Distinguish concepts
Separate equality from equity, and equity from economic efficiency.
Equity and Redistribution of Income and Wealth
Efficiency is not the same as fairness. A market outcome can allocate resources efficiently yet still leave a distribution of income and wealth that society regards as inequitable. This chapter examines poverty, redistribution and the trade-offs governments face when trying to protect low-income households while preserving incentives.
Equity & equalityEfficiencyAbsolute povertyRelative povertyRedistributionUniversal basic incomePoverty trap
What this chapter prepares you to do
Measure poverty
Explain absolute and relative poverty, poverty lines, headcount ratios and the income gap.
Explain redistribution
Analyse negative income tax, transfer payments, benefits, UBI and taxation.
Evaluate incentives
Explain the poverty trap and assess trade-offs between protection, work incentives and efficiency.
High-grade habit: when evaluating redistribution, separate the objective from the side effects. A policy may reduce poverty or inequality but also alter work incentives, tax burdens, administrative costs and the allocation of resources.
Chapter sections
22.1
Equity and inequality
Some inequality of income and wealth exists in all societies. People differ in talents, education, training, skills and experience, and they own different quantities of assets. These differences create unequal income-earning opportunities and unequal wealth.
Equality is not the same as equity. Equality refers to identical outcomes, such as everyone receiving the same income. Equity is about fairness: people in the same economic circumstances should receive equal treatment and should not be disadvantaged for irrelevant reasons. The textbook uses unequal treatment of male and female workers as an example of inequity.
Equality
A situation in which people receive the same amount of income or wealth. Complete equality is not the same as fairness and is not normally achievable.
Equity
Fair treatment. In the chapter's framework, people in the same situation should receive equal treatment and equal opportunities.
Equity therefore concerns fairness, not identical outcomes. Two people with the same skills, experience and circumstances should not be treated differently for irrelevant reasons. Unequal treatment can arise, for example, through discrimination.
Income differences
Education, skills, experience and occupation affect earning power.
Wealth differences
Ownership of property, financial assets and other resources differs across households.
Equal opportunity
Equity requires people in comparable circumstances to have a fair chance to apply, train, progress and be treated equally.
Government policy can try to improve equity by creating a legal framework for equal treatment in recruitment, training, promotion and dismissal. The textbook notes that legislation can raise awareness and prohibit discrimination, but proving unequal treatment in individual cases can still be difficult.
Exam distinction: inequality describes different outcomes; inequity is a judgement that treatment or distribution is unfair.
22.2
Equity and efficiency
Allocative efficiency is concerned with whether resources are used to maximise social welfare, for example where marginal social benefit equals marginal social cost. Equity asks whether the resulting distribution is fair. The two objectives do not automatically coincide.
Why efficiency can conflict with equity: a tobacco tax may be justified because it corrects a demerit-good or externality problem. Yet if low-income households spend a larger share of their income on tobacco, the same policy can be regressive. A policy can therefore move a market closer to an efficient quantity while making the distribution of disposable income less equal.
An economy may reach an efficient allocation but still have a distribution of income and wealth that society regards as unacceptable. Different distributions of income can be associated with different Pareto-efficient outcomes.
The possible trade-off
A policy designed to improve efficiency may worsen equity, while a redistributive policy may alter incentives or resource allocation. For example, an indirect tax used to correct a market failure may place a relatively heavy burden on low-income households.
Do not write: “efficient = fair.” Instead, explain that efficiency and equity are different criteria and may sometimes conflict.
22.3
Poverty
Poverty is related to inequality but is not the same thing. Inequality concerns the distribution across society; poverty asks whether individuals or households have sufficiently low resources to be classified as poor.
A common measure is the headcount ratio: the percentage of the population living below a chosen poverty line. The textbook also stresses that this does not show the depth of poverty. Two countries can have the same headcount ratio even if the incomes of poor households are much further below the line in one country. The income gap therefore helps measure the intensity as well as the incidence of poverty.
Absolute poverty
A household cannot afford the minimum bundle of goods and services needed for basic survival. An absolute poverty line is set in terms of a minimum real standard of living.
For international comparison, the textbook uses the World Bank’s then-current International Poverty Line of PPP$1.90 per day in 2011 prices and notes that the line has to be recalibrated as prices change. This is a historical textbook benchmark rather than a timeless figure.
Relative poverty
A household has too little income to participate normally in the society in which it lives. The textbook example defines the line as a percentage of median adjusted household disposable income.
In the European example used in the book, relative poverty is measured against 60% of median adjusted household disposable income. “Adjusted” matters because household needs depend on size and composition. Persistent poverty refers to remaining below the relative-poverty threshold over several years, not merely falling below it temporarily.
Headcount ratio
Population living below the poverty line ÷ total population × 100
Population living below the poverty line ÷ total population × 100
The headcount ratio measures the proportion of the population below a poverty line. However, it does not show how far below the line people are. The income gap — the distance between household income and the poverty line — helps indicate the intensity of poverty.
Absolute and relative measures
An absolute poverty line must be updated over time as prices change if it is to represent the same real minimum. A relative line moves with typical living standards because it is tied to median income. The textbook uses the World Bank's then-current international poverty line and European relative-poverty examples to illustrate the distinction.
Easy comparison: absolute poverty asks, “Can this household afford the minimum needed for survival?” Relative poverty asks, “Is this household’s income so far below the normal income of this society that participation in ordinary social life is difficult?” A rich country may have almost no absolute poverty on the international line but still have significant relative poverty.
Evaluation: a fall in the headcount ratio can occur even if the poorest households receive no improvement, so use the income gap when discussing the depth of poverty.
22.4
Policies towards equity and inequality
Policies towards equity
Governments can establish legal frameworks intended to reduce discrimination and support equal opportunity in recruitment, training, promotion and dismissal. Such laws can improve formal equality of treatment, although discrimination may remain difficult to detect or prove.
Negative income tax
A negative income tax combines taxation and benefits. Above a specified income level, people pay tax; below that level, they receive a payment through the tax system. The aim is to guarantee a minimum income while phasing support out as earnings rise.
Simple negative-income-tax example: suppose the no-tax income threshold is $20,000 and a person earns $10,000. If the negative income tax is 20% of the $10,000 shortfall, the person receives $2,000 through the tax system, giving total cash income of $12,000. As earned income rises, the transfer is gradually withdrawn.
Simple illustration: suppose the no-tax threshold is $20,000 and a 20% negative income tax applies to the income shortfall. A person earning $10,000 has a shortfall of $10,000 and receives 20% × $10,000 = $2,000, giving total cash income of $12,000.
Transfer payments and benefits
Government can redistribute income through transfer payments in cash or in kind. Education, healthcare, housing support and pensions are examples of ways resources can be transferred toward households.
Means-tested benefits target support on households below a specified income level, which can reduce the fiscal cost but requires information, monitoring and administration. Universal benefits are paid without reference to current income. The textbook gives a contributory pension in Pakistan as an example of a benefit available to those who meet the contribution requirement irrespective of income.
| Type | How it works | Possible strength | Possible weakness |
|---|---|---|---|
| Means-tested benefit | Paid only when income or resources fall below a specified level. | Targets assistance at those judged most in need. | Requires assessment and monitoring; withdrawal can weaken work incentives. |
| Universal benefit | Paid without reference to current household income, subject to the scheme's eligibility rules. | Simple access and no stigma from income testing. | Also goes to higher-income recipients and may be expensive. |
| Benefits in kind | Support is provided as services such as education or healthcare rather than cash. | Directly increases access to important services. | Still has to be financed and may not match every household's preferences. |
Universal basic income (UBI)
A universal basic income is a regular payment to everyone regardless of economic circumstances. The textbook presents the argument that it can provide a simple safety net and may be cheaper to administer than complicated means-tested systems. It also notes the counterargument that unconditional income could weaken incentives to seek employment.
The textbook discusses Finland’s 2017–18 pilot, in which 2,000 randomly selected unemployment-benefit recipients received a regular payment. Recipients reported higher wellbeing, but the experiment did not provide clear evidence that they were more likely to find work. This illustrates why UBI evaluation must consider both income security and labour-market incentives.
Arguments in favour
- Provides a guaranteed safety net.
- Avoids complex means testing.
- Recipients do not lose the payment simply because they take a job.
- Can reduce income insecurity.
Arguments against
- Potentially expensive when paid to everyone.
- May require higher taxes or spending cuts elsewhere.
- May weaken work incentives for some recipients.
- Evidence from pilot schemes can be mixed.
The poverty trap
The poverty trap occurs when taking a job, working more hours or earning more brings little or no increase in disposable income because benefits are withdrawn and/or taxes rise. The individual therefore has a weak financial incentive to increase earnings.
Easy example: a worker earns an extra $100 by taking more hours, but loses $70 of means-tested benefits and pays $25 more tax. Disposable income rises by only $5. The very high effective withdrawal rate weakens the incentive to work more even though the person’s gross earnings have risen.
Higher gross earnings
→Benefits withdrawn
+Tax liability rises
→Small gain in disposable income
→Weak work incentive
Policy dilemma: generous targeted benefits protect low-income households, but rapid withdrawal can create very high effective marginal tax rates. Governments must balance income protection against incentives to work.
Taxation and redistribution
Progressive direct taxation can reduce post-tax income inequality because higher-income households pay a larger proportion of income in tax. Indirect taxes tend to be regressive when lower-income households spend a larger share of their income on taxed consumption.
The textbook distinguishes the redistributive effects of progressive direct taxes and regressive indirect taxes. A larger reliance on income tax can reduce post-tax inequality, while shifting the tax mix toward expenditure taxes can increase inequality because lower-income households tend to spend a larger share of their income.
More progressive direct tax
Can redistribute disposable income towards lower-income groups, but very high rates may affect incentives.
Greater reliance on indirect tax
Can increase inequality if low-income households bear a larger tax burden relative to their income.
Intergenerational effects
Redistribution also has a time dimension. High taxation today to finance current consumption may reduce resources available for future generations, while taxation used to finance investment that improves future living conditions may impose costs on the present generation. The textbook therefore stresses the need for a long-term balance.
Redistribution also has a time dimension. High taxation today may finance services or investment that benefit future generations, but it can also reduce current living standards. Conversely, low taxes today may shift the burden of public debt or under-investment onto future taxpayers. The book therefore treats the balance across generations as part of the wider issue of sustainable policy.
Evaluation framework: ask who gains, who pays, how accurately the policy targets need, how it changes work incentives, what it costs to administer, and whether the redistribution is sustainable over time.
Chapter 22 revision checklist
□ Distinguish equality from equity.
□ Explain why inequality exists in all societies.
□ Explain equal treatment and equal opportunity.
□ Distinguish equity from allocative efficiency.
□ Explain why an efficient allocation may still be inequitable.
□ Define absolute poverty.
□ Define relative poverty.
□ Explain the role of a poverty line.
□ Calculate and interpret a headcount ratio.
□ Explain why the income gap adds information to the headcount ratio.
□ Explain why poverty lines need updating over time.
□ Explain policies designed to promote equal treatment.
□ Explain how a negative income tax works.
□ Define transfer payments.
□ Distinguish means-tested and universal benefits.
□ Explain arguments for and against UBI.
□ Define the poverty trap.
□ Explain how benefit withdrawal and taxation can weaken work incentives.
□ Explain how progressive direct and regressive indirect taxes affect inequality.
□ Evaluate redistribution using incentives, administration, fairness and intergenerational effects.
20 questions. Each answer is marked immediately with a short explanation of why it is correct or incorrect.