Economics of inequality and poverty

📚The economics

Equality, equity and economic inequality

Equality means everyone has the same; equity means fairness, a normative idea (1.2). Most people accept some inequality as fair (rewarding effort and skill), but see extreme inequality, or inequality of opportunity, as inequitable.

Measuring inequality: the Lorenz curve and Gini coefficient

• The Lorenz curve plots the cumulative percentage of income received against the cumulative percentage of households, ranked from poorest to richest.
• The 45° diagonal is the line of perfect equality (the poorest 20% get 20% of income, and so on).
• The Gini coefficient = A ÷ (A + B), from 0 (perfect equality) to 1 (one household has everything); sometimes shown as an index from 0 to 100. Nordic countries are around 0.25–0.28; Indonesia’s consumption-based Gini has been around 0.38 in recent years; South Africa’s is above 0.6.
• A move of the curve towards the diagonal (e.g. after taxes and transfers) shows reduced inequality.

Limitations: the same Gini can hide different shapes (inequality among the poor or among the rich); it says nothing about absolute living standards; data are often based on surveys that miss the very rich; and income and consumption Ginis differ.

Poverty

Measuring poverty — single indicators:

• International poverty lines: the World Bank’s extreme poverty line (updated in 2025 to $3.00 a day at 2021 PPP) plus higher lines for middle-income countries. Countries also set national poverty lines (Indonesia’s BPS line is based on the cost of a minimum food and non-food basket).
• Minimum income standards: the income needed for a socially acceptable standard of living, based on what members of the public say is needed.

Composite indicators: the Multidimensional Poverty Index (MPI), from the UNDP and Oxford (OPHI), measures deprivation in health (nutrition, child mortality), education (years of schooling, school attendance) and living standards (cooking fuel, sanitation, drinking water, electricity, housing, assets). A person deprived in a third or more of the weighted indicators is multidimensionally poor. It shows how people are poor, not just how little money they have.

Difficulties of measuring poverty: choosing the line is a value judgment; one line cannot reflect different costs of living across regions (Jakarta versus rural Nusa Tenggara); income is hard to measure in informal and subsistence economies (consumption surveys are used instead); household surveys miss homeless people and may not show inequality within households (between men and women); a single money line ignores access to services; and small changes in the line move millions of people in or out of “poverty”.

Causes of inequality and poverty

• Inequality of opportunity: unequal access to good schools, healthcare, finance and networks, often determined by birth, place and parents’ income.
• Different levels of resource ownership: land, property and capital are unequally owned (2.12).
• Different levels of human capital: education, skills and health drive earnings.
• Discrimination by gender, race, ethnicity, religion, caste or disability lowers pay and opportunities.
• Unequal status and power: weak bargaining power of informal workers; political influence of the wealthy.
• Government tax and benefits policies: regressive taxes, weak social protection, subsidies that favour the better-off (fuel subsidies).
• Globalization and technological change: reward skilled workers and capital owners; automation and import competition hit some low-skilled jobs.
• Market-based supply-side policies: cuts to top tax rates, weaker unions and lower benefits may widen inequality (3.7).

Why inequality matters

• Economic growth: high inequality can reduce growth: the poor cannot invest in education or businesses, so talent is wasted; demand is weaker because the rich save more of their income; instability deters investment. Some inequality provides incentives, but beyond a point the IMF and others find it harms sustained growth.
• Standards of living: poorer health, lower life expectancy and weaker education for low-income groups; relative deprivation.
• Social stability: crime, protest, political polarization and loss of trust in institutions.

Taxation to reduce inequality

• Average tax rate = total tax paid ÷ total income × 100. Marginal tax rate = the rate paid on the next unit of income (the rate of the highest band reached).
• Direct taxes are paid directly to the government by the person or firm taxed: personal income tax, corporate income tax (on profits), and wealth taxes (on property, inheritance, capital gains).
• Indirect taxes are taxes on spending (VAT, excise duties), collected via sellers.

Evaluation of taxation: progressive income and wealth taxes redistribute and fund public services, but very high rates may reduce incentives to work and invest, encourage avoidance, evasion and capital flight, and are hard to collect where most work is informal (only a minority of Indonesian workers pay income tax). Indirect taxes are easy to collect but regressive, unless basic foods are exempt (Indonesia exempts staples such as rice from VAT).

Other policies to reduce poverty and inequality

• Reducing inequality of opportunity / investing in human capital: free and better schooling, scholarships, early-childhood programmes, universal health coverage (Indonesia’s JKN, with premiums paid for poor members). Powerful but slow.
• Transfer payments: payments with no output in return: pensions, unemployment and disability benefits, child benefits, and conditional cash transfers paid if children attend school and health check-ups (Indonesia’s PKH, Brazil’s Bolsa Família). Can create dependency or disincentives if poorly designed; targeting errors.
• Targeted spending on goods and services: subsidized food (rice for poor households), free school meals, social housing.
• Universal basic income (UBI): an unconditional regular payment to every citizen. Simple, no stigma, a safety net in an age of automation; but very expensive, may reduce work incentives, and benefits the rich too unless taxed back. Trialled in Finland and Kenya.
• Policies to reduce discrimination: anti-discrimination laws, equal pay rules, quotas, affirmative action.
• Minimum wages: raise the pay of the lowest-paid workers, but may cause unemployment if set well above equilibrium (3.3), and do not help informal workers.

✏️Worked example HL

(a) The poorest to richest 20% of households receive 5%, 10%, 15%, 22% and 48% of income. Construct the Lorenz curve and estimate the Gini coefficient.
(b) Personal income tax is 5% on the first Rp 60 million of taxable income, 15% on the next Rp 190 million (up to 250 million) and 25% from 250 to 500 million. Calculate the tax paid, the average tax rate and the marginal tax rate on taxable income of Rp 400 million.
(c) A household spends Rp 5.55 million on goods including VAT at 11%. Calculate the VAT paid.

(a) Cumulative shares: 5, 15, 30, 52, 100. Plot these at 20, 40, 60, 80 and 100% of households, starting from (0, 0). The area under the curve is five trapezia, each 0.2 wide:

\[ B = 0.2 \times \frac{(0 + 0.05) + (0.05 + 0.15) + (0.15 + 0.30) + (0.30 + 0.52) + (0.52 + 1)}{2} = 0.304 \]

\[ \text{Gini} = \frac{A}{A + B} = \frac{0.5 - 0.304}{0.5} = 0.392 \approx 0.39 \]

(b) 5% × 60 = 3.0; 15% × 190 = 28.5; 25% × 150 = 37.5. Total tax = Rp 69 million. Average tax rate = 69 ÷ 400 × 100 = 17.25%. Marginal tax rate = 25% (the band the last rupiah falls in).

(c) The price including VAT is 111% of the pre-tax price, so VAT = 5.55 × 11 ÷ 111 = Rp 0.55 million (pre-tax spending Rp 5.0 million).

Check it. The Gini must be between 0 and 1, and the Lorenz curve must be convex and below the diagonal (each quintile’s share at least as large as the one before). The average tax rate (17.25%) lies below the marginal rate (25%), as it must under a progressive tax.

Taxing all income at the top rate. Rp 400 million is not taxed at 25% throughout (that would be Rp 100 million). And in (c), 11% of the tax-inclusive price (Rp 0.61 million) is wrong: the 11% applies to the pre-tax price.