Income distribution and welfare

What you'll learn

• How income, wealth, poverty and inequality are different but connected.
• How economists measure inequality using quantiles, Gini coefficients and the Lorenz curve.
• Why governments may aim for a more even distribution of income.
• How to evaluate the causes and consequences of poverty and inequality.

Why distribution matters for welfare

In macroeconomics, governments do not only care about how much an economy produces. They also care about who receives the benefits of that production.

A country can have rising GDP per head while many households still struggle with rent, food, energy bills or transport costs. This is why distribution matters: two economies with the same national income may produce very different living standards depending on how income is shared.

A key idea is the diminishing marginal utility of income: an extra £1 usually gives more additional welfare to a low-income household than to a very high-income household. This gives an economic reason for redistribution, not just a moral one.

Income, wealth, distribution and inequality

So, income is measured “per week” or “per year”, while wealth is measured “at a date”. A household may have low income but high wealth, for example a retired homeowner. Another may have high income but low wealth, for example a graduate with a good salary but large debts and no property.

Income inequality and wealth inequality are related, but wealth is usually more unequal. This is because wealth can be accumulated over time, inherited, and boosted by rising asset prices such as house prices.

The objective of a more even distribution of income

A government may aim for a more even distribution of income as part of its wider economic policy objectives. This means reducing excessive income gaps and improving living standards for lower-income households.

This does not usually mean making everyone’s income exactly equal. Some income differences may reflect skills, training, responsibility, risk-taking or hours worked. The objective is usually to reduce unfair or harmful inequality, not remove all incentives.

Governments may try to achieve this through:

• Progressive taxation, where higher-income households pay a higher proportion of income in tax.
• Welfare benefits, such as Universal Credit, child benefit or housing support.
• Minimum wage policies, such as the National Living Wage.
• Education and training, which can improve earning potential.
• Public services, such as the NHS and state education, which improve living standards without directly increasing money income.

Absolute and relative poverty

Absolute poverty is often measured against a fixed real-terms standard. Globally, the World Bank uses international poverty lines, but in the UK exam context you should focus on whether households can meet basic needs after allowing for prices.

Relative poverty is about exclusion from normal living standards in that society. For example, a household may be able to buy food and shelter but still be unable to afford internet access, school trips, transport to work, or adequate heating.

Inequality data: quantiles and ratios

Economists use data to compare inequality across countries, over time, or before and after government intervention.

For example, the top decile is the highest-income 10% of households. The bottom quintile is the lowest-income 20%. Quantiles help economists see whether income growth is concentrated at the top, middle or bottom of the distribution.

Useful inequality measures include:

• 90:10 ratio: income at the 90th percentile divided by income at the 10th percentile.
• 80:20 ratio: income share of the top 20% divided by income share of the bottom 20%.
• Top 1% share: the proportion of total income received by the richest 1%.
• Median income: the income of the middle household, less distorted by extreme incomes than the mean.

The Gini coefficient

A higher Gini coefficient means a more unequal distribution. For example, a country with a Gini coefficient of 0.35 is more unequal than one with a Gini coefficient of 0.25.

However, always check what is being measured. A Gini coefficient can refer to income before taxes and benefits, income after taxes and benefits, or wealth. These may give very different results.

The Lorenz curve

The Lorenz curve is a diagram showing the distribution of income. It plots the cumulative percentage of households on the horizontal axis against the cumulative percentage of income on the vertical axis.

The 45-degree line shows perfect equality. For example, the bottom 20% of households would receive 20% of total income, the bottom 50% would receive 50%, and so on.

The Lorenz curve lies below the line of equality because income is unequally distributed. The further the curve bends away from the equality line, the greater the inequality.

The Gini coefficient is based on the areas in the diagram:

$$G=\frac{A}{A+B}$$

where area A is between the line of equality and the Lorenz curve, and area B is below the Lorenz curve.

Causes of poverty and inequality

Poverty and inequality rarely have one single cause. In strong essays, link causes together rather than listing them separately.

Labour market causes

Differences in wages are a major source of income inequality. Higher-skilled workers often earn more because their labour is more productive or in shorter supply. Technological change can increase demand for skilled workers while reducing demand for routine jobs.

Globalisation can also widen wage gaps. Some UK workers face competition from lower-cost overseas labour, while highly skilled professionals may benefit from larger global markets.

Unemployment, underemployment and insecure work can cause poverty because households receive less earned income and may rely on benefits.

Education, health and opportunity

Low educational attainment can reduce access to high-paid work. Poor health can limit working hours or productivity. Poverty can also reduce educational outcomes, creating a cycle where disadvantage is passed between generations.

This links to Amartya Sen’s idea of capabilities: poverty is not only low income, but a lack of real freedom to achieve valued outcomes, such as being healthy, educated and able to participate in society.

Wealth, inheritance and asset prices

Wealth inequality can drive income inequality. People with property, shares or pensions may receive rent, dividends or capital gains. Inheritance can allow some households to buy homes or avoid debt, while others face high rents and limited savings.

In the UK, rising house prices have often benefited existing homeowners while making it harder for younger or lower-income households to build wealth.

Tax and benefit systems

Government policy can either reduce or increase inequality. Progressive taxes and benefits usually reduce disposable income inequality. However, cuts to benefits, frozen thresholds, weak enforcement of labour standards or regressive indirect taxes can increase pressure on low-income households.

Consequences of poverty and inequality

Effects on individuals and families

Poverty can reduce living standards directly. Households may face food insecurity, fuel poverty, overcrowded housing, debt, stress and worse health outcomes. Children in poverty may have fewer educational resources, which can reduce future earnings.

Inequality can also reduce welfare through relative deprivation. People may feel excluded if they cannot participate in normal social and economic life.

Effects on the economy

High poverty can reduce labour productivity if workers suffer poor health, poor nutrition or low skills. It can also increase government spending on healthcare, housing support and welfare benefits.

High inequality may reduce aggregate demand if more income goes to richer households with a lower marginal propensity to consume. Redistributing income towards poorer households may therefore increase consumption in the short run.

However, some inequality can support economic efficiency. Higher rewards may encourage education, effort, enterprise and innovation. For example, entrepreneurs may take risks because successful businesses can generate high returns.

Effects on society and politics

Severe inequality may weaken social cohesion, increase crime, reduce trust in institutions and create political instability. It may also reduce equality of opportunity if richer households can buy better education, housing and networks.

Evaluation: how serious are poverty and inequality?

The impact depends on the type, size and persistence of inequality.

Income inequality may be less damaging if there is high social mobility, meaning people can move up the income distribution through education, work and enterprise. But if inequality is caused by inherited wealth, discrimination or poor access to education, it may become entrenched and harder to justify.

The short-run and long-run effects can also differ. In the short run, redistribution may boost welfare and consumption. In the long run, education, health and housing policies may be more effective because they tackle the causes of low earnings rather than only topping up incomes.

A balanced judgement is that governments should usually aim to reduce poverty as a priority, because poverty directly damages living standards and economic welfare. Reducing inequality is also important where it limits opportunity or harms social cohesion, but policy needs to preserve incentives and avoid government failure.