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DP IB Economics: HL Your notes

3.4 Inequality & Poverty

Contents
Measuring Inequality & Poverty
Causes Of Inequality & Poverty
Using Taxation to Reduce Inequality & Poverty
Other Policies to Reduce Inequality & Poverty

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Measuring Inequality & Poverty

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Inequality & Poverty Terminology
Equality describes situations where economic outcomes are similar for different people or different
social groups
Income equality would mean everyone, irrespective of their job, is paid the same
Inequality in the distribution of income is one cause of absolute and relative poverty
Equity refers to the idea of fairness and is a normative concept
Equity in the distribution of income means that there is fairness in the wage differentials that exist
in society e.g. those with higher qualifications or skills are paid more than those with less
The size of acceptable wage differentials is a matter of much debate
Income and wealth inequality are two different concepts
Income inequality refers to the unequal distribution (flow) of income to households i.e rent,
wages, interest and profit
Wealth inequality refers to differences in the amount of assets that households own
Absolute poverty is a situation where individuals cannot afford to acquire the basic necessities for a
healthy and safe existence
These necessities include shelter, water, nutrition, clothing and healthcare
In 2022, the World Bank defined absolute poverty as anyone who was living on less than $1.90 a
day (the so called international poverty line)
Absolute poverty is more prevalent in developing countries than in developed ones
Relative poverty is a situation where household income is a certain percentage less than the median
household income in the economy
Poverty in a household is considered relative to income levels in other households
Households that are living with less than 50% of the median household income are considered to
be in relative poverty
Relative poverty is the main form of poverty that occurs in developed countries

Measuring Inequality - the Lorenz Curve & Gini

Coefficient
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The two main measures of income inequality are the Lorenz Curve and the Gini coefficient

The Lorenz Curve Your notes

The Lorenz Curve is a visual representation of the income inequality that exists between households in
an economy
Data is commonly presented in quintiles (population divided into 5 groups i.e 20%) or deciles
(population divided into 10 groups i.e 10%)
E.g. in 2020, 49% of the income flow in Bolivia went to the top 20% of households while only 4%
went to the bottom 20%
Perfect income distribution is not the goal (20 % of the population gets 20% of the income; 40% gets
40% percent of the income etc.)
That would equate to socialism and completely remove incentives for work as everyone would be
paid equally
More equal income distribution is desired as it reduces poverty and social unrest
What constitutes acceptable income equality is a normative economic issue

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An illustration of Income Inequality for Bolivia (blue line) and Sweden (red line) and the UK (yellow line)
using a Lorenz Curve Model. The income distribution in Bolivia is more unequal than that of Sweden

Diagram Analysis
The line of equality represents perfect income distribution (not desirable)
In Bolivia the bottom 20% of households receive 4% of the income flow while in Sweden they receive
9% of the income flow
In the UK the top 10% of households receive 45% of the income flow while in Sweden they receive
25%
Sweden has a more equal distribution of income than the UK

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The Gini Coefficient

The Lorenz curve can be used to calculate the Gini Coefficient Your notes

The Gini Coefficient is calculated using the area beneath the line of equality

Diagram Analysis
A
Gini Coefficient =
A+B

A represents the area between the line of equality and Bolivia's Lorenz curve
B represents the area under the Lorenz curve
A value of 0 represents absolute equality (socialism) and 1 represents perfect inequality
In 2017, Estonia's coefficient was 0.3 as compared with a value of 0.62 in South Africa
The distribution of income in Estonia was more equitable than in South Africa

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Governments use progressive taxation and transfer payments to shift the Gini coefficient closer to
zero
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Worked Example
Using a Lorenz curve diagram, explain what happened to income inequality in Bolivia between 2008
and 2016 [4]
Income Gini Coefficient Data for Bolivia

Income Gini Coefficient 2008 0.51

Income Gini Coefficient 2016 0.43

Answer:

Step 1: Determine if inequality has improved or worsened

The closer to zero, the closer the country is moving to perfect equality.
The situation in Bolivia has improved so the Lorenz curve is moving closer to the line of perfect
equality
Step 2: Draw and label the Lorenz Curve for each year

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(2 marks for a correctly labelled diagram with a shift inwards of the Lorenz curve)

Step 3: With reference to your diagram, explain what has happened to the income inequality
between the two time periods
The closer the Gini coefficient is to zero, the more equal the distribution of income in a country. [1
mark] Bolivia's Gini coefficient has moved closer to zero indicating that there is less income
inequality in 2016 than there was in 2008 and this is illustrated by an inward shift of the Lorenz curve
towards the line of perfect equality [1 mark]

Constructing a Lorenz Curve from Quintile Data

The Lorenz Curve plots the percentage of a nation’s total income against the percentage of the
nation’s population, and thereby shows how much each quintile (or one fifth) of the population earns
of the total income

% of Population Poorest 20% 2nd 20% 3rd 20% 4th 20% 5th 20% Gini Index

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Bangladesh 8.6% 12.4% 16.2% 21.4% 41.4% 32.4

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Canada 7.4% 12.6% 17% 23% 40% 32.5

South Africa 2.3% 4.8% 8.2% 16.5% 68.2% 63.00

Vietnam 6.6% 11.5% 15.9% 22.1% 43.9% 36.8

Source: World Bank

The country with a Gini Index closest to zero has the most income equality
Bangladesh has the best income equality and South Africa has the worst
The Lorenz curve for Bangladesh will be closest to the line of perfect equality and furthest away for
South Africa

Worked Example
Using information from the table above, construct a Lorenz Curve diagram which shows the
distribution of income for the country with the highest inequality and the country with the lowest
inequality [4]

Answer:
Step 1: Identify the countries with the best and worst income inequality
South Africa has the worst and Bangladesh has the best [1 mark]
Step 2: Change the income data so that it is cumulative from quintile to quintile

% of Population Poorest 20% 2nd 20% 3rd 20% 4th 20% 5th 20% Gini Index

Bangladesh 8.6% 21% 37.2% 58.6% 100% 32.4

South Africa 2.3% 7.1% 15.3% 31.8% 100% 63.00

[1 mark]

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Step 3: Draw the Lorenz Curve Diagram

Your notes

[2 marks]

Measuring Poverty
There are many single indicators of economic development. These can be used to compare the
relative standing of countries at any point in time. They also serve to provide targets for improving the
lives of citizens. Examples include
Energy consumption per person
The proportion of the population with access to clean water
Number of girls completing primary education
Another single indicator is the International Poverty Line (IPL)
This is the absolute minimum level of income that a person must receive in order to meet the basic
needs required for human survival - currently $1.90 a day

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The Minimum Income Standard (MIS) is another useful indicator

The Minimum Income Standard (MIS) identifies the lowest amount of income needed for what Your notes
society views as an acceptable standard of living in the country
The value differs from region to region as adjustments are made for those living in urban versus
rural areas due to the different costs of living associated with each
A composite indicator can provide more meaningful data for comparisons between countries
One useful composite indicator is the Multi-dimensional Poverty Index (MPI)
Characteristics of the MPI
1. Launched in 2010 by the Oxford Poverty and Human Development Initiative at the University of
Oxford
2. The MPI uses a survey to measure the complexities of poor people’s lives, individually and collectively,
each year
3. The MPI tracks deprivation across three dimensions and 10 indicators
Health (child mortality, nutrition)
Education (years of schooling, enrolment)
Living standards (water, sanitation, electricity, cooking fuel, housing, assets)
4. The survey first identifies which of these 10 deprivations each household experiences
5. Households are then categorised as poor if they suffer deprivations across 1/3 or more of the
weighted indicators
6. The MPI can focus in on regions, ethnicities and also any of the three dimensions
7. This adaptability makes it a useful tool for policymakers and non-government organisation (NGOs)
working to reduce poverty

Difficulties in Measuring Poverty

Poverty is multi-dimensional concept and difficult to quantify
Poverty is usually measured through self reported surveys and this gives rise to multiple discrepancies
in - and between - countries
Households who identify as poor may exhibit very different characteristics from each other
Urban households may have very different ideas of their poverty level compared to rural households
Urban areas tend to have higher immigrant households whose status can change relatively quickly as
they seize opportunities

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Rural households may remain in long-term poverty

Poverty data for different ages, gender and disabilities is not easily available Your notes

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Causes Of Inequality & Poverty

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The Causes of Inequality & Poverty
Causes of Poverty
There are many causes of poverty. However, poor countries have several common characteristics
which can be summarised in a poverty cycle diagram

Poverty is caused by a lack of both economic growth and human development

Low wages represent the intersection of economic growth and human development and are the major
cause of poverty
Low wages are usually the result of unemployment, informal employment, a lack of skills, or a
primary sector based economy

Education and healthcare cost money and with lower wage levels these are not accessible, resulting in
poor human capital
People find it harder to stay well or to recover from illness resulting in lower productivity and
shorter life expectancy

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Low productivity results in low wages and the cycle continues

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Populations with a large number of dependents (old people and children) for each working household
tend to experience higher levels of poverty
Causes of Inequality
There are numerous factors that cause wealth and income inequality
It is generally true that developed countries have a larger tax base and are able to provide a better level
of support to the poorest households in the economy, than developing countries are able to
Cause of Wealth & Income Inequality

Cause Explanation

Differences in human The higher the skill level the higher the level of income
capital
A country with a poor education system will see greater inequality than one
with a good education system

Inequality of Access to education and health can vary significantly within communities
opportunity and between different regions
Inequality in education and healthcare leads to inequality of opportunity in
the job market

Different levels of Assets generate income

resource ownership
The more equal the asset ownership in an economy the less the inequality in
income distribution

Discrimination Gender, race - or any other discrimination increases income inequality in

an economy

Unequal status and Countries with strong trade union membership provide workers with more
power power and higher levels of income
With low trade union membership, the exploitation of workers through low
wages is easier and income inequality is worse

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Government tax and Countries that provide a range of benefits (such as unemployment,
benefits policies pension, disability, child support, housing support etc) raise the income of
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the lowest 20% of the population resulting in more equal distribution
Progressive tax systems allow all income earners to contribute to public
revenue according to their ability
Decreasing taxes on the lower end and increasing it on the upper end
would mean that the system is more progressive and there would be a
more equal distribution of income

Globalisation and Globalisation is the economic integration of different countries through

technological increasing freedoms in the cross-border movement of people,
change goods/services, technology and finance
This integration of global economies has impacted national cultures,
spread ideas, speeded up industrialisation in developing nations and led to
de-industrialisation in developed nations
Countries which are more isolated will experience higher levels of wealth
and income inequality

Market based Supply-side policies such as deregulation, privatisation and trade

supply-side policies liberalisation can provide great opportunities but also increase inequality
E.g. Privatisation of state owned assets often allows a few people to get
rich (those who buy the asset) and the service provided by the newly
privatised firm may become more expensive to access

The Costs of Income & Wealth Inequality

Capitalism is at the heart of free market economics
Under Capitalism, inequality is inevitable
Workers with higher skills receive higher wages
Workers with little to no skills receive little to no wage
Individuals with higher income will acquire more assets leading to higher levels of income
In turn, they can keep on acquiring assets
Individuals with lower income will find it hard to acquire assets

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The principles of capitalism are considered important as the incentive to acquire income raises
productivity and output
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However, the long-term outcome of capitalism is that the factors of production become
concentrated in ownership with relatively few individuals developing extreme wealth, at the expense of
many who lose out
The costs of inequality
1. Impact on economic growth
At some point, increasing levels of inequality becomes a disincentive for workers to work and be
productive
This means that some resources (labour) in the economy are not being used efficiently. National
output falls and economic growth slows
Government unemployment payments and welfare benefits may increase
Government tax revenues may decrease with increasing inequality

2. Impact on living standards

If the inequality gap grows, the rich get richer and the poor, relatively poorer
Over time, this will reduce the standard of living
The wealthier will access better education and healthcare creating even less opportunity for
poorer households in the future
3. Impact on social stability
More equal societies tend to be more stable, tolerant and considerate with lower levels of crime
and better standards of living
Less equal societies tend to be characterised by political instability, strife, social unrest - and in
extreme cases this can lead to revolutions

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Using Taxation to Reduce Inequality & Poverty

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The Role of Taxation
The main source of government revenue is taxation
Taxation is used to redistribute income so as to reduce income inequality in a nation

Types of taxes
Direct taxes are taxes imposed on income and profits
They are paid directly to the government by the individual or firm
E.g. Income tax, corporation tax, capital gains tax, national insurance contributions, inheritance
tax
Indirect taxes are imposed on spending
The less a consumer spends the less indirect tax they pay
Examples of indirect tax include Value Added Tax (19% VAT rate in the European Union in 2022),
taxes on demerit goods such as excise duties on fuel or cigarettes

Types of tax systems

Tax systems can be classified as progressive, regressive or proportional
Most countries have a mix of progressive (direct taxation) and regressive (indirect taxation) taxes in
place
An Explanation of tax Systems

System Explanation Diagram

Progressive As income rises, a larger percentage of

income is paid in tax (called the marginal
tax rate)
In the diagram, when personal income
rises from Y1 to Y2, the tax rate rises from
TR1 to TR2

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Regressive As income rises, a smaller percentage of

income is paid in tax
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In the diagram, when personal income
rises from Y1 to Y2, the tax rate falls from
TR1 to TR2
All indirect taxes are regressive
In the USA, Federal income tax is
progressive but almost all State taxes are
regressive (the bottom 20% of income
earners pay as much as 6x the % of their
income than the top 20%)

Proportional As income rises, the same percentage of

income is paid in tax
In the diagram, when personal income
rises from Y1 to Y2, the tax rate remains
constant at 20%
In 2022, Bolivia was using this system with
a proportional tax rate of 13%

The link Between Taxation & the Reduction of Income Inequality & Poverty

Progressive A progressive tax system redistributes Higher redistribution → better

taxation from those with higher income to those education/healthcare → better human
with lower income and reduces income capital → better productivity → higher
inequality income
Redistribution often starts with the
provision of free education and
healthcare
Many governments use tax revenues to
provide multiple levels of financial
support to poor households including
disability payments, heating subsidies,
travel subsidies etc.

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Sometimes the benefits of a good

progressive tax system are eradicated by
the penalties imposed through multiple Your notes
regressive (indirect) taxes

Direct & Indirect tax rate Calculations

Indirect tax rate calculations focus on calculating the taxes paid by consumers on expenditure
Indirect taxes usually have to be identified from a table, before the calculations are made

Direct tax rate calculations usually focus on the calculation of marginal and average tax rates from a
set of data provided
Marginal tax rates represent the amount of additional tax paid for every additional dollar earned
as income
Marginal tax rates increase as income increases
Average tax rates are calculated using the following formula

total taxes paid

Average tax rate = x 100
total income

Worked Example
Using information from the table below, calculate the average tax rate paid by an employee who
earns $25,000 a year [4]

Income ($ per year) Rate of Income Tax

1 - 10,000 5%

10,001 - 18,000 10%

18,001 - 35,000 20%

35,001 and over 30%

Answer:

Step 1: Calculate the tax paid on the first $10,000

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5% x 10,000 = $500

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Step 2: Calculate the tax paid on income between $10,001 - $18,000
10% x $7,999 = $799.90

Step 3: Calculate the tax paid on income between $18,001 and $25,000 (the employees income)
20% x 6,999 = $1,399.80 [1 mark]
Step 4: Add the marginal tax paid together to obtain the total tax bill for the employee
$500 + $799.90 + $1,399.80 = $2,699.70 [1 mark]

Step 5: Calculate the average rate of tax for the employee

total taxes paid

Average tax rate = x 100
total income

2,699 . 70 [1 mark]
Average tax rate = x 100
25,000

Averagre tax rate = 10 . 7988 %

Step 6: Present your answer rounded to two decimal places

Average tax rate = 10.80% [1 mark]

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Other Policies to Reduce Inequality & Poverty

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Other Policies
The poverty cycle diagram (below) was introduced in the previous subtopic and helps to explain the
causes of poverty
Any policy that helps to break the poverty cycle at any point will help to improve the standards of
living within a country
Policies used to alleviate poverty include promoting economic growth, improving education,
providing more generous state benefits, progressive taxation, and the establishment/increase of a
national minimum wage

Policies which help to improve any factor in the diagram will help to alleviate poverty

How Different Policies Alleviate Poverty

Policy Explanation Impact on Poverty Cycle

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Investing in human capital Investing in this supply-side Higher education/skill levels →

e.g. education policy increases the potential higher human capital →
Your notes
output of the country (shifts the increased productivity → higher
production possibility frontier output → higher income
outwards)

More generous transfer Transfer payments are usually More benefits → higher wages →
payments given to the poorest and most better education/healthcare →
vulnerable people in society better human capital → better
productivity → higher wages
Transfer payments include
unemployment and disability
payments, pension payments,
heating discounts, public
transport subsidies etc.

Establishment/increase of Minimum wages are set above Higher wages → better

national minimum wage the free market rate education/healthcare → better
human capital → better
Firms are not allowed to pay productivity → higher wages
anyone less than the legal rate

Establishing a universal A universal basic income (UBI) is Minimum income for all → better
basic income a guaranteed minimum income education/healthcare → better
level - and when necessary, paid human capital → improved labour
by the government to each offer → decreasing
individual in society unemployment

Targeted government This can be aimed at the greatest Higher education/skill levels →
spending on needs in society higher human capital →
goods/services increased productivity → higher
E.g. Providing more schools, output → higher income
teachers or hospitals

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Policies to reduce Discrimination occurs in many Less discrimination → better

discrimination different forms (age, ethnicity, productivity → higher wages
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gender, disability etc) and in
each case results in social
exclusion leading to inequalities
of opportunity and income
Reducing discrimination reduces
inequality

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