Tag: income effects

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Inequality: the ‘defining issue of our day’?

Wes Streeting and Andy Burnham are seeking to become UK Prime Minister in a challenge to Keir Starmer. They have both responded to an essay by Tony Blair, former Labour Prime Minister, where he argued that current Labour policies were holding back business. But the essay never mentioned inequality. According to Burnham and Streeting, inequality and the related issue of poverty are fundamental to the crises facing society in western democracies. Countries’ economic success is typically measured in terms of growth in GDP. But when the benefits of growth go largely to those at the top of the income scale, while people on lower incomes struggle to make ends meet, this feeds resentment. Populist politicians stoke such resentment and offer simplistic solutions, such as protectionism, blaming outsiders and promising a return to better times.

But just what has happened to inequality over recent years and has poverty deepened? How are inequality and poverty affecting people’s lives and what is the impact on the economy? And what policies should governments follow to tackle the problem?

Income inequality

The chart shows UK inequality as given by the Gini coefficient, where 1 represents complete inequality, with one person earning the whole of national income and 0 represents perfect equality, with everyone earning the same. The higher the figure, therefore, the greater the inequality. As you can see, inequality is greatest when looking at original income – that is, income before taxes and benefits. Gross income includes benefits, and disposable income is income after both benefits and taxes. You can see that both benefits and taxes reduce inequality. When we take housing costs into account with the disposable income measure, however, inequality increases.

The chart shows that income inequality rose until the early 2000s, since when there have been only slight changes, although there has been a small decline recently.

The UK has higher income inequality than most high-income countries, although it is not as high as in the USA. It is sixth most unequal of the 38 OECD countries and the most unequal OECD member in Europe.

Globally, in 2025, the top 10% of the world’s population earned 53% of global income, while the bottom half earned just 8%. The reports listed below provide data and analysis on UK and global inequality.

Wealth inequality

When we turn to wealth, inequality in the UK is even greater. The richest 10% of households hold around 41% of wealth, while the poorest 50% hold just under 10%. The Gini coefficient is around 0.6. This has been drive by a rise in property and share prices and the system of inheritance whereby family wealth can accumulate over the generations.

Globally, the top 10% of the world’s population held 75% of global wealth in 2025, whereas the bottom 50% held just 2%. And a tiny group of people – the top 0.001% of the adult population (about 56,000 individuals) – held about 6% of global wealth, up from 4% in 1995. Such extreme wealth inequality has thus increased.

Inequality and poverty

There is no single measure of poverty. It could be measured in terms of basic needs. Here poverty would be where a person is unable to afford basic food, shelter, heating and lighting, clothing, footwear and basic toiletries. Normally, however, it is measured in relative terms. A typical measure, and one used by the Joseph Rowntree Foundation, is based on a proportion of median income. Poverty is defined as income below 60% of the median income, with deep poverty below 50% and very deep poverty below 40%.

In 2023/24, 14.2 million people were in poverty (20% of the population), of whom around 4.5 million were children. Of the 14.2 million, 6.8 million people (nearly half) were in very deep poverty,

Causes of poverty include one or more of the following: low skills or education, low pay, unemployment, inadequate benefits or a benefit system that is confusing or difficult to access, chronic sickness, disability, unavailability or cost of suitable housing, discrimination, a breakdown of personal relationships, substance abuse, abuse from others, a criminal record. Once in poverty, it becomes difficult to escape as people become deskilled, demotivated and judged by society.

But even if people are not earning less than 60% of median income, they can still struggle to escape inequality. Many people have low skills; many routine jobs are being replaced by automation or AI; many graduates face high debts; people struggle to get on the housing ladder; the rising cost of basic items dampens real incomes, especially of the low paid; people may face discrimination of various sorts; people do not have an option of joining a union in their workplace; people may have a large number of dependants.

The policy agenda

If inequality rises up the political agenda in the UK, especially with a potential leadership race in the Labour party, what might politicians focus on? The government has already done the following:

  • It has raised the minimum wage (the ‘National Living Wage’) substantially from £10.42 in 2023/24 to £11.44 in 2024/25, to £12.21 in 2025/26 and lowered the age limit from 23 to 21. There have been larger percentage rises for 18–20 year-olds and those under 18.
  • The two-child limit to the child benefit element in Universal Credit has been scrapped and so now parents are eligible for benefits for all children.
  • The Employment Rights Act has ended exploitative zero-hour contracts by providing rights to guaranteed hours.
  • It has expanded free school meal entitlements.
  • It has capped Universal Credit debt deductions at 15% of increased incomes (down from 25%) to help the poorest households retain more of their monthly income.
  • It has expanded free school meals and made more money available for free nursery place.
  • Landlords can no longer evict tenants for no reason; they must have a valid reason such as wanting to sell the property or severe rent arrears.
  • Landlords cannot increase rents more than once per year and tenants can appeal excessive or above-market rent increases to an independent tribunal.

But despite these policy measures, many claim that they will do too little to tackle inequality and poverty. Some on the left argue that taxes on property and other forms of wealth will be required to tackle wealth inequality. Others argue that more emphasis on education and training is necessary to provide workers with the skills to earn more in the labour market. Others argue for greater expenditure on public services.

Generally, however, measures to tackle inequality and poverty require government expenditure, which must be funded. This is why many on the centre left argue that economic growth is a necessary condition for any significant redistribution. It is, they argue, the best way of providing the tax revenue to fund redistribution.

Incentives and disincentives

Many on the right argue that redistributing incomes through higher taxes and benefits will act as a disincentive to work and to invest. As we argue in Essentials of Economics, higher income taxes could discourage people from working and investing; higher wealth taxes could discourage people from saving and investing.

The key to analysing these arguments is to distinguish between the income effect and the substitution effect of raising taxes. Raising income tax does two things.

  • It reduces disposable incomes. People therefore are encouraged to work more in an attempt to maintain their consumption of goods and services. This is the income effect. ‘I have to work more to make up for the higher taxes’, a person might say.
  • It reduces the opportunity cost of leisure. Since higher income taxes reduce take-home pay, an extra hour taken in leisure now involves a smaller sacrifice in consumption. Thus people may substitute leisure for consumption, and work less. This is called the substitution effect. ‘What is the point of doing overtime’, another person might say, ‘if so much of the overtime pay is going in taxes?’

The relative size of the income and substitution effects is likely to differ for different types of people. For example, the income effect is likely to dominate for those people with a substantial proportion of long-term commitments, such as those with families, with mortgages and other debts. They may feel forced to work more to maintain their disposable income. Clearly for such people, higher taxes are not a disincentive to work. The income effect is also likely to be relatively large for people on higher incomes, for whom an increase in tax rates represents a substantial cut in income.

The substitution effect is likely to dominate for those with few commitments: those whose families have left home, the single, and second income earners in families where that second income is not relied on for ‘essential’ consumption. A rise in tax rates for these people is likely to encourage them to work less.

Although high income earners may work more when there is a tax rise, they may still be discouraged by a steeply progressive tax structure. If they have to pay very high marginal rates of tax, it may simply not be worth their while seeking promotion or working harder.

What those on the centre and left argue is that tackling inequality and poverty requires more than just changing the tax and benefits system. What is required is policies that encourage greater upward social mobility, greater social cohesion and greater expenditure on infrastructure that will support the poor, such as greater expenditure on education and training, on support for very young children, on preventative healthcare, on social housing and on local public transport.

Articles

Reports

Data

Questions

  1. Is the UK becoming more or less equal? Does the answer depend on how inequality is measured?
  2. Is the world becoming more or less equal?
  3. Summarise the arguments against redistributing incomes from the rich to the poor.
  4. Summarise the arguments in favour of redistributing incomes from the rich to the poor.
  5. Explain the income and substitution effects of making income tax more progressive.
  6. How is the greater adoption of AI likely to affect income distribution?
  7. How does social mobility affect income distribution? What measures can be adopted to increase social mobility?
  8. Compare the relative merits and problems of raising income taxes, wealth taxes and expenditure taxes as means of redistributing incomes more equally.
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Why do people in some countries work much longer hours than in others?

Workers in the UK and USA work much longer hours per year than those in France and Germany. This has partly to do with the number of days paid holiday per year, partly with the number of hours worked per day and partly with the number of days worked per week.

According to the latest OECD figures, in 2017 average hours worked per year ranged from 2257 in Mexico (the OECD’s highest) to 1780 in the USA, 1710 in Japan, 1681 in the UK, 1514 in France, 1408 in Denmark and 1356 in Germany (the OECD’s lowest). Annual working hours have been falling in most countries across the decades, as the chart shows. However, in most countries the process has slowed in recent years and in the UK, the USA and France working hours have begun to rise. (Click here for a PowerPoint of the chart.)

But why do working hours differ so much from country to country? How do they relate to productivity? How do they relate to human happiness and welfare more generally?

Causes of the differences

There are various reasons for the differences in hours worked between countries.

In a situation where individual workers can choose how many hours to work, they have to decide the best trade off for them between income and leisure. As wages rise over time, there will be substitution and income effects of these extra hourly wages. Higher wages make work more valuable in terms of what people can buy from an extra hour’s work. There is thus an incentive to substitute work for leisure and hence work longer. This is the substitution effect. On the other hand, higher wages allow people to work fewer hours for a given income. This is the income effect.

As incomes rise, generally the substitution effect will tend to decline relative to the income effect. This is because of the diminishing marginal utility of income. Richer people will tend to value a given rise in income less than poorer people and therefore will value the income from extra work less than poorer people. Richer people will prefer to work fewer hours than poorer people. Generally workers in richer OECD countries work fewer hours than those in poorer OECD countries.

But this does not explain why people in the USA, Canada, Japan and the UK work longer hours than people in Germany, Denmark, Norway, The Netherlands and France.

One possible explanation for these differences is the role of trade unions. These tend to be stronger in countries with lower working hours. Reducing the working week or obtaining longer holidays is one of the key objectives of unions.

Another is income distribution. The USA, despite its high average (mean) income, has a relatively unequal distribution of income compared with Germany or France. The post-tax-and-benefits Gini coefficient in the USA is around 0.39, whereas in Germany it is 0.29, meaning that Germany has a more equal distribution of disposable income than the USA. In fact, rises in real incomes in the USA over the past 10 years have gone almost exclusively to the top 10 per cent of earners, leaving the median income little changed. In fact median household income only rose above its 2007 (pre-recession) level in 2016.

Social and cultural explanations may also be important. People in countries with higher working hours relative to hourly wages may put a greater store on consumption relative to leisure. The desire to shop may be very strong. The ‘Anglo-Saxon’ economic model pursued by right-of-centre governments in English-speaking countries, such as the USA, Canada, Australia and the UK puts emphasis on low taxes, low regulation, low public expenditure and self-advancement. Such a model encourages a more individualistic approach to work, with more emphasis on earning money.

Then there is the attitude to hours worked generally. There is a saying that in the UK the last one to leave the office is seen as the hardest working, whereas in Germany the last one to leave is seen as the least efficient. Social pressures, from colleagues, family, friends and society more generally can have a major effect on people’s choices between work and leisure.

Productivity

Productivity, in terms of output per hour worked, tends to decline as workers work longer hours. People get tired and possibly bored and demotivated towards the end of a long day or week. If workers are paid by the output they produce and if productivity declines towards the end of the day, then the hourly wage would fall as the day progresses. This would act as a disincentive to work long hours. In practice, most workers are normally paid a constant rate per hour for normal-time working. For overtime, they may even be paid a higher rate, despite their likely lower productivity. This encourages them to work longer hours than if they were paid according to their marginal productivity.

Linking pay more closely to productivity could encourage people to opt for fewer hours (if they had the choice). Indeed some companies are now encouraging workers to choose their hours – which may mean fewer hours as people seek a better work–life balance. (See the BBC article below about PwC’s employment strategy.) Alternatively, some other employers adopt the system of giving workers a set amount of work to do and then they can leave work when it is finished. This acts as an incentive to work more efficiently.

It is interesting that countries where workers work more hours per year tend to have a lower output per hour worked relative to output per worker than countries where workers work fewer hours. This is illustrated in the chart opposite. The USA, with its longer working hours, has higher output per person employed than France and Germany but very similar output per hour worked.

Hours and happiness

So are people who choose to work longer hours and take home more money likely to be happier than those who choose to work fewer hours and take home less money? If people were rational and had perfect knowledge, then they would choose the balance between work and leisure that best suited them.

In practice, labour markets are highly imperfect. People often do not have choices about the amount they work; they work the hours they are told. Even if they do have a choice, they are unlikely to have perfect knowledge about the impact of long hours on their health and happiness over their lifetime. They may not even be good judges of the shorter-term effects of more work and more pay. They may believe that more money will buy them more happiness only to find soon afterwards that they are wrong.

Articles

Data

Questions

  1. What factors are likely to encourage workers to work longer hours?
  2. Give some examples of jobs where workers have flexibility in the amount of hours they work per week and jobs where the working week is of a fixed length.
  3. For what reasons are annual working hours longer in the USA than in Germany?
  4. Would it be in employers’ interests if the government legislated so as to reduce the maximum permitted working week? Explain.
  5. What is meant by ‘efficiency wages’? How relevant is the concept to the issue of the average number of hours worked per year from country to country?
  6. Explain why people in poorer countries tend to work more hours per year than people in richer countries.
  7. If workers’ wages equalled their marginal revenue product, why might some workers choose to work more and others choose to work less (assuming they had a choice)?
  8. Are jobs in the gig economy and zero-hour contract jobs in the interests of workers?
  9. Is South Korea wise to cut its work limit from 68 hours a week to 52?
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Inequality and economic growth

What is the relationship between the degree of inequality in a country and the rate of economic growth? The traditional answer is that there is a trade off between the two. Increasing the rewards to those who are more productive or who invest encourages a growth in productivity and capital investment, which, in turn, leads to faster economic growth. Redistribution from the rich to the poor, by contrast, is argued to reduce incentives by reducing the rewards from harder work, education, training and investment. Risk taking, it is claimed, is discouraged.

Recent evidence from the OECD and the IMF, however, suggests that when income inequality rises, economic growth falls. Inequality has grown massively in many countries, with average incomes at the top of the distribution seeing particular gains, while many at the bottom have experienced actual declines in real incomes or, at best, little or no growth. This growth in inequality can be seen in a rise in countries’ Gini coefficients. The OECD average Gini coefficient rose from 0.29 in the mid-1980s to 0.32 in 2011/12. This, claims the OECD, has led to a loss in economic growth of around 0.35 percentage points per year.

But why should a rise in inequality lead to lower economic growth? According to the OECD, the main reason is that inequality reduces the development of skills of the lower income groups and reduces social mobility.

By hindering human capital accumulation, income inequality undermines education opportunities for disadvantaged individuals, lowering social mobility and hampering skills development.

The lower educational attainment applies both to the length and quality of education: people from poorer backgrounds on average leave school or college earlier and with lower qualifications.

But if greater inequality generally results in lower economic growth, will a redistribution from rich to poor necessarily result in faster economic growth? According to the OECD:

Anti-poverty programmes will not be enough. Not only cash transfers but also increasing access to public services, such as high-quality education, training and healthcare, constitute long-term social investment to create greater equality of opportunities in the long run.

Thus redistribution policies need to be well designed and implemented and focus on raising incomes of the poor through increased opportunities to increase their productivity. Simple transfers from rich to poor via the tax and benefits system may, in fact, undermine economic growth. According to the IMF:

That equality seems to drive higher and more sustainable growth does not in itself support efforts to redistribute. In particular, inequality may impede growth at least in part because it calls forth efforts to redistribute that themselves undercut growth. In such a situation, even if inequality is bad for growth, taxes and transfers may be precisely the wrong remedy.

Articles

Inequality ‘significantly’ curbs economic growth – OECD BBC News (9/12/14)
Is inequality the enemy of growth? BBC News, Robert Peston (6/10/14)
Income inequality damages growth, OECD warns Financial Times, Chris Giles (8/10/14)
OECD finds increasing inequality lowers growth Deutsche Welle, Jasper Sky (10/12/14)
Revealed: how the wealth gap holds back economic growth The Guardian, Larry Elliott (9/12/14)
Inequality Seriously Damages Growth, IMF Seminar Hears IMF Survey Magazine (12/4/14)
Warning! Inequality May Be Hazardous to Your Growth iMFdirect, Andrew G. Berg and Jonathan D. Ostry (8/4/11)
Economic growth more likely when wealth distributed to poor instead of rich The Guardian, Stephen Koukoulas (4/6/15)
So much for trickle down: only bold reforms will tackle inequality The Guardian, Larry Elliott (21/6/15)

Videos

Record inequality between rich and poor OECD on YouTube (5/12/11)
The Price of Inequality The News School on YouTube, Joseph Stiglitz (5/10/12)

Reports and papers

FOCUS on Inequality and Growth OECD, Directorate for Employment, Labour and Social Affairs (December 2014)
Trends in Income Inequality and its Impact on Economic Growth OECD Social, Employment and Migration Working Papers, Federico Cingano (9/12/14)
An Overview of Growing Income Inequalities in OECD Countries: Main Findings OCED (2011)
Redistribution, Inequality, and Growth IMF Staff Discussion Note, Jonathan D. Ostry, Andrew Berg, and Charalambos G. Tsangarides (February 2014)
Measure to Measure Finance and Development, IMF, Jonathan D. Ostry and Andrew G. Berg (Vol. 51, No. 3, September 2014)

Data

OECD Income Distribution Database: Gini, poverty, income, Methods and Concepts OECD
The effects of taxes and benefits on household income ONS

Questions

  1. Explain what are meant by a Lorenz curve and a Gini coefficient? What is the relationship between the two?
  2. The Gini coefficient is one way of measuring inequality. What other methods are there? How suitable are they?
  3. Assume that the government raises taxes to finance higher benefits to the poor. Identify the income and substitution effects of the tax increases and whether the effects are to encourage or discourage work (or investment).
  4. Distinguish between (a) progressive, (b) regressive and (c) proportional taxes?
  5. How will the balance of income and substitution effects vary in each of the following cases: (a) a cut in the tax-free allowance; (b) a rise in the basic rate of income tax; (c) a rise in the top rate of income tax? How does the relative size of the two effects depend, in each case, on a person’s current income?
  6. Identify policy measures that would increase both equality and economic growth.
  7. Would a shift from direct to indirect taxes tend to increase or decrease inequality? Explain.
  8. By examining Tables 3, 26 and 27 in The Effects of Taxes and Benefits on Household Income, 2012/13, (a) explain the difference between original income, gross income, disposable income and post-tax income; (b) explain the differences between the Gini coefficients for each of these four categories of income in the UK.
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Who won’t benefit from child benefit?

In his speech to the Conservative Party conference, the Chancellor of the Exchequer, George Osborne, announced that from 2013 child benefit would not be paid to any household where one or both parents had a high enough income to pay tax at the 40% rate. This means that if either parent earns over £43,875, they will receive no child benefit for any of their children. If, however, neither parent pays tax at 40%, then they will continue to receive it for all their children. Thus if both parents each earned, say, £43,870, giving a total household income of £87,740, they would continue to receive child benefit.

Not surprisingly, people have claimed that it is very unfair to penalise households where one person earns just over the threshold and the other does not work or earns very little and not penalise households where both parents earn just below the threshold. So what are the justifications for this change? What are the implications for income distribution? And what are the effects on incentives? Are there any people who would be put off working? The following articles look at these questions.

Articles
How benefit cuts could affect you Guardian, Patrick Collinson and Mark King (5/10/10)
Q&A: Child benefit measures will be messy Financial Times, Nicholas Timmins (5/10/10)
Cameron Defends Cut in Child Benefits for Stay-at-Home Mothers Bloomberg Businessweek, Thomas Penny and Kitty Donaldson (5/10/10)
Three million families hit by child benefit axe Telegraph, Myra Butterworth (5/10/10)
George Osborne’s child benefit plans are characterised by unfairness Telegraph letters (5/10/10)
Child benefit: case study Telegraph, Harry Wallop (5/10/10)
Child benefit cuts ‘tough but necessary’ say ministers BBC News (4/10/10)
Child Benefit Changes – Should Parents Take a Pay Cut? Suite101, John Oyston (5/10/10)
No such thing as an easy reform BBC News blogs: Stephanomics, Stephanie Flanders (5/10/10)
Child benefit saga: Lessons to be learned BBC News blogs: Stephanomics, Stephanie Flanders (6/10/10)

Speech
Higher rate taxpayers to lose child benefits from 2013: extracts from speech BBC News, Nick Robinson (5/10/10)
Our tough but fair approach to welfare Conservative Party Conference Speech, George Osborne (4/10/10)

Data and information
Child Benefit: portal HMRC
Child Benefit rates HMRC
Income Tax, rates and allowances HMRC

Questions

  1. Assess the fairness arguments for not paying child benefit to any household where at least one person pays tax at the 40% rate.
  2. For a family with three children, how much extra would a parent earning £1 below the threshold have to earn to restore their disposable income to the level they started with?
  3. What incentive effects would result from the proposals? How might ‘rational’ parents respond if one parent now stays at home and the other works full time and earns over £43,870, but where both parents have equal earning potential?
  4. What income and substitution effects are there of the proposed changes?
  5. Discuss other ways in which child benefit could be reformed to achieve greater fairness and save the same amount of money.
  6. What are the arguments for and against tapering the reduction in child benefit as parents earn more?