Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

IMF Survey : Sound Policy Design: the Efficient Way to Cut Inequality

March 13, 2014

  • Inequality growing across many regions in the world
  • Fiscal policies can help countries reduce inequality
  • Redistributive policies should be designed with efficiency in mind

To support sustainable economic growth, redistribution should be done with fiscal instruments that achieve distributional objectives at a minimum cost to economic efficiency.

São Paulo, Brazil. The Paraisópolis favela borders the affluent district of Morumbi in São Paulo, Brazil (photo: Tuca Vieira)

São Paulo, Brazil. The Paraisópolis favela borders the affluent district of Morumbi in São Paulo, Brazil (photo: Tuca Vieira)

Fiscal Policy and Income Inequality

Growing inequality in recent years has put increased pressure on fiscal policy to redistribute income. While the question of just how much redistribution the state should do, in the end, rests with national governments, the design of the policies themselves has a critical bearing on their effects on efficiency and growth.

The design of these growth-friendly, efficient redistributive fiscal policies is addressed in a new IMF staff paper on fiscal policy and income inequality. This study is just the latest look by IMF staff at how inequality affects growth. A paper by IMF research staff released last month also examined this connection.

Assessing the effect of tax and spending policies on efficiency, along with how they affect distributional goals, has long been a component of the IMF’s policy advice to member countries in the context of its technical assistance. In IMF lending programs, a common concern is how to design fiscal policy measures in a way that is consistent with the authorities’ distributional objectives. The paper brings together the extensive experience of the IMF across these areas.

“When it comes to fiscal redistribution, design matters,” said IMF First Deputy Managing Director David Lipton. “Redistribution, if poorly designed, or pushed too far, can be distortive,” he said, “but some redistributive fiscal policies can in fact help improve efficiency and support growth, such as those that enhance the human capital of low-income households.

Trends in inequality

Over the last three decades, inequality has increased in most countries. While the level of inequality has declined in Latin America and sub-Saharan Africa recently, what is striking are the persistent differences across regions, with Latin America still having the highest inequality and the advanced economies having the lowest.

More recently, there has been attention to the rising share of top income earners. The paper suggests that the trends across countries appear mixed. In some economies, such as the United States and South Africa, the share of the top one percent has increased dramatically in recent decades, but not so in continental Europe and Japan, where it has been largely unchanged. There are differing views of the causes of the rising share of the top one percent. Some emphasize the impact of globalization and new technologies, while others highlight policy choices, such as reductions in tax rates, and others the rent-seeking behavior of executives.

Country experience in using redistributive policy

Around the world, countries have turned to various types of redistributive policies as a way to deal with inequality. The IMF staff paper finds that advanced economies, on average, have been able to reduce inequality by roughly a third through a combination of social transfers (e.g., welfare and pension benefits) and redistributive taxes (e.g., progressive income taxes). Other benefits, such as public spending on health, education, and housing, help reduce inequality further.

There is also evidence that an appropriate mix of measures can help offset the negative effects of fiscal adjustment on inequality. In about half of a sample of 27 advanced and emerging European economies that undertook fiscal adjustment during 2007–2012, inequality increased. However, in many of these cases, the increase was muted by the design of the measures. In two-thirds of the economies, fiscal measures led to either a decrease in inequality or at least partly offset the effect of growing inequality.

In developing countries, fiscal policy has played a more modest role. Tax revenues are much lower (as a share of national output) in developing economies, with the exception of emerging Europe. In terms of composition, taxes on consumption account for a much larger share, which tend to be less redistributive than taxes on income. Similarly, on the expenditure side, redistributive spending is much lower than in advanced economies, particularly for social protection spending.

The study also found that a larger share of social spending in developing economies benefits higher-income groups. With the exception of emerging Europe, the poorest 40 percent of the population receive less than 20 percent of the benefits of social protection spending. The coverage of social benefits, in terms of the percentage of poor households that receive benefits, is also low, except in emerging Europe and Latin America.

A similar situation exists for education and health spending. In many developing economies, the poorest 40 percent receive less than 40 percent of the total benefits. This is because the poor often do not have access to these services, which contributes to inequality of opportunity and low intergenerational mobility.

Options for achieving efficient redistribution

According to the paper, there are four key considerations in designing efficient redistributive fiscal policy:

• First, redistributive fiscal policy should be consistent with macroeconomic policy objectives. The level of spending on redistribution, for example, should be consistent with macroeconomic stability; in addition, the benefits of additional spending on redistribution should be compared with the benefits of raising spending on other priority areas, such as infrastructure.

• Second, taxes and expenditures should be evaluated jointly. For example, an increase in value added tax (VAT) revenues, used to finance higher spending in primary education, could on net be progressive.

• Third, the design of redistribution policies should balance redistributive and efficiency objectives. Some redistributive policies may in fact enhance efficiency, such as those that strengthen human capital. But for some instruments there may be a tradeoff.

• Fourth, design should take into account administrative capacity.

Based on these principles, a range of reform options emerge that could achieve redistribution efficiently. On the tax side, some countries could consider making their income tax systems more progressive. For example, in economies where a flat rate is used, there may be scope for more tax progression at the top. Some advanced economies could also consider relieving low-wage earners from income tax or social contributions.

Generally, consumption taxes (such as the VAT) are an inferior way to efficiently achieve redistributive goals when compared against direct taxes. Because the rich generally spend more in absolute terms on necessities such as food or energy, they enjoy considerable benefits when these items are afforded exemptions or reduced rates. For these taxes, some governments could look at minimizing exemptions and special rates, in order to efficiently raise revenues to help finance pro-poor spending. Where capacity constraints prevent spending programs from reaching the poor, the case for some differentiation in VAT rates (e.g., for basic foods) can be strong.

On the spending side, governments could aim to improve access to education and health care services. According to the IMF paper, improving the access of low-income families to education is an efficient tool for boosting equality of opportunity, and over the long run, it can also reduce income inequality.

Along the same lines, improving the access of the poor to health care services in developing economies can help strengthen equality of opportunity in an efficient manner. In advanced economies, maintaining the access of the poor to health services during periods of constrained government spending is also consistent with efficient redistribution.

Such policies offer a “win-win” opportunity that can improve both equality and efficiency.