Government Policies to Reduce Poverty and Inequality
Government policies used to reduce poverty and inequality include progressive taxation, means-tested and universal benefits, a legal minimum or living wage, and investment in education and training.
Before you start
Make sure you're comfortable with these topics first:
Method
- For any policy, build a chain: identify the mechanism by which it reduces poverty or inequality, then identify a possible unintended consequence, then evaluate how large that consequence is likely to be.
- Learn the minimum wage diagram for a competitive labour market: a minimum wage set above the free market equilibrium wage creates an excess supply of labour (a rise in unemployment as more people want to work at the higher wage than firms wish to hire), shown as the gap between the supply and demand curves at the new, higher wage.
- Learn the monopsony counter-argument: where a single dominant employer has wage-setting power, it restricts employment below the competitive level to keep wages down; a minimum wage introduced between the monopsony wage and the competitive wage can raise both the wage and the level of employment, because it removes the employer's incentive to under-hire.
- Learn the efficiency wage argument: a higher wage can raise worker productivity and reduce staff turnover and recruitment costs, partly offsetting the cost to a firm of a minimum wage rise.
- Distinguish targeted, means-tested policies (which concentrate resources on the poorest but can create a poverty trap through benefit withdrawal) from universal policies (which avoid this incentive problem but cost more per pound transferred to a low-income household, since better-off households receive the payment too).
- For an evaluation question, weigh the intended distributional benefit against the labour market, fiscal or incentive costs, and judge how the outcome depends on elasticity of labour demand, the market structure of the labour market, and the time period considered.
Worked example
A firm employs 40 workers on the National Living Wage, each working 35 hours a week. The wage rises from 10.42 pounds an hour to 11.44 pounds an hour. Assuming the firm keeps all 40 workers and their hours unchanged, calculate the increase in the firm's weekly wage bill.
- Find the increase in the hourly wage: 11.44 - 10.42 = 1.02 pounds an hour.
- Find the weekly increase in pay per worker: 1.02 x 35 = 35.70 pounds a week.
- Multiply by the number of workers to find the total weekly increase in the wage bill: 35.70 x 40 = 1,428 pounds a week.
- State the answer: the firm's weekly wage bill rises by 1,428 pounds, which the firm must cover through higher prices, lower profit margins, higher productivity or, in the long run, a smaller workforce.
Practice questions
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Q1What makes a tax 'progressive'?Show answer
Answer: The average (and typically the marginal) rate of tax paid rises as income rises, so higher earners pay a larger proportion of their income in tax.
Q2Distinguish a means-tested benefit from a universal benefit.Show answer
Answer: A means-tested benefit is paid only to households below an income or asset threshold; a universal benefit is paid to everyone in an eligible group (e.g. all pensioners) regardless of income.
Q3What is a monopsony in a labour market?Show answer
Answer: A labour market with a single, dominant buyer of labour, which has the power to set the wage rather than accept a market-determined wage.
Q4In April 2024 what was the National Living Wage for workers aged 21 and over in the UK?Show answer
Answer: 11.44 pounds an hour.
Q5Give one way that investing in education and training can reduce inequality over the long run.Show answer
Answer: It raises workers' human capital and productivity, which can raise their marginal revenue product and therefore their future wage, reducing the wage gap linked to skills.
Q6Define a universal basic income.Show answer
Answer: An unconditional, regular cash payment made by the government to every citizen (or every adult), regardless of income, employment status or means-testing.
Q7Give one criticism of means-tested benefits as a way to reduce poverty.Show answer
Answer: They can create a poverty trap, since benefits are withdrawn as earned income rises, leaving a household with little extra net income from working more.
Exam-style questions
Written in the style of a A Level Economics exam paper, with a full mark scheme.
Explain how progressive taxation can reduce income inequality.
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Evaluate the likely economic effects of a significant increase in the National Living Wage.
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