Redistribution of Income and Wealth
Income and Wealth
Income: the flow of money a person or household receives over a period of time, such as wages, benefits, interest, rent and profit.
Wealth: the stock of assets a person or household owns at a point in time, such as a house, savings, shares and a pension, minus any debts.
Income is like water flowing into a bath; wealth is the water already in it. The two are linked. Income that is saved builds wealth, and wealth earns more income as rent, interest and dividends. That is why wealth is shared far more unequally than income: those who own assets keep adding to them.
Redistribution: government action that moves income or wealth from better-off households to worse-off ones, through taxes, benefits and public services.
Taxation
Taxes are grouped by how they change with income:
| Type | Share of income paid in tax | UK example |
|---|---|---|
| Progressive | Rises as income rises | Income tax: nothing on the first slice of income, then higher rates on higher bands |
| Proportional | Stays the same at every income | Rare; a flat-rate tax on all income would be one |
| Regressive | Falls as income rises | VAT and duties on tobacco and alcohol, as poorer households spend more of their income |
Wealth is taxed separately, mainly through inheritance tax on large estates and capital gains tax on profits from selling assets such as shares or a second home.
When a government makes taxes more progressive:
- Low-income households: higher earners pay more → the revenue funds benefits and services → poorer households' incomes and living standards rise → inequality and relative poverty fall.
- High earners: they keep less of each extra pound → some work less, move abroad or find ways to avoid the tax → less revenue than expected.
How much a tax change redistributes depends on:
- How mobile the tax base is: high earners and firms that can easily move abroad limit how high rates can go.
- How the money is spent: revenue only narrows the gap if it is spent on benefits and services that reach poorer households.
Incentives and the Poverty Trap
Some benefits are means-tested: paid only to households with low income or savings, and reduced as income rises. Universal Credit in the UK is one. Others are universal, paid to everyone in a group whatever their income, such as the State Pension.
Poverty trap: when a low-paid worker who earns more is barely better off, because they pay more tax and lose means-tested benefits at the same time.
Worked Example: An Extra £100 a Week
Sam works part-time and gets a means-tested benefit. Sam takes on extra hours worth £100 a week. Suppose income tax and National Insurance take 30% of the extra pay, and the benefit falls by 60p for every £1 earned after tax.
| Step | Working | Answer |
|---|---|---|
| Tax and National Insurance | 30% × £100 | £30 |
| Pay after tax | £100 − £30 | £70 |
| Benefit lost | 60% × £70 | £42 |
| Sam keeps | £70 − £42 | £28 |
Sam keeps £28 of the extra £100. That is an effective tax rate of 72%, far higher than the top rate of income tax. After travel or childcare costs, the extra hours may not pay at all.
The poverty trap weakens incentives:
- For workers: little gain from extra hours or a promotion → people stay on low hours → incomes stay low and benefit spending stays high.
- For firms: staff turn down extra shifts → harder to fill hours → recruitment costs rise.
The trap is reduced by withdrawing benefits more slowly as income rises, raising the income at which tax starts, or raising the minimum wage (unit 3.5.3).
Each has a cost. A slower withdrawal means more households, further up the income scale, receive benefits, so spending rises. That is the trade-off between equity and incentives.
The Provision of Services
Governments also redistribute by providing services free or below cost, paid for from taxes. In the UK these include the NHS, state schools, social housing and free school meals.
- Living standards: a household doesn't pay for a GP visit or a school place → these services are worth far more compared with a low income than a high one → the gap in living standards narrows.
- Opportunity: free schooling and healthcare for every child → skills depend less on parents' income → higher earnings as adults, which reduces inequality in the next generation.
How much services redistribute depends on:
- Quality and access: better-off families can move near the best schools, so free services don't reach everyone equally.
- Cost: services are paid for by taxes, and higher taxes can weaken incentives to work and invest.
Keep income and wealth separate. A rise in house prices makes homeowners wealthier without changing anyone's income, so wealth inequality can widen while income inequality stays the same. Income tax and benefits mainly change income; inheritance and capital gains taxes are the ones aimed at wealth.
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