoint of a society’s income distribution, above and below which an equal number of individuals (or families) belong.

© 2005 Thomson 64 Gottheil - Principles of Economics, 4e Do We Have to Live with Poverty? Poverty threshold The level of income below which families are considered to be poor.

© 2005 Thomson 65 Gottheil - Principles of Economics, 4e Do We Have to Live with Poverty? Another way of identifying poverty is by describing some minimal acceptable physical standard of living that people ought to have.

© 2005 Thomson 66 Gottheil - Principles of Economics, 4e EXHIBIT 12PERCENTAGE OF PERSONS BELOW THE POVERTY LEVEL, BY RACE, NA = not available * Refers to data for 1959 Source: Bureau of the Census, Statistical Abstract of the United States, 2002 (Washington, D.C.; Department of Commerce, 202), p. 442.

© 2005 Thomson 67 Gottheil - Principles of Economics, 4e Exhibit 12: Percentage of Persons Below the Poverty Level, by Race, 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.

© 2005 Thomson 68 Gottheil - Principles of Economics, 4e EXHIBIT 13FAMILIES IN POVERTY, BY SELECTED CHARACTERISTICS: 2000 * Refers to 1994 Source: Statistical Abstract of the United States, 2002 (Washington, D.C.: Department of Commerce, 2002), p. 444.

© 2005 Thomson 69 Gottheil - Principles of Economics, 4e Exhibit 13: Persons and Families in Poverty, by Selected Characteristics: 2000 According to Exhibit 13, what characteristic was most associated with poverty in 2000? Within this list, families headed by a single mother were at the highest risk for living in poverty.

© 2005 Thomson 70 Gottheil - Principles of Economics, 4e Fighting the War on Poverty Cash assistance Government assistance in the form of cash.

© 2005 Thomson 71 Gottheil - Principles of Economics, 4e Fighting the War on Poverty In-kind assistance Government assistance in the form of direct goods and services, such as Medicaid or food stamps.

© 2005 Thomson 72 Gottheil - Principles of Economics, 4e EXHIBIT 14CASH AND NONCASH BENEFITS FOR PERSONS WITH LIMITED INCOME: 2001 Source: Statistical Abstract of the United States, 2002 (Washington, D.C.: Department of Commerce, 2002), p. 344.

© 2005 Thomson 73 Gottheil - Principles of Economics, 4e Exhibit 14: Cash and Noncash Benefits for Persons with Limited Income: 2001 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.

© 2005 Thomson 74 Gottheil - Principles of Economics, 4e EXHIBIT 15POPULATION BELOW 50 PERCENT OF MEDIAN INCOME (LATEST OECD DATA) Source: OECD Economic Surveys, Germany, 1996 (Paris: OECD, 1996), P. 90.

© 2005 Thomson 75 Gottheil - Principles of Economics, 4e Exhibit 15: Population Below 50 Percent of Median Income (Latest 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 U.S. number have dropped by less than 1 percent.

© 2005 Thomson 76 Gottheil - Principles of Economics, 4e The Negative Income Tax 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.

© 2005 Thomson 77 Gottheil - Principles of Economics, 4e The Negative Income Tax 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.

© 2005 Thomson 78 Gottheil - Principles of Economics, 4e EXHIBIT 16THE NEGATIVE INCOME TAX APPLIED (TAX = 50%)

© 2005 Thomson 79 Gottheil - Principles of Economics, 4e Exhibit 16: The Negative Income Tax Applied (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.

© 2005 Thomson 80 Gottheil - Principles of Economics, 4e Exhibit 16: The Negative Income Tax Applied (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? This leaves an after-tax income independently derived of $5,000.

© 2005 Thomson 81 Gottheil - Principles of Economics, 4e Exhibit 16: The Negative Income Tax Applied (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 still receives the $10,000 negative income tax, so total after-tax income is $15,000.