## MACRO-STRUCTURAL POLICIES AND INCOME INEQUALITY IN LOW-INCOME DEVELOPING COUNTRIES

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### Executive summary — context, objective, approach
- Context and objective:
  - Despite strong growth over the past two decades, income inequality remains high in many low-income developing countries (LIDCs).
  - The note explores how policies and reforms aimed at boosting growth affect income inequality in LIDCs and how complementary policy measures can offset adverse distributional effects.
  - Examines: (i) distributional consequences of selective economic reforms and macro-structural policies generally considered growth-enhancing; (ii) channels and mechanisms through which inequality is likely to be affected given structural characteristics common to most LIDCs; and (iii) scope for complementary policies to ensure reform packages boost growth without widening inequality.
- Approach and scope:
  - Combines cross-country empirical analysis (major reform events over the past three decades) with detailed country-case studies using a dynamic general equilibrium (DGE) framework that incorporates features common to LIDCs.
  - Focused macro-structural reforms: selected fiscal reforms (tax policy measures, higher public infrastructure investment); financial sector reforms; agricultural sector reforms.
  - Income inequality measured by the Gini coefficient for disposable income.

### Key empirical and model-based findings
- General:
  - Distributional consequences of growth-enhancing macro-structural policies in LIDCs are important and depend on reform design and country-specific characteristics.
- Specific findings:
  - Tax policies: distributional impact depends on tax instruments chosen and how additional budgetary resources are deployed.
  - Infrastructure: better and more infrastructure investment can both boost growth and lower inequality levels.
  - Financial sector reforms: can exacerbate inequality if financial access is limited to a small share of the population and labor mobility is constrained.
  - Agricultural reforms: can worsen income inequality where agriculture is large and productivity gains benefit mostly the rural better-off.
- Mechanisms highlighted:
  - Reforms that increase inter-sectoral productivity differentials can increase inequality where productivity gaps are large and labor mobility is constrained.
  - Changes in relative prices of tradable vs non-tradable goods can affect low-income workers (who work mostly in non-tradable sectors), altering profits and wages and potentially increasing inequality.
  - Reforms reducing borrowing costs can increase inequality when financial access is limited, since high-income individuals and high-productivity sectors typically access credit.

### Domestic resource mobilization — direct and indirect taxes, and public investment
- Direct taxes:
  - Direct taxes can be progressive but high marginal rates can reduce incentives for entrepreneurship and capital accumulation.
  - Empirical evidence: major direct tax reforms in LIDCs have been associated, on average, with a decrease in inequality.
  - Effect of direct tax increases on inequality is imprecisely estimated with wide variation across cases.
  - Large informal sector reduces tax base, may require higher tax rates, raising efficiency losses and incentivizing informality; empirically informality did not play a statistically significant role in affecting the effect of direct tax reforms on inequality.
- Indirect taxes (VAT and consumption taxes):
  - Consumption taxes are generally regressive absent offsetting public spending.
  - VAT hikes tend to widen consumption inequality; they reduce overall consumption and aggregate demand, lowering prices of non-tradable goods while tradable-good prices remain broadly stable, reducing revenues and employment in non-tradable sectors that typically employ low-skilled, lower-income workers.
  - Informality implications for VAT reforms:
    - Larger informality → lower tax base → higher rates → accentuated regressivity.
    - Demand for informal goods contracts less than for formal goods, partially shielding informal producers’ incomes and potentially reducing income inequality.
    - But shifts toward informal activities depress aggregate output and growth.
  - Empirical estimates:
    - A one-standard-deviation increase in the VAT rate is associated with an increase in the Gini coefficient of about 0.2 percent one year after the tax increase.
    - Five years after the tax increase, the increase is about 1.5 percent.
    - The VAT effect on inequality tends to be greater in countries with a small share of informal sector.
- Public infrastructure investment:
  - Infrastructure investment can reduce within-sector inequality by boosting productivity and demand for unskilled and low-income workers; effects on between-sector inequality depend on how gains are distributed and on labor mobility.
  - Empirical evidence:
    - An exogenous increase in public investment of 1 percent of GDP results in a reduction of the Gini coefficient of about 0.3 percent one year after the increase.
    - Five years after the increase, the reduction in the Gini coefficient is about 2.3 percent.
    - The medium-term effect is approximately equivalent to one standard deviation of the average change in the Gini coefficient (2.4 percent) in the sample.
    - Public investment shocks do not lead to a reduction in inequality in countries with low public investment efficiency (proxied by a survey-based measure of wastefulness of government spending).

### Financial sector reforms and inclusion
- Financial reforms that lower cost of capital can boost growth but may increase inequality if access does not expand; benefits accrue mainly to households and firms that can access cheaper credit.
- Reforms increasing access to financial services can lower inequality while boosting growth by helping households smooth income and increasing savings available for private investment.
- Empirical evidence:
  - On average, financial sector reforms implemented in LIDCs over the past three decades have not had a statistically significant effect on inequality.
  - Heterogeneity: financial reforms associated with rising inequality in LIDCs with limited financial inclusion.
- Financial inclusion metrics referenced:
  - Bank accounts per 1,000 people; share of adults holding accounts at formal financial institutions.

### Agricultural reforms — heterogeneity and mechanisms
- Agricultural productivity increases can drive structural transformation and higher growth due to large productivity gaps between agriculture and other sectors.
- Distributional consequences depend on reform type and country features:
  - Productivity-raising measures (services, R&D) can benefit agricultural workers and reduce sectoral inequality.
  - Removing subsidies or price controls can increase productivity but may worsen poverty and inequality if poor, low-productivity farmers lose out—benefits may accrue mainly to better-integrated, high-productivity farmers.
  - Limited labor mobility can exacerbate inequality if workers cannot move to higher-income sectors.
- Empirical patterns:
  - Agricultural liberalization does not appear significantly correlated with inequality overall, but tends to increase inequality in countries with a relatively large share of employment in agriculture.
- Complementary measures:
  - Infrastructure investments (electrification, irrigation), agricultural R&D, and conditional cash transfers can mitigate adverse distributional impacts.

### Country case studies — reform packages and calibrated scenarios
- Case-study countries: Honduras, Guatemala, Uganda, Republic of Congo, Ethiopia, Myanmar, Malawi.
- Reform categories analyzed:
  - Domestic resource mobilization: Honduras, Guatemala, Uganda, Republic of Congo.
  - Financial sector reforms: Ethiopia, Myanmar.
  - Agricultural reforms: Malawi.
- Selected country indicators (2015 or latest available):
  - Real GDP Growth (Percent): Honduras 3.6, Guatemala 4.1, Uganda 4.8, Republic of Congo 2.3, Ethiopia 10.2, Myanmar 7.3, Malawi 2.9.
  - Poverty Rate (Percent of Population): Honduras 16.0, Guatemala 59.3, Uganda 34.6, Republic of Congo 37.0, Ethiopia 33.5, Myanmar 25.6, Malawi 70.9.
    - Note: Poverty measured as percent of population with income < $1.90 per day (2011 PPP) except Guatemala and Myanmar (national poverty line).
  - Gini Index: Honduras 50.6, Guatemala 53.0, Uganda 42.4, Republic of Congo 40.2, Ethiopia 33.2, Myanmar 29.0, Malawi 46.1.
  - Public Debt (Percent of GDP): Honduras 46.0, Guatemala 24.2, Uganda 34.4, Republic of Congo 70.6, Ethiopia 56.1, Myanmar 34.3, Malawi 82.0.

### Selected case-study results and policy implications
- Honduras (2013 reform: VAT 15 → 18 percent; recurrent spending cuts 6 percent of GDP; expand Vida Mejor by 0.5 percent of GDP):
  - Observed outcomes: sovereign spreads declined by about 400 basis points from a 2013 peak of 770 basis points; growth increased by almost 1 percent over two years to reach 3.6 percent in 2015.
  - Simulation: VAT hike directly reduced consumption and output (amplified by large informality estimated at 53 percent of GDP) but net output effect was positive due to reduced sovereign spreads stimulating investment.
  - Distributional outcome: VAT hike direct impact neutral; including sovereign spread reduction the reform was overall progressive; expansion of cash transfers boosted consumption and reduced inequality.
- Guatemala (raise revenue by 1 percent of GDP via PIT reform or VAT increase):
  - Simulation: PIT reform (raising top PIT rate to 10 percent, bottom at 5 percent) would have smaller negative effects on activity than VAT and would reduce inequality marginally.
  - VAT hike (13 → 16 percent) would have significant negative effects due to large informal sector and weak VAT enforcement; would reduce demand for formal goods, lower formal sector prices and returns, and reduce incomes of agriculture workers; VAT reform would not substantially reduce sovereign spreads in contrast to Honduras.
  - Using additional PIT revenues for higher infrastructure spending would more than mitigate negative impact on output and offset the progressivity of the PIT reform; expanding cash transfers would improve inequality but at some economic cost.
- Uganda (large informality; tax-to-GDP ratio 11 percent in FY2012/13):
  - Estimated required rate increases to raise revenue-to-GDP ratio by 1 percent of GDP:
    - PIT rates should increase by 34 percentage points.
    - CIT rates should increase by 12 percentage points.
    - VAT rate hike needs to be 2 percentage points.
  - Increasing VAT rate would be slightly progressive and raise revenue with smaller negative impact on activity than PIT and CIT hikes given statutory rates and informality patterns; channeling additional revenue to infrastructure would enhance productivity but could offset VAT progressivity unless part reallocated to targeted cash transfers.
- Republic of Congo (post-oil-price shock context):
  - Increasing energy prices would be slightly progressive with no significant impact on growth; higher energy prices mostly affect higher-income households, lowering inequality, and could expand agricultural export sector and rural incomes.
  - Increasing VAT would reduce private consumption and increase inequality.
  - Spending additional resources on infrastructure and increasing its efficiency by 20 percent could increase GDP by almost 7 percent; impact on inequality broadly neutral if productivity increases proportionally across sectors.
- Ethiopia (financial sector reform: raise deposit rates; reduce share of credit to public sector from two-thirds to half):
  - Simulation: reform can boost private sector activity and growth—higher deposit rates increase private saving and lending resources; private sector credit increases, lending rates fall, investment more than triples.
  - Distributional effect: reform likely to increase inequality because limited financial access concentrates benefits in manufacturing and modern services; limited rural-urban mobility sustains wage differentials; export agriculture shifting to manufacturing could reduce small farmers’ incomes.
  - Mitigants: improve financial access, increase labor mobility (strengthen land rights, infrastructure, training), and enlarge cash transfer programs in short term.
- Myanmar (financial deepening, deposit rates 8 percent → 9 percent; reduce public-sector credit share):
  - Simulation: increasing private credit boosts urban activity, growth, reduces poverty and inequality; greater labor mobility than Ethiopia allows migration and wage convergence; rural infrastructure investment further boosts growth and reduces inequality.
- Malawi (reduce maize fertilizer subsidy from 100 to 80 percent; reduce procurement costs by 25 percent; add cash transfers 0.5 percent of GDP; agricultural R&D 0.5 percent of GDP):
  - Expected outcomes: efficiency gains, slight rise in output, shift to higher-value agriculture, higher exports and incomes for exporters, higher capital stock and private consumption.
  - Distributional trade-off: reform increases inequality because subsidies act as cash transfers for many small farmers—reducing subsidies would reduce incomes of small and poor farmers, exacerbating poverty and inequality.
  - Mitigants: well-targeted cash transfers to rural poor and increased agricultural R&D reduce inequality and amplify positive effects on private investment and GDP.

### Complementary policies and policy lessons
- No one-size-fits-all; targeted accompanying measures implemented with pro-growth reforms can contain adverse distributional effects, but feasibility depends on administrative capacity and political economy constraints.
- Specific design and accompanying measures:
  - Channel additional resources into highly progressive spending to reduce inequality.
  - Infrastructure investment, if efficient, can increase output and reduce inequality; investment in electrification, irrigation, agricultural R&D and services can reduce sectoral productivity gaps.
  - Financial deepening combined with expanded access to financial services fosters inclusive growth.
  - Conditional targeted cash transfers can have immediate impact and support human capital; accessible education and training increase labor mobility but take time.
  - Structural reforms reducing informality (regulatory simplification) and enhancing labor mobility (strengthened property rights) are politically difficult but can boost productivity and shared growth.

### Empirical methodology and modeling framework (summary)
- Empirical method:
  - Local projection method (Jordà, 2005) used to estimate impulse-response functions; baseline uses log of Gini (Solt, 2016), country and time fixed effects, reform shocks, and control variables including lags.
  - Extended specification allows responses to vary with country-specific characteristics (public investment efficiency, informality, financial inclusion) using normalized z_i,t.
- Reform identification:
  - Reforms identified where annual change in reform indicator exceeds two standard deviations above average annual change (except public investment shocks and tax reforms).
  - Tax reform indicators measured as lagged changes in VAT rate or personal income tax rate (IMF Tax Rate Database DART).
  - Public investment shocks: difference between actual public investment and expected public investment (IMF WEO analysts), sample of 24 LIDCs from 1995 to 2014.
  - Domestic financial liberalization index: composite of five equally weighted sub-indices: interest rate controls; credit controls; restrictions on bank competition; degree of state ownership; quality of banking supervision/regulation.
  - Agriculture reform indicator captures degree of government intervention in the main agricultural export commodity (maximum, high, moderate, no intervention).
- DGE model features (Appendix 2):
  - Small open economy with agriculture, manufacturing, services, energy, export commodities; heterogeneous households (large farmers, rural households, urban low-skill and high-skill); informal activities and credit constraints; limited labor mobility and sectoral productivity parameters calibrated to match data moments.
  - Government taxes: consumption taxes τ_f and τ_m, import taxes τ*, corporate taxes τ_k, labor income tax τ_w; transfers and spending calibrated to match revenue shares.
  - Calibration targets include sectoral shares, tax revenue shares, food consumption shares, urban and rural Gini; model period one year; discount factor β = 0.96.
  - Ethiopian fiscal calibration (selected parameters):
    - Consumption Tax on Domestically Produced Food τ_a = 0.06
    - Consumption Tax on Non-Food τ_m = 0.06
    - Import Taxes τ* = 0.32
    - Corporate Taxes τ_k = 0.24
    - Corporate Taxes Export Sector τ_r = 0.12
    - Labor Income Tax τ_w = 0.06
  - Calibration outcomes presented for shares of tax revenues and sectoral shares (see model tables for exact data-model comparisons).

### Caveats, limitations, and interpretation
- Empirical results identify associations rather than definitive causal effects due to challenges isolating truly exogenous reform events and potential omitted variables.
- Case-study modeling provides mechanism insights but results depend on modeling methodology and parameter values.
- Societal preferences over distributional shifts vary across countries; policy choices reflect trade-offs between growth, equity, administrative capacity, and political economy.

*Source: IMF staff analysis in "MACRO-STRUCTURAL POLICIES AND INCOME INEQUALITY IN LOW-INCOME DEVELOPING COUNTRIES" (sdn1701).*

### EXECUTIVE SUMMARY ___________________________________________________________________________ 5

### EXECUTIVE SUMMARY

### Context and objective
- Despite strong growth over the past two decades, income inequality remains high in many low-income developing countries (LIDCs).
- The note explores how policies and reforms aimed at boosting growth affect income inequality in LIDCs and how complementary policy measures can offset adverse distributional effects.
- It examines: (i) the distributional consequences of selective economic reforms and macro-structural policies generally considered growth-enhancing; (ii) the channels and mechanisms through which inequality is likely to be affected given structural characteristics common to most LIDCs; and (iii) the scope for complementary policies to ensure reform packages boost growth without widening inequality.

### Approach and scope
- Combines cross-country empirical analysis (major reform events over the past three decades) with detailed country-case studies based on a dynamic general equilibrium framework that incorporates features common to LIDCs.
- Focused set of macro-structural reforms analyzed: selected fiscal reforms (tax policy measures, higher public infrastructure investment); financial sector reforms; and reforms to the agricultural sector.
- Income inequality is measured by the Gini coefficient for disposable income.

### Key findings (empirical and model-based)
- Distributional consequences of growth-enhancing macro-structural policies in LIDCs are important and depend on reform design and country-specific characteristics.
- Specific findings:
  - The distributional impact of tax policies depends not only on the tax instruments chosen (indirect taxes usually seen as regressive and direct income taxation usually seen as progressive) but also on how additional budgetary resources are deployed.
  - Better and more infrastructure investment can both boost growth and lower inequality levels.
  - Financial sector reforms can exacerbate inequality if financial access is limited to a small share of the population and labor mobility is constrained.
  - Reforms that boost agricultural output can worsen income inequality where the agricultural sector is large and productivity gains benefit mostly the rural better-off.

### Mechanisms and channels relevant for LIDCs
- Reforms that increase inter-sectoral productivity differentials can increase inequality, particularly where the productivity gap across sectors is large and labor mobility is constrained, because poor individuals usually work in low-productivity sectors and cannot easily move to higher-productivity sectors.
- Reforms that change relative prices of tradable versus non-tradable goods affect incomes of low-income workers (who work mostly in non-tradable sectors), with price shifts altering profits and wages and potentially increasing inequality.
- Reforms that reduce borrowing costs can increase inequality when financial access is limited, since only high-income individuals and high-productivity sectors typically access credit; limited labor mobility amplifies this effect.

### Complementary policies and policy lessons
- Accompanying measures can make reforms supportive of growth while limiting adverse distributional effects.
- There is no one-size-fits-all recipe; targeted policy interventions implemented with pro-growth reforms can contain adverse distributional effects—but their feasibility depends on administrative capacity and political economy constraints.
- Examples of complementary measures discussed include conditional cash transfers and measures to enhance labor mobility (such as strengthening land ownership rights), noting both implementation challenges and time required for impact.

### Caveats and interpretation
- Empirical results identify associations rather than definitive causal effects due to standard limitations in isolating truly exogenous reform events and potential omitted variables.
- The case-study modeling provides insights into mechanisms but results depend on modeling methodology and parameter values.
- Societal views on whether distributional shifts are unwelcome will vary across countries.

### Structure of the note (overview)
- Discussion of mechanisms through which policies affect inequality in LIDCs and role of country-specific features (inter-sectoral productivity differences, labor mobility, informality, infrastructure, access to finance).
- Empirical analysis of distributional consequences of major reform events.
- Country-case studies using a dynamic general equilibrium framework.
- Final discussion of main policy takeaways for making pro-growth reforms more inclusive in LIDCs.

*INTERNATIONAL MONETARY FUND*

### 8.      Boosting budgetary revenues is a policy priority in most LIDCs, to enable governments

### 8.      Boosting budgetary revenues is a policy priority in most LIDCs, to enable governments

### Overview
- LIDCs still have fiscal revenues at about 20 percent of GDP, much lower than in AEs and EMs.
- Strengthening domestic resource mobilization is a key objective in the Addis Ababa Action Agenda (AAAA) and emphasized by the G20 action plan on the 2030 agenda for sustainable development.
- Two prominent resource mobilization measures examined for their typical effects on income distribution in LIDCs: tax reforms (direct and indirect) and public spending (infrastructure investment).

### Policies for Domestic Resource Mobilization — Direct taxes
- Direct taxes can be progressive by applying higher rates to higher incomes, aiding redistribution and reducing inequality, but high marginal rates can reduce incentives for entrepreneurship and capital accumulation.
- Empirical evidence: major direct tax reforms in LIDCs have been associated, on average, with a decrease in inequality (Figure 5).
- The effect of direct tax increases on inequality is imprecisely estimated, indicating wide variation across cases.
- A large informal sector reduces the tax base, requiring higher tax rates to meet revenue targets, increasing efficiency losses and incentivizing a shift to the informal sector—motivating the use of indirect taxes.
- Empirically, informality does not seem to have played a (statistically significant) role in affecting the effect of direct tax reforms on inequality.

### Policies for Domestic Resource Mobilization — Indirect taxes (VAT and consumption taxes)
- LIDCs often rely on consumption taxes, which are generally regressive when considered without offsetting additional public spending.
- Poor households spend a larger share of income on consumption; an increase in the VAT rate tends to widen consumption inequality.
- VAT hikes reduce overall consumption and aggregate demand, lowering prices of non-tradable goods while tradable-good prices remain broadly stable; this reduces revenues and employment in the non-tradable sector, which typically employs low-skilled, lower-income workers, increasing income inequality across sectors.
- Implications of informality for VAT reforms feature offsetting forces:
  - Larger informality implies a lower tax base, implying higher rates and accentuated regressivity.
  - Demand for informal goods contracts less than for formal (taxed) goods, partially shielding informal producers’ incomes and potentially reducing income inequality.
  - But shifts toward informal activities (lower marginal productivity) depress aggregate output and growth.
- Empirical evidence: on average, VAT rate increases in LIDCs over the past two decades have been associated with higher inequality.
  - A one-standard-deviation increase in the VAT rate is associated with an increase in the Gini coefficient of about 0.2 percent one year after the tax increase.
  - Five years after the tax increase, the increase is about 1.5 percent.
- The effect of VAT increases on inequality tends to be greater in countries with a small share of informal sector, suggesting informality may reduce the regressivity of the VAT, but high informality can create important inequality-growth trade-offs.

### Public spending — Infrastructure investment
- Deficient physical infrastructure is widely viewed as a major constraint on growth in LIDCs; quantity, quality, and accessibility of economic infrastructure lag considerably behind AEs and EMs.
- Infrastructure investment can reduce within-sector inequality by boosting productivity and increasing demand for unskilled and low-income workers; but it can affect between-sector inequality if gains are captured unevenly across sectors.
- Limited labor mobility can prevent workers from taking advantage of higher wages in higher-productivity sectors, exacerbating sectoral inequality; policies to facilitate labor mobility can reduce growth-inequality trade-offs.
- The efficiency of public investment critically influences its distributional effects.
- Empirical evidence: on average, public investment expansions were associated with lower inequality in LIDCs over the last three decades.
  - An exogenous increase in public investment of 1 percent of GDP results in a reduction of the Gini coefficient of about 0.3 percent one year after the increase.
  - Five years after the increase, the reduction in the Gini coefficient is about 2.3 percent.
- The medium-term effect is approximately equivalent to one standard deviation of the average change in the Gini coefficient (2.4 percent) in the sample.
- Public investment shocks do not lead to a reduction in inequality in countries with low public investment efficiency (investment efficiency proxied by a survey-based measure of wastefulness of government spending).

### Financial Sector Reforms
- Financial sector reforms can lower the cost of capital and boost growth, but may increase inequality if they reduce costs without expanding access; benefits accrue mainly to better-off households and firms that can access cheaper credit.
- Reforms that increase access to financial services can lower inequality while boosting growth by helping households smooth income fluctuations and increasing savings available for private investment.
- Empirical evidence: on average, financial sector reforms implemented in LIDCs over the past three decades have not had a statistically significant effect on inequality.
- Heterogeneity: financial reforms appear to be associated with rising inequality in LIDCs with limited financial inclusion.
- Financial access metric: bank accounts per 1,000 people (median shown by country group); financial inclusion measured by the share of adults holding accounts at formal financial institutions.

### Agricultural Sector Reforms
- Reforms to boost agricultural productivity can induce structural transformation and higher growth due to the large productivity gap between agriculture and other sectors.
- Distributional consequences vary:
  - Increasing agricultural productivity through services or R&D can benefit agricultural workers and reduce sectoral inequality.
  - Eliminating inefficient subsidies or price controls may improve productivity but increase poverty and inequality if many poor, low-productivity farmers lose out—benefits accrue mainly to high-productivity farmers better integrated into markets.
  - Limited labor mobility can exacerbate inequality if workers cannot move to higher-income sectors.
- Complementary policies matter: infrastructure investments (electrification, irrigation) can boost agricultural productivity with beneficial effects on both growth and inequality.
- Transitional support: where administrative capacity and fiscal considerations allow, governments could consider cash transfers to the rural poor to mitigate negative distributional impacts of reform during the transition.

*Source: IMF staff analysis as presented in the chapter on domestic resource mobilization, public investment, financial sector, and agricultural reforms in LIDCs.*

### 22.      Empirically, reforms aiming at reducing government interventions in the agricultural

### 22.      Empirically, reforms aiming at reducing government interventions in the agricultural

### Agricultural reforms and inequality: empirical patterns
- Reforms aiming at reducing government interventions in the agricultural sector do not appear to be significantly correlated with inequality overall, but the relation differs widely across countries.
- Agricultural productivity gap: agricultural productivity proxied by the ratio of labor productivity in the agricultural sector to that in the non-agricultural sector (based on 2014 or latest available data) shows large sectoral gaps, particularly in LIDCs, consistent with limited labor mobility and misallocation of labor.
- Key mechanisms:
  - Individuals face constraints preventing movement across sectors: poorly defined land property rights, difficulties financing acquisition of skills, and underdeveloped financial markets.
  - Large rural–urban income differentials can account for a large fraction of inequality within and across countries; differential incomes reflect self-selection based on skills and financial frictions that make skills costly to acquire.

### Heterogeneous impact of agricultural liberalization
- Agricultural sector reforms (identified using the Ostry, Prati, and Spilimbergo (2009) agriculture liberalization indicator) include removal of export marketing boards and reductions in the incidence of administered prices.
- Empirical finding: agriculture reforms tend to increase inequality in countries with a relatively large share of employment in agriculture.
  - Interpretation: reforms—such as removal of subsidies—are significantly associated with reductions in the income of workers who are unable to move to higher-productivity sectors, thereby increasing inter-sectoral inequality.

### Macro-structural case studies: framework and scope
- Purpose: examine macroeconomic and distributional effects of reform packages using a dynamic general equilibrium (DGE) framework calibrated to country-specific household data.
- Model features:
  - Small and open economy with sectors: agriculture, manufacturing, services, energy, commodities for exports.
  - Worker types: rural and urban; skilled and unskilled.
  - Captures inequality across sectors (driven by mobility) and within sectors (productivity shocks, land holdings distribution).
  - Incorporates informal sector activities and diverse credit constraints.
  - Assumes only the government has access to external capital markets.
- Case studies considered: Honduras, Guatemala, Uganda, Republic of Congo, Ethiopia, Myanmar, Malawi.
- Reform categories analyzed:
  - Domestic resource mobilization (Honduras, Guatemala, Uganda, Republic of Congo).
  - Financial sector reforms (Ethiopia, Myanmar).
  - Agricultural reforms (Malawi).

### Country-level reform packages (summary of main measures considered)
- Honduras:
  - Objectives: Address macroeconomic imbalances and restore sustainable growth.
  - Main measures: Increase VAT rate from 15 to 18 percent; recurrent public spending cuts (6 percent of GDP).
  - Other measures: Expand the conditional cash transfer program "Vida Mejor" by 0.5 percent of GDP.
  - Overall: Higher VAT rate plus expansion of cash transfer program.
- Guatemala:
  - Objectives: Increase domestic revenues to finance higher investment/social spending.
  - Main measures: Increase revenue-to-GDP ratio by 1 percent of GDP by either (i) changing PIT structure (from a flat tax to a two-rate tax: rate increases to 10 percent for the highest income bracket and remains at 5 percent for all other income levels); or (ii) increasing VAT rate from 13 to 16 percent.
  - Other measures: Channel higher revenue to (i) investment spending or (ii) the cash transfer program.
  - Scenarios: Scenario 1 — PIT reform plus higher investment spending; Scenario 2 — PIT reform plus expansion of cash transfer program.
- Uganda:
  - Objectives: Increase domestic revenues to finance higher investment in infrastructure and human capital.
  - Main measures: Increase revenue-to-GDP ratio by 1 percent of GDP by either (i) increasing PIT rates (currently 10-40 percent depending on the income level) and CIT rate (currently 30 percent); or (ii) increasing VAT effective rate (estimated at 8 percent; current statutory rate 18 percent) through tax administration measures.
  - Other measures: Increase infrastructure investment spending by 1 percent of GDP.
  - Overall: Increase VAT effective rate and increase investment spending.
- Republic of Congo:
  - Objectives: Domestic resource mobilization (2 percent of GDP) to finance higher and more efficient investment spending.
  - Main measures: Increase revenue-to-GDP ratio by 2 percent of GDP per year by: (i) increasing fuel prices; (ii) increasing VAT rate by 5 percentage points.
  - Other measures: Increase investment spending by 2 percent of GDP and increase its efficiency.
  - Overall: Increase energy prices plus increase investment spending and its efficiency.
- Ethiopia:
  - Objectives: Financial sector reforms to stimulate the private sector's contribution to growth.
  - Main measures: (i) Increase deposit rates (currently estimated at about 150 percent below market rate); and (ii) reduce share of credit to the public sector in total credit from two-thirds to half.
  - Other measures: (i) Increase access to deposits for 25 percent of the rural population; (ii) increase sectoral labor mobility (2 percent of the rural population employed in agriculture moves to work in urban and higher-productivity sectors); (iii) expansion of the cash transfer program by 1 percent of GDP.
  - Overall: Higher deposit rates; reduction of the share of credit channeled to public sector; expansion of cash transfers; increase in financial access and labor mobility.
- Myanmar:
  - Objectives: Enhance financial deepening and increase infrastructure to stimulate private sector activities.
  - Main measures: (i) Increase deposit rates from (currently fixed) 8 percent to 9 percent; and (ii) reduce share of credit to the public sector in total credit by a third.
  - Other measures: Increase investment spending in infrastructure by 1 percent of GDP in rural areas.
  - Overall: Higher deposit rates; reduction of share of credit channeled to public sector; higher investment in infrastructure.
- Malawi:
  - Objectives: Enhance productivity and diversification in agriculture.
  - Main measures: (i) Reduction of the subsidized rate of the maize fertilizer from 100 to 80 percent; and (ii) reduction of the procurement costs (by 25 percent).
  - Other measures: (i) Introduction of cash transfers to rural poor (0.5 percent of GDP); and (ii) higher spending in agricultural R&D (0.5 percent of GDP).
  - Overall: Reduction of agricultural subsidies; increase in spending on agricultural R&D; introduction of cash transfers.

### Selected country indicators (2015 or latest available)
- Real GDP Growth (Percent): Honduras 3.6, Guatemala 4.1, Uganda 4.8, Republic of Congo 2.3, Ethiopia 10.2, Myanmar 7.3, Malawi 2.9.
- Poverty Rate (Percent of Population): Honduras 16.0, Guatemala 59.3, Uganda 34.6, Republic of Congo 37.0, Ethiopia 33.5, Myanmar 25.6, Malawi 70.9.
  - Note: Poverty rate measured by percent of population with an income of less than $1.90 per day (2011 PPP) except where noted: Guatemala and Myanmar's poverty rates measured by percent of population that lives below the national poverty line.
- Gini Index: Honduras 50.6, Guatemala 53.0, Uganda 42.4, Republic of Congo 40.2, Ethiopia 33.2, Myanmar 29.0, Malawi 46.1.
- Public Debt (Percent of GDP): Honduras 46.0, Guatemala 24.2, Uganda 34.4, Republic of Congo 70.6, Ethiopia 56.1, Myanmar 34.3, Malawi 82.0.

### Case study findings — Honduras
- Context: Honduras faced slowing growth, weakened fiscal accounts, and a rise in public debt-to-GDP by 15 percentage points over three years to 45 percent of GDP in 2013.
- Reform package (implemented in 2013): VAT increase from 15 to 18 percent; recurrent public spending cuts (6 percent of GDP); expansion of Vida Mejor conditional cash transfer by 0.5 percent of GDP.
- Observed outcomes after reform:
  - Sovereign spreads declined by about 400 basis points from their 2013 peak of 770 basis points, reducing domestic borrowing rates.
  - Growth increased by almost 1 percent over two years, reaching 3.6 percent in 2015.
- Simulation results:
  - The VAT hike had a direct negative impact on consumption and output (amplified by a large informal sector estimated at 53 percent of GDP), but this was more than offset by the reduction in sovereign spreads which stimulated investment and led to a net positive output effect.
  - Distributional effects:
    - Direct impact of the VAT hike on income inequality was neutral.
    - Incorporating the reduction in sovereign spreads, the reform was overall progressive.
    - Mechanisms: lower sovereign spreads increased investment (benefitting high-income savers/credit-access households) but induced greater labor demand in manufacturing, increasing labor opportunities for the urban poor and reducing urban poverty and inequality.
  - Expansion of the cash transfer program:
    - Estimated to boost consumption and reduce income inequality.
    - Conditionality (school enrollment) is expected to increase skills and labor productivity, minimizing trade-offs between distributional goals and efficiency in the medium term.

### Case study findings — Guatemala
- Context: Tax revenues about 10 percent of GDP in 2015; authorities considering measures to mobilize resources for investment and social spending.
- Reform alternatives analyzed:
  - Raise PIT (increase PIT rate for highest income bracket from 7 to 10 percent) to raise revenue by 1 percent of GDP.
  - Increase VAT rate by 4 percentage points (from current rate of 12 percent) to raise revenue by 1 percent of GDP.
- Simulation results and implications:
  - Increasing direct taxation (PIT) would have smaller negative effects on economic activity than VAT hikes and would reduce inequality, though marginally, reflecting limited tax progression across income levels.
  - VAT hikes are likely to have significant negative effects due to a large informal sector producing mostly non-tradable goods and weak enforcement of VAT invoicing:
    - VAT reform would reduce demand for formal goods, lower formal sector prices and marginal returns, and distort consumption and investment decisions.
    - Unlike Honduras, a VAT reform in Guatemala would not lead to a substantial reduction in sovereign spreads (so fiscal consolidation would not be offset by lower borrowing costs).
    - Reduction in private demand would reduce food prices (food prices are not fixed), inducing a sharp reduction in incomes of agriculture workers and increasing poverty.

### Policy implications and mitigation options (from case studies)
- Structural reforms can have significant distributional effects; the direction and magnitude depend on country-specific features such as:
  - Size of informal sector.
  - Share of employment in agriculture.
  - Degree to which reforms affect sovereign spreads and borrowing costs.
  - Presence and design of mitigating measures (cash transfers, investment in skills, agricultural R&D, rural infrastructure).
- Mitigating measures that can make reforms palatable from both growth and distributional perspectives include:
  - Targeted cash transfer programs (often with conditionalities such as school enrollment) to protect vulnerable groups and enhance human capital.
  - Complementary spending on infrastructure and agricultural R&D to support productivity and labor mobility.
  - Financial sector reforms to improve access to credit and savings for rural populations and small firms.
  - Designing tax mixes that rely relatively more on direct taxation where informality and tax evasion weaken VAT effectiveness.

*International Monetary Fund — Macro-Structural Policies and Income Inequality in Low-Income Developing Countries (excerpt).*

### 32.      Using the additional revenues raised by the PIT for higher infrastructure spending

### 32.      Using the additional revenues raised by the PIT for higher infrastructure spending

### Guatemala — PIT reform, infrastructure spending, and cash transfers
- Main finding:
  - Using additional revenues raised by the PIT for higher infrastructure spending would more than mitigate the negative impact of the PIT reform on output and offset the progressivity of the reform; an expansion of cash transfers, in contrast, would improve inequality, but at some economic costs.
- Mechanisms:
  - Higher investment spending would boost output because of Guatemala’s high infrastructure gap and the relatively high rate of return of public capital.
  - If productivity increases proportionally across sectors, higher investment spending would slightly increase inequality, offsetting the progressivity of the PIT reform.
  - Larger cash transfers would help reduce inequality but would lead to a reduction in savings and investment, with a negative impact on economic activity.

### Uganda — mix of tax measures to raise revenue for physical and human capital
- Context and targets:
  - Tax revenue-to-GDP ratio currently at 13 percent of GDP.
  - Analysis considers increases in rates of VAT, PIT, and CIT.
- Key structural features reproduced in the analysis:
  - Presence of a large informal sector: 85 percent in the agricultural sector and 30 percent in the rest of the economy.
  - Low tax efficiency: tax-to-GDP ratio—11 percent in fiscal year 2012/13.
  - Inequality and poverty: Gini index nationwide 40 percent, rural 34 percent, urban 41 percent, and poverty rate 19.7 percent (based on the 2012/13 Uganda National Panel Survey).
- Simulation results:
  - Increasing the VAT rate would be slightly progressive and raise revenue with a smaller negative impact on economic activity than PIT and CIT hikes.
  - Rationale: relatively high statutory PIT and CIT rates in Uganda compared to other LIDCs; large informal sector shields incomes of informal producers, making the VAT slightly progressive.
  - Estimated required rate increases to raise revenue-to-GDP ratio by 1 percent of GDP:
    - PIT rates should increase by 34 percentage points.
    - CIT rates should increase by 12 percentage points.
    - VAT rate hike needs to be 2 percentage points.
- Role of government expenditure:
  - Channeling all additional revenue to infrastructure investment would enhance productivity, but would totally offset the progressive effect of the VAT hike.
  - If part of spending were reallocated from additional infrastructure investment to targeted cash transfers, the VAT reform could reduce inequality while still boosting growth (though to a lesser extent).

### Republic of Congo — energy prices, VAT, and infrastructure investment
- Context:
  - After the drop in oil prices beginning in 2014, GDP growth fell to 2.3 percent in 2015 and the fiscal deficit reached 18.5 percent of GDP.
  - Authorities consider boosting non-oil revenues and/or higher domestic energy prices; reform package assumes additional resources channeled to infrastructure investment and increased public investment efficiency.
- Simulation results:
  - Increasing energy prices would be slightly progressive with no significant impact on economic growth.
    - Higher energy prices reduce energy demand and overall demand, negatively impacting GDP growth, but a reallocation of resources to less energy-intensive activities would increase economic efficiency and broadly offset the negative impact on GDP growth.
    - Since mostly higher-income households and firms consume energy, increasing energy prices would be progressive, lowering inequality.
    - Poverty would fall because the agricultural export sector (a low energy-intensive sector) would expand, increasing demand for agricultural inputs, pushing up agricultural-goods prices and rural incomes.
  - Increasing the VAT rate would reduce private consumption and demand and increase inequality.
  - Investment channeling and efficiency:
    - Spending additional resources on infrastructure and increasing its efficiency by 20 percent could increase GDP by almost 7 percent.
    - The impact on inequality would be broadly neutral if productivity increases proportionally across sectors.

### Cross-cutting parameter and technical assumptions (relevant to investment scenarios)
- Productivity elasticity assumed to be 0.2 (in the same range used by Berg and others (2013) with respect to an increase in public investment).

### Ethiopia — financial sector reform, private credit, and inequality
- Financial context:
  - Commercial Bank of Ethiopia accounts for approximately 60 percent of financial system assets.
  - About two-thirds of total bank credit is channeled to finance government-owned enterprises.
  - Interest rates on deposits are negative in real terms: average rate for savings deposits is 5.38 percent while inflation is at about 8 percent.
- Reform considered:
  - Increase deposit rates and reduce the share of funds that banks must channel to the public sector to 50 percent.
- Simulation results:
  - Reform can boost private sector activity and economic growth:
    - Higher deposit rates increase private saving, expanding available lending resources.
    - Private sector credit would increase, pushing down lending rates and increasing investment—which would more than triple—contributing to economic growth and higher tax revenues; government borrowing could be reduced and cost of public debt financing contained.
  - Distributional effect:
    - The reform is likely to increase inequality.
    - With limited financial access, benefits accrue mostly to manufacturing and modern services, increasing profitability and wages there.
    - Limited rural-urban mobility means agricultural workers have little opportunity to shift to higher-productivity sectors, so wage differentials persist and inter-sectoral inequality rises.
    - Exporting agricultural firms switching to manufacturing could lower demand for agricultural inputs and reduce incomes of small farmers.
- Policy complements to mitigate inequality:
  - Improve financial access to broaden who benefits from higher deposit rates.
  - Increase sectoral labor mobility via strengthening land rights, improving infrastructure and housing, and providing accessible training and education to equip the labor force with needed skills.
  - In the short term, enlarging existing cash transfer programs would help mitigate negative distributional impacts with only a marginal negative impact on growth.

### Myanmar — financial deepening, private credit, infrastructure for agriculture
- Reform package:
  - Measures to increase credit to the private sector, reduce the infrastructure gap, increase deposit rates, and reduce share of credit to public sector.
  - Financial sector features captured: fixed nominal interest rate on savings (8 percent), inflation 9.5 percent, large state bank participation, low credit to rural sector.
- Simulation results:
  - Increasing credit to the private sector would boost urban economic activity and growth and reduce poverty and inequality.
    - An increase in deposit rates and a reduction in share of credit channeled to public sector would boost private sector credit, lower borrowing costs, and stimulate private investment in industrial sector and GDP.
    - Higher capital accumulation in the industrial sector would increase labor demand and wages, with spillovers to non-capital-intensive sectors such as agricultural exports.
    - Labor mobility appears less constrained in Myanmar than in Ethiopia, so higher urban wages would promote migration to urban areas, reducing cross-sector inequality.
    - A larger urban and richer population would increase demand and prices for agricultural goods, raising rural wages and incomes and further decreasing inequality.
  - Additional rural infrastructure investment (rural roads, electrification, irrigation) would further boost growth while reducing inequality and rural poverty.

### Malawi — agricultural subsidy reform
- Reform considered:
  - Reduction in maize fertilizer subsidy program coupled with administrative reforms to reduce procurement costs.
- Expected outcomes:
  - The reform is expected to generate gains in efficiency and a slight rise in output.
    - It would reduce incentives to overproduce maize and shift production to higher-value agricultural goods, stimulating exports and increasing incomes of exporters due to lower input costs and higher supply.
    - This translates into a higher capital stock, higher output, and higher private consumption.
  - Distributional trade-off:
    - The reform would increase inequality.
    - Because subsidies function as cash transfers for many small farmers, reducing subsidies would lead to an important reduction in the income of small and poor farmers, exacerbating poverty and inequality.

*Source: IMF staff analysis in "MACRO-STRUCTURAL POLICIES AND INCOME INEQUALITY IN LOW-INCOME DEVELOPING COUNTRIES" (chapter content provided).*

### 49.      Cash transfers to the rural poor can help

### 49.      Cash transfers to the rural poor can help

### Short-term mitigation and long-term productivity
- Cash transfers to the rural poor can help mitigate the impact of the subsidy reform on poverty and inequality in the short term.
- Well-targeted cash transfers would be a very efficient way to reach households most affected by the reform.
- Increasing spending for agricultural R&D would increase the productivity of small farmers, boosting agricultural profitability and income in the longer term.
- An increase in agricultural R&D, combined with an expansion of the cash transfer program, would reduce inequality.
- These measures would amplify the impact of the subsidy reform on private investment and boost GDP and, in turn, bring additional revenues.

### Policy lessons to make growth more inclusive (summary of Section HOW TO MAKE GROWTH MORE INCLUSIVE: POLICY LESSONS)
- The distributional impact of macro-structural policies and reforms in LIDCs is complex and depends on:
  - the policy and reform design;
  - interplay with country-specific economic characteristics—including inter-sectoral productivity differences, the extent of labor mobility, limited infrastructure, level of informality, and level of access to financial services;
  - multiple transmission channels and second-round effects.
- Pro-growth reforms that create distributional trade-offs can be complemented by policies that limit adverse distributional effects.
- Governments can adjust reform design and/or introduce targeted accompanying measures to make pro-growth reforms more inclusive.

### Specific design and accompanying measures
- On program design:
  - Resource mobilization measures can reduce inequality if the additional resources are channeled into highly progressive spending.
  - Infrastructure investment, if executed efficiently, can increase output and reduce inequality.
  - Investment in electrification and irrigation, and in agricultural R&D and agricultural services, can boost productivity while reducing sectoral productivity gaps, benefiting both growth and equality.
  - Reforms that boost financial deepening and access to financial services can foster inclusive growth.
- On accompanying measures:
  - A wider policy package can include measures that alleviate growth-inequality trade-offs.
  - Some complementary policies have immediate impact, such as conditional targeted cash transfers—which can also increase productivity in the longer term if well-designed.
  - Other measures, such as accessible education to equip the labor force with the right skills, will take time to bear fruit.
  - Key structural reforms (regulatory simplification to reduce informality; policies to enhance labor mobility, such as strengthened property rights) can be politically difficult but can boost productivity and growth for all.

### Empirical methodology (Appendix 1)
- The analysis uses the local projection method (Jordà, 2005) to estimate impulse-response functions, a flexible alternative to vector autoregression (autoregressive distributed lag) specifications that does not impose dynamic restrictions and is suited to estimating nonlinearities.
- Baseline specification:
  - y is the log of the Gini coefficient (data source Solt, 2016).
  - α_i are country fixed effects; γ_t are time fixed effects.
  - R_i,t denotes the reform shock in the area considered.
  - X_i,t is a set of control variables including three lags of reform shocks and lags of inequality growth.
- Extended specification allows the response to vary with the state of country-specific economic characteristics (e.g., public investment efficiency, informality, financial inclusion), using z_i,t normalized to have zero mean and unit variance and including F(z_i,t) among controls.

### Identification of reforms and shocks
- Reforms (except public investment shocks and tax reforms) are identified as episodes where the annual change in the reform indicator exceeds by two standard deviations the average annual change over all observations.
- Tax reform indicators (VAT reform and PIT reform) are measured as the (lagged changes) of the value-added tax (VAT) rate or the personal income tax rate; source: IMF Tax Rate Database (DART).
- Public infrastructure investment shocks: difference between actual public investment and the public investment expected by analysts as of October (based on the IMF’s World Economic Outlook) of the same year; data cover a sample of 24 low-income developing countries (LIDCs) from 1995 to 2014.
- Domestic financial liberalization index is a composite of five equally weighted sub-indices: (i) interest rate controls; (ii) credit controls; (iii) restrictions on bank competition; (iv) degree of state ownership; and (v) quality of banking supervision and regulation.
- Agriculture reform indicator captures the extent of government intervention in the market for the main agricultural export commodity with four degrees of intervention: (i) maximum; (ii) high; (iii) moderate; or (iv) no intervention.

### Figure and illustrative metrics
- Figure 15: Economic and Distributional Impact of Reform to Agriculture in Malawi (Cumulative change over 5 years).
  - Axis tick values shown in the figure: -4, -2, 0, 2, 4, 6.
  - Series labeled: Real GDP (Left Scale, Percent), Gini Index (Right Scale), Poverty Rate (Right Scale).
  - Series shown: Agricultural subsidy reform; Cash transfers; Agricultural productivity reform; Overall.

### Identified reform episodes (verbatim table lines)
- Agricultural Reforms20171961-2003
- Financial Reforms50191974-2005
- Tax Reforms
- Value-Added Tax80291995-2015
- Personal Income Tax528551982-2015

*International Monetary Fund — MACRO-STRUCTURAL POLICIES AND INCOME INEQUALITY IN LOW-INCOME DEVELOPING COUNTRIES (excerpt).*

### Appendix 2. Modeling Methodology

### Appendix 2. Modeling Methodology

### Model structure and key assumptions
- Small open economy populated by a continuum of heterogeneous households who live indefinitely and face idiosyncratic shocks.
- Three goods: food (non-tradable), services (non-tradable), and manufacturing (tradable and numeraire). Prices: p_s for services (݌௦), p_m for manufacturing (݌௠), p_f for food (݌௔).
- Continuum of infinitely-lived agents with productivity risk; three agent types: large farmers (μ_farms), rural households (μ_rural), and urban households (μ_urban). Total mass of agents normalized to 1.
- Markets are incomplete. Households save at a risk-free interest rate r (ݎ). Entrepreneurs borrow at (1+φ)r where φ captures the risk premium.
- Capital account is closed and the trade balance is always zero.

### Agents, endowments, and decisions
- Rural households:
  - Endowed with one unit of labor and a small plot of land d_s (݀௥).
  - Choose hours on own plot (h_s, ݄௥) and hours working for large farms (h_w, ݄1ே௥) for wage w_r (ݓ௥).
  - Face idiosyncratic productivity shocks ε_r (ε௥) following AR(1); can save in risk-free bond b_r (ܾ௥).
  - Small-farm average factor productivity κ_s (ݖ௔).
  - Lump-sum taxes/transfers to rural households denoted T_r (ܶ௥݌ቀ...).

- Urban households:
  - Endowed with one unit of time. Two types: low-skilled (subscript l, ݑ௨,௟) and high-skilled (subscript h, ݑ௨,௛).
  - μ_u,l share of urban households is low-skill producing services y_u,l,s (ݕ௨...௦); μ_u,h share is high-skill working in manufacturing for wage w_m (ݓ௠).
  - Face idiosyncratic productivity shocks ε_u,l and ε_u,h following AR(1); save in risk-free bonds b_u,l and b_u,h (ܾ௨,௟ and ܾ௨,௛).
  - Service sector average labor productivity θ_s (ݖ௦). Services assumed non-taxable when produced in household enterprises.

- Large farmers:
  - Own large plots of land and produce domestic food and exports. Capital k_f (݇௙) follows law of motion: k' = x + (1−δ)k, where x is investment and δ is depreciation.
  - Hire labor from small farmers and accumulate capital; production for exports uses land d*, capital k, and labor l*.
  - No idiosyncratic risk; stationary state assumed (prices constant through time).
  - Pay taxes on domestic land and capital income at rate τ_dom (τ௥) and on exports at rate τ* (τ௟).

- Firms (manufacturing):
  - Competitive firms rent capital k_m (݇௠), hire effective labor h_m (݄௠), and buy tradable intermediate goods m (ݍ௠) to maximize profit.
  - Face borrowing cost (1+φ)r, consumption tax τ_m (τ௠), and manufacturing total factor productivity z_m (ݖ௠).

### Preferences and household optimization
- Household utility over consumption of food (c_f), services (c_s), and manufacturing (c_m):
  - U(c_f,c_s,c_m) = log(c_f − c̄) + ω log(c_s) + γ log(c_m)
  - Subsistence level c̄ (ܽത) calibrated to match share of food consumption at bottom quintile.
  - γ calibrated to match household expenditure on manufacturing; ω calibrated to match household expenditure on food.
  - Discount factor β set to 0.96.

- Urban and rural household problems specified as dynamic stochastic optimization with budget constraints that include (1+τ_f)p_f c_f + (1+τ_m)p_m c_m + p_s c_s and savings; taxes include lump-sum transfers that depend on household income.

### Production sectors and technology
- Agricultural export sector: Cobb-Douglas production with inputs land, capital, labor. Productivity z* (ݖ∗) calibrated to match share of exports of this sector in GDP.
- Manufacturing sector: Cobb-Douglas production; price of manufacturing and manufacturing productivity z_m normalized to 1.
- Agriculture sector (domestic food): productivity z_a (ݖa) calibrated to match share of agricultural sector in GDP. Large farmers’ land normalized to 1; small farmers’ land calibrated following Teshome and others (2014). Share parameter α_a set following Adamopoulos and Restuccia (2014).
- Service sector: productivity z_s (ݖs) calibrated to match share of services in GDP. When services represent the informal sector, productivity is adjusted by excluding modern services (banking, telecom, tourism) from data.

### Taxes, government, and fiscal policy
- Government collects:
  - Value-added/consumption taxes on food τ_f (τ௔) and manufacturing τ_m (τ௠).
  - Trade taxes τ* (τ∗).
  - Corporate taxes τ_k (τ௙).
  - Labor income taxes τ_w (τ௪).
- Government spends on manufacturing goods G (ܩ) and gives or collects lump-sum taxes/transfers specific to each household type (T_r, T_u, T_f).
- Government budget constraint (revenue = spending on manufacturing + transfers + food subsidies) expressed as:
  - τ_f p_f Y_f + τ_m p_m Y_m + τ* π* + τ_k π_k + τ_w (labor income tax revenues across household types) = G + sum of transfers/subsidies
  - Exact expression provided in the model text with distributions aggregated by Γ(·,·).

- Tax schedule calibrated to match revenue and expenditure estimates from IMF staff; model tax estimates typically below statutory rates to capture inefficiency, informality, and tax evasion.

### Market clearing conditions and equilibrium
- Four markets clear in equilibrium; conditions depend on the stationary distribution Γ(·,·) and household type shares:
  i. Urban labor market:
     - μ_u,h ∫ε Γ(·) h_u,h = H_m (݄௠)
  ii. Rural labor market:
     - μ_r ∫ε h_r Γ(·) = μ_f h_f (domestic labor used by large farms)
  iii. Capital market:
     - k_m = μ_u,l ∫b_u,l Γ + μ_u,h ∫b_u,h Γ + μ_r ∫b_r Γ
  iv. Services market and v. Food market:
     - Relative prices adjust so non-tradable goods markets clear; conditions provided with full aggregation expressions involving Γ.

- Stationary competitive equilibrium defined by a stationary distribution of assets and shocks Γ and sequences of prices {p_s, p_f, w_m, w_r, r} such that, given exogenous productivities, taxes, transfers, and manufacturing/export prices, agent allocations solve their optimization problems, markets clear, and government budget balances. Walras’ law implies balanced current account given government and individual budget constraints.

### Idiosyncratic shocks and calibration of inequality
- Persistency ρ (ߩ) of idiosyncratic shocks set identical across agent types; value chosen following Peralta-Alva, Mendes Tavares, and Tam (forthcoming) (estimates from Ghana).
- Variance of shocks calibrated to match Gini coefficients of urban and rural sectors from household survey data.
- Calibration of idiosyncratic shocks ensures low-productivity rural households devote majority of time to working for big farms, while high-productivity rural households spend more time on own farms.

### Calibration methodology and parameter choices
- Model period: one year.
- Most parameters jointly calibrated to match data moments (household consumption shares, sectoral shares, Gini, tax revenue shares).
- Specific calibration steps:
  - γ matches household expenditure on manufacturing (Household Consumption Expenditure Surveys).
  - ω matches household expenditure on food.
  - c̄ matches share of food consumption at bottom quintile.
  - β = 0.96.
  - z* calibrated to match export share of that sector in GDP.
  - Manufacturing price and z_m normalized to 1.
  - z_a calibrated to match agriculture share of GDP; small farms land per Teshome et al. (2014); α_a set as in Adamopoulos and Restuccia (2014).
  - z_s calibrated to match services share in GDP; informal-sector adjustments made by excluding modern services.
  - Income share parameters in sectors set following literature (e.g., values from United States in Adamopoulos and Restuccia (2014)).
  - Labor force shares (urban/rural) set using household survey and employment data.
  - Fiscal parameters set to match revenue/expenditure estimates; tax estimates reflect informality and evasion.

### Ethiopian case study calibration (selected fiscal parameters and targets)
- Fiscal Policy Parameters (Table A2.1):
  - Consumption Tax on Domestically Produced Food τ_a = 0.06
  - Consumption Tax on Non-Food τ_m = 0.06
  - Import Taxes τ* = 0.32
  - Corporate Taxes τ_k = 0.24
  - Corporate Taxes Export Sector τ_r = 0.12
  - Labor Income Tax τ_w = 0.06

- Calibration targets and model outcomes (Table A2.2):
  - Share of Labor Income Tax in Government Revenue: Data 0.16, Model 0.13
  - Share of Corporate Tax in Government Revenue: Data 0.17, Model 0.21
  - Share of Value-Added Tax in Government Revenue: Data 0.29, Model 0.28
  - Share of Import Tax in Government Revenue: Data 0.39, Model 0.38
  - Share of Exports in GDP: Data 14.0, Model 19.0
  - Share of Agriculture in GDP: Data 0.47, Model 0.52
  - Share of Food Consumption in Total Consumption: Data 0.70, Model 0.71
  - Share of Food Consumption in Total Consumption – Rural Households: Data 0.74, Model 0.75
  - Urban Gini: Data 0.37, Model 0.31
  - Rural Gini: Data 0.26, Model 0.27

*Source: sdn1701 - Appendix 2. Modeling Methodology (IMF).*

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- Nehru, V., 2015, “Developing Myanmar’s Financial Sector to Support Rapid, Inclusive, and Sustainable Economic Growth,” April, Asian Development Bank (ADB) Economics Working Paper Series, No. 430.  
- Jeong, H., and R. M. Townsend, 2007, "Sources of TFP Growth: Occupational Choice and Financial Deepening," Economic Theory, 32 (1): 179–221.  
- Kwon, H. U., F. Narita, and M. Narita, 2015, “Resource Reallocation and Zombie Lending in Japan in the 1990s,” Review of Economic Dynamics, 18: 709–32.  

### Tax policy, VAT, and informality
- Jenkins, G. P., H. Jenkins, and C. Y. Kuo, 2006, “Is the Value Added Tax Naturally Progressive?” Queen’s University Economics Department Working Paper No. 1059, Ontario, Canada.  
- Keen, M., 2008, “VAT, Tariffs, and Withholding: Border Taxes and Informality in Developing Countries,” Journal of Public Economics, 92: 1892–1906.  
- Keen, M., 2009, “What Do (and Don’t) We Know about the Value Added Tax? A Review of Richard M. Bird and Pierre-Pascal Gendron’s The VAT in Developing and Transitional Countries,” Journal of Economic Literature, 47 (1): 159–70.  
- Stiglitz, J. E., and S. Emran, 2007, “Equity and Efficiency in Tax Reform in Developing Countries,” July. Available at SSRN: http://ssrn.com/abstract=1001269 or http://dx.doi.org/10.2139/ssrn.1001269  

### Methods, data, and macroeconomic analysis
- Jordà, Ò. 2005, “Estimation and Inference of Impulse Responses by Local Projections.” American Economic Review, 95 (1): 161–82.  
- Auercach, A., and Y. Gorodnichenko, 2012, “Measuring the Output Responses to Fiscal Policy,” American Economic Journal: Economic Policy, 4 (2): 1–27.  
- Stock, J., and M. Watson, 2007, “Why Has US Inflation Become Harder to Forecast?” Journal of Money, Banking and Credit 39 (1): 3–33.  
- Solt, F., 2016, “The Standardized World Income Inequality Database,” Social Science Quarterly, 97 (5): 1267–81.  
- Rodrik, D., 1999, “Where Did All the Growth Go? External Shocks, Social Conflict, and Growth Collapses,” Journal of Economic Growth, 4 (4): 385–412.  

### Country and region–specific IMF and World Bank reports
- International Monetary Fund, 2015c, Uganda: Staff Report for the 2015 Article IV Consultation and Fourth Review Under the Policy Support Instrument: Annex V, Country Report No. 15/175, Washington.  
- International Monetary Fund, 2015d, The Federal Democratic Republic of Ethiopia: Selected Issues, Country Report 15/326, Washington.  
- International Monetary Fund, 2015e, Malawi: Selected Issues, Country Report 15/346, Washington.  
- International Monetary Fund, 2015f, “Macroeconomic Developments and Prospects in Low-Income Developing Countries: 2015,” November, Washington.  
- International Monetary Fund, 2016a, Honduras: 2016 Article IV Consultation, Third and Fourth Reviews under the Stand-By Arrangement and the Arrangement under the Standby Credit Facility, Country Report 16/362, Washington.  
- International Monetary Fund, 2016b, Guatemala: Selected Issues and Analytical Notes, Country Report 16/282, Washington.  
- International Monetary Fund,2017, “Macroeconomic Developments and Prospects in Low-Income Developing Countries: 2016,” January, Policy Paper, Washington.  
- World Bank, 2016, Poverty and Shared Prosperity 2016: Taking on Inequality. Washington: World Bank. DOI: 10.1596/978-1-4648-0958-3.  

### Other relevant contributions
- Monchunk, V., 2014, Reducing Poverty and Investing in People–The New Role of Safety Nets in Africa. Washington: World Bank.  
- Summer, L., 2016, “The Age of Secular Stagnation.” Available at http://larrysummers.com/2016/02/17/the-   age- of-secular-stagnation/, February 5.  

*Content from: sdn1701 - REFERENCES*

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_Source: https://www.imf.org/-/media/files/publications/sdn/2017/sdn1701.pdf_