DEPARTMENT OF ECONOMICS

UNIVERSITY OF DAR ER SALAAM

Lecture Note Five Income Distribution (1)

By Semboja Haji Hatibu Haji

Unedited Training Notes Presented at the EC-366 Contemporary Issues in Economic Development Date Sunday, 10 November 2013

Lecture Five:

Income distribution

Topic 2 of EC366 covers issues related with income distribution. The topic of income distribution consists of two sub-topics. These are [1] size distribution of income and [2] inequality of income and measures. This lecture Note Five introduces some basic concepts of income distribution.

5.1.

Definitions of Income

Income may be defined as; 1. The flow of cash or cash-equivalents received from work (wage or salary), capital (interest or profit), or land (rent). 2. Accounting: (1) an excess of revenue over expenses for an accounting period. Also, called earnings or gross profit and (2), is an amount by which total assets increase in an accounting period. 3. Economics: Consumption that, at the end of a period, will leave an individual with the same amount of goods (and the expectations of future goods) as at the beginning of that period. Therefore, income means the maximum amount an individual can spend during a period without being any worse off. Income (and not the GDP) is the engine that drives an economy because only it can create demand. 4. Law: Money or other forms of payment (received periodically or regularly) from commerce, employment, endowment, investment, royalties, etc. We will note that [in 3] income may be treated as the consumption and savings opportunity gained by an entity within a specified timeframe that is generally expressed in monetary terms. However, for households and individuals, income as noted in above [1] is the sum of all the wages, salaries, profits, interests payments, rents and other forms of earnings received... in a given period of time." For firms, income generally refers to "net-profit"what remains of revenue total after expenses have been subtracted. In the field of public economics, the term may refer to the accumulation of both monetary and non-monetary consumption ability, with the former (monetary) being used as a proxy for total income. 5.1.1. Income Distribution Income distribution is the manner in which income is divided among the members of the economy. A perfectly equal income distribution would mean everyone in the country has exactly the same income. The income distribution in the some developed economies, while more equal than most nations of the world, is far from perfectly equal. A certain amount of inequality in the income distribution is to be expected because resources are never equally distributed. Some labor is naturally going to be more productive--better able to produce the stuff that consumers want--and thus get more income. The same is true for capital, land, entrepreneurship.

However, without government intervention, an unequal distribution of income tends to perpetuate itself. Those who have more income, can invest in additional productive resources, and thus can add even. 5.2. Theories of Income Distribution

Income distribution is the allocation of income among the owners of the factors of production. Theories of income distribution are based on 4 elements: These are [1] Marginal productivity, [2] Needs, [3] Social Usefulness, and [4] Equality. Again, we treat income distribution as the allocation of income among the owners of the factors of production. There are various ideas or theories of income distribution. The early social philosophers crusaded not only for economic equality but also for social and political equality. For instance, the French philosopher Rousseau contended that private property was robbery and it did not exist in the state of nature. Another social scientist, Babeuf stated that nature has given to every man an equal right in the enjoyment of all goods. Likewise, Proudhon, a believer in equality and bitter enemy of private property, claimed that employers robbed labourers by not rendering to them the full value of their labor. In the case of Karl Marx, he said that the capitalist is a recipient, of surplus value or profit. He claimed further that the capitalist, in the process of accumulating wealth for her/him therefore robs and exploits the worker. The mal-distribution of income and wealth among the less-developed countries has been more widespread. The gap between the rich and the poor is getting wider and wider. Only very few are rich while most of the people exist under the poverty line. 5.2.1. Basis of the Theories of Income Distribution In view of the extreme poverty in the less developed regions of the world which has emanated from unjust distribution of wealth and income not a few countries have charged or changed or modified their economic systems in the hope of improving the social and economic conditions of their peoples. They have introduced radical economic, social and political reforms to uplift the masses from their miserable conditions. This means there is a redistribution of wealth and income based on social and economic justice. Several theories of income distribution are based on the following: 1. Marginal productivity holds that the income of the factor of production is equal to the value of its marginal product. This is simply means that the owners of the factors of production are paid based on their contribution to production under a competitive market condition. However, there are government laws to comply with, and that the market is not perfectly competitive. Another, capitalists have another idea of income distribution. 2. Needs determine the amount of income of families or individuals. Those who have more needs receive more incomes in proportion to their needs. Some countries, especially the highly developed ones, have been using this theory of income distribution. They provide allowances to the children of their employees.

3. Social Usefulness is the basis of income distribution. Jobs which are more useful to society are paid higher. Jobs under this category are teachers, farmers, fishermen, doctors, and nurses. Such theory encounters difficulties in implementation. Singers, actors, comedians, and other groups are most likely to oppose such social usefulness theory of income distribution. What about culture usefulness? 4. Equality refers to an income distribution in which all members of society receive an equal amount of income. This is the idea of communism in an attempt to erase the gap between the rich and the poor. Such theory is good to other but not to all. Those who are lazy and those who have little qualifications are happy under this arrangement. However, those who are highly qualified and ambitious are discouraged or demoralized. Consequently, both economy and society will not progress for lack of economic incentives to deserving individuals.

5.3.

Economic definitions

In economics, "factor income" is the return accruing for a person, or a nation, derived from the "factors of production": rental income, wages generated by labor, the interest created by capital, and profits from entrepreneurial ventures. In consumer theory 'income' is another name for the "budget constraint," an amount to be spent on different goods x and y in quantities and at prices and income. We noted that the income equation in the consumer theory implies two things. First buying one more unit of good x implies buying less units of good y. So, is the relative price of a unit of x as to the number of units given up in y. Second, if the price of x falls for a fixed, then its relative price falls. The usual hypothesis is that the quantity demanded of x would increase at the lower price, the law of demand. The generalization to more than two goods consists of modelling y as a composite good. The theoretical generalization to more than one period is a multi-period wealth and income constraint. For example the same person can gain more productive skills or acquire more productive income-earning assets to earn a higher income. In the multi-period case, something might also happen to the economy beyond the control of the individual to reduce (or increase) the flow of income. Changing measured income and its relation to consumption over time might be modelled accordingly, such as in the permanent income hypothesis. 5.3.1. Full and Haig-Simons income Full income refers to the accumulation of both, monetary and non-monetary consumption ability of any given entity, such a person or household. According to the what economist Nicholas Barr describes as the "classical definition of income:" the 1938 Haig-Simons definition, "income may be defined as the... sum of (1) the market value of rights exercised in consumption and (2) the change in the value of the store of property rights..." Since the consumption potential of non-monetary goods, such as leisure, cannot be measured, monetary income may be thought of as a proxy for full income. As such, however, it is criticized for being unreliable, i.e. failing to accurately reflect affluence and that is consumption opportunities of any given agent. It omits the utility a
4

person may derive from non-monetary income and, on a macroeconomic level, fails to accurately chart social welfare. According to Barr, "in practice money income as a proportion of total income varies widely and unsystematically. Non-observability of full-income prevents a complete characterization of the individual opportunity set, forcing us to use the unreliable yardstick of money income." On the macro-economic level, national per-capita income, increases with the consumption of activities that produce harm and omits many variables of societal health 5.3.2. Income inequality We will note that income inequality refers to the extent to which income is distributed in an uneven manner. Within a society can be measured by various methods, including the Lorenz curve and the Gini coefficient. Economists generally agree that certain amounts of inequality are necessary and desirable but that excessive inequality leads to efficiency problems and social injustice. National income, measured by statistics such as the Net National Income (NNI), measures the total income of individuals, corporations, and government in the economy. 5.3.3. Income in philosophy and ethics Throughout history, many have written about the impact of income on morality and society. Saint Paul wrote; for the love of money is a root of all kinds of evil:' (1: Timothy 6:10 (ASV)). Some scholars have come to the conclusion that material progress and prosperity, as manifested in continuous income growth at both individual and national level, provide the indispensable foundation for sustaining any kind of morality. This argument was explicitly given by Adam Smith in his Theory of Moral Sentiments and has more recently been developed by Harvard economist Benjamin Friedman in his book The Moral Consequences of Economic Growth. 5.4. Typologies of Incomes

There are various uses or and typologies of income. Let us revisit some of these typologies of income. 5.4.1. Personal Income Total compensation received by an individual. Personal income includes compensation from a number of sources - salaries, wages and bonuses received from employment or selfemployment; dividends and distributions received from investments; rental receipts from real estate investments; profit-sharing from a business and so on. In most jurisdictions, personal income above a certain exemption threshold is subject to taxation. Personal income is generally computed on a pre-tax basis. Personal income determines consumer consumption, and since consumer spending drives much of the economy, trends in personal income on a quarterly and annual basis are closely tracked by national statistical organizations, economists and analysts.

Personal income tends to display a rising trend during periods of economic expansion, and show a stagnant or slightly declining trend during recessionary times. Since the 1980s, rapid economic growth in economies such as China, India and Brazil has spurred substantial increases in personal incomes for millions of their citizens. 5.4.2. Fixed Income A type of investing or budgeting style for which real return rates or periodic income is received at regular intervals at reasonably predictable levels. Fixed-income budgeters and investors are often one and the same - typically retired individuals who rely on their investments to provide a regular, stable income stream. This demographic tends to invest heavily in fixed-income investments because of the reliable returns they offer. Individuals who live on set amounts of periodically paid income face the risk that inflation will erode their spending power. Fixed-income investors receive set, regular payments that face the same inflation risk. The most common type of fixed-income security is the bond; bonds are issued by federal governments, local municipalities or major corporations 5.4.3. Disposable Income The amount of money that households have available for spending and saving after income taxes have been accounted for. Disposable personal income is often monitored as one of the many key economic indicators used to gauge the overall state of the economy. For example, let's assume your household personal income includes $100,000 from salaries and you are paying at the 35% tax rate. Your household's disposable income would then be $65,000 ($100,000 - $35,000). Economists use DPI to gauge households' rate of savings and spending. 5.4.4. Accrued Income Income that is earned in a fund or by company by providing a service or selling a product, but has yet to be received. Mutual funds or other pooled assets that accumulate income over a period of time but only pay it out to shareholders once a year are, by definition, accruing their income. Individual companies can also accrue income without actually receiving it, which is the basis of the accrual accounting system. For example, assume that a company is expected to complete services for another company once per month for six consecutive months, but that under the terms of the contract, it will not receive monetary payment for these services until the end of the six-month period. The company performing the services can accrue a percentage of the income earned after each month, even though physical payment will not take place until after the six-month period. 5.4.5. Household Income It is the combined gross income of all the members of a household who are 18 years old and older. Individuals do not have to be related in any way to be considered members of the same household. Alternatively, household income is the combined income of all members of a

household who jointly apply for credit. Household income is an important risk measure used by lenders for underwriting loans. Average household income is a frequently reported economic statistic. Because many households consist of a single person, average household income is usually less than average family income, another frequently reported economic statistic, because a household consisting of a single person is not included in the average family income calculation. 5.4.6. Community Income Income earned by taxpayers who live in community property regions, districts or villages. Community income is considered to belong equally to both spouses, just as with all other property that is owned or acquired by either spouse during the marriage. Income that is earned by either spouse before or after a marriage is not considered to be community income. 5.4.7. Gross Income It is an individual's total personal income before taking taxes or deductions into account. Or it may be a company's revenue minus cost of goods sold. Also it is called "gross margin" and "gross profit. Our gross income is how much you make before taxes. It is the figure people are looking for when they ask how much you gross a month. This is an important number when analyzing a company, it indicates how efficiently management uses labor and supplies in the production process. Keep in mind that gross income varies significantly from industry to industry. 5.4.8. Comprehensive Income The change in a company's net assets from non-owner sources over a specified period of time. Comprehensive income is a statement of all income and expenses recognized during that period. The statement includes revenue, finance costs, tax expenses, discontinued operations, profit share and profit/loss. Companies typically report comprehensive income in a separate statement from income resulting from owner changes in equity, but have the option of providing information in a single statement. Many firms shy away from the single statement approach because it mixes owner and non-owner activity, which can muddle the underlying information. 5.4.9. Discretionary Income The amount of an individual's income that is left for spending, investing or saving after taxes and personal necessities (such as food, shelter, and clothing) have been paid. Discretionary income includes money spent on luxury items, vacations and non-essential goods and services. Discretionary income is derived from disposable income, which equals gross income minus taxes. Aggregate discretionary income levels for an economy will fluctuate over time, typically in line with business cycle activity. When economic output is strong (as measured by GDP or
7

other gross measure), discretionary income levels tend to be high as well. If inflation occurs in the price of life's necessities, then discretionary income will fall, assuming that wages and taxes remain relatively constant. Discretionary spending is an important part of a healthy economy - people will only spend money on things like travel, movies and consumer electronics if they have the funds to do so. Some people will use credit cards to purchase discretionary goods, but increasing personal debt is not the same as having discretionary income. 5.4.10. Earned Income Income derived from active participation in a trade or business, including wages, salary, tips, commissions and bonuses. This is the opposite of unearned income. Earned income includes any income that a person or company receives for work they have done. If your boss gives you an advance on your next check, this would be considered unearned income because you haven't yet done anything to earn it. 5.4.11. Fee Income It is revenue taken in by financial institutions from account-related charges to customers. Charges that generate fee income include non-sufficient funds fees, overdraft charges, late fees, over-the-limit fees, wire transfer fees, monthly service charges, account research fees and more. Credit unions, banks and credit card companies are types of financial institutions that earn fee income. Financial institutions earn a significant portion of their income from fees, also called noninterest income. Interest income, which is money earned by lending out customers' deposits in the form of mortgages, small business loans, lines of credit, personal loans, student loans and by allowing customers to carry a credit card balance makes up another significant portion of financial institutions' income. 5.4.12. Adjustment Income Income paid to the dependent(s) of a primary wage earner in the event of his or her death. These funds, usually provided through life insurance policies, are intended to provide financial support as the beneficiary adjusts to becoming self-sufficient. An example of adjustment income would be funds provided to a widow upon the death of her spouse to allow time to recover emotionally and receive career counselling and job training if necessary 5.4.13. Net income In business, net income also referred to as the bottom line, net profit, or net earnings is an entity's income minus expenses for an accounting period. It is computed as the residual of all revenues and gains over all expenses and losses for the period, and has also been defined as the net increase in stockholder's equity that results from a company's operations. In the context of the presentation of financial statements, some countries define net income as synonymous with profit and loss
8

Net income is a distinct accounting concept from profit. Profit is a term that "means different things to different people" and different line items in a financial statement may carry the term "profit", such as gross profit and profit before tax. In contrast, net income is a precisely defined term in accounting. Net income can be distributed among holders of common stock as a dividend or held by the firm as an addition to retained earnings. As profit and earnings are used synonymously for income (also depending on usage), net earnings and net profit are commonly found as synonyms for net income. Often, the term income is substituted for net income, yet this is not preferred due to the possible ambiguity. Net income is informally called the bottom line because it is typically found on the last line of a company's income statement (a related term is top line, meaning revenue, which forms the first line of the account statement). The items deducted will typically include tax expense, financing expense (interest expense), and minority interest. Likewise, preferred stock dividends will be subtracted too, though they are not an expense. For a merchandising company, subtracted costs may be the cost of goods sold, sales discounts, and sales returns and allowances. For a product company advertising, manufacturing, and design and development costs are included. 5.5. Income and distribution

Distribution in economics refers to the way total output, income, or wealth is distributed among individuals or among the factors of production (such as labour, land, and capital). In general theory and the national income and product accounts, each unit of output corresponds to a unit of income. One use of national accounts is for classifying factor incomes and measuring their respective shares, as in National Income. But, where focus is on income of persons or households, adjustments to the national accounts or other data sources are frequently used. Here, interest is often on the fraction of income going to the top (or bottom) x percent of households, the next y percent, and so forth (say in quintiles), and on the factors that might affect them (globalization, tax policy, technology, etc.). In macroeconomics, income distribution is how a nations total GDP is distributed amongst its population. Income and distribution has never been a central concern of economic theory and economic policy. Classical economists such as Adam Smith, Thomas Malthus and David Ricardo were mainly concerned with factor income distribution, that is, the distribution of income between the main factors of production, land, labour and capital. Modern economists have also addressed this issue, but have been more concerned with the distribution of income across individuals and households. Important theoretical and policy concerns include the relationship between income inequality and economic growth. The distribution of income within a community may be represented by the Lorenz curve. The Lorenz curve is closely associated with measures of income inequality, such as the Gini coefficient. The concept of inequality is distinct from that of poverty and fairness. Income inequality metrics (or income distribution metrics) are used by social scientists to measure the distribution of income, and economic inequality among the participants in a particular
9

economy, such as that of a specific country or of the world in general. While different theories may try to explain how income inequality comes about, income inequality metrics simply provide a system of measurement used to determine the dispersion of incomes.

5.5.1. Causes We will note in the next lecture note that there are many and complex causes of income inequality. Some causes of income distribution and levels of equality/inequality include: tax policies, economic policies, labor union policies, monetary policies, the market for labor, abilities of individual workers, technology and automation, education, globalization, gender, race, and culture. 5.5.2. Distribution measurement internationally Using Gini coefficients, several organizations, such as the United Nations (UN) and the US Central Intelligence Agency (CIA), have measured income inequality by country. 5.5.3. Trends Economic inequality tends to increase over time as a country develops, and to decrease as a certain average income is attained. This trend is commonly known as the Kuznets curve after Simon Kuznets. However, many prominent economists disagree with the need for inequality to increase as a country develops.

10

There are two ways of looking at income inequality, within country inequality (intra-country inequality) - which is inequality within a nation; or between country inequality (inter-country inequality) which is inequality between countries. According to intra-country inequality at least in the OECD countries, a May 2011 report by OECD stated that the gap between rich and poor within OECD countries (most of which are "high income" economies) "has reached its highest level for over 30 years, and governments must act quickly to tackle inequality". Furthermore, increased inter-country income inequality over a long period is conclusive, with the Gini coefficient (using PPP exchange rate, un-weighted by population) more than doubling between 1820 and the 1980s from .20 to .52 (Nolan 2009:63). However, scholars disagree about whether inter-country income inequality has increased (Milanovic 2011), remained relatively stable (Bourguignon and Morrison 2002), or decreased (Sala-i-Martin, 2002) since 1980. What Milanovic (2005) calls the mother of all inequality disputes emphasizes this debate by using the same data on Gini coefficient from 1950-2000 and showing that when countries GDP per capita incomes are unweight by population income inequality increases, but when they are weighted inequality decreases. This has much to do with the recent average income rise in China and to some extent India, who represent almost two-fifths of the world. Notwithstanding, inter-country inequality is significant, for instance as a group the bottom 5% of US income distribution receives more income than over 68 percent of the world, and of the 60 million people that make up the top 1% of income distribution, 50 million of them are citizens of Western Europe, North America or Oceania (Milanovic 2011:116,156). The size distribution of income We will note in other lectures that the size distribution of income is one of two ways to measure inequality in income; other is functional distribution of income. Under this method, income of individuals and households is collected and arranged in ascending order. This data is, then, divided among groups. Most common method is to divide data into "quintiles" (i.e., in five groups, each representing 20% of data) and "deciles" (i.e. in ten groups, each representing 10% of data) in percentage form. Then, it is determined that what percentage of total income is received by each income group.

11