Essay 3 on the 2022 AQA A level economics paper assessed the different policy options to reduce income inequality. Here is an exemplar response:
Income is a flow of money received by individuals or businesses over time. The most significant source of income for most individuals is earned through their wage from work, however other sources of income can come from renting property or interest on savings.
The main source of differences in pre-tax income is therefore due to differences in wage rates which can be explained by the operation of labour markets. One policy that would help to reduce inequality in pre-tax income would be to increase the national minimum wage.
As the diagram shows, the equilibrium wage in this labour market would be at W, the imposition of a minimum wage increases the legal wage which must be paid to workers up to Wmin. This policy would target those on the lowest incomes and help to lift them up closer to higher income groups, thus helping to reduce inequality. However, there are issues with this approach – increasing the minimum wage will increase the quantity of labour supplied to Ls, while reducing labour demand to Ld. The result is a surplus of supply over demand and a rise in unemployment. So while some workers on low wages find their incomes increasing, others may find their income falling back as they become unemployed. A further problem would be that the higher minimum wage may simply inflate wages at each level due to rising wage demands from those on higher than the minimum wage and therefore have little effect on inequality.
Another method of reducing inequality of pre-tax incomes would be to tackle large employers monopsony power. Single employers of labour tend to employ fewer workers at a lower wage rate than in more competitive labour markets. Policies such as the minimum wage (mentioned above), but also encouraging and increasing the power of trade unions can help to balance out these labour markets and allow low paid workers to earn a higher wage.
The diagram shows the wage that the monopsonist would pay (Wm), however a powerful trade union negotiating higher wages would bring about a bilateral monopoly. The outcome would be higher wages in this labour market, and as a result inequality is reduced through increasing these incomes before tax.
An alternative approach to this would be to use taxes and welfare benefits to reduce inequality. A progressive taxation system would be needed, where those on higher incomes pay not only a higher amount of tax, but a higher proportion of their income. So for example in the UK the basic rate of tax is 20%, but the highest earners pay up to 45% on additional income earned. This could be coupled with a generous system of welfare benefits – paying people directly if they are unemployed or in particularly low wage jobs. The combination of these policies would be to reduce inequality in disposable incomes – the expectation would be for the Lorenz curve to shift left, closer to the line of perfect equality.
The main issue with these policies though, are their adverse impact on incentives. Those approaching the 45% tax band may decide it is hardly worth their while continuing to further their income if almost half of it will be lost immediately in tax. If incentive to work is reduced in this way, it may have a negative impact on economic growth, the productive capacity of the economy and therefore be counterproductive in achieving the intended aims of the policy.
This does raise the debate of how much of government attention should be allocated to reducing inequality at all. While the distribution of income exists in the field of positive economics, how equitable (fair) the distribution of income is based on more normative judgements. Some would argue that those who are skilled and well trained as deserving of significantly higher incomes, while others would contend that not everyone gets a fair start in life and it is the role of the state to redistribute incomes wherever possible.
On balance, I think it is an essential role for the state to play in reducing inequalities and I would focus primarily on reducing pre-tax incomes. I think the focus should be more on labour markets to produce more equal outcomes in terms of pay. I would therefore impose policies such as NMW, combined with repealing any legislation which curbs the power of trade unions. I would also introduce legislation limiting the maximum differential between highest and lowest earners in all organisations. This would incentivise managers to ensure their lowest paid staff are given a fair wage, as their own wage would also depend on this. Finally, I think that inequality is such a significant issue in society, that we should go further than any of these policies which focus on incomes, introducing wealth taxes to further the redistribution. Inherited wealth is one of the main reasons for persistent inequality in society and a wealth tax at even a moderate level of around 1% on wealth above, for example, £10m would go a long way to resolving this.
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