In this chapter we consider some of the causes of the huge gap between rich and poor in the UK, something that is visible in nearly every country regardless of their stage of economic development.

Poverty, Inequality and Market Failure

In a market economy an individual’s ability to consume goods & services depends upon his/her income. An unequal distribution of income and wealth may result in an unsatisfactory allocation of resources. The relatively poor do not have access to the range of goods and service consumed by ‘average’ citizens. High inequality may also lead to alienation and encourage crime with negative consequences for all. The market system will not respond to the needs and wants of those with insufficient economic votes to have any impact on market demand because what matters in a market based system is your effective demand for goods and services.

When we are discussing inequality and poverty, we cannot escape having to make value judgements. Ultimately, what is an ‘unacceptable’ distribution of income and what if anything the government should do about this is a value judgement and is a political issue beyond the remit of economics as a subject? That said there is plenty of evidence that high and rising levels of inequality of income and wealth can lead to negative social consequences.

Absolute poverty

Absolute poverty measures the number of people living below a certain income threshold or the number of households unable to afford certain basic goods and services. What we choose to include in a basic acceptable standard of living is naturally open to discussion.

Relative poverty

Relative poverty measures the extent to which a household’s financial resources falls below an average income threshold for the economy. Although living standards and real incomes have grown because of higher employment and sustained economic growth over recent years, the gains in income and wealth have been unevenly distributed across the population. 

There is little doubt that Britain has become a more unequal society over the last 20-25 years.

How many people live below the poverty line?

The most commonly used threshold of low income in Britain is 60% of median household income after deducting housing costs. This is a relative measure of poverty, which rises each year as average income rises and it is the measure now used to measure the number of households in a country living below the poverty line.

• Around two-thirds of individuals live in households that have incomes below the mean
• In contrast, just 2% of individuals have incomes above three times the national average
• Nearly 13 million people live in poor households whose income is less than sixty per cent of median income
• In 2003 3.6 million children were living in poor households – 28 per cent of all children. This compares with 1.9 million children in 1979

Proportion of people whose income is below various fractions of median household disposable income
UK
	Below
	60 per cent	Below half
	of median	of median
	income	income
1961	12.8	7.4
1971	13.6	6.3
1981	12.1	4.5
1991	20.1	11.7
2001	17.0	9.7
2004	16.8	9.4
Source: Social Trends 36

The Poverty Trap

The poverty trap affects people living in households on low incomes. The poverty trap creates a disincentive to look for work or work longer hours because of the combined effects of the income tax and welfare benefits system. For example, a worker might be given the opportunity to earn an extra £50 a week by working ten additional hours. This boost to his/her gross income is reduced by an increase in income tax and national insurance contributions. The individual may also lose some income-related welfare benefits. The combined effects of this might be to take away over 70% of a rise in income, leaving little in the way of extra net or disposable income.

When one adds in the possible extra costs of more expensive transport charges and the costs of arranging child care, then the disincentive to work may be quite strong.

Government Policies to Reduce Poverty

The Labour government has said on many occasions that it wants to reduce relative poverty in the UK. It has set ambitious targets for reducing the level of child poverty and it also wants to reduce the problem of poverty among older households.

Policies to reduce relative poverty normally focus on (a) changes to the tax and benefits system and (b) policies designed to increase employment and reduce unemployment.

When evaluating different policies to reduce poverty consider some of these related issues:

• Cost: The cost of schemes such as an increase in welfare benefits or the New Deal
• Effectiveness: The effectiveness of policies – e.g. the possible low “take-up” of means tested benefits by the poorest households
• Impact on others in the economy: Whether introducing a more progressive welfare system might damages towards wealth creation in other parts of the economy

Some of the main policy measures are summarised below:

1. Changes to the tax and benefits system

To many economists, the tax system is the most obvious place to start if the government wants to make a serious effect on the scale of relative poverty. For example, increases in higher rates of income tax would make the British tax system more progressive and reduce the post-tax incomes of people at the top of the income scale. The risk is that higher rates of direct taxation may act as a disincentive for people to earn extra income and might damage enterprise and productivity.

Lower "starting rates" of income tax would help to reduce the poverty trap and encourage people to look for a job. One of the problems with this is that all taxpayers would benefit from lower starting rates of tax and increased tax allowances whether or not they are poor. Therefore it is an expensive way of alleviating relative poverty.

2. A switch towards greater means-tested benefits

Means testing allows welfare benefits to go to those people and families in greatest need. A means-test involves a check on the financial circumstances of the benefit claimant before paying any benefit out.  This would help the welfare system to target help for those households on the lowest incomes. However means tested benefits are often unpopular with the recipients.

3. Linking the state retirement pension to average earnings rather than prices

This policy would help to relieve relative poverty among low-income pensioner households. Their pension would rise in line with the growth of average earnings each year. However given the demographic pressures on the welfare state (not least the long run increase in the number of people of pension age) such a strategy would be extremely expensive and put great pressure on total government spending. Other areas of spending might suffer a reduction in funding. Or the burden of taxation might have to increase to fund a substantial increase in spending on state pensions.

4. Special employment measures (including New Deal)

Government employment schemes seek to raise employment levels and improve the employment prospects of the long-term unemployed. Many schemes have been tried in the past - the latest of which is Labour's New Deal strategy that focuses on reducing long-term unemployment among youth and older workers. The New Deal includes employment subsidies and employment training for participants on the scheme.

5. Regional Policy Assistance

Relative poverty is often worse in areas where unemployment is well above the national average. The government may allocate increase funds for regional policy initiatives to attract new businesses into depressed areas and to improve the infrastructure of these regions. There are doubts though about the cost-effectiveness of regional policy funding. The European Union provides regional “structural” funds for areas where GDP is less than seventy-five per cent of the European Union average. Regions such as Cornwall, Wales, Scotland, Northern Ireland and the North East and North West of England have been in receipt of these funds over recent years.

6. Increased spending on education and training          

Unemployment is a cause of poverty and structural unemployment makes the problem worse. There are millions of households in the UK where no one in the family is in any kind of work and this increases the risk of poverty. There are substantial long term benefits from improving the educational attainment of families on low incomes and improving their prospects in the labour market.

7. The National Minimum Wage

The National Minimum Wage (NMW) was introduced in April 1999. It is a statutory pay floor - employers cannot legally undercut the NMW. 

A minimum wage will help to reduce relative poverty for people who earn very low wages. But only a small percentage of the employed labour force is directly affected by the minimum wage.
Since 1999, the beneficial impact of the minimum wage has been concentrated on the lowest paid workers in service sector jobs where there is little or no trade union protection. Female workers have been affected more than males – thus the NMW is making some contribution to closing the long-term gender pay gap in the British economy. There is an argument that workers in all jobs deserve a fair rate of pay for the job they do and that a minimum wage should reduce exploitation of lower-paid workers by some employers.

However a minimum wage may cost jobs in some industries. To the extent that this worsens the living standards of those affected it has a negative impact on poverty.

Further background reading on poverty and inequality in the UK

• Breadline Britain (BBC) http://news.bbc.co.uk/1/hi/in_depth/business/2005/breadline_britain/default.stm
• Child Poverty Action Group (CPAG) www.cpag.org.uk/
• Institute of Public Policy Research www.ippr.org.uk
• Joseph Rowntree Foundation www.jrf.org.uk/
• The changing face of poverty (BBC) http://news.bbc.co.uk/1/hi/business/4070112.stm