"Fiscal Policy and Income Inequality," by David Lipton, First Deputy Managing Director, IMF, Washington, D.C., March 13, 2014

IMF News, March 13, 2014

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"Fiscal Policy and Income Inequality," by David Lipton, First Deputy Managing Director, IMF, Washington, D.C., March 13, 2014

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Bibliographic details

• Published: March 13, 2014

Overview and purpose

• Speech presenting key findings of a new IMF study on fiscal policy and income inequality; "As prepared for delivery" at The Peterson Institute for International Economics.
• Core message: when it comes to fiscal redistribution, design matters—redistributive fiscal policies should achieve distributional objectives at minimum cost to economic efficiency.

Trends in inequality

• Income inequality has been rising in many parts of the world over recent decades.
• Gini coefficient:
  • Ranges from 0 to 1, with larger values representing higher inequality.
  • Over the last three decades, the Gini coefficient has increased in most countries.
  • Latin America and sub-Saharan Africa have exhibited declining levels of inequality more recently.
  • Persistent regional differences: Latin America has the highest inequality; advanced economies have the lowest.
• Top-income shares:
  • In some economies (United States, South Africa) the share of the top one-percent has increased dramatically; in continental Europe and Japan it has been largely unchanged.
  • Causes debated: globalization, new technologies, policy choices (reductions in tax rates), rent-seeking behavior of executives.
• Wealth distribution:
  • Wealth is much more unequally distributed than income (higher Gini coefficients for wealth).
  • High concentration of wealth and rising top-one-percent shares have fueled debate on income and wealth taxation.

Country experiences with redistributive instruments

• Advanced economies:
  • Average market income Gini (in the absence of fiscal redistribution): 0.43.
  • Redistributive transfers and taxes reduce inequality by about a third, with about two-thirds of this reduction coming from transfers.
  • In-kind benefits (public health, education, housing) further reduce the market Gini, on average, by more than 10 percent in the countries selected.
  • Conclusion: fiscal policy (direct and in-kind benefits) has played a major role in reducing inequality in advanced economies, with variation across countries.
• Developing economies (including emerging and low-income countries):
  • Tax revenues are significantly lower, except in emerging Europe.
  • Tax composition: indirect taxes (e.g., VAT) account for a much larger share and tend to be less progressive than direct taxes.
  • Redistributive expenditures are much lower, particularly social protection.
  • Targeting and coverage concerns:
  • With the exception of emerging Europe, the poorest 40 percent receive less than 20 percent of the benefits of social protection spending.
  • Coverage of social benefits (percentage of poor households receiving benefits) is low, except in emerging Europe and Latin America.
  • Energy subsidies often used as social assistance disproportionately benefit upper-income groups.
  • Education and health spending:
  • In many developing economies, the poorest 40 percent receive less than 40 percent of the total benefits, contributing to inequality of opportunity and low intergenerational mobility.
  • Poor often lack access because services are concentrated in urban areas while many poor live in rural areas.
• Fiscal consolidation experiences:
  • Several economies adopted progressive adjustment measures during recent consolidations, lowering the burden on the bottom 20 percent relative to upper-income groups.
  • Examples cited: Greece, Latvia, Portugal, Romania, Spain (cuts in public sector pay had smaller effect on lower pay-scale civil servants); Spain and the United Kingdom (income tax increases borne more heavily by upper-income groups).

Principles for designing efficient redistributive fiscal policy

• Four key considerations:

1. Redistributive fiscal policy should be consistent with macroeconomic policy objectives (e.g., level of spending consistent with macroeconomic stability; compare benefits of redistribution with other priorities such as infrastructure). 2. Taxes and expenditures should be evaluated jointly (e.g., increased VAT revenues used for secondary education could be progressive on net). 3. Design should account for both redistributive and efficiency objectives (some policies enhance efficiency, such as those strengthening human capital; others require managing tradeoffs). 4. Design should take into account administrative capacity.

Policy options and instruments discussed

• Taxes:
  • Income taxes:
  • Make income tax systems more progressive where appropriate (scope in some economies using a flat rate).
  • Since the mid 1990s, 27 countries—especially in Central and Eastern Europe and Central Asia—have introduced flat tax systems, usually with a low marginal rate.
  • Caution: top personal income tax rates must be set with care to avoid avoidance/evasion and potential revenue loss.
  • In many developing economies, bringing informal operators into the personal income tax can enhance fairness and equity.
  • Property taxes:
  • Greater use of property taxes as a revenue source and efficient redistributive instrument.
  • In developing economies, only Colombia, Namibia, Russia, South Africa, and Uruguay collect more than 1 percent of GDP through recurrent property taxes.
  • Indirect taxes (VAT):
  • Generally less effective for redistribution than direct taxes.
  • Recommendation: minimize exemptions and special rates to efficiently raise revenues to finance pro-poor spending.
  • Examples:
  • Elimination of reduced VAT rates in the United Kingdom, with proceeds used to increase social benefits, would significantly reduce inequality.
  • IMF work on Ethiopia: a uniform VAT with proceeds used for education and health would have a strong progressive impact.
  • Caveat: where capacity constraints prevent spending programs from reaching the poor, there can be a case for some differentiation in VAT rates (e.g., basic foods).
• Expenditures and social programs:
  • Education:
  • Improve access for low-income families to boost equality of opportunity and reduce income inequality over the long run.
  • Advanced economies: increase access to tertiary education for low-income families via scholarships and loans.
  • Developing economies: strengthen access to quality secondary education, for example by eliminating tuition fees.
  • Health:
  • Improve access to health care services for the poor in developing economies to enhance opportunity efficiently.
  • Examples of recent steps toward universal coverage: China, Ghana, India, Mexico.
  • Advanced economies: maintain poor access to health services during expenditure constraints.
  • Social transfers:
  • Advanced economies: increase use of active labor market programs and in-work benefits; require beneficiaries to participate in job training as condition for benefits (examples: Belgium, the Slovak Republic, Slovenia).
  • Developing economies: expand conditional cash transfer programs (benefits conditional on child attendance at health clinics and school); means-testing keeps fiscal cost low.
  • Impact example: direct impact of such transfers in Brazil and Mexico accounts for one-fifth of the reduction in inequality between 1995 and 2004 in these two countries.
  • Administrative capacity strengthening is required to implement these programs effectively.
  • Pensions:
  • Pensions have played an important role in reducing income inequality.
  • To improve sustainability and maintain protection of the elderly poor, consider increasing effective retirement ages, accompanied by protections for lower-income workers (disability pensions, social assistance).
  • In developing economies, expand noncontributory, means-tested social pensions to ensure wider coverage at reasonable fiscal cost.
  • Social pensions exist in some emerging and low-income developing countries, including Chile, Ethiopia, India, and South Africa.
  • The speech notes a related IMF book launch: "Equitable and Sustainable Pensions: Challenges and Experience" (examines equity issues, generational and gender equity, and presents 12 country case studies).

Conclusions

• Fiscal policy has been the primary tool available to governments to affect income distribution and has played a major role in reducing inequality in the past.
• Whether redistributive fiscal policies help or hurt growth depends on design; details matter.
• Much is now known about how governments can best balance equity and efficiency concerns; the IMF stands ready to assist members in designing such policies.

“Fiscal Policy and Income Inequality,” by David Lipton, First Deputy Managing Director, IMF, Washington, D.C., March 13, 2014.

References

• India and the IMF
• Mexico and the IMF
• South Africa and the IMF
• Spain and the IMF
• The Federal Democratic Republic of Ethiopia and the IMF
• United Kingdom and the IMF
• Speeches
• PRESS CENTER
• https://www.imf.org/en/home