The Distribution of Income and Wealth: Poverty and Inequality

AQA A-level Economics 7136 · specification section 3.1.7

Why this topic matters

This is a whole numbered section of the specification, 3.1.7, and it is examined on Paper 1 alongside market failure. It is also the topic where candidates most often confuse two things that sound alike and are not: income and wealth, and poverty and inequality.

Get those two distinctions right and most of the marks follow.

Income and wealth are not the same thing

Income is a flow: money received over a period. Wages, interest, rent, profit, benefits.

Wealth is a stock: the value of assets held at a point in time. Property, pensions, shares, savings.

The link runs both ways. Wealth generates income (a house earns rent, shares pay dividends), and income can be saved to become wealth. That feedback is why wealth is distributed far more unequally than income in almost every economy: those with assets earn more, save more and acquire more assets.

Causes of an unequal distribution of income: differences in skills and qualifications, in the demand for and supply of particular kinds of labour (the wage differentials of 4.3), in hours worked, in whether people are employed at all, in bargaining power, discrimination, and the fact that unearned income from wealth accrues only to those who already hold it.

Causes of an unequal distribution of wealth: inheritance, differences in the ability to save, asset price rises benefiting existing owners, pension entitlements, and home ownership.

Measuring inequality

The Lorenz curve

▶

Plot the cumulative percentage of the population, poorest first, on the horizontal axis, and the cumulative percentage of income on the vertical.

• Perfect equality is the 45-degree line: the poorest 20 per cent would receive 20 per cent of income.
• The actual distribution sags below that line.
• The further the curve bows away from the line, the more unequal the distribution.

The Gini coefficient

The Gini coefficient turns that picture into one number: the area between the 45-degree line and the Lorenz curve, divided by the whole area beneath the 45-degree line.

• 0 means perfect equality.
• 1 means one person receives everything.

Higher means more unequal. It is quoted either as a decimal (0.35) or as a Gini index out of 100 (35), and either is acceptable provided you are consistent.

Its limitation is the one worth writing: a single number can stay unchanged while the distribution underneath it changes shape, because a fall in inequality at the bottom can offset a rise at the top. Two economies with the same Gini can look very different.

Poverty

Absolute poverty

Absolute poverty is an income below the level needed to afford the basic necessities of life: food, shelter, clothing, clean water. It is measured against a fixed real standard, so it can in principle be eliminated, and it falls when real incomes rise.

Relative poverty

Relative poverty is an income far below the typical income in that society, conventionally below 60 per cent of median income. It is measured against a moving standard.

Two consequences follow, and both are examined:

• Relative poverty can rise while everyone is getting richer, if the incomes at the top rise faster.
• Relative poverty cannot be eliminated by growth alone, because the threshold moves with the median. Only a change in the distribution reduces it.

That is the single most useful sentence in this topic: growth reduces absolute poverty, redistribution reduces relative poverty.

The poverty trap

The poverty trap arises when earning more leaves someone little or no better off, because as income rises they simultaneously pay more tax and lose means-tested benefits.

The combined effect is a very high marginal deduction rate, which can approach or exceed 100 per cent over some income ranges. The result is a disincentive to work more hours or take a better-paid job, which is a genuine market distortion created by the policy intended to relieve poverty.

The related unemployment trap is where someone is barely better off in work than on benefits, because benefits are withdrawn as earnings begin.

Policies to reduce poverty and inequality

• Progressive taxation, where the average rate rises with income. Reduces post-tax inequality directly, but very high rates may weaken incentives and encourage avoidance.
• Benefits and transfers, universal or means-tested. Means-testing targets money where it is needed but creates the poverty trap above; universal benefits avoid that trap but cost far more and go partly to those who do not need them.
• A national minimum wage, which raises the lowest wages, subject to the employment effects analysed in 4.3, and which does nothing for those out of work.
• Negative income tax or universal basic income, paying a guaranteed sum that is withdrawn gradually, designed specifically to reduce the marginal deduction rate and so weaken the poverty trap.
• Education and training, raising human capital so that the pre-tax distribution itself becomes less unequal. Slow, but it addresses the cause rather than the symptom.
• Inheritance and wealth taxes, which act on the stock rather than the flow, and so on the more unequal of the two distributions.
• Free or subsidised provision of healthcare, education and childcare, which raises the real living standards of the poorest without appearing in the income statistics at all.

The equity and efficiency trade-off

Redistribution has a cost, and a good answer states both sides.

Against: taxes and withdrawn benefits blunt the incentive to work, save and take risks; high rates may drive mobile labour and capital abroad; and administering means-tested systems is expensive.

For: the marginal utility of income is higher for the poor, so transfers raise total welfare; poverty itself wastes human capital through worse health and education, which lowers long-run growth; and very unequal societies bear costs in crime, health and social cohesion.

The judgement worth reaching is that the trade-off is real but not fixed. Policies acting on the causes of inequality, education, health and training, raise efficiency and equity together, whereas policies acting only on the outcome face the trade-off directly.

Common exam mistakes

• Treating income and wealth as interchangeable. One is a flow, one is a stock.
• Saying growth will end relative poverty. It cannot: the threshold moves with the median.
• Describing the Lorenz curve without saying what either axis measures.
• Reading a higher Gini as more equality.
• Explaining the poverty trap as simply "benefits make people lazy" instead of the marginal deduction rate.
• Asserting the equity and efficiency trade-off without acknowledging the policies that avoid it.

Quick revision

• Income is a flow, wealth a stock, and wealth is the more unequally distributed.
• Lorenz curve: further from the 45-degree line means more unequal. Gini: 0 equal, 1 maximally unequal.
• Absolute poverty is a fixed real standard; relative poverty is 60 per cent of median income and moves with it.
• The poverty trap is a high marginal deduction rate from tax paid plus benefits withdrawn.
• Growth attacks absolute poverty; redistribution attacks relative poverty.
• The equity and efficiency trade-off is real for transfers and weak or absent for education and health.