If there are concerns that the free market leads to inequity then there are policies that the government can try to use to reduce inequality in wealth and income. There are three main types of policies that are available:
1. Monetary Benefits
A simple way to redistribute income is to pay benefits to those on low incomes. Money is raised through the tax system and then paid to low income individuals and families in order to increase their disposable income. There are two types of such benefits:
a. Means-tested.
These benefits are only paid to those on low incomes. They are targeted directly at those who are seen to be most in need. An example would be unemployment benefit. However, they are not always claimed by those for whom they are designed. They can also create a disincentive to work. If such benefits are reduced through an individual earning more, then there is an incentive not to earn more. This is the so-called poverty trap.
b. Universal benefits.
These are paid out to everyone in certain categories regardless of their wealth and income. Examples include universal state pensions and child benefit. Such benefits overcome the two problems associated with means-tested benefits. However, they imply paying out money to many who do not need it and therefore tend to be expensive to operate.
2. The Tax System
The tax system can be used in order to reduce inequalities in income and wealth. This is specifically through the use of progressive taxes. Progressive taxes lead to those earning higher incomes being taxed a higher percentage of their income than those on lower incomes. Thus income differentials are reduced. Most income tax systems are progressive in nature. The average rate of tax rises as people earn higher incomes. Taxes on products which are bought usually tend to be regressive.
Taxes can also be imposed upon wealth in order to reduce wealth inequalities. One example might be inheritance tax. Individuals who inherit more than a certain amount of wealth may have to pay some of the value of that wealth in tax to the government.
3. Direct Provision of Goods and Services
A further way of reducing inequalities in society is for the government to provide certain important services free of charge to the user. Such services are financed through the tax system. If such services are used equally by all citizens, then those on lowest incomes gain most as a percentage of their income. Inequality is thus lowered.
The two most significant examples of such free provision in many contemporary societies are health care and education. These markets are characterized by various market failures. However, these failures do not, according to standard economic theory, justify free provision to the consumer. The justification must free: They are the material equivalent of monetary universal benefits.
Resource: AS Level and A Level ECONOMICS, Colin Bamford, Keith Brunskill, Gordon Cain, Sue Grant, Stephen Munday, Stephen Walton, University of Cambridge, 2002.
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