- Lorenz curve shows what percentage of the population owns what percentage of the total income in an economy. It is calculated in cumulative terms. The further the curve is from 45 degree line of absolute equality, the more unequal the distribution of income.
- Gini coefficient is a coefficient index that measures the ratio of the area between the Lorenz curve and the line of absolute equality to the total area under the figure. The higher the figure, the more unequal the distribution of income.
- Direct taxes are taxation imposed on people’s wealth or income, or firm’s profits. In theory, such taxes are unavoidable. Examples include income tax.
- Indirect taxes is a tax on expenditure or consumption that is ‘hidden’. It increases the firm’s costs and is added to the selling price of the good or service. It is also known as avoidable tax. Examples include GST and VAT.
- Progressive tax is a system of direct taxation where tax is levied at an increasing rate for successive ‘brackets’ of income. As a person’s income rises, they pay a higher proportion of their income to taxes. The marginal tax rate is greater than the average tax rate.
- Marginal tax rate is the rate of tax paid on additional income earned.
- Regressive tax is a system of taxation where tax is levied at a decreasing average rate as income rises. This form of taxation takes a greater proportion of tax on low-income earners than high-income earners. Indirect taxes are regressive tax.
- Proportional tax is a system of taxation where the proportion of income paid is constant for all income levels.
Equity vs. Equality
- Equity is government distributing income more “fairly” depending on people’s status.
- Equality is government giving the same income, regardless of people’s status.
- Governments aren’t aiming for equality, since higher income act as an incentive for people to work harder.
- For example, if a government aims for equality, people earning low income might have higher income than they had before, which gives them an incentive to for work harder. But, people with high income will be demotivated because they’re working in the same position as people who used to earn low income.
- So the government has to aim for equity by giving fair amount of income to people regarding their skills and abilities depending on their work performance and how they contribute to the country’s economy.
Lorenz Curve and Gini Coefficient
Remember when you plot the graph, you add up all the percentiles till they total up to 100!!
- As seen on the graph above, Madagascar has a smaller gap between 4th to 5th percentile compared to Bolivia. This means that Madagascar distributes income fairly than Bolivia.
- Low income countries (low HDI) = higher levels of inequality (higher Gini index).
- Countries with high Gini index could have high standards of living in low income groups.
- Countries with low Gini index may face widespread poverty in most income groups.
- Increased income equality isn’t always necessary in order to raise a country’s standards of living.
- Increased national income and constant distribution of income = poor income groups getting the same proportion of a larger amount.
Causes of poverty:
- Individuals are born into a family where incomes were low.
- They received poor or no education at all.
- They may have suffered from poor health care and malnutrition.
- They found it necessary to find work before completing their education.
Consequences of poverty:
- Low living standards.
- Lack of access to sufficient health care.
- Low levels of education.
- Low levels of human capital.
- Unemployment and/or Underemployment.
Taxation to reduce the gap between rich and poor for distribution of income
1. Direct taxes
- Imposed on people’s income or wealth, and on firm’s profits.
- Unavoidable taxes because households and firms are required to declare their full income to the government and pay taxes according to their income.
- Rich people have to pay more taxes than people with low income, therefore creating equity in the economy.
- Creates equal distribution of wealth.
- Less direct tax rate = more saving and investment by an individual.
- Creates social conflict between rich and poor.
- Individuals/firms have to go through many formal procedures = time consuming process.
- High direct tax rate = lack of efficiency, productivity and motivation.
2. Indirect taxes
- Added to the selling price of a good or service.
- Avoidable taxes since households and firms have an option to buy it or not.
- Examples include VAT for UK and GST for Canada and Australia
- Only means of reaching the poor. – contributing to the economy.
- Reduce the consumption of demerit goods.
- Indirect taxes on necessities and merit goods = increase in revenue.
- Discourage industries when raw materials are taxed.
- Shops charge more for products so that there’s more revenue, regardless of indirect tax imposed on those products.
- Rich and poor people pay the same amount of money, which is seen unfair by the society.
3. Progressive taxes
- High income earners = increased amount of tax to pay for.
- Since people are able to earn more income, they should also pay more tax.
- Promotes equality of incomes because rich people have to pay more tax than poor people in a society.
- Reduces saving as rich people are able to save more than poor people. If rich people pay high taxes, their savings will decrease.
- May falsify financial statements so that people only have to pay less tax for the government.
4. Regressive taxes
- High income = less amount of tax paid.
- Good source of government revenue.
- Reduces consumption of demerit goods.
- Worsen income inequality.
- Cause poverty as poor people have to pay more tax.
5. Proportional taxes
- Same % of tax paid for all income levels.
- Tax-payers can easily and quickly calculate amount of tax that goes to the government.
- Neutral to wealth and income distribution.
- No structural change in a society.
- Burden of tax falls more on poor sections of the society.
6. Transfer payments
- Governments use taxes to redistribute income and provide assistance to groups in the economy to improve standards of living.
- They are not included in the national income as they don’t represent the payment for the production of a good or service.
- They are payments made to increase income of certain groups in an economy.
- Examples include unemployment benefits, payments to disabled people, child support assistance, pensions and subsidies to producers.
The table shows the income tax “brackets” that apply to different ranges of earnings in an economy.
- Individual A (low income) earns $15,000 per year and spends $5,000 on goods and services, of which 15% is indirect tax.
- Individual B (middle income) earns $45,000 per year and spends $20,000 on goods and services, of which 15% is indirect tax.
- Individual C (high income) earns $100,000 per year and spends $60,000 on goods and services, of which 15% is indirect tax.
- Calculate the total direct tax paid by individuals A, B, C.
- Calculate the total indirect tax paid by individuals A, B, C.
- Calculate the total tax paid by individuals A, B, C.
4.Calculate the average indirect tax rate paid by individuals A, B, C.
5. Calculate the average direct tax paid by individuals A, B, C.
6. Calculate the total tax rate paid by individuals A, B, C.
7. Consider a country imposes a proportional tax of 25%. Calculate the total tax paid by individuals A, B, C.
8. Consider a country that imposes a flat tax rate of $7,000. Calculate the total tax paid by individuals A, B, C.
9. Calculate the new average tax rate for Individuals A, B, C if their total income increased by $20,000.
10. Calculate the marginal tax rate based on increase in income by $15,000 for individuals A, B, C.