Government Policies to Reduce Income Inequality

Market dynamics of skilled vs unskilled labor

• Globalization and foreign trade expand opportunities for high-skilled workers to sell services internationally, raising demand for high-skilled labor
• Lower-skilled workers face a larger global supply, increasing competition and potentially reducing wages in lower quintiles
• View of high-skilled labor market:
  • Supply-side effects: additional education and on-the-job training tend to increase high-skilled labor supply and lower relative wages
  • Demand-side effects: new technology and globalization increase demand for high-skilled labor and raise relative wages
  • Result: greater inequality when demand for skilled labor grows faster than supply; if lower-skilled supply exceeds demand, lower quintile wages may fall
• Overall implication: the combination of these forces can widen income disparity between high-skilled and low-skilled workers

Wealth vs income inequality; measurement and data

• Key distinction:
  • Income: flow of money received over a period (e.g., per year)
  • Wealth: stock of value of assets minus debts accumulated over time
• Wealth components include: money in bank, financial investments, pension funds, home value
• Debts subtracted when calculating wealth (e.g., mortgages, credit card debt)
• Wealth inequality tends to be greater than income inequality because differences in income compound into wealth over time
• Measurement tools:
  • Quintile (or other percentile) distributions can be applied to both income and wealth
  • The Federal Reserve's Survey of Consumer Finances (SCF) is published every three years and reports data on wealth
• Economic role of inequality measures:
  • Economists use income/wealth distributions to discuss policy options and tradeoffs, not to dictate a single ‘right’ level of inequality

Three main policy tools to reduce inequality (redistribution, opportunity, inheritance policy)

• Redistribution: moving income from higher-income to lower-income groups
  • Public programs historically used to support poverty reduction include:
  • TANF (Temporary Assistance for Needy Families)
  • EITC (Earned Income Tax Credit)
  • SNAP (Supplemental Nutrition Assistance Program)
  • Medicaid
  • Progressive taxation funds these programs
  • Tax data example (2018 household returns):
  • Top 1%: average pre-tax income ≈ 1{,}679{,}000 per year; average federal tax rate ≈ 25.4\%
  • Top 1%: effective tax rate ≈ 20.4\%
  • Bottom two quintiles: negative effective income tax due to credits like the EITC
  • The presence of redistribution through taxes and antipoverty programs does not itself resolve how much redistribution is appropriate; tradeoffs remain
• Ladder of Opportunity (public policy to expand equal opportunity)
  • Idea: create a broad ladder of opportunities so that all children have a reasonable path to economic success based on interests and efforts, not merely family background
  • Public policy initiatives (illustrative categories, Table 15.8):
  • Children:
    • Improved day care
    • Enrichment programs for preschoolers
    • Improved public schools
    • After-school and community activities
  • College level:
    • Widespread loans and grants for those in financial need
    • Opportunities for retraining and acquiring new skills
    • Internships and apprenticeships
    • Public support for a range of institutions from two-year community colleges to large research universities
  • Adults:
    • Opportunities for retraining and acquiring new skills
    • Internships and apprenticeships (continued or expanded)
  • Rationale: a more accessible ladder of opportunity can reduce the transmission of inequality across generations
• Inheritance and estate taxation
  • Debate: should wealth transfer across generations be limited by taxation, or should family wealth be preserved to reward savings and entrepreneurship?
  • United States position: estate tax exists but high exemptions limit reach
  • 2022 estate tax threshold (exemption) ≈ 12{,}060{,}000
  • Implication: only a tiny share of households pays the estate tax; the tax targets very high levels of wealth
  • Public policy question: how much inheritance should be taxed to reduce intergenerational perpetuation of wealth without discouraging saving and risk-taking?

Tradeoff between incentives and income equality

• Core idea: policies to reduce poverty or inequality can dampen incentives for work and entrepreneurship if taken too far
• Poverty trap concept: guaranteeing a minimum income could reduce the incentive to work
• Traditional view (Figure 15.10(a)): a higher emphasis on equality tends to come at the cost of lower economic output
  • As equality rises from point A to B, economic output typically falls
• Alternative view (Figure 15.10(b)): there are policy designs that can increase both equality and output
  • Example: free public education provides redistribution (higher value of schooling for low-income children than their tax payments) while also expanding the skilled workforce for the future
  • In this view, equality and economic growth can be complementary, not strictly opposed
• Practical takeaway: it is possible to design policies that improve equality with minimal harm to incentives, or even enhance incentives, by focusing on education, training, and adaptable social programs

Policy relevance beyond economics: political and social context

• Policies to reduce inequality can sustain support for a market economy by alleviating social tensions and reducing incentives for anti-market backlash
• Without some level of inequality reduction, popular scrutiny of market outcomes could fuel calls for restrictive interventions (e.g., price controls, protectionist measures, or other anti-market policies)
• The Occupy movement highlighted concerns about inequality and the distribution of burdens from economic downturns (e.g., the 2008–2009 Great Recession)
• Debate framing:
  • Pro-reduction side: reducing inequality can improve overall economic health and social cohesion; long-run higher education and training raise productivity
  • Anti-reduction side: excessive redistribution can weaken incentives and reduce economic growth

Contextual notes and real-world relevance

• In a globalized economy, wage disparities reflect both skill-biased technological change and global competition
• Wealth inequality often surpasses income inequality due to compounding over time and differences in asset accumulation
• Policies that promote equal opportunities (education, training, anti-discrimination) can help reduce intergenerational poverty and support long-term growth
• The estate tax mechanism illustrates a policy instrument aimed at limiting intergenerational wealth concentration without broadly penalizing savings or entrepreneurship

Key formulas and data to memorize

• Effective tax rate (example data):
  ext{Effective tax rate} = rac{ ext{Total taxes paid}}{ ext{Total income}}
• Wealth definition (stock of assets net of debts):
  ext{Wealth} = ext{Assets} - ext{Debts} = igl( ext{cash} + ext{investments} + ext{home value} + ext{other assets}igr) - ext{debts} {}
• Wealth vs income distribution: wealth inequality tends to be greater than income inequality due to asset accumulation over time
• Estate tax threshold (2022):
  ext{Estate tax exemption} = ext{ ext{15-yr value}} \ ext{(in 2022)}
  ightarrow 12{,}060{,}000 ext{ USD}
• Notational references
  • TANF, EITC, SNAP, Medicaid: major poverty alleviation programs referenced
  • SCF: Survey of Consumer Finances, published every three years

Notes on interpretation and exam readiness

• Understand the dynamics of supply and demand in the high-skilled vs low-skilled labor markets and how globalization and technology influence wages
• Be able to explain why wealth distribution can be more unequal than income distribution and how wealth is measured differently from income
• Identify and describe the three main policy tools to reduce inequality: redistribution, ladder of opportunity, and inheritance taxation
• Explain the tradeoff between incentives and equality, and discuss how certain policies (like universal public education) can potentially improve both equality and growth
• Recognize the social and political dimensions of inequality debates, including the implications for market stability and social cohesion
• Be able to cite the example data points (top 1% pre-tax income, effective tax rate, estate tax threshold) and explain what they illustrate about redistribution and policy design