7.7 The Australian government’s response to address inequality in the distribution of income and wealth

The effects of inequality in the distribution of income and wealth

Negative effects of inequality: • In equ ali t y di v i des s o ci ety and red uc e s i n c l us i v en e s s , s oci al co hes i o n, and a s p e c t s of n o n - mat er i a l we l f a re • In equ ali t y a f f e c ts edu c a t i on a l outco mes , red uce s e ffi c ien cy of l a bou r res o urces and l owe r s t he n at i o n ’s pot e n t i a l o utp ut, i nco mes and p ros p e r i t y • In co me i ne qua l i t y l i mi ts the mar k et s i ze , s t op s s o m e fi rms ga i ni ng eco no mi es o f l arge -s c a l e p rodu ct i on, s l ows eco no mi c g ro w th a nd re d uces purc ha s i n g p o w er • In equ ali t y m a y i ncreas e eco no mi c i ns t a b i l i t y a nd w o rs en t he boom - b us t cy cl e • In equ ali t y c a us es mar k et fai l ure w h e re t he re i s t h e u n der produc t i o n o f s o ci al l y b ene fic i a l b ut n eces s ary goods and s er v i ces .

Positive effects of inequality: • In equ ali t y m a y i ncreas e the i ncenti v e t o w o rk h ard , boos t i ng nati o nal o utp ut • In equ ali t y m a y p ro v i d e i ncreas ed i nc e nt i v e s t o ga i n i m prov ed s k i l l s a n d ed ucati o n • In equ ali t y prom otes i ncreas ed i ncent i v e s t o rel o c at e t o pl a c e s w here there are j ob s • In equ ali t y c a n pro v i d e i ncreas ed i n c e nt i v e s f o r b u s i n es s r i s k -t ak i ng that i s need ed for e x pan s ion a n d a g ro w i ng eco no my • In equ ali t y c a n hel p p ro mo te i ncrea s e d l e v e l s o f s av i n g s re qu i re d to finance hi g her i nv e s t m e nt t ha t g ro w s t h e e c on om y ’s p ro d ucti v e cap a c i t y • In equ ali t y re wa rd s s ucces s ful ho us e hol d s a nd i n div i dua l s f or thei r eff o r ts . 7.6.1 One perspective — excessive inequality has negative effects and reduces society’s general wellbeing

There are compelling reasons why excessive levels of inequality in the distribution of income and wealth are bad for most people, not just the poor. Extreme inequality lowers average living standards and society’s general wellbeing. • Inequality creates a social divide,

reduces cohesion, and erodes society’s non-material wellbeing.

Inequality divides society into the

‘haves’ and ‘have nots’. In some parts of any city, there are families living comfortably in palatial dwellings located on tree-lined streets, well away from the filth of factories and the noise of freeways and trains. However, in other areas, there are overcrowded suburbs that include none of the luxuries of affluence. Here, unemployment, racial ghettos, crime, drugs, despair, poverty, and welfare dependence are far more commonplace. The people

FIGURE 7.26 Severe income inequality divides society, reduces social cohesion and may cause social unrest, violence and crime. living in these areas may well resent those who are better off and start to see the system as unfair. This weakens social cohesion and can lead to great discontent, unrest, crime, violence, political protest and even revolution. For many low-income groups, there is social and economic exclusion, and opportunities

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to become rich are limited. Sometimes, those who are well-off find they cannot enjoy their wealth, and for their personal safety are forced to have personal protection and 24-hour security surveillance. • Inequality affects educational outcomes, reduces efficiency of labour resources and lowers potential output, incomes and prosperity. Perhaps one of the most serious problems of having significant income and wealth inequality is that it results in reduced educational outcomes and employment opportunities for children from disadvantaged households. For instance, sometimes their home environment is not supportive for good study habits, so their academic results can be lower and dropout rates are higher. Often there is pressure to leave school early to get a job and earn money, rather than go on to tertiary study. There is also a lot of evidence suggesting that children from disadvantaged households, growing up in some neighbourhoods and hanging out with their local peers, lowers educational success. In contrast, children growing up in advantaged households, even if they only have mediocre academic ability, will tend to value education more highly, mix with more ambitious friends, perhaps go to better funded and resourced schools, have access to quality teachers and private tutors, stay at school longer, go onto tertiary study and be employed in better paid and perhaps more satisfying jobs. In other words, significant economic and hence social inequality significantly lower the quality of Australia’s human capital resources. This represents a waste of labour resources. It acts as a barrier to growing Australia’s productive capacity, potential GDP and average incomes. Countries that invest more in education, skills and training, and ensure that access is inclusive, are far more prosperous and enjoy better material and non-material living standards for all. Well-known economist, John Kenneth Galbraith, in his book, Inequality and Instability, noted that more equal or egalitarian societies have a lower average unemployment rate over the long-term, faster technical progress, better labour productivity and quicker rates of GDP and income growth. • Income inequality stops firms gaining economies of large-scale production and slows economic growth. When there is much inequality, purchasing power is not spread across the whole population. The market size is reduced. It limits the demand for locally made goods and services that, in turn, means that Australian firms tend to gain fewer economies of large-scale production (i.e. they have higher average production costs per unit of output). This forces local firms to charge higher prices, cutting the purchasing power of incomes. They also become less internationally competitive with lower sales, reduced output and higher unemployment. This makes most people worse off. • Inequality may increase economic instability and the boom-bust cycle. Some economists argue that significant inequality in the distribution of incomes and wealth increases the likelihood of recession and economic instability, worsening the boom-bust cycle. One way this can happen is that high income individuals spend a smaller proportion of their income and save more, than those on lower incomes. This tends to slow the rate of growth in aggregate demand, limiting economic activity and leading to higher levels of unemployment than would otherwise occur in more equal societies. In response to weaker economic activity, governments typically try to use expansionary policies like cutting interest rates to stimulate spending. This can lead to booming asset prices (called an asset bubble) and unsustainably high house prices (e.g. 2021–22). While good for the rich, first-home buyers are forced to take out bigger home mortgages. Then, worried about rising inflation, governments reverse their policy and raise interest rates, causing unemployment to rise. Because of unemployment and being unable to meet loan repayments, some lower-income households default on their loan repayments, popping the asset bubble and bringing on a crash. Some economists believe that this type of scenario explains the cause of the Global Financial Crisis of 2008–09. • Inequality causes market failure and the underproduction of socially beneficial but necessary goods and services. Another drawback of great inequality is that the economy tends to overproduce luxury goods and services such as cars, yachts and high-end housing and, at the same time, underproduce necessities like affordable healthcare, housing, education, public transport and legal services. Those with low incomes lack UNCORRECTED PAGE PROOFS sufficient spending power in these markets to indicate the types of things they want to see produced. They are effectively excluded from decision making, and so society’s overall satisfaction of wants is reduced.

In other words, inequality can distort the allocation of resources and thereby significantly lower society’s average material living standards.

7.6.2 Another perspective — inequality has positive effects and improves society’s wellbeing

There is also some agreement amongst economists that modest levels of inequality in income and wealth can be beneficial and improve society’s general wellbeing. There are a number of arguments advanced, often based on the idea that inequality creates incentives to improve efficiency in resource allocation and production, promote stronger economic growth, expand employment opportunities, increase general incomes and raise material living standards. In his book, Equity and Efficiency — the Big Trade-Off, economist, Arthur Okun argued there was an inescapable trade-off or conflict between equity and economic efficiency. He claimed that government policies including steeply progressive rates of income tax on the rich, generous welfare payments for the poor, free public services and high minimum wages designed to promote more equality, unfortunately undermine beneficial incentives, lowering the economy’s efficiency and hence the wellbeing of all. • Inequality may increase the incentive to work hard. The promise of higher pay can motivate employees to work extra hours or overtime (and give up some of their leisure or holidays), try harder, and be more productive and efficient on the job. This helps to strengthen material living standards. However, if all wage rates were equal, it is likely that there would be no such incentive. Productive capacity and the rate of economic growth would probably be lower, and goods and services would be more expensive, depressing living standards. • Inequality provides increased incentives to gain improved skills and education. Skilled and educated workers usually receive higher pay since they are scarcer and generally more productive or efficient. An advantage of inequality is that it can provide young people with the incentive to stay at school longer and go into tertiary education. In the longer term, this also helps to promote stronger economic growth and better living standards. • Inequality promotes increased incentives to relocate for gaining employment. Given the desire for self-improvement, income inequality can cause people to move from one job to better paid employment. Here, wage differences act as price signals to allocate labour to areas of greatest need or utility. Pay differences also make it possible for firms to fill job vacancies, even if these are in different towns or states, or perhaps involve unpleasant work. Again, inequality helps promote better living standards. • Inequality provides increased incentives for business risk-taking and expansion. Income inequality provides financial incentives to reward or compensate businesspeople to take calculated risks with their money and undertake investment in new technology and equipment needed for expanding the firm. If there was no opportunity for entrepreneurs to earn extra profits through their decision making, Australia’s rate of economic growth would be much slower, employment opportunities reduced, and material living standards diminished. UNCORRECTED PAGE PROOFS

• Inequality helps promote increased levels

of savings to finance higher investment and

expansion of the economy. Some claim that as a result of income inequality, the rich are more able to save a higher percentage of their income than if it was shared more evenly. In turn, better savings help to increase investment in new technology and equipment, finance business expansion and create improved job opportunities and income for others, even the poor. This boosts material living standards. • Inequality rewards successful households and individuals. In some ways, inequality in wealth and income shows success. It allows the fortunate to enjoy more opportunities for a great lifestyle such as living comfortably in pleasant suburbs, gaining personal fulfilment, enjoying social interaction and benefiting from international travel and leisure.

FIGURE 7.27 Inequality allows successful individuals on higher incomes to enjoy more varied choices including opportunities for international travel and the purchase of more goods and services. In part, because a little inequality can sometimes be beneficial, governments in former socialist countries today use this as an incentive to change behaviour and improve economic outcomes. It is also interesting to note that the Australian government does not seek to promote total equality in the distribution of income and wealth. Rather, it tries to strike an equitable balance as defined by the political party. 7.6 Activities

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Track your results and progress Find all this and MORE in jacPLUS 7.6 Exercise 7.6 Quick quiz 7.6 Exercise 1. a. Explain how significant inequality in the distribution of the income and wealth cake is likely to negatively influence each of the following: (3 marks) i. educational outcomes, economic growth and living standards ii. social cohesion iii. economic stability iv. the allocation of resources towards socially beneficial and necessary goods and services. b. Sometimes, income inequality can have positive effects. Identify and outline four important reasons why some income inequality is often seen as beneficial for society’s living standards. (4 marks) Fully worked solutions and sample responses are available in your digital formats. UNCORRECTED PAGE PROOFS

7.7 The Australian government’s response to address inequality in the distribution of income and wealth

KEY KNOWLEDGE

• the economic responses undertaken by relevant economic agents at a local, national and international level, to address the economic issue, including government policies

Source: VCE Economics Study Design (2023–2027) extracts © VCAA; reproduced by permission. An equitable distribution of income and wealth means sharing income, wealth, goods and services in a fair and reasonable way. Of course, people have different values or perspectives about what is fair or unfair. We sometimes see these opinions displayed when an umpire in a sporting competition makes a particular decision. One side sees it as a good call, but the other believes it’s unfair! When it comes to the ways that final income and wealth are distributed, the government steps in as the umpire using economic policies to promote a more equitable distribution. It seeks to reduce inequality that is partly the result of the free operation of the labour market. The Australian government’s goal of an equitable distribution of income is defined as a situation where all people have sufficient income to purchase or have access to basic goods and services and enjoy reasonable living standards at a level deemed generally acceptable to most. Here, the government’s intention is not to create equality. It only seeks to narrow the income-wealth gap a little and promote greater fairness. There is no precise target for the Gini coefficient, nor is it clear as to exactly what is meant by access to basic goods and services or an acceptable standard of living. As shown in figure 7.28, the Australian government uses a range of policies designed to reduce the level of inequality and redistribute incomes and wealth in a more equitable way.

FIGURE 7.28 Australian government policy measures to help promote a more equitable distribution of income and wealth Australian government policies used to promote a more equitable distribution of income and wealth Using progressive income tax Provision of welfare for the neediest Provision of free or subsidised essential services Stabilisation policies to regulate AD and reduce the severity of booms and recessions Encouragement of superannuation Setting the minimum wage

Antidiscrimination laws 7.7.1 Using progressive income tax on individuals to promote equity There are three main types of tax that can affect the distribution of income and wealth including progressive, regressive and proportional taxes. However, in looking at these taxes, we will discover that only progressive UNCORRECTED PAGE PROOFS taxes work to directly promote a more equitable distribution of income.

Progressive personal income tax can help reduce inequality and increase equity. Using the Robbin Hood principle (i.e. take from the rich to give to the poor), they work in two ways to help narrow the gap between high- and low-income earners and make the final distribution of income more equitable: • The direct effect on higher income earners: First, they work directly to reduce inequality in the distribution of disposable income by taxing upper income earners at higher marginal tax rates (expressed as a proportion of income), than those charged on lower incomes. For instance, when an individual gains taxable income from earning wages, and receives rent, interest, or dividends from shares, income tax has to be paid at varying marginal tax rates. As shown in figure 7.29 (see part 1), these rates start at zero per cent on all taxable income up to $18 200 per year. This is called the tax-free threshold. It benefits all taxpayers. However, beyond this level of income, the marginal tax rate on additional dollars rises through four steps or tax brackets to eventually reach the top marginal income tax rate of 45 per cent of each additional dollar of income in excess of $180 000. In addition, there is a 2 per cent Medicare Levy on most incomes that is designed to help pay for our largely free healthcare system. • The indirect effect on lower income earners: Second, the personal income tax system also works indirectly to increase the final disposable income, especially of lower income earners. The money raised (mostly from taxing high income earners) is used to pay for welfare benefits (i.e. cash payments to the neediest individuals including the aged and unemployed), increasing their disposable income and purchasing power. Tax revenue is also used to pay for government-provided essential services like public health and education (i.e. more often used by low-income individuals who tend to use the public system). You will also see from figure 7.29 that, currently, big changes to the personal tax system are scheduled from July 2024. Notice that the current 32.5 and 37.0 per cent tax brackets will disappear and be combined into one huge 30 per cent tax bracket. In addition, the tax threshold for hitting the 45 per cent tax bracket will be pushed out to an annual taxable income in excess of $200 000. Clearly, although this will make the tax system simpler, it will also become less steeply progressive (especially when compared with a top rate of 75 per cent back in 1951 or 67 per cent in 1984). It will allow for greater income inequality and may also mean that the value of tax revenue raised will be relatively lower. Will this mean that there is less money available for welfare and essential services, adversely affecting low-income earners? Proportional income tax on companies Proportional taxes have a fairly neutral effect on income distribution. While personal income tax is an example of a progressive tax, not all taxes are progressive. For example, there are also proportional taxes where the tax rate remains constant as income rises. An example of a proportional tax is company tax. In 2022–23, large businesses paid at the rate of 30 per cent of each dollar of profit, while small companies were taxed at 25 per cent. Here, small and medium-sized firms (abbreviated to SMEs) are defined as those with a turnover below $50 million per year. By their nature, proportional taxes tend to have a fairly neutral effect on how evenly or unevenly income is distributed. Regressive indirect taxes Regressive indirect taxes increase inequality and reduce equity. Some of Australia’s taxes are regressive because the rate of tax paid as a proportion of income decreases as income rises. Examples of indirect regressive taxes include the goods and services tax (or GST) that is levied at the general rate of 10 per cent on most (but not all) and the excise taxes on petrol, tobacco and alcohol that are as high as 40 per cent. They are added onto the price of goods and services at the point of sale, making items dearer for buyers. Regressive taxes lead to increased inequality because a low-income buyer purchasing an item (such as a $20 UNCORRECTED PAGE PROOFS haircut with 10 per cent or $2 GST) will be paying a larger proportion of income in tax than a high-income person making exactly the same purchase. This is illustrated in figure 7.30. In fact, Australian estimates suggest that low-income individuals in quintile 1 pay indirect taxes equal to around 20 per cent of their income, while high-income earners making up quintile 5 only pay about 9 per cent of their income in indirect tax. This is highly unfair and regressive because these taxes make things more expensive and reduce the access of low-income earners to basic goods and services.

Part 1: Current and future rates of personal income tax

Current marginal tax rates on taxable personal incomes (between July 2020 to June 2024) New marginal tax rates on personal incomes (scheduled to start from July 2024)

Marginal rate of tax (percentage)

50 50

45

40

35

30

25

20

15

10

5

0

Part 2: Recent changes to personal income tax

Taxable income thresholds ($) $0 to $18 200 Current rates of personal income tax (from July 2020 to June 2024) Marginal tax rates (%) Taxable income thresholds ($) $0 to $18 200 0 $18 201 to $45 000 19 $18 201 to $45 000 19 30 (replaces the 32.5$45 001 to $120 000 32.5 $45 001 to $200 000 per cent bracket) NA (the 37 per cent tax$120 001 to $180 000 37 NA bracket is abolished) $180 001 and over 45 $200 001 and over 45

$0 to $18 200 Scheduled rates of personal income tax (from July 2024) Marginal tax rates (%)

$18 201 to $45 000 $45 001 to $120 000 $120 001 to $180 000 $180 001 and over

$0 to $18 200 $18 201 to $45 000 $45 001 to $200 000

37 32.5 30

19 19 0 0 $200 001 and over

Income from higher-income earners is redistributed to lower-income earners 45 Marginal rate of tax (percentage) 5 10 15 20 25 30 35 40 45 45 0 Taxable income, tax bracket ($) Taxable income, tax bracket ($) FIGURE 7.30 The regressive effects of the GST (or most other indirect taxes)

Haircut costs $20.00 GST = $2.00 Rich person on $1000 per week income pays $2.00 GST = 0.2% of income in tax.

? Poor person on $100 per week income pays $2.00 GST = 2.0% of income in tax or 10 times the rate of the rich person.

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Total cost = $22.00

One exception to the regressive nature of most indirect excise taxes is the luxury car tax. This is only applied to expensive imported vehicles that are typically purchased by those on higher incomes.

A review of different types of tax and their effects on distribution

So far we have seen that there are three types of taxes: • progressive • proportional • regressive. Each affects the distribution of income in different ways. Only progressive taxes narrow the income gap between high and low income earners, while regressive taxes widen inequality. Table 7.2 illustrates some of the features of these taxes.

TABLE 7.2 Features of hypothetical progressive, regressive and proportional taxes

Annual taxable income ($) Amount of tax ($) and average tax rate (%) applicable for a ‘progressive’ tax Amount of tax ($) and average tax rate (%) applicable for a ‘regressive’ tax Amount of tax ($) and average tax rate (%) applicable for a ‘proportional’ tax

$5000 $0 tax = a rate of 0% $1000 tax = an average rate of 20% $1000 tax = an average rate of 20% $10 000 $1000 tax = an average rate of 10% $1500 tax = an average rate of 15% $2000 tax = an average rate of 20% $15 000 $3000 tax = an average rate of 20% $1800 tax = an average rate of 12% $3000 tax = an average rate of 20%

Impact of tax on income distribution Has a levelling effect on the distribution of incomes; e.g. personal income tax is a progressive tax Causes income distribution to become more uneven; e.g. the GST is a regressive tax

Has a fairly neutral impact on the distribution of income; e.g. company tax is a proportional tax 7.7.2 Using cash welfare payments to promote equity Welfare benefits represent the government fortnightly payments of cash to the neediest members of the community including the unemployed, aged, carers, those with disabilities, war veterans, and students. They represent over 35 per cent of all Australian government outlays in the annual budget and, as shown in table 7.3, typically range in value between $600 and $1000 per fortnight. In paying benefits, Centrelink uses both a means test (i.e. income test or cut-off) and an assets test (i.e. wealth test or cut off) designed to exclude higher-income and wealthier individuals from gaining access to welfare. This ensures that the money goes to where it is most needed, and the system is affordable and sustainable for other taxpayers. Welfare benefits help to narrow the income gap by lifting the disposable income and hence the purchasing power of those on lower incomes. They mean that these individuals can more readily afford to purchase basic goods and services, improving their living standards. Even so, you may recall that welfare recipients are likely to be in poverty. This is because benefit rates are too low and not sufficiently generous. Opponents of making welfare more generous often note that this could act as a disincentive for people to take personal responsibility for finding employment and earning income. 7.7.3 Using free or subsidised government services to promote equity UNCORRECTED PAGE PROOFS Federal and state governments use their budgets to provide a range of community services (e.g. public education, health, some prescription drugs and housing) free of direct charge or at a relatively low, subsidised price. These are regarded as merit goods because, if not paid for by the government, they would be underproduced and too expensive for ordinary families. Providing these services makes them more affordable for the poor than would otherwise be the case.

Name of benefit

Age pension (single) Target group

Aged person (single) who are retired

Maximum value per fortnight ($ rounded)

987.60

JobSeeker (previously called Newstart)

Single unemployed, no dependants over 21 years while looking for work 691.00

Youth allowance (living away from home aged 18–24)

Single, aged over 18, living away from home, undertaking full-time study or training 679.00

Austudy (single, no children) Single, over 25, in full-time study to cover expenses 679.00

Family tax benefit (one child aged 0–12)

Lower income couples with one child 162.54 Carer payment A single individual prevented from working because they are caring for a dependant 987.60 Disability support pension Single, aged over 21, longer term medical, health and impairment conditions

987.60 Source: Data derived from Department of Human Services, Centrelink, April 2022, see https://www.servicesaustralia.gov.au/guideto-australian-government-payments?context=1. From the point of view of the poor, having access to these government services is as good as having extra income. Indeed, it has been estimated that government services provide a cost saving or benefit of around $300–$400 a week for those individuals in the lowest two income quintiles (but less than half of this amount for those in quintile 5). However, with the Australian government’s weakened financial position involving large budget deficits (where budget receipts are less than budget outlays) over the last decade, there has been an attempt by the government to recover some of the costs of providing services through a shift towards the ‘userpays principle’ (i.e. consumers of these services are expected to pay the cost to the government of producing these items). Examples here can be found especially in areas like transport, education and health. This trend is likely to increase inequality because the poor lack the income to pay, depriving some of access to these basic services. 7.7.4 Using policies to stabilise AD to the level of economic activity to promote equity Generally, rising prices or inflation, as well as unemployment, cause inequality in the distribution of Australia’s income. Both problems reduce the purchasing power of individuals. To help avoid inflationary booms, or during recessions where there is high unemployment, the Australian government changes taxes and government spending in a countercyclical way to regulate spending. The Reserve Bank of Australia (RBA) also changes interest rates. Together, the policies adopted represent either a contractionary or expansionary approach: • In an inflationary boom, typically taxes and interest rates rise and government spending is reduced. slowing AD to curb inflation. • In a recession (e.g. during 2020–21–22), typically taxes and interest rates are cut and government spending increased, stimulating AD to boost employment. Keeping both inflation and unemployment under control helps to promote greater equality in income UNCORRECTED PAGE PROOFS distribution.