Sources Of Income Inequality

There is no denying the fact that income inequality within as well as across the countries has increased significantly especially after the second wave of globalization. The rich-poor gap, which has widened in the past few decades, speaks volumes about the gravity of the problem of unequal income distribution in the world. It is, therefore, pertinent to analyze the issue of income inequality in detail.

There are basically three major sources of the rising income inequality: tax policy, tax enforcement, and employment structure. Here is a brief analysis of these sources:

Taxation Policy

Taxes are important tools used by the governments to redistribute revenues in a bid to reduce income inequality. This objective of fiscal policy ultimately ends up with welfare maximization of the society because income redistribution from rich segment of the society to the poor will enhance purchasing power of the latter and thus will lead to higher level of consumption in the society. Furthermore, higher consumption of goods and services also boosts economic growth.

Taxation policy deals with tax structure — the type of taxes as well as tax rates and tax bases. Direct taxation policy concentrates on collection of tax revenues through direct taxes such as income tax, wealth tax, inheritance tax, gift tax, etc. This policy ensures that people pay taxes according to their income. It, thus, tries to achieve horizontal as well as vertical equity. So, direct taxation policy plays a crucial role in reducing income inequity.

Unfortunately, many countries have increasingly resorted to indirect taxation policy as a fiscal instrument over the past many years. Indirect tax rates increased in all the regions except in North America and Latin America. Average indirect tax rates in Asia and Europe increased from 11.7pc and 18.88pc in 2009 to 12.5pc and 20.18pc. In North America, the average indirect rate remained constant at 5pc during that period.

Thus indirect taxation policy over the years could be an important source of income inequality in many countries.

In Pakistan, the World Bank, in a recent study, has concluded that taxation on poor was equal to that on the middle income as households in the lowest decile pay about 2.4pc of the total taxes while consuming only 3pc of the total consumption.

In Pakistan, in order to collect tax revenues, generally indirect taxation policy along with several withholding taxes is followed. Several types of withholding tax are regressive in nature as these are included in the final prices of goods and services to be purchased and consumed by the rich as well as the poor in the same country.

Enforcement Policy

Weak enforcement of tax policy has resulted in tax evasion, thus enriching the already rich and depriving the government from revenues to finance much needed public services such as security, law and order education, health, etc. It is worth mentioning that an effective legal, judicial and security infrastructure is direly needed in the country. The corporate tax evasion is massive as the multinational corporations pay little or even zero taxes by shifting the income to low tax jurisdiction or tax havens.

Similarly, there is massive tax evasion by the corporate taxpayers in Pakistan due to weak policy enforcement.

For example, the corporate tax is an important source of revenue in Pakistan. It currently raises 2.5pc of the GDP, which comprises about 25% of all federal tax revenues (World Bank 2009). The scale of non-compliance is suspected to be large in Pakistan but credible evidence on the amount of corporate tax evasion has been lacking due to problems with the data as well as the methodology. The Federal Board of Revenue (FBR) reports an estimate of the corporate evasion rate equal to 45pc. A World Bank study puts the evasion rate to as high as 218pc of actual corporate income tax payments.

Tax audits along with other enforcement measures such as penalties, additional taxes, etc., are considered effective tools against tax evasion. But tax audits have been discontinued for quite some time and there has been a virtual moratorium on other enforcement measures since years.

Employment Structure

The world has witnessed a massive growth in the multinational enterprises (MNEs) over the last century, with a rapid flow of trade and investment across the borders. Over 60pc of world trade is conducted by the MNEs. They have been exploiting the human resources in the developing countries. But, labour force is employed at lower wages in such countries but the businesses are making substantial incomes and it has resulted in huge income inequalities. Weak enforcement of labour laws in developing countries has been responsible for providing the MNEs with lacunae which they use to exploit the labour force. Furthermore, laws are not clear and the legal and enforcement frameworks are also being utilized by the large enterprises for accumulating wealth.

In a nutshell, the problem of income inequality has gained much importance in the recent years and has been vigorously debated in the print and electronic media.
In Pakistan, the gravity of the problem can be assessed from the fact that hundreds of children have lost their lives in the Sindh’s Tharparker region due to non-availability of food despite the fact that Pakistan is an agrarian economy with abundant grain production. Therefore, it is suggested that the government must revisit its taxation policy and adopt a policy with main focus on direct taxes. It also needs to adopt strict measures to ensure compliance so as to curb tax evasion and avoidance. There is a need to enforce clear and strict labour laws so that the employees get due wages. Increasing wages is important for reducing income inequality and boosting economic growth.

The writer is a joint Japan-World Bank Scholar
and has Graduated in Taxation Policy & Management
from Keio University, Japan.
He can be reached at

Leave a Reply

Your email address will not be published. Required fields are marked *