Poverty & Inequality: Absolute vs Relative, Lorenz Curve, Gini Coefficient & Redistribution

1

Absolute Poverty vs Relative Poverty

1. Absolute poverty (Subsistence Poverty): Occurs when a household's income is insufficient to afford the basic physical necessities required to sustain human life, food/calories, clean water, shelter, basic clothing, and sanitation. The World Bank defines extreme global absolute poverty using an international poverty line of $2.15 per day (at 2017 Purchasing Power Parity, PPP). Absolute poverty can be completely eradicated through economic growth and targeted aid. 2. Relative poverty: Measures poverty in comparison to the average living standards of a specific society at a specific time (reflecting social exclusion, inability to participate in normal societal activities). In the UK and EU, a household is in relative poverty if its disposable income is below 60% of the national median household income (measured either Before Housing Costs BHC or After Housing Costs AHC). Because it is defined relative to the median, relative poverty can never be eliminated by economic growth alone if top and middle incomes grow faster than the bottom.

Save

2

Income Inequality (Flow) vs Wealth Inequality (Stock)

Never confuse income and wealth in an exam essay: 1. Income is a flow of money received by factors of production over a given period of time (e.g., weekly wages/salaries from labour, monthly rent from land, annual interest from capital, and dividends/profits from enterprise, plus state welfare transfer payments). Original Income is market income before taxes and benefits; Disposable Income is Original Income minus direct taxes plus cash welfare benefits; Final Income is Disposable Income minus indirect taxes plus benefits-in-kind (free NHS healthcare and state education). 2. Wealth is a stock of marketable financial and physical assets owned at a single point in time (property/housing equity, land, stocks and shares, pension funds, savings, art) minus debts. In every country, wealth is distributed far more unequally than income (in the UK, the Gini coefficient for disposable income is ~0.35, whereas the Gini coefficient for wealth exceeds ~0.62) because wealth accumulates across generations through inheritance, capital gains, and compound interest, and high wealth generates unearned passive investment income (rent, dividends) that further widens income inequality.

Save

3

Measuring Inequality: The Lorenz Curve and Gini Coefficient

1. The LORENZ curve: A graphical representation of inequality plotting the cumulative percentage of the population (ranked from poorest to richest on the horizontal axis, 0% to 100%) against the cumulative percentage of national income (or wealth) they receive on the vertical axis (0% to 100%). The diagonal 45° line represents the Line of Perfect Equality (where the poorest 20% earn 20% of income, the poorest 50% earn 50%, etc). The bowed curve below the 45° line is the Lorenz Curve: the further the Lorenz Curve bows away from the 45° line toward the bottom-right corner, the greater the inequality. 2. The GINI coefficient: Let Area A be the area trapped between the 45° Line of Perfect Equality and the Lorenz Curve, and let Area B be the remaining area beneath the Lorenz Curve (so the whole right-angled triangle under the 45° line has area A + B = 0.5). The Gini Coefficient is G = A ÷ (A + B) (ranging from 0 to 1, or 0% to 100%): G = 0: Perfect equality (Lorenz curve lies on the 45° line, Area A = 0). G = 1: Perfect inequality (one person holds 100% of all income, Area B = 0). Internationally, Nordic welfare states (Denmark, Sweden, Norway) have low Gini coefficients (~0.26-0.28), the UK and USA have relatively high Gini coefficients among developed nations (~0.35 and ~0.41), and South Africa/Brazil exceed 0.50-0.63.

Save

4

Causes of Inequality: Kuznets Curve vs Piketty's r > g

Why does inequality rise within and between countries? 1. The KUZNETS curve (Simon Kuznets 1955): An inverted-U curve plotting Income Inequality (Gini) on the y-axis against GDP per capita on the x-axis. As a developing economy industrialises (moving workers from low-paid rural agriculture into high-productivity urban factories, the Lewis Dual-Sector Model), inequality initially rises sharply. Once the economy matures into an advanced industrial democracy, inequality falls as universal education expands skilled labour supply, trade unions grow, and progressive welfare states redistribute income. 2. PIKETTY'S critique (Thomas Piketty 2014 'Capital in the Twenty-First Century'): Piketty showed that since 1980, inequality in the US and UK has surged upwards again (invalidating Kuznets) because under free-market capitalism, the rate of return on capital/wealth (r - rents, dividends, stock/house price gains, ~5% per year) consistently exceeds the rate of economic and wage growth (g - ~1.5-2% per year): r > g. Alongside globalisation (offshoring manufacturing jobs), skill-biased technological change (AI/automation), declining trade union density, and regressive tax cuts, wealth concentrates ever more tightly at the top.

Save

5

Economic Consequences of Inequality (Capitalist Incentive vs Structural Drag)

1. ARGUMENTS that some inequality IS beneficial (Free-Market / Neo-liberal view: Hayek, Friedman): Trickle-Down & Enterprise Incentives: Wage and profit differentials incentivize workers to acquire human capital (university degrees, long hours), entrepreneurs to take commercial risks and innovate, and high-income earners (who have a high Marginal Propensity to Save, MPS) to accumulate savings that finance capital investment (Harrod-Domar model). 2. ARGUMENTS that high inequality HARMS growth (Keynesian / IMF / Wilkinson & Pickett 2009 'The Spirit Level'): Depressed Aggregate Demand: Because the rich have a much lower Marginal Propensity to Consume (MPC) than the poor, concentrating income at the top starves the economy of consumer spending (C) and weakens the multiplier. Wasted Human Capital (Opportunity Inequality): Children born into poverty suffer worse nutrition, overcrowded housing, and underfunded schools, preventing talented individuals from reaching their productive potential. Social and Health Costs: Higher crime rates, mental illness, lower life expectancy, and political polarisation/instability.

Save

6

Government Policies to Redistribute Income & The Laffer Curve / Poverty Trap

1. Progressive, proportional & regressive taxation: Progressive Tax: As income rises, the marginal and average percentage rate of tax paid rises (e.g., UK Income Tax: £12,570 personal allowance at 0%, 20% Basic Rate, 40% Higher Rate, 45% Additional Rate, shifts the Lorenz curve inward toward the 45° line). Proportional (Flat) Tax: The percentage tax rate stays constant as income rises. Regressive Tax: As income rises, the percentage of income paid in tax falls (e.g., indirect taxes like VAT at 20%, council tax, and excise duties on fuel/tobacco, hit the poorest deciles hardest as a % of their disposable income). 2. Welfare transfers & public services: Means-tested benefits (Universal Credit, targeted and cheaper for the Exchequer, but creates the poverty trap where high marginal withdrawal rates of 55%+ combined with income tax/NI create an effective marginal tax rate of 70%+, destroying the incentive to work extra hours) vs Universal benefits (Child Benefit, State Pension, or Universal Basic Income - no poverty trap or stigma, but astronomically expensive). 3. The LAFFER curve (Arthur Laffer): Plots Tax Revenue (y-axis) against the Tax Rate % (0% to 100% on the x-axis): at 0% tax rate, revenue is £0; at 100% tax rate, nobody works legally so revenue is also £0. Raising marginal income/corporation tax rates beyond the optimal peak rate T* reduces total tax revenue because high earners work less, emigrate ('brain drain'), or engage in tax avoidance/evasion.

Save

1. Q1

   Explain how the Lorenz Curve and Gini Coefficient are used to measure income inequality, and explain how the UK tax and benefit system causes the Gini Coefficient for 'Final Income' to be significantly lower than for 'Original Income'. (6 marks)

   Check Mark Scheme

   Click “Check Mark Scheme” to compare your answer, 1. Lorenz Curve & Gini Formula: The Lorenz Curve plots the cumulative % of population (from poorest to richest on the x-axis) against the cumulative % of income on the y-axis; the Gini Coefficient is G = Area A / (Area A + Area B), where A is the area between the 45° Line of Perfect Equality and the Lorenz Curve [2 marks]. 2. Original Income (Gini ~0.50 in the UK): Original income is raw market income from wages, rent, and dividends before any government intervention, which is highly unequal because retired pensioners, unemployed, and disabled households earn near-zero market income while top executives earn millions [1 mark]. 3. Cash Benefits and Direct Taxes (Disposable Income, Gini ~0.35): Cash welfare transfer payments (State Pension, Universal Credit, Disability Benefits) boost the income of the poorest deciles, while progressive direct taxes (Income Tax at 20%/40%/45% and National Insurance) take a higher % from top deciles [2 marks]. 4. Benefits-in-Kind vs Indirect Taxes (Final Income, Gini ~0.29): Although indirect taxes like VAT and excise duties are regressive, free universal public services (benefits-in-kind: NHS healthcare and state schooling) represent a massive proportional boost to low-income households, shifting the Lorenz Curve for Final Income closest to the 45° line [1 mark].

2. Q2

   Evaluate the view that rising income and wealth inequality is always harmful to an economy's macroeconomic performance. (8 marks)

   Check Mark Scheme

   Click “Check Mark Scheme” to compare your answer, 1. [AO1/AO2 Why Inequality Harms Performance - 3 marks] High inequality reduces Aggregate Demand and economic growth because higher-income households have a much lower Marginal Propensity to Consume (MPC) and hoard wealth in unproductive assets (property/offshore savings), whereas low-income households spend almost 100% of their income locally (boosting the Keynesian multiplier). Also, inequality of opportunity traps low-income children in under-resourced schools and poor health (Wilkinson & Pickett 2009), wasting human capital and lowering long-run productivity (LRAS) while increasing fiscal spending on crime, healthcare, and welfare. 2. [AO3 Counter-Argument: Why Some Inequality Boosts Growth - 3 marks] Neo-classical and free-market economists argue that complete equality destroys economic incentives: wage differentials are essential to reward hard work, long medical/engineering training, and labour mobility from declining to growing sectors. Similarly, profit and wealth rewards incentivize entrepreneurial risk-taking and innovation (Schumpeter's creative destruction), and high earners' higher Marginal Propensity to Save (MPS) provides the pool of domestic loanable funds required by banks to finance business capital investment (Harrod-Domar model). 3. [AO3 Synthesis / Judgement - 2 marks] As IMF research (Ostry et al. 2014) demonstrates, the relationship is non-linear: moderate wage differentials grounded in meritocracy and productivity incentivize supply-side growth, whereas extreme, entrenched wealth inequality driven by inherited rent-seeking (Piketty's r > g) stifles social mobility and destabilises macroeconomic growth.

3. Q3

   Compare and evaluate increasing the top rate of progressive income tax versus introducing a Universal Basic Income (UBI) as policies to reduce poverty and inequality. (8 marks)

   Check Mark Scheme

   Click “Check Mark Scheme” to compare your answer, 1. [AO1/AO2 Increasing Top Progressive Income Tax - 2 marks] Raising the Higher/Additional rates of income tax (e.g., from 45% to 55%) and lowering thresholds directly reduces post-tax disposable income of the highest deciles, automatically lowering the Gini coefficient and generating fiscal revenue that can be hypothecated to fund public education, NHS healthcare, and targeted welfare. 2. [AO3 Evaluation of High Marginal Tax Rates (Laffer Curve) - 2 marks] However, the Laffer Curve warns that pushing marginal tax rates beyond the optimal peak T* triggers work disincentives (substitution effect toward leisure), tax avoidance/income-shifting into lower-taxed capital gains/corporations, and 'brain drain' emigration of mobile entrepreneurs and high-earners, potentially reducing total tax receipts. 3. [AO1/AO2 Universal Basic Income (UBI) - 2 marks] A UBI provides every adult citizen with an unconditional, tax-free basic cash payment regardless of income or employment status: it completely eliminates absolute poverty, removes administrative bureaucracy and stigma, and eradicates the 'poverty trap' of means-tested benefits because workers keep every extra pound they earn (minus standard income tax). 4. [AO3 Evaluation of UBI - 2 marks] Despite successful small-scale trials (e.g., Finland 2017-18 showing improved mental well-being), a nationwide UBI large enough to replace existing housing/disability benefits would carry an astronomical fiscal cost (requiring massive tax rises across middle earners), gives money inefficiently to wealthy households who do not need it, and could still reduce labour supply among second earners or trigger demand-pull inflation.

4. Q4

   Explain how globalisation and technological change have contributed to rising income inequality within developed economies such as the UK and USA since 1980. (5 marks)

   Check Mark Scheme

   Click “Check Mark Scheme” to compare your answer, 1. Globalisation & Offshoring of Manufacturing (Stolper-Samuelson Effect): The integration of labour-abundant economies (such as China, India, and Vietnam) into global supply chains led transnational corporations (TNCs) to offshore routine, medium-skilled factory jobs from Western industrial heartlands, depressing wages and causing structural unemployment for blue-collar workers [2 marks]. 2. Skill-Biased Technological Change (Automation & AI): Advances in computing, robotics, and AI act as a complement to high-skilled university graduates (data scientists, financiers, executives, boosting their MPP and MRP sky-high) while acting as a direct substitute for routine clerical and manual workers (hollowing out the middle class) [2 marks]. 3. Winner-Takes-All Global Markets & Declining Union Power: Global digital markets allow tech founders and CEOs to capture global monopoly rents, while the threat of international relocation has weakened domestic trade union collective bargaining power [1 mark].

Related study guides