Economics International Baccalaureate (IB) Practice Question: 1. Explain how the Lorenz curve and the Gini coefficient are used to measure income inequality. 2. Using real-world exa...

**Answers may include: ** Definition (Key Terms)

• Income Inequality: The uneven distribution of income among individuals or households in an economy.
• Lorenz Curve: A graphical representation plotting the cumulative percentage of the population (on the x-axis) against the cumulative percentage of total income they receive (on the y-axis).
• Gini Coefficient: A numerical index (ranging from 0 to 1) derived from the Lorenz curve that quantifies the degree of income inequality.

Economic Theory

• Lorenz Curve Construction

  • Plots cumulative share of the population in ascending order of income on the horizontal axis.
  • Plots the corresponding cumulative share of total income on the vertical axis.
  • The line of perfect equality (diagonal) indicates a distribution where each percentage of the population earns the same percentage of total income.
  • The Lorenz curve usually bows below the line of perfect equality; the more it bows, the greater the level of income inequality.

• Gini Coefficient Calculation

  • Computed as the ratio of the area between the Lorenz curve and the line of perfect equality (Area A) to the total area under the line of perfect equality (Area A + B).
  • Value Range: 0 indicates perfect equality, 1 indicates maximum inequality.
  • Used for cross-country comparisons of income distribution or to assess changes in one country’s inequality over time.

• Policy and Analytical Use

  • Governments and economists analyze changes in the Lorenz curve and Gini coefficient to gauge the effectiveness of redistributive policies, tax reforms, and social welfare programs.
  • A shifting Lorenz curve (closer to the line of equality) and a declining Gini coefficient suggest reducing income inequality, while the opposite indicates a growing gap between high- and low-income earners.

Diagram

Answers may include:

Definition

• Taxation: A system where a government imposes charges on individuals or firms to generate revenue, commonly used to fund public goods and services.
• Equity in income distribution: A fair or just allocation of income across different groups in society, often measured through metrics such as the Gini coefficient.

Explanation/Economic theory

• Governments aim to achieve equity by using taxation to redistribute income from higher-income earners to lower-income earners.
  • This redistribution can occur through direct transfer payments, subsidies for essential services, or provision of public goods.
• Progressive taxation reduces disposable income disparities by taking a larger percentage from higher-income groups.
  • For instance, a progressive income tax rate may start low (e.g., 10%) for lower-income brackets and increase to higher rates (e.g., 40%+) for top-income brackets.
  • Hence, total tax revenue rises, allowing government spending on welfare programs and universal services such as healthcare or education.
• Lorenz curve can be used to illustrate the distribution of income before and after taxation.
  • A less bowed Lorenz curve (after progressive taxation) indicates a more equitable income distribution.
  • The government’s goal is often to reduce the Gini coefficient (where 0 represents perfect equality and 1 represents perfect inequality).
• Greater equity via taxation may stimulate broader economic growth by increasing lower-income consumers’ purchasing power.
  • Higher consumption can increase aggregate demand (AD), potentially driving economic growth.
  • However, higher taxes might reduce incentives to work, save, and invest if rates become excessively high, potentially lowering long-run aggregate supply (LRAS) growth.

Diagram

• Shift in Lorenz curve to be closer to the line of perfect equality

Evaluation

• Short-run and long-run impacts on major stakeholders

  • Consumers:
    • Short run: Low-income groups may benefit from immediate tax relief or government assistance, increasing disposable income.
    • Long run: Better access to education and healthcare can improve productivity and employability. However, high-income earners may face disincentives to earn more due to higher marginal tax rates.
  • Producers:
    • Short run: Potential increase in aggregate demand from higher spending by low-income consumers, but producers may face reduced profit margins if corporate taxes rise.
    • Long run: Possible decrease in investment if higher taxes reduce retained earnings, affecting future output growth.
  • Government:
    • Short run: Higher tax revenues to fund public goods, welfare, and income support programs.
    • Long run: Risks of capital flight or brain drain if taxes are perceived as too high, reducing growth prospects.
  • Society:
    • Short run: More equitable distribution of disposable income can lower social tensions and poverty rates.
    • Long run: Potential negative effects on efficiency and innovation if high taxes significantly reduce incentives.

• Real-world examples

  • Nordic countries (e.g., Sweden, Denmark) have top marginal income tax rates exceeding 50%. These countries consistently report some of the lowest Gini coefficients, indicating a high level of equity.
  • United States has a progressive tax structure with multiple brackets; however, it maintains a relatively higher Gini coefficient (around 0.41 in recent years), suggesting that taxation alone may not fully address income inequality.
  • Brazil historically has a regressive system of indirect taxes contributing to high inequality (Gini around 0.53). Reforms that introduced more progressive elements have aimed to reduce this gap, though improvements remain limited without complementary policies such as education reforms.

Conclusion

• Taxation can be effective in narrowing income disparities, particularly when it is progressive, but the effectiveness depends on how the revenue is utilized (e.g., funding education and healthcare).
• Excessive tax rates may disincentivize productivity and investment, indicating that taxation must be balanced with other policies such as targeted government spending and job creation measures.
• Therefore, while taxation is a crucial policy tool for equity, complementary measures are often required to enhance its effectiveness and sustain growth.