This technical report by UK Office for National Statistics is intended to provide further detail on how the effects of taxes and benefits on household income (ETB) estimates are produced.
The report also provides further information on the measurement of income inequality. From financial year ending (FYE) 2015 the ETB data are split into two annual statistical bulletins. The first release – Household Disposable Income and Inequality (HDII) – provides headline estimates from the ETB data, to disposable income, and has been designed to provide more timely figures of main indicators relating to the distribution of household income and inequality, ahead of the main article. The main ETB statistical bulletin is published later in the year, building on the first release, and includes indirect taxes (for example VAT) and imputed income from benefits in kind (for example NHS, Education). The first HDII bulletin is based on the same dataset as the main ETB release and the data are not revised on a scheduled basis, meaning that the figures in the first release are fully consistent with those in the full ETB publication.
Redistribution of income
Household members begin with income from employment, private pensions, investments and other non-government sources. This is referred to as “original income” Households then receive income from cash benefits. The sum of cash benefits and original income is referred to as “gross income”. Households then pay direct taxes. When direct taxes are subtracted from gross income the result is referred to as “disposable income”. Indirect taxes are then paid via expenditure. Disposable income minus indirect taxes is referred to as “post tax income” Households finally receive a benefit from services (benefits in kind). Benefits in kind plus post-tax income is referred to as “final income”.
Note that at no stage are deductions made for housing costs.
Presenting income inequality: Lorenz curve and income shares
There are a number of different ways in which inequality of household income can be presented and summarised. Detailed analysis of income inequality from the effects of taxes and benefits (ETB) estimates was published on 8 April 2016 in the “ effects of taxes and benefits on income inequality, 1977 to financial year ending 2015”.
Income inequality can be illustrated graphically using a Lorenz curve. (see Article) A Lorenz curve is created by ranking households from poorest to richest and graphing the cumulative share of household income and the cumulative share of households, as proportions of the total household income and the total number of households, respectively. The cumulative share of households gives a 45 degree line. When the cumulative share of income also gives a 45 degree line, this represents a situation where income is equally divided amongst all households. Higher income inequality is represented by an increase in the area between the cumulative share of household income curve and the cumulative share households curve. Where all the area under the 45 degree line is shaded, income is at its most unequal – all income is held by one household.
Summary measures of income inequality
Gini Coefficient
It is possible to summarise a Lorenz curve in a single figure – a Gini coefficient. The Gini coefficient is probably the most commonly used measure of income inequality internationally and is effectively a summary of the differences between each household in the population and every other household in the population. Using the Lorenz curve, the Gini coefficient is calculated by taking the ratio of the shaded area and the area below the 45 degree line of perfect equality (the 45 degree line triangle). A distribution of perfectly equal incomes has a Gini coefficient of zero (or 0%). As inequality increases, and the Lorenz curve bellies out, so does the Gini coefficient, until it reaches its maximum value of 1 (or 100%).
One of the main strengths of the Gini is that it takes into account changes in relative incomes in all areas of the income distribution. It is always the case that an increase in the income of a household with an income greater than the median will lead to an increase in the Gini coefficient, as will a decrease in the income of a household whose income is below the median. The size of this increase in the coefficient will depend on the proportion of households that have an income between the median and that of the household whose income has changed.
An improved process for calculating the Gini Coefficient has been implemented from the FYE 2016 analysis which has resulted in a change to the levels of rounding applied. Although not significant, there are minor differences to previously published Gini estimates. The Gini coefficient for disposable income in FYE 2017 was 32.2%, compared with the FYE 2016 value of 31.6%.
Original income is more unequal for retired households than for non-retired households (Gini coefficients of 58.0% and 42.9% respectively, in FYE 2017). This is because the majority of those who are retired have little income from wages and salaries as they are not active in the labour market. In contrast, the Gini coefficient for gross income is markedly reduced among retired households (29.8%) and is smaller than the equivalent Gini coefficient for non-retired households (35.4%), in FYE 2017. This is primarily because of the addition of the state pension and pension credit. Inequality, as measured by the Gini coefficient, is lower for retired households at both the disposable and post-tax income stages than for non-retired households. In recent years, there is evidence of an increase in inequality for retired households. Compared with the most recent low point, in FYE 2010, the Gini coefficient for disposable income amongst retired households has increased significantly by 3.7 percentage points. This in part reflects a growing gap between retired households in receipt of income from private pensions and those without private pensions (see What has happened to the income of retired households in the UK over the past 40 years?).
There has been more year-on-year variation in the Gini coefficients for retired households than for the overall population, though this is primarily a consequence of the smaller sample size on which these estimates are based. In all Gini coefficients shown, income measures are equivalised using the modified-OECD scale. Strictly speaking, it could be argued that the equivalence scales used here are only applicable to disposable income because this is the only income measure relating directly to spending power. Since the scales are often applied, in practice, to other income measures, it is considered appropriate to use them to equivalise original, gross and post-tax income for the purpose of producing Gini coefficients. However, it is not felt to be appropriate to equivalise the final income measure because this contains notional income from benefits in kind (such as that from the NHS): the equivalence scales used in this analysis are based on actual household spending and do not, therefore, apply.
