What is the best way to deal with income and wealth inequality?

Written by Luke Heritage

May 28th, 2024

It is estimated by the World Inequality Report (2022) that the wealthiest 10% own 76% of global wealth, with inequality becoming a growing problem in contemporary societies, such as the UK and the US. Income and wealth inequality can construct implications that vary from the extent of decreased social unity to hindrances in economic growth (Berg and Ostry, 2011). Although income and wealth inequality are inherent in economies that are not centrally planned, the worsening extent of this phenomenon, as mentioned before, suggests that our economies could be regressing. Therefore, addressing income and wealth inequality presents an important problem to mitigate, however, measures used to reduce this inequality could present unintended consequences.

Why is income and wealth inequality a problem?

According to the theory of endogenous growth and economic policy, it is seen that income inequality is harmful to economic growth, as it can lead to policies that are made to protect the rich (Persson and Tabellini, 1991). These policies may not protect people’s rights to own assets thus slowing overall investment when the middle and lower classes are unable to fully benefit from their previous investments (Persson and Tabellini, 1991).Income and wealth inequality may also be harmful to democracy, as giving few people much greater resources to affect political processes may undermine political choices (Wright, 2000). A collapse of democracy, in terms of the economy, can lead to more policies that protect the rich, with examples in the past including Trickle-Down economics, a policy which proposed for untaxed wealth to “trickle down” to the less fortunate who work for the wealthy (Lockwood et al., 2017), but has now been criticised heavily, with research showing that it has caused income and wealth inequality over the past 50 years (Kiersz and Andy, 2011). Additionally, tax cuts on the rich may be mostly spent on positional goods such as assets, and not on entrepreneurship that will trickle down income for the lower-income workers (Frank, 1999). Therefore, these policies can act as automatic exemplifiers, where a multiplier effect can occur with initial inequalities widening itself through rational mechanisms.

What are ways to deal with income inequality?

A highly effective method to reduce income inequality, which is used in the UK and the US, is the implementation of a progressive tax system on income. Progressive taxation operates on the principle that workers with higher incomes should pay a higher proportion of their earnings in tax (Sommerfeld et al., 1992). By doing so, it redistributes income from the affluent to the less privileged, thus narrowing the gap between the rich and the poor. However, the highest-income workers are usually those with the most resources, and progressive taxation can be deemed ineffective, as it may promote excessive administration costs, a misallocation of capital and more tax evasion, due to tax arbitrage (Bankman and Griffith, 1987). Alternatively, tax arbitrage can be proved to benefit individuals at the bottom of the income distribution, as increased tax arbitrage can expose loopholes, where tax revenue may rise when they are found out, (Agell and Persson, 1990), thus the effectiveness of progressive taxation is higher in this circumstance. 

Another method to reduce income inequality, also used in the UK and US, could be the use of social welfare programmes. Social welfare programmes may include unemployment-related benefits, food assistance, housing subsidies and healthcare coverage. Nobel laureate economist, Joseph Stiglitz (2012) argued that robust social safety nets are an essential method for ensuring opportunity to all members of society, thus allowing access to the poorest to be able to increase their incomes and close the inequality gap. This can include unemployment-related benefits, that can allow the unemployed to survive whilst they look for higher paying jobs. However, unemployment-related benefits and other forms of social safety nets can be deemed ineffective if they create “crowding out” effects in private social assistance methods. This theory can reduce the effect on income inequality as efforts made by the private sector are diminished, meaning that efforts made by the state have to increase further, which is most likely to be rather costly. 

Finally, another effective method to reduce income inequality could be public expenditure on education. Using Becker’s (2009) and Schultz’s (1961) theory of human capital, it can be inferred that an injection of public expenditure on the quality of education can contribute to an individual’s productivity and earning potential. This is likely to reduce the gap between the top earners and the bottom earners if expenditure is directed towards deprived areas with limited opportunities for high incomes being earned. Furthermore, expenditure on early childhood education can create greater social benefits (Heckman, 2011) thus allowing for the quality of opportunities to increase in deprived areas, which can in turn create greater income equality in the long term. Alternatively, public education provision may reduce income inequality if the individuals surrounding the direction of spending are too impoverished to access education due to external costs such as travel, leaving only the higher income children attending good schools, and potentially exacerbating the problem of income equality (Slywester, 2000).

What are ways to deal with wealth inequality?

A method of reducing wealth inequality could be wealth-related taxes, that aim to redistribute the value of assets to the state, which can therefore be distributed to the poor through state expenditure, thus reducing wealth inequality. Pikkety (2014) highlighted the role of inheritance in perpetuating wealth inequality and argued that inherited wealth contributes significantly to the concentration of wealth among the richest families, meaning that taxes are the only way to break this trend of inequality. Pikkety (2014) therefore proposed policy recommendations such as progressive wealth taxes and financial market transparency. However, wealth-related taxes may result in “wealth flight” when the wealthy decide to leave countries with higher wealth taxes for countries with lower wealth tax, to keep a higher proportion of their assets for their successors (Wardell-Johnson, 2018), thus creating a trade-off between distribution and growth in the economy. But the theory of “if you tax them, they will flee” has been disproved by independent analysts, where evidence has been assembled that the effect of taxes on migration is mostly small (Tannenwald et al., 2011). Additionally, even if wealth tax is implemented, and migration does occur, it has been shown that redistribution can occur with high growth rates, if an efficiency gap is maintained, meaning that capital flight will only occur in the most inefficient countries (Rehme, 1995). 

Another method of reducing wealth inequality could be the promotion of home ownership, allowing the less wealthy to build their asset collection, and closing the inequality gap. Usually, the ownership of property has been seen as a way for less wealthy individuals to build their wealth (Berry, 1999), and home ownership promotion policies such as regulatory measures to help households, like access to credit or low-interest rates, can help this (Hilber and Schöni, 2016; Mulheirn at al., 2022). This approach was used by Margaret Thatcher’s Conservative government, through the Right to Buy scheme, where eligible tenants were offered the opportunity to buy their homes at a significant discount (Murie, 2016). This in turn would theoretically allow the less wealthy to build up their net worth at a reduced price, thus creating wealth. However, this policy did not apply to most, meaning that most people in the UK have had to purchase their houses at full price. It is also important to note that house prices have been unstable after the 1970s (OECD, 2021), and now, relative to incomes, rising house prices have made it difficult to purchase a home in the UK (MacLennon and Long, 2023). This means that is likely that the UK will have to implement more home ownership-related policies, to reduce wealth inequality through this channel. Moreover, if this channel is deemed effective, it may bring the less wealthy proportion of the population subject to a “wealth effect” (Schooley and Worden, 2008), which can in turn lead them to invest more of their disposable incomes into assets, due to a psychological investor confidence effect, allowing them to generate further returns and increase their wealth, thus reducing wealth inequality. In reality, this is quite unlikely to occur, as home ownership is likely to have used up a less wealthy individual’s money, leaving them with minimal money to invest. 

Finally, one more method of reducing wealth inequality could be the addressing of financial inclusion. As mentioned before, lower interest rates may incentivise lower-income households to apply for mortgages to own homes, however, there are other ways that financial inclusion can promote a generation of wealth for poorer individuals. An example could be microfinance, which refers to the practice of providing capital to low-income individuals who may be excluded from conventional credit access through commercial banks (D’Angelo, 2018). An increase in the number of microfinance institutions may incentivise lower-income individuals to take out more loans, and thus grow their wealth to a point where they can outgrow microfinance institutions and use commercial bank credit (D’Angelo, 2018). However, methods such as microfinance may have limited impact, as not every poor person is available, or able for entrepreneurship, meaning that only a small number of people would be able to become wealthier, which is not nearly enough to close the inequality gap (Karadima, 2021). Therefore, financial inclusion may only contribute to the problem of inequality, through methods of microfinance, thus it may be deemed as partially effective.

Conclusion

Overall, income and wealth inequality can theoretically be alleviated using numerous methods, however, in practice, none of them have worked, as seen by the vast inequality present in our global society. Perhaps it could be that the rich have so many resources that tax evasion and avoidance is becoming easier, with an estimated $496 billion gross tax gap in 2014-2016 by the IRS (Internal Revenue Service, 2023).  “Even excellent auditors have difficulty in detecting hidden offshore wealth,” as explained by Reck (2021) highlights how tax can be so easily avoided and evaded, that tax policies are no longer effective in reducing inequality. Until these practices are completely alleviated, it is not possible to reduce the problem of inequality to be reduced, and due to the immense number of resources available to the wealthy nowadays, this reality is completely unlikely.

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All statistics are available at:

World Inequality Report. (2022). Methodology. Retrieved from https://wir2022.wid.world/methodology/