IB Economics HLTopic 3 — Inequality and PovertyPaper 1, 2 & 3Core skill~12 min read
Using Taxation to Redistribute Income
Tax is how a government moves money from one part of the income distribution to another. The theory is short; the calculations are where marks are won and lost. Get comfortable with marginal versus average tax rates and this becomes one of the most reliable data-response topics in the course.
📚 What you need to know
Direct taxes are paid straight to the government on income and profits. Indirect taxes are paid on spending, collected by the seller.
Progressive: as income rises, the percentage paid rises. Regressive: the percentage falls. Proportional: the percentage stays the same.
The marginal tax rate is the rate on your next dollar. The average tax rate is total tax divided by total income.
Almost all indirect taxes are regressive, because poorer households spend a larger share of their income.
Progressive tax plus spending on education, health and transfers shifts the Lorenz curve inwards and lowers the Gini.
Limits: avoidance and evasion, disincentive effects, capital flight, and time lags before human capital improves.
Why tax can shrink the gap
A government does two things at once. It takes a bigger slice from high incomes, and it spends that money on things the poorest could not buy for themselves — schools, clinics, transport, unemployment and disability payments. Both halves matter. Taxing the rich but spending nothing on the poor does very little for poverty.
Progressive tax → funds free schooling and healthcare → better human capital → higher productivity → higher incomes for the poorest
Direct and indirect taxes
Direct taxes
Indirect taxes
Charged on
Income and profit
Spending
Who pays it over
The individual or firm, directly
The supplier, who collects it in the price
Examples
Income tax, corporation tax, capital gains tax, inheritance tax, social insurance contributions
VAT or sales tax, excise duties on fuel, alcohol and tobacco
Usual effect on inequality
Reduces it, if the rates are progressive
Increases it, because these taxes are regressive
Why is a flat 20% sales tax regressive? Because a low-income household spends nearly everything it earns, while a high-income household saves a chunk. The tax lands on spending, so it takes a bigger bite out of the smaller income.
The three tax systems
The trick is to watch the percentage, not the amount. In every system a richer person pays more dollars. What separates the three is what happens to the share of income taken.
If a graph in an exam has the amount of tax on the vertical axis instead of the rate, all three lines slope upwards and the diagram tells you nothing. Always check the axis label first.
Marginal and average tax rates
Income tax is charged in bands. Each band has its own marginal rate, and that rate only applies to the income inside that band. This is the bit almost everyone gets wrong at first: moving into a higher band does not tax your whole income at the new rate, only the part above the threshold.
Average tax rate
average tax rate = (total tax paid ÷ total income) × 100
WORKED EXAMPLE
Calculate the average tax rate [4 marks]
An economy uses these bands: $0–12,000 is taxed at 0%; $12,001–30,000 at 20%; $30,001–60,000 at 35%; above $60,000 at 45%. Calculate the average tax rate for a worker earning $45,000 a year.
Step 1: tax on the first band0% × $12,000 = $0Step 2: tax on the second band ($12,000 to $30,000, so $18,000 of income)20% × $18,000 = $3,600Step 3: tax on the third band (only up to $45,000, so $15,000 of income)35% × $15,000 = $5,250Step 4: add the bands together$0 + $3,600 + $5,250 = $8,850Step 5: divide by total income($8,850 ÷ $45,000) × 100 = 19.666…Average tax rate = 19.67%marginal rate here is 35%, average is only 19.67% — never confuse the two
WORKED EXAMPLE
Identify the type of tax system [2 marks]
Ana earns $20,000 and pays $2,000 in tax. Ben earns $60,000 and pays $4,800. State and justify the type of tax system.
Step 1: work out each average rateAna: (2,000 ÷ 20,000) × 100 = 10%Ben: (4,800 ÷ 60,000) × 100 = 8%Step 2: compare as income rises
Ben pays more dollars but a smaller share of his income.
Regressive“he pays more tax” is not a justification — always convert to a percentage first
What tax can and cannot do
Strengths
Direct and fast: a change in rates hits take-home pay within months.
Raises the revenue needed for schools, clinics and transfers.
Progressive rates pull the Lorenz curve inwards and cut the Gini.
Can also correct negative externalities at the same time.
Limits
Avoidance and evasion. High earners can hire advisers; the informal economy is invisible to the tax office.
Disincentives. Very high marginal rates may reduce the reward for extra work or investment.
Capital flight and brain drain. Firms and skilled workers can move somewhere cheaper.
Time lags. Better schooling raises incomes a decade later, not this year.
Gains from progressive income tax can be cancelled out by heavy regressive indirect taxes.
Strong evaluation line. Judge the tax system as a whole, not one tax. A country can have a very progressive income tax and still end up with a regressive overall burden once VAT and excise duties are added in.
💡 Exam tips
Show every band separately in a tax calculation. Method marks are given even if the final figure slips.
Round only at the very end, and to two decimal places unless told otherwise.
Write the units. “$8,850” and “19.67%” are different answers to different questions.
Define progressive using the word proportion or percentage of income, never “pays more tax”.
Link tax back to the Lorenz curve and Gini whenever the question is about inequality — it connects the topic.
For evaluation, mention avoidance, disincentives and the regressive pull of indirect taxes.
⚠ Common mix-ups
Taxing the whole income at the top rate. Only the income inside a band is charged at that band’s rate.
Marginal instead of average. The marginal rate is on the next dollar; the average is the whole bill over the whole income.
Calling a tax progressive because rich people pay more money. They do in every system. It is the percentage that decides.
Forgetting indirect taxes are regressive. This single point turns a decent evaluation into a strong one.
Confusing avoidance with evasion. Avoidance is legal, evasion is not.
Assuming tax revenue automatically helps the poor. It only does if the spending is targeted at them.
Up next: Other Policies That Reduce Inequality — transfers, minimum wages, universal basic income and targeted spending, and how to judge which one actually works.
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