Taxation is how a government turns the income distribution the market produced into the one it wants. But not every tax narrows the gap — some widen it. This page shows you which is which, how to calculate the rates examiners ask for, and how to argue about the trade-offs without sounding one-sided.
📚 What you need to know
Direct taxes are paid on income and profits (income tax, corporation tax, capital gains, inheritance). Indirect taxes are paid on spending (VAT, excise duties).
Progressive: the average tax rate rises with income. Proportional: it stays the same. Regressive: it falls as income rises.
Marginal tax rate = tax on the next dollar earned. Average tax rate = total tax ÷ total income.
Indirect taxes are regressive, because poorer households spend a larger share of their income.
Redistribution shifts the Lorenz curve inwards and lowers the Gini.
Other policies: transfer payments, a national minimum wage, universal basic income, free education and healthcare, and anti-discrimination law.
Every policy has a cost: incentive effects, opportunity cost, tax avoidance and administrative burden.
Direct and indirect taxes
Feature
Direct taxes
Indirect taxes
Levied on
Income, profits and wealth
Spending on goods and services
Examples
Income tax, corporation tax, capital gains tax, inheritance tax
Value added tax, excise duties on fuel, alcohol and tobacco
Who pays it over
The individual or firm, directly to the government
The seller collects it and passes it on
Effect on inequality
Usually progressive, so it narrows the gap
Usually regressive, so it widens the gap
Three tax systems, one diagram
The label depends entirely on what happens to the average rate as income rises. Plot the average tax rate against income and each system has an obvious shape.
Under all three systems a rich household usually pays more tax in dollars. Only the progressive system takes a larger share of a larger income.
The two rates
Average tax rate = ( total tax paid ÷ total income ) × 100
Marginal tax rate = ( change in tax ÷ change in income ) × 100
WORKED EXAMPLE
Using the tax bands below, calculate the total tax bill and the average tax rate for someone earning $60,000. [4]
Band of income ($)
Marginal rate
0 – 12,000
0%
12,001 – 40,000
20%
40,001 – 90,000
40%
90,001 and above
45%
Step 1: tax each band separatelyFirst 12,000 at 0% = $0Next 28,000 at 20% = $5,600Next 20,000 at 40% = $8,000Step 2: add them up0 + 5,600 + 8,000 = $13,600Step 3: average rate(13,600 ÷ 60,000) × 100 = 22.67%Tax = $13,600; average rate = 22.67%The marginal rate is 40% but the average is only 22.67%. Never apply the top rate to the whole income — that is the classic error here.
Check your answer is progressive by testing a second income. At $25,000 the bill is $2,600, so the average rate is 10.40%. Average rate rising from 10.40% to 22.67% as income rises from $25,000 to $60,000 confirms the system is progressive.
Why indirect taxes widen the gap
A sales tax charges everyone the same percentage on what they buy. That sounds fair until you remember that low-income households spend nearly all of their income while high-income households save a large part of theirs. The tax is proportional to spending, and therefore regressive relative to income.
WORKED EXAMPLE
VAT is 20%. Household P earns $15,000 and spends $14,000; household Q earns $100,000 and spends $50,000. Show that VAT is regressive. [4]
Step 1: extract the tax from VAT-inclusive spendingWith 20% VAT, the tax is 20/120 of the price paid.P: 14,000 × 20 ÷ 120 = $2,333.33Q: 50,000 × 20 ÷ 120 = $8,333.33Step 2: express each as a share of incomeP: (2,333.33 ÷ 15,000) × 100 = 15.56%Q: (8,333.33 ÷ 100,000) × 100 = 8.33%P pays 15.56% of income, Q pays 8.33% — regressiveQ pays far more in dollars but a much smaller share of income. That is exactly what regressive means.
What redistribution does to the Lorenz curve
Tie this back to the measurement page. Progressive taxes and transfer payments together raise the income share of the poorest groups and lower that of the richest. Every cumulative point on the curve rises, so the curve moves towards the diagonal and the Gini falls.
The gap between the two curves is the whole of what tax and benefit policy achieves. In some countries it is worth more than 0.15 of a Gini point.
The full policy toolkit
Learn these as chains, not as a list. The chain is where the analysis marks are.
Policy
How it works
The chain
Progressive income tax
Higher earners pay a larger share of income, funding services and transfers
Higher revenue → more spending on the poorest → higher disposable income → lower Gini
Transfer payments
Unemployment, disability, child and pension payments go to the lowest-income households
More benefits → higher disposable income → less relative poverty → stronger consumption
Free education and healthcare
Removes the price barrier to building human capital
Better schooling and health → higher human capital → higher productivity → higher wages
National minimum wage
A legal floor above the market wage for the lowest-paid
Higher wage for those in work → higher income → less in-work poverty, but a risk of job losses
Universal basic income
A guaranteed payment to every citizen regardless of income or work
Income floor for all → no benefits trap → more security to retrain, but very expensive to fund
Targeted government spending
Schools, clinics, transport and housing built where the need is greatest
Better public services → higher real living standards → more opportunity → higher future income
Anti-discrimination policy
Removes pay and hiring gaps not justified by productivity
Fairer access to jobs → better use of talent → higher output and lower inequality
Notice the pattern. Almost every route runs through human capital. That is why education and healthcare appear in both the poverty cycle and the policy table — they are the point where the cycle is easiest to break.
Evaluating redistribution honestly
A top-band answer never stops at “this reduces inequality”. It asks what the policy costs.
Incentive effects. Very high marginal rates may discourage extra work, or push high earners and firms to relocate. How large this effect is in practice is genuinely disputed.
Tax avoidance and evasion. The higher the rate, the greater the reward for finding a way around it, so revenue may rise by less than expected.
Opportunity cost. Money spent on transfers is money not spent on infrastructure or debt reduction.
The benefits trap. If benefits are withdrawn sharply as earnings rise, the effective marginal rate on a low-paid worker can be higher than on a rich one.
Time lags. Education spending takes a decade to show up in wages; transfers work within a month. The right mix depends on the time frame in the question.
Administrative cost and targeting. Means-testing is expensive and some eligible households never claim; universal payments are simple but go to people who do not need them.
It depends on the starting point. A country with a Gini of 0.55 and no safety net has far more to gain from redistribution than one already at 0.28.
WORKED EXAMPLE
Evaluate the view that raising the top rate of income tax is the best way to reduce inequality. [15-style plan]
The case for
Raises revenue from those most able to pay; funds transfers and services; shifts the Lorenz curve inwards and lowers the Gini.
Against 1: it may not raise much
Avoidance, relocation and reduced work effort mean revenue can rise by less than the rate change suggests.
Against 2: it targets income, not wealth
Wealth inequality is larger and is untouched by income tax; property and inheritance taxes reach it instead.
Against 3: alternatives may work better
Spending on education and healthcare tackles the cause of low income rather than compensating for it.
Judgement: useful, but not sufficient on its ownEnd with a condition: the best mix depends on the country’s current Gini, the strength of its tax administration, and whether the aim is absolute or relative poverty.
💡 Exam tip
Work through tax bands one band at a time. Applying the top rate to the whole income is the single most common calculation error.
Say explicitly whether the average rate rises, stays flat or falls — that is the definition being tested.
For VAT questions, remember the tax is 20/120 of a VAT-inclusive price, not 20/100.
Draw the Lorenz shift when a question asks about the effect of redistribution. Two labelled curves plus an arrow.
Distinguish policies that treat the symptom (transfers) from those that treat the cause (education, health, anti-discrimination).
Every evaluation should end with a condition: it depends on the size of the incentive effect, the time frame, or the country’s starting point.
⚠ Common mix-up
Marginal and average tax rates. Being “in the 40% band” does not mean paying 40% of everything.
Assuming regressive means the rich pay less money. They usually pay more in dollars but a smaller share of income.
Calling all direct taxes progressive. A flat-rate income tax is direct but proportional.
Confusing tax avoidance with tax evasion. Avoidance is legal; evasion is not.
Forgetting that transfers are not counted in GDP. They redistribute income; they do not create output.
Writing a one-sided policy answer. Without incentive effects, opportunity cost or the benefits trap, an evaluation cannot reach the top band.
That completes 3.3 and 3.4. Up next: Demand-side and Supply-side Policies — the toolkit governments use to chase every objective on these pages at once.
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