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Discuss the extent to which fiscal policy alone can reduce income inequality (25 marks)

Income inequality can be defined as the difference in the income gained by the richest in society and the poorest. It can be measured using the Palma ratio, which is calculated by dividing the cumulative income of the highest earning 10% of the population by that of the lowest earning 40%. The lower the country’s Palma ratio, the less income inequality there is. The latest Palma ratio figure for the UK is 1.07, whereas that of Brazil is 2.23, therefore one can conclude that there is less income inequality in the UK than Brazil. The UK’s fiscal policy refers to the use of taxation and expenditure by the government to achieve its economic objectives, in this case to reduce income inequality by redistributing income, this may be in the form of welfare benefits (such as the Jobseekers’ Allowance), direct taxation (such as income tax) and indirect taxation (such as excise duty). However, it can be debated as to whether fiscal policy “alone” can reduce income inequality as the question suggests.

One way in which the government can reduce income inequality is by increasing welfare benefit payments, one of which is the Jobseekers’ Allowance. This offers those who are seeking employment but currently unemployed an income, as opposed to them having no income, as a result redistributing national income such that the poorest in society also gain a share. However, the effectiveness of this is questionable, as it increases the replacement ratio, whereby one may earn a higher income by remaining unemployed than being employed, incentivising people to remain unemployed instead of partaking in employment, thus leading to voluntary unemployment and causing labour market failure. In addition to this, it may be that such a policy is of detriment to society, as increased welfare expenditure may decrease the funding available to the government for providing merit goods such as education and healthcare, leading to under provision and thus social inefficiency. The amount by which inequality is reduced, depends on the extent by which welfare payments increase, if increased by a large amount it will mean that there is less income inequality than if increased minimally. The equity of this policy is also debatable as it is subject to abuse, as people may attempt to trick the system by claiming benefits when in reality they have no incentive to work, it may be seen as unfair to increase welfare benefits for someone who is not actively seeking employment and is remaining voluntarily unemployed when someone is working many hours for a minimal wage. The effectiveness of this policy depends on the cause of income inequality, if it is caused by a failure in the labour market whereby wages are lower than the marginal revenue product of labour (MRPL) it is unlikely that increasing welfare benefits is an economically efficient solution in solving income inequality as it will increase unemployment, however if there are circumstantial reasons (such as disability) causing one to remain unemployed, it is the only effective policy to provide that individual with income.

Another fiscal policy which the government could implement is a decrease in indirect taxation. An indirect tax is a tax placed upon goods and services (an example being the excise duties placed upon fuel, tobacco and alcohol). All indirect taxes increase as consumption of the product increases; therefore, they are regressive in that, a poor individual who consumes at the same level as a rich individual pays a higher proportion of their income than a rich person. Consequently, leaving the poor worse off than the rich. A decrease in indirect taxation will leave the poor better off, thereby reducing income inequality. However, the very function of an indirect tax is to discourage the consumption of demerit goods. If lowered, the marginal private cost of consumption will decrease causing more to be consumed leading to more negative externalities and a loss of social efficiency will result. In addition to this, it may be that tax revenue gained by the government decreases, as indirect taxes are often hypothecated into merit good provision, a decrease in tax revenue may lead to under provision and further increase social inefficiency. An example of this is tax revenue gained from tobacco duty being ringfenced into improving the UK’s healthcare system to reduce the negative externalities of smoking. The change in tax revenue gained depends on the price elasticity of demand of the good, if demand for the good is price inelastic, an increase in taxation will increase tax revenue, however if it is elastic it will do the opposite. In the case of tobacco, tax revenue will decrease as it is price inelastic due to its habitual nature, therefore to maintain the same quality of healthcare, the government will have to increase its spending, worsening the UK’s budget deficit. The timescale of this policy must also be brought into question as taxes can only adjusted at the end of each financial year from April 6th of the previous year to April 5th of the next year, therefore this policy is rather unmanageable and is subject to time lags. The amount by which indirect taxes are lowered may determine the extent to which income inequality is reduced, if reduced by a large amount, there will be a large decrease in income inequality, however if increased minimally, income inequality will decrease minimally.

An alternative fiscal policy that could be implemented is adjustment to direct taxation. Direct taxation in its very essence is a means of redistributing income from the richest to the poorest and is progressive. This means someone with a high income pays a higher percentage of their income than someone who has a low income. An example of direct tax is the UK’s income tax which is mandatory for all people whose yearly income exceeds £11,500. There are a number of ways in which the UK government can adjust direct taxation to achieve less income inequality. The first of which is increasing the minimum tax-free allowance, which currently stands at £11,500, by doing this, those on the lowest incomes will get to keep a greater percentage of their total income. In conjunction with this, marginal tax rates could be lowered, currently anyone who earns in excess of £11,500 is taxed at a rate of 20%, therefore if they earn £11,501, they are obligated to pay £0.20 income tax, this is known as the basic rate. If the government lowers the basic rate, for instance to 15% it will mean that only £0.15 of each pound earned above the minimum tax-free allowance is deducted from a person’s income. This will also leave them will more income, thus reducing income inequality. The effectiveness of both measures depends very much on how the rich are taxed, if the higher and additional (second highest and highest) tax rates are increased it will mean that the richest in society will keep a lower proportion of their income after tax, thereby reducing the difference in income between the poorest and the richest. However, the equity of this policy is highly debatable as many may see it as being unfair to charge high earners who have taken risks and innovated to achieve success. Therefore, an unintended consequence of exercising this policy is that people may emigrate to other countries where tax rates are lower, causing large leakages from the circular flow of income. This, like the previous policy is subject to time lags as it can only be implemented once the financial year has fully elapsed. If tax rates are set too low consumption may increase by a large amount, putting inflationary pressure on goods and services, leading to cost push inflation. The effect of cost push inflation may even offset the decrease in taxation and may affect welfare of the poor leaving them even worse off as a result.

The fiscal policies mentioned so far take a relatively myopic approach to reducing income inequality. A longer-term solution to the problem is supply side policy, an example of such is the government increasing its expenditure on education and training in order to increase the human capital of the unemployed, giving them more transferable skills which will in turn increase labour force flexibility, allowing more people to partake in employment and thus gain income. However, this policy is subject to very long time lags as it takes a large amount of time to obtain the necessary skills to become qualified in certain professions. In addition to this, it depends on the willingness of people to be educated, as people may ignore or be unaware of positive externalities due to imperfect information, making the irrational decision of not fully utilising the education on offer to them. In addition to this, this policy requires a high amount of expenditure from the government in the short-term in the hope that the labour force will become more flexible in the long-term.

A labour market-oriented policy which the government could implement is an increased national minimum wage (NMW). The NMW is defined as a wage floor set by the government to prevent exploitation of employees. In some cases, one may remain unemployed due to the wages on offer to them being too low, making it more economically viable for them to remain voluntarily unemployed and claim welfare benefits. If the NMW is increased it will increase the lowest wage that firms are stipulated to pay to their lowest earning employees and thus may incentivise more people to find work and gain income, thus increasing their income and reducing income inequality. The amount by which NMW must be increased depends ultimately on the replacement ratio, if it is high, people will earn more from claiming benefits than working, consequently the government will have to increase NMW by a large amount. This may then increase the average cost of labour (ACL) for firms and put inflationary pressures on the prices of goods as firms may account for increased costs by increasing prices, leading to cost push inflation. An unintended consequence of this may also be that firms may substitute labour with capital machinery due to the lower costs of using machinery compared to employing workers, causing more unemployment and redundancies, although this does depend on a number of factors such as the wage elasticity of labour demand, if it is elastic, it is likely that firms may substitute labour for capital, leading to a loss of jobs which is more than proportionate to the increase in NMW, however if it is inelastic job losses will be less than proportionate to the increase in NMW. As well as this, it depends on the structure of the labour market, as a monopsonistic employer is likely to increase employment as NMW increases. The equity of this policy is also debatable as the MRPL that some workers contribute to their employer may be less than the NMW making it unfair on firms who are employing these workers as it takes away from their profits. Another detrimental effect of this policy may be that FDI into the UK by overseas firms may decrease as their costs of production will increase.

It is therefore logical to conclude that fiscal policy “alone” does not reduce income inequality and that the best option for doing so may be a combination of a number of policies. It depends very much on what is causing the income inequality in society, there are various factors which may increase it such as low wages, in which case raising NMW or lowering taxes for the those on lower incomes are ideal solutions. However, if income inequality has been caused by a lack of education it is logical for the government to increase its expenditure on education and training to boost labour force flexibility.

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