INEQUAILITY OF INCOME
The degree of inequality of income in an advanced economy can be measure by measuring the amount of income that is earned through different segments of the population. For example, “if we break down all workers into five different segments in regards to how much money they make: the top 20 percent, the second 20 percent, the third 20 percent, the fourth 20 percent, and the bottom 20 percent,” then an individual is able to create a chart that details how much income each segment of the population earns out of the total amount of income for that area (Carter, 2016).
The first part of measuring the degree of inequality, or equality, would be to fine the total income for the area. For example, the average income for the five different segments of the population would be, $10,000, $25,000, $50,000, $75,000 and $100,000. The next step would be to figure out the percentage of the total income each segment makes. If the segments are all equal sizes, then there is no need to worry about weighting the average incomes. For this example, all of the segments are the same size. Thus, all that needs to be done are calculations in order to find the percentage of total income each segment makes (Carter, 2016).
For the total income, the average amounts of income for each segment should be added together ($10,000 + $25,000 + $50,000 + $75,000 + $100,000 = $260,000). Next, an economist would find the percentage of the total income that each segment earns. This is done by dividing the total income of the segment by the total income for the population. For the first segment, $10,000/$260,000 = .038. For the second segment, $25,000/$260,000 = .096. For the third segment, $50,000/$260,000 = .192. For the fourth segment, $75,000/$260,000 = .288, and for the last segment, $100,000/$260,000 = .384. What these numbers represent is that the bottom fifth of the population represents less than four percent of the total income in that area, while the top fifth represents almost forty percent (Carter, 2016).
Economists also look at cumulative figures when it comes to income distribution. In order to use cumulative figures, the percentages are added together are each level in order to see the amount of income earned by all of the people who exist throughout the population. For example, the bottom segment represents 3.8 percent of the income. The bottom segment and the second segment (3.8 + 9.6 = 13.4) represents 13.4 percent of the total income. The first, second, third, and fourth segments (3.8 + 9.6 + 19.2 + 28.8 = 61.4) represent 61.4 percent of the total income. Lastly, the first, second, third, fourth, and fifth segments (3.8 + 9.6 + 19.2 + 28.8 + 38.4 = 99.9) represent 99.9 percent of the total income (Carter, 2016).
Tax policies can play a role when it comes to the inequality of post-tax income distribution. “In addition, tax policy is crucial for raising revenues to finance public expenditures on transfers, health and education that tend to favor low-income households, as well as on growth enabling infrastructure that can also increase social equity” (Carter, 2016). It is believed that income inequality was affected originally by the tax system. By analyzing current tax systems, economics were able to discover that under certain conditions, tax productivity may actually improve inequality when it comes to income.
Direct and indirect taxes can be used to help reduce the degree of inequality. Indirect taxes are when every person (whether poor or rich) pays the same amount when it comes to consumption expenditures. “But since the poor pay a higher proportion of their income as tax, indirect tax tends to increase the disparity in societal wellbeing” (Ilaboya & Ohanba, 2013, p. 1). Direct takes, on the other hand, tend to be more equitable. This is due to the fact that direct taxes fluctuate with income. The more income a person makes, the more direct taxes they are assessed. “Direct taxes enhances the redistribution function of taxation as they help reduce income inequality” (p. 1).
For example, a study was conducted in Europe to attempt to see the impact that direct and indirect taxes have different households with different incomes. One average, the households in the study paid $7,400 a year in direct taxes. This number was equivalent to 19 percent of their gross income. Richer households, on the other hand, paid both higher proportions of their income in direct taxes and higher amounts of direct taxes. Thus, direct taxes reduced the level of inequality when it comes to income. The top fifth of households paid $20,300 per year on average in direct taxes. This represented 24 percent of the individual’s total gross income. For the lowest fifth, on the other hand, the average direct tax bill was $1,300 a year. This consisted of ten person of their total gross income. The total differences of income for this same were $63,600 per year and $11,400 per year for the top and bottom fifth of the population respectively (Creamer, 1999).
With indirect taxes, on the other hand, each household is responsible for paying taxes on their expenditures instead of their income. The top fifth of households paid two and a half times in indirect taxes as the lowest fifth ($9,100 and $3,500 a year respectively). These means the higher income households spent more on expenditures on goods and services than the poor individuals. “However, although richer households pay more in indirect taxes than poorer ones, they pay less as a proportion of their income” (Ilaboya & Ohanba, 2013, p. 4). This means that indirect taxes are actually acting to increase the inequality when it comes to income. For example, the study found that the richest fifth of households only paid 14 percent of their income in indirect taxes. The bottom fifth, on the other hand, paid approximately 31 percent of their income in indirect taxes. The poorer individuals end up paying a higher percent of their income in indirect taxes than in direct taxes.
Direct and indirect taxes can have an impact when it comes to income inequality. With indirect taxes, income inequality is only increased. With direct taxes, on the other hand, income inequality is decreased. Applying the concept of direct taxes to developed countries is a way to limit the amount of income inequality that exist throughout a particular area. Indirect taxes not only increase the amount of inequality in income, but they also are unfair on the poorer individuals throughout society. The top fifth and bottom fifth of the area in the European study earned an income of $63,600 and $11,400 per year respectively. With indirect taxes, these individuals only paid $9,100 and $3,500 in indirect taxes per year. In other words, the top fifth spent 14.3 percent ($9,100/$63,600 = .143) of their income on indirect taxes, whereas the bottom fifth spent 30.7 percent ($3,500/$11,400 = .307) of their income on indirect taxes. Thus, indirect taxes do not help the issue with inequality of income throughout a particular area. Indirect taxes actually do the opposite; the increase the amount of income inequality that exists throughout a particular are. Therefore, direct taxes should be used in order to limit the amount of income inequality that exists throughout a given area.
References
Carter, A. (n.d.) How tax can reduce inequality. Retrieved on 8 March 2016, from http://www.oecdobserver.org/news/fullstory.php/aid/3782/How_tax_can_reduce_inequal ty.html
Creamer, H. (1999). Direct versus indirect taxation: the design of the tax structure revisited. Retrieved on 8 March 2016, from http://idei.fr/sites/default/files/medias/doc/by/cremer_h/direct_indirect.pdf
Garfinkel, I. (2006). A re-examination of welfare states and inequality in rich nations: how in-kid transfers and indirect taxes change the story. Journal of Policy Analysis and Management, 24(4), 897-919.
Ilaboya, O. & Ohanba, N. (2013). Direct verse indirect taxation and income inequality. European Journal of Accounting Audit and Finance Research, 1(1), 1-15.
