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Income Distribution and Tax Structures Review for AP Economics

By — McGraw-Hill Professional
Updated on Mar 2, 2011

Review questions for this study guide can be found at:

Public Goods, Externalities, and the Role of Government Review Questions for AP Economics

Main Topics: Equity as a Goal, Marginal and Average Tax Rates, Progressive Taxes, Regressive Taxes, Proportional Taxes.

In the case of pollution and other negative externalities, the marketplace fails to protect the victims of spillover costs. In the case of public goods or other positive externalities, the market fails to provide an adequate quantity to satisfy the needs of society. As we saw above, the government is called to action to move the market outcome closer to the societal efficient outcome. The government is also called to action to remedy issues of equity, or fairness. This section discusses equity, distribution of income, and tax structures to move closer to a more equitable outcome.

Equity as a Goal

While we tout the efficiency of competitive markets with a fervor that approaches deification, the one thing even the most efficient market does not do is provide equity, or fairness. Some consumers can afford a new Mercedes, some cannot; but I doubt that this is a good example of the unfairness of markets. But some consumers cannot afford pediatric services for their infant children. Even if these services are exchanged at the efficient quantity where the marginal social benefit is equal to the marginal social cost, even the most die-hard advocates of the free market can see that it is an outcome that should be remedied through some form of income redistribution.

An Equal Share?

There are some who propose that the economic resources should be equally divided amongst all members of society. This egalitarian, or equal share view, seems fair but has at least one serious criticism. Egalitarianismsuffers from an issue of compensation that fails to match productivity. In other words, the incentives to work hard, take risks and seek a competitive advantage are greatly reduced. If you were guaranteed an equal share of the resources, how hard would you work?

Example:
All students in your class are assured of being compensated with a "B," regardless of the effort and productivity that might merit a B. C-level students lack the motivation to become more productive because they are guaranteed compensation above their productivity. A-level students lack the motivation to produce A-level work because they know compensation falls below that. The high productivity students get disenchanted, disgruntled, and work even less.

Productivity Share?

If egalitarianism suffers from a lack of productivity incentives, maybe everyone's share of economic resources should be based upon individual productivity. In other words, this marginal productivity theorysays your wage is a function of your marginal revenue product. If markets are competitive, this can be quite efficient. In theory, this could even be fair. The flaw in this method of income distribution is that not all citizens are given a fair shake at demonstrating to the labor market their true marginal revenue product. Think of all of the advantages, large or small, that you were lucky enough to be born with. Now imagine all of them being removed from your past and present. Productive individuals who have few advantages can overcome obstacles with hard work, but some societal barriers (e.g., discrimination, a disability) prevent them from ever receiving a compensation equal to their productivity.

How Do We Measure the Income Distribution?

There are a couple of common ways to see a nation's income distribution. Whether or not we think this is "fair" is another question entirely.

  1. Quintiles
  2. Economists sort households from the lowest incomes to the highest incomes and then divide that range into fifths, or quintiles.In each quintile lies 20 percent of all households. Table 11.1 illustrates the income distribution in 2001 as published by the Bureau of the Census. If income were perfectly distributed, each 20 percent of the families in the United States would have 20 percent of the total income.

  3. Lorenz Curve and Gini Ratio
  4. The above quintile distribution can be graphically illustrated with a Lorenz curve(see Figure 11.6). The farther the Lorenz curve lies below the hypothetical line of perfect equality, the more unequal the distribution of income. This distance of the actual distribution of income from the line of perfect equality is calculated by constructing a Gini ratio,the area of the gap between the perfect equality line and the Lorenz curve (A) as a ratio of the entire area (A + B). The closer the Gini ratio is to zero, the more equal the distribution. The closer to one, the more unequal the income distribution.

Gini ratio = Area A/(Area A + Area B)

ncome Distribution and Tax Structures

What Are the Sources of Inequality?

The market is not always a good mechanism for distributing income equally. There are some commonly accepted factors for income inequality.

Can Income Be Redistributed?

Our economic system emphasizes a productivity-based distribution of resources, but we know that this system does not overcome all of the equity issues that are theoretically solved by egalitarianism. We have decided that the government should have a role in income distribution. The idea behind redistribution of income is that the government collects taxes from one segment of society and transfers it to another. These transfers come in the form of social programs like government housing, Medicare, or public education. And while most agree that these programs are essentially good, how government decides to tax is a hotly debated issue along philosophical and political grounds. We summarize the nature of progressive, regressive, and proportional taxes, and use the marginal and average concepts again in this new context.

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