Policy Options on Income

Inequality and Poverty: Some

Basic Considerations
 Altering the functional distribution is a traditional economic approach. It
is argued that as a result of institutional constraints and faulty government
policies, the relative price of labor in the formal, modern, urban sector is
higher than what would be determined by the free interplay of the forces of
supply and demand. For example, the power of trade unions to raise
minimum wages to artificially high levels (higher than those that would
result from supply and demand) even in the face of widespread
unemployment is often cited as an example of the “distorted” price of labor.
From this it is argued that measures designed to reduce the price of labor
relative to capital (e.g., through market-determined wages in the public
sector or public wage subsidies to employers) will cause employers to
substitute labor for capital in their production activities. Such factor
substitution increases the overall level of employment and ultimately raises
the incomes of the poor, who have been excluded from modern-sector
employment and typically possess only their labor services.
 Given correct resource prices and utilization levels for each type of productive factor
(labor, land, and capital), we can arrive at estimates for the total earnings of each asset.
But to translate this functional income into personal income, we need to know the
distribution and ownership concentration of these assets among and within various
segments of the population. Here we come to what is probably the most important fact
about the determination of income distribution within an economy: The ultimate
cause of the unequal distribution of personal incomes in most developing countries is
the unequal and highly concentrated patterns of asset ownership (wealth) in these
countries. The principal reason why 20% of their population often receives over 50% of
the national income is that this 20% probably owns and controls well over 90% of the
productive and financial resources, especially physical capital and land but also
financial capital (stocks and bonds) and human capital in the form of better education
and health. Correcting factor prices is certainly not sufficient to reduce income
inequalities substantially or to eliminate widespread poverty where physical and
financial asset ownership and education are highly concentrated.
It follows that the second and perhaps more important line of policy to reduce poverty
and inequality is to focus directly on reducing the concentrated control of assets, the
unequal distribution of power, and the unequal access to educational and income-
earning opportunities that characterize many developing countries. A classic case of
such redistribution policies as they relate to the rural poor, who comprise 70% to 80%
of the target poverty group, is land reform. The basic purpose of land reform is to
transform tenant cultivators into smallholders who will then have an incentive to raise
production and improve their incomes.

Asset ownership Redistribution policies Land reform

• The ownership of land, • Policies geared to • A deliberate attempt to
physical capital reducing income reorganize and transform
(factories, buildings, inequality and expanding existing agrarian systems
machinery, etc.), human economic opportunities in with the intention of
capital, and financial order to promote improving the distribution
resources that generate development, including of agricultural incomes
income for owners. income tax policies, rural and thus fostering rural
development policies, and development.
publicly financed services.
Any national policy attempting to improve the living standards of the bottom 40%
must secure sufficient financial resources to transform paper plans into program
realities. The major source of such development finance is the direct and
progressive taxation of both income and wealth. Direct progressive income taxes
focus on personal and corporate incomes, with the rich required to pay a
progressively larger percentage of their total income in taxes than the poor.
Taxation on wealth (the stock of accumulated assets and income) typically involves
personal and corporate property taxes but may also include progressive inheritance
taxes. In either case, the burden of the tax is designed to fall most heavily on the
upper-income groups. In reality, in many developing countries (and some
developed countries), the gap between what is supposed to be a progressive tax
structure and what different income groups actually pay can be substantial.
Progressive tax structures on paper often turn out to be regressive taxes in practice,
in that the lower and middle-income groups often end up paying a proportionally
larger share of their incomes in taxes than the upper-income groups. The reasons
for this are simple.
 The poor are often taxed at the source of their incomes or expenditures (by
withholding taxes from wages, general poll taxes, or indirect taxes levied on the
retail purchase of goods such as cigarettes and beer). By contrast, the rich derive
by far the largest part of their incomes from the return on physical and financial
assets, which often go unreported. They often also have the power and ability to
avoid paying taxes without fear of government reprisal. Policies to enforce
progressive rates of direct taxation on income and wealth, especially at the highest
levels, are what are most needed in this area of redistribution activity.

Progressive income tax Regressive tax Indirect taxes

• A tax whose rate • A tax structure in • Taxes levied on goods
increases with increasing which the ratio of taxes ultimately purchased by
personal incomes. to income tends to consumers, including
decrease as income customs duties (tariffs),
increases. excise duties, sales taxes,
and export duties.
 The direct provision of tax-financed public consumption goods and services to the
very poor is another potentially important instrument of a comprehensive policy
designed to eradicate poverty. Examples include public health projects in rural villages
and urban fringe areas, school lunches and preschool nutritional supplementation
programs, and the provision of clean water and electrification to remote rural areas.
Direct money transfers and subsidized food programs for the urban and rural poor, as
well as direct government policies to keep the prices of essential foodstuffs low,
represent additional forms of public consumption subsidies. Direct transfers and
subsidies can be highly effective, but they need to be designed carefully. There are four
significant problems require attention. First, when resources for attacking poverty are
limited as they always are they need to be directed to people who are genuinely poor.
 Second, it is important that beneficiaries not become unduly dependent on the
poverty program; in particular, we do not want to give the poor less incentive to build
the assets, such as education, that can enable them to stay out of poverty. But a “safety
net” can also be valuable to encourage the poor to accept a more entrepreneurial
attitude toward their microenterprises. This is much more possible when the poor do
not fear that their children will suffer terrible consequences if their small businesses
fail. Third, we do not want to divert people who are productively engaged in
alternative economic activities to participate in the poverty program instead. Finally,
poverty policies are often limited by resentment from the nonpoor, including those
who are working hard but are not very far above the poverty line themselves. When a
subsidy of goods consumed by the poor is planned, it should be targeted to the
geographic areas where the poor are found and should emphasize goods that nonpoor
people do not consume. This helps conserve resources for the program and
minimizes efforts by nonpoor people to benefit from the program. For example,
nutritional supplements can be provided for any woman who brings her baby to the
neighborhood poverty program center located in villages and neighborhoods with a
high incidence of absolute poverty. Although more affluent mothers could use the
program, few would risk the stigma of venturing into the poorer villages and
neighborhoods, let alone the center itself. The nutritional supplements help poor
mothers and their small children stay healthy and thus help break the cycle of
poverty
 Public consumption Subsidy
• All current • A payment by the
expenditures for government to
purchases of goods and producers or distributors
services by all levels of in an industry to prevent
government, including the decline of that
capital expenditures on industry, to reduce the
national defense and prices of its products, or
security to encourage hiring.