This study in Tigray, Northern Ethiopia, using micro data collected from a sample of households asses the contributions of farm and off-farm income sources to the over all income inequality. Some interesting results are obtained. Due to entry barriers, relatively wealthy farm households dominate the most lucrative rural non-farm activities such as masonry, carpentry and petty trade. This has widened the income inequality in rural areas. The main sources of inequality are non-farm activities such as non-farm skilled wage work and non-farm self-employment. Since the present public works program favors the poor, it reduces the income inequality that exists in the rural areas. If off-farm employment become the main source of income inequality in rural areas, its role in the alleviation of poverty will be very limited. Therefore a policy reform is required to manage the redistribution effect of expanding economic activities into off-farm employment. In order to reduce the income inequality effect of diversifying income sources into non-farm activities, the underlying elements that hinder participation of poor households in non-farm activities such as credit constraints and lack of skill, have to be tackled by providing credit and technical training to the poor. Provision of information the public on the labor market could also be helpful to reduce the transaction cost of searching for non-farm jobs. Moreover improving rural infrastructure can reduce spatial income inequality.