Speech

"Leveraging Fiscal Policy for Inclusive Growth" by Naoyuki Shinohara, Deputy Managing Director, International Monetary Fund

May 2, 2014

As Prepared for Delivery

First of all let me thank the organizers for putting together this panel discussion. Let me start with the general trend and then move to the role of fiscal policy.

The inclusive growth challenge in Asia

Income inequality has been rising in many parts of the world in recent decades. This, and the social tensions associated with fiscal consolidation that many have faced in part stemming from the global financial crisis, have put the distributional impact of governments’ tax and spending policies at the heart of the public debate in many countries. Of course, the question of just how much redistribution the state should do is, at its core, a political one that economic analysis cannot answer.

But economic studies show, on average, inequality is associated with lower growth. Thus fiscal redistribution can help support growth because it reduces inequality. Redistributive policies can generate a tradeoff between equality and efficiency. Design matters, and smart design can help to minimize the adverse effects of redistributive policies on incentives to work, save, and invest.

Let us now move to the discussion of trends in inequality. Over the last three decades, the Gini coefficient has increased in most countries, indicating an increase in inequality. In Latin America and sub-Saharan Africa, however, there has been a declining level of inequality more recently. What is most striking, however, are the persistent differences across regions, with Latin America having the highest inequality and the advanced economies having the lowest.

In Asia, since the early 1990s Asia’s fast growth has delivered a major reduction in poverty. Nevertheless, about 20 percent of the region’s population still lives below the poverty line—a poverty rate that is twice higher than in Latin America and Middle East and North Africa. Moreover, inequality in the distribution of income has increased, especially in countries with large population. Even though some decline in the impact of growth on poverty is to be expected as poverty rates fall, it is worrisome that the rise in inequality in emerging Asia has been larger than in other emerging regions, leaving parts of Asia less equitable than the Middle East.

The role of policies for fostering inclusive growth

These developments, along with the growing evidence that high income inequality can be detrimental to macroeconomic stability and growth, call for effective policy measures. Certain drivers of inequality, such as skill-biased technological change, are largely beyond governments’ reach. But policies also matter, and reforms can support a more equitable distribution of the gains from growth. Examples of these are labor market policies that ensure homogenous employment protection across different workers, institutional reforms to strengthen governance, or measures to promote financial inclusiveness.

Various studies show that fiscal policy is the most important policy tool affecting income distribution. For example, in advanced economies—where more empirical evidence is available—direct income taxes and transfers (including pensions and family benefits) have reduced the inequality by about a third, with about two-thirds of this coming from transfers.

Enhancing the efficiency of tax revenues

In developing countries in general, fiscal policy has played a much more modest role here. In Asia as well, low levels of both taxes and social spending limit the redistributive impact of fiscal policy. In emerging economies (EMEs) and low-income countries (LICs) in the region, the average ratio of revenues to GDP in 2012 was around 20 percent, compared with about 30 percent in Latin America and 37 percent in emerging Europe/Community of Independent States.

The relatively low revenue intake is partly due to an explicit policy choice favoring a low tax environment. However, tax yields, which broadly control for differences in tax rates, also tend to be small in several Asian EMEs and LICs reflecting deficiencies in tax administration, a sizable informal sector and narrow tax bases often due to poorly targeted and complex tax exemptions. In terms of composition of tax revenue, indirect taxes, like VAT, account for a much larger share, which tend to be less progressive than direct taxes such as income tax.

Raising the level and composition of public spending on pro-inclusive growth items

Public spending on education and health is also inadequate in many parts of Asia. In spite of still relatively poor health conditions, and the surge in per capita income of the past decade, government expenditure on health and education has barely increased in Asian EMEs and LICs since the early 2000s. Furthermore, in most of Asia, public spending on education and health is typically nearly 4 percentage points of GDP lower than in peers in other regions. Expanding public health and education spending, well targeted for low-income households, would support income redistribution and reduce poverty.

The level and composition of spending for social protection could also be enhanced in a number of Asia economies. In several EMEs and LICs social benefits represent a smaller share of total government spending than in peers in some other regions, while the weight of subsidies, such as energy subsidy, is typically higher. Social benefits make up only an average 6 percent of total public expenditure in Asia—much less than the 30 percent share in Latin America. Conversely in Asian EMEs and LICs the average weight of subsidies—which are typically untargeted and often regressive—is about 10 percent of total spending, compared to a share of less than 1 percent in Latin America. Many countries use energy subsidies as a form of social assistance, but these subsidies disproportionately benefit upper-income groups.

Against this background, a number of questions arise. Can Asian economies beef up their social protection systems to enhance redistribution, without jeopardizing their growth dynamism? How can untargeted subsidies be phased out? On the tax policy side, what crucial reforms are needed to enhance progressivity and boost revenues to finance social expenditure?

I am looking forward to a fruitful discussion on these issues.