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How can Government policy help?

What role does government policy play in influencing economic inequality and promoting opportunity?

We have argued that inequality is potentially harmful for economic growth and therefore living standards or economic well-being. Inequality is also objectionable on moral grounds, to the degree of individual value judgments regarding what is “fair”.

For these reasons governments around the world have adopted policies to reduce both inequality of outcomes and inequality of opportunity. Inequality of outcomes are addressed through taxation and transfer payments (also known as welfare payments or social expenditure).

Taxation revenue as a share of GDP averaged 34% across all 35 OECD countries in 2015. This figure has increased slowly and steadily from 31% over the previous 30 years since 1985. These taxes are a mixture of primarily three types:

  • income taxes on individuals and corporate entities
  • property taxes
  • consumption taxes (such as a GST or VAT).

Social expenditures across all 35 OECD countries averaged 21% of GDP in 2015, compared with 16.5% in 1985. These consist mainly of old age pensions, disability pensions, unemployment benefits and family benefits.

Taxes and social expenditures certainly mitigate the inequality that would have resulted if incomes and wealth were solely determined by what people could earn and accumulate through the market returns for their labour and assets. They have also increased relative to the size of the economy over recent decades, which implies that they have further mitigated inequality over that time.

Reducing inequality through taxes and transfers may be a double-edged sword

We have to consider the other side to reducing taxes. For example, the potential for it to harm incentives to work, save and invest; all of which are good for economic growth. These disincentive effects may therefore reduce the economic cake and harm economic growth.

The OECD has found that taxes on labour income have more harmful effects than taxes on consumption. They estimate that a shift of 1% of tax revenues from income taxes to consumption and property taxes would increase GDP per person by between a quarter of a percentage point and one percentage point in the long run. This is particularly the case for second income earners in a household who may, for example, be parents of young children or older workers phasing down their work hours. An increase in income taxes reduces their take-home pay which may be the difference between accepting a job and rejecting it. Such people may effectively drop out of the labour force which would reduce GDP.

Similarly, more generous unemployment benefits and family benefits (particularly if means-tested) can reduce the effective income from taking a job in the sense that the benefits are foregone. Such benefits impose additional effective tax rates on income from working. However, this does not deny the role of Active Labour Market Policies, such as unemployment assistance for workers who face redundancy due to economic disruption. The aim of these policies is not income redistribution per se, but re-skilling and job retraining.

Governments face a balancing act

Inequality may reduce GDP, but so may policies to reduce inequality of outcomes. However there is no double-edged sword in the case of policies to reduce inequality of opportunity.

Promoting education at all ages from early childhood through to post-secondary level promotes human capital of individuals and of the whole society which boosts GDP. Moreover education of people from disadvantaged backgrounds boosts social mobility, preventing inequality from becoming entrenched across generations.

The same applies to schemes to retrain workers who have become unemployed, and to provide quality healthcare to enable sick workers to return to work all workers to be more healthy and therefore productive, and to provision of child care to encourage young parents to spend less time out of the workforce to care for young children. All of these things reduce inequality and social disadvantage, and therefore boost GDP and national economic well-being.

Your task

Are you aware of any government policies in your country that aim to reduce economic inequality and promote opportunity? Share these with us in the comments section below.

References

Revenue Statistics - OECD Countries: Comparative Tables. Retrieved from https://stats.oecd.org/Index.aspx?DataSetCode=SOCX_AGG

Social Expenditure - Aggregated data. Retrieved from https://stats.oecd.org/Index.aspx?DataSetCode=SOCX_AGG

Johansson, A et.al, Tax and Economic Growth. ECO/WKP (2008)28 Retrieved from https://www.oecd.org/tax/tax-policy/41000592.pdf


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This article is from the free online course:

Exploring Economics: Will the Next Generation Be Worse Off?

Griffith University

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