'Fairness' - a subjective concept

The inequalities of income have long been a concern for politicians, who are inclined to debate whether these inequalities are ‘fair’. But fairness, like beauty, lies largely in the eye of the beholder, and this subjective concept does not readily lend itself to rigorous economic analysis.

Rewards for risk-takers and skilled workers

At the top end of the income spectrum, a system that relies for its success on a few people taking risks and judging correctly market trends needs to reward success. Similarly, those with skills in short supply will be able to command a premium over and above the average wage.

The extent to which the top performers exceed the average can be left to the market to determine, or policymakers can try to define what is acceptable, and manage the distribution through progressive taxation. This debate got an additional lease of life during the banking turbulence of 2008-09 when a number of people seemed to be well rewarded for risk taking and were not held accountable when their institutions were brought to the brink of collapse as a result.

Low wages may hinder economic growth

At the other end of the income range, low wages are not only politically and socially undesirable but have little to commend them in economic terms.

Very low wages (and therefore living standards) may hinder economic growth, because young people might be forced to take up paid employment at a very early age, and thereby forgo the medium- to long-term economic benefits of education. In the present recession, attention is increasingly focused on the disproportionately high representation of 16-25 year olds in the jobless total. The longer people take to enter the labour market it seems the less likely they are to make the effort when an opportunity arises.

Achieving a middle way

Somewhere between the extremes is an 'acceptable' distribution which offers sufficient incentive to the risk takers and top performers but which does not create a socially-deprived underclass of ill-educated low paid workers caught in a vicious downward spiral.

This balance can be achieved through a system of collective bargaining (which had become very sophisticated but highly confrontational in the UK in the 1970s) or by government action, such as taxation or the Minimum Wage.

Undesirable effects of government intervention

A redistributive tax and benefits systems can, of course, be taken too far. In many developed economies, systems intended to ensure that the weakest are protected have created inflexibilities in the labour market to the extent that they hinder economic growth.

Generous unemployment benefits, for example, may deter the jobless from seeking work, or extensive tax-credits may discourage low-paid workers from looking for better jobs.

High tax rates, on the other hand, can discourage productive employment, or drive work (and sometimes workers) overseas.

A key indicator of income inequalities is the ‘Gini coefficient’, a technical measure of income distribution within an economy.

It varies from zero, which indicates absolute equality with every household having identical income, to one which implies absolute inequality with a single household accounting for a country’s entire income.

An international comparison of income inequalities is compiled by the OECD, which shows that inequalities are greatest in the more dynamic emerging economies.

Latin America is one of the most unequal regions, with Mexico having a Gini coefficient approaching 0.5 in the mid 2000s. In richer countries, values of between 0.3 and 0.4 are more common, implying a more equal distribution of incomes.

Source: OECD

With a Gini coefficient slightly over 0.3 the UK is fairly typical of many developed economies in terms of income distribution, which partly reflects the redistribution of income through the tax and benefit system.

Government intervention affects households in various ways. Money is taken from households through taxes (both direct and indirect), and given back either in the form of cash (‘welfare’) benefits or through the provision of free or subsidised services.

In assessing the redistributive workings of the system, a useful approach is to look at ‘final income’ compared with ‘original income’. A summary of the steps involved is outlined in Table 12.2: Calculation of Final Income.

In general, households at the lower end of the income distribution tend to be net beneficiaries of the system, while those in the upper income brackets are net contributors (paying more in tax than they receive in benefits).

Taken as a whole, government intervention has the effect of reducing the differences in households ‘original income’.

Official figures show that, in 2007-08 income of the top fifth of households was around six times greater than that of the bottom fifth.

The gap has widened since New Labour won the 1997 election when the differential was 5.3 times. In this same period, the share of the top 10% rose from 26% to 28.6% while the bottom 10% declined, from 3.1% to 2.6%. The chart below shows the effects of these interventions on household incomes ranked in quintile groups.

Source: ONS

Cash Benefits

It is worth noting that the disbursement of cash benefits has helped close the gap measured in terms of incomes, the majority of which go to households in the lower part of the distribution, with the poorest two-fifths receiving nearly 60% of the total.

Indeed, for the bottom fifth, cash benefits represented a little over 53% of gross income in 2007/08.

The tax system

The tax system has a much smaller effect on redistribution. Income tax is ‘progressive’ (not a term of approval but a technical definition meaning that it takes a larger proportion of income from those with higher incomes).

In 2007/08, the top fifth of households paid a quarter of their gross incomes in direct tax, while the bottom fifth paid just 11%.

Indirect taxes

The same is not true of indirect taxes, such as VAT.

For the top fifth of households, for instance, indirect taxes account for 10% of gross income, compared to 27.9% for the bottom fifth.

Since indirect taxes, such as VAT and excise duties on tobacco, alcohol and petrol (which raise almost as much as income tax), are the same regardless of earnings, taxation has a smaller overall effect (compared to benefits) on income inequality.

Also of interest is the trend in income inequality over time. An accessible analysis for the UK is that conducted regularly by the Institute of Fiscal Studies (IFS), using data from the Department of Work and Pensions.

The latest IFS study suggests that income inequality (measured by the Gini coefficient) has risen on balance since 1997 despite the genuine attempts by the current government to reduce the gap, emphasising how difficult it is to fine tune income inequality in a developed, market –based, economy.

Source: Institute of Fiscal Studies

Given the host of redistributive policies implemented by Labour during its terms in office, it is reasonable to wonder why this should be.

A possible explanation is rising inequality in underlying (original) incomes, but another key point is that the most heavily redistributive policies were not implemented until Labour’s second term in office.

These have included large increases in means-tested benefits and tax credits, particularly those giving benefits to pensioners and to people with children.

The aim of redistribution is generally taken to be the eradication (or avoidance) of poverty. This in itself raises a whole host of questions about what, exactly, constitutes ‘poverty’.

Broadly speaking, poverty may be defined either as ‘absolute poverty’ or ‘relative poverty’.

Absolute poverty

The concept of absolute poverty is intuitively obvious to most people, and at its most basic can be defined in terms of, say, an income that is insufficient for an adequate diet.

Poverty in this sense is not generally considered to be an issue in the UK today, although it is certainly a problem in some less-fortunate parts of the world. As countries get richer, absolute poverty generally diminishes over time.

Relative poverty

This does not hold true for the alternative approach, based on the concept of ‘relative poverty’. Such measures are generally based on an income level relative to average or median incomes.

The IFS, for instance, measures poverty by counting the number of people whose income is below 60% of the median. This is also the measure against which the government assesses progress towards its 2004/05 ‘child poverty’ target.

Levels of relative poverty increased during the 1980s but, like income inequality, stabilised during the 1990s. From 1996/97 when the current Government took office to 2004/05 poverty across the population followed a gradual downward trend, although some of that fall was reversed in the following three years.

Beneficiaries of government policies

Children and pensioners are the groups which have benefited most over the last ten years. Given that Government policies have been heavily focused on these groups, it is perhaps not surprising that other groups have not fared so well.

Working-age parents saw just a marginal improvement in the decade after 1996/97 but for working age non-parents, the extent of relative poverty increased on balance over the period.

Source: Institute of Fiscal Studies

Shortcomings of 'relative poverty'

The concept of relative poverty, although widely used, suffers from two shortcomings.

In the first place, the dividing line between poverty and non-poverty is necessarily somewhat arbitrary – why, for instance, use 60% of median income, rather than 50%, or 70%?

And secondly, no matter how rich a country becomes, there will always be some people less well-off than the rest – even though they may all be wearing Armani suits and driving Porsches.

Indicators of relative poverty, therefore, generally confirm what the Good Lord noted two thousand years ago: “the poor ye have always with you”.