Income Inequality and Fiscal Policy; by Francesca Bastagli, David

I M F S T A F F D I S C U S S I O N N O T E

September 27, 2012

SDN/12/08 (Revised)

Income Inequality and Fiscal Policy

Francesca Bastagli, David Coady, and Sanjeev Gupta

I N T E R N A T I O N A L M O N E T A R Y F U N D

INTERNATIONAL MONETARY FUND

Fiscal Affairs Department

Income Inequality and Fiscal Policy

Prepared by Francesca Bastagli, David Coady, and Sanjeev Gupta

Authorized for distribution by Carlo Cottarelli

September 27, 2012

JEL Classification Numbers:

D30, D63, H20, I14, I24

Keywords:

Income inequality, fiscal policy, tax and

expenditure policy

Authors’ E-mail Addresses:

[email protected]; [email protected]; and

[email protected]

For their detailed comments and discussion, we are grateful to Jochen Andritzky, Anthony Annett, Olivier

Basdevant, Andreas Bauer, Alberto Behar, Andrew Berg, Carlo Caceres, Benedict Clements, Carlo Cottarelli,

Luis Cubeddu, James Daniel, Christine Dieterich, Ruud de Mooij, Roberto Fattal, Enrique Flores, David

Furceri, Rodrigo Garcia-Verdu, Maria Gonzalez, Borja Gracia, Francesco Grigoli, Mark Horton, Dora Iakova,

Emilia Jurzyk, Michael Keen, Padamja Khandelwal, Russell Krelove, Paolo Mauro, Roger Nord, Karen Ongley,

Alejandro Simone, Martin Sommer, and Jaejoon Woo. We are especially grateful for research assistance

provided by Matias Antonio.

DISCLAIMER: This Staff Discussion Note represents the views of the authors and

does not necessarily represent IMF views or IMF policy. The views expressed herein

should be attributed to the authors and not to the IMF, its Executive Board, or its

management. Staff Discussion Notes are published to elicit comments and to further

debate.

Contents Page

Executive Summary ...................................................................................................................3

I. Introduction ............................................................................................................................4

II. Trends in Income Inequality .................................................................................................6

III. Fiscal Policy and Income Inequality ..................................................................................10

A. Advanced Economies ..............................................................................................11

B. Developing Economies ...........................................................................................15

IV. Fiscal Consolidation and Income Inequality .....................................................................19

A. Advanced Economies ..............................................................................................19

B. Developing Economies ...........................................................................................20

V. Summary and Conclusions..................................................................................................21

References ................................................................................................................................28

Table

1. Changes in Disposable Income Inequality Across Regions, 1990–2005 ..............................8

Figures

1. Trends in Disposable Income Inequality, 1980–2010 ...........................................................7

2. Gross Income Share of Top One-Percent in Selected Advanced and Developing

Economies, 1925–2010 ..........................................................................................................9

3. Disposable Income Inequality Trends Since the Financial Crisis, 2007–2010 ...................10

4. Redistributive Impact of Income Taxes and Transfers in the EU for Early 2000s ..............12

5. Diminishing Redistributive Impact of Fiscal Policy Since the Mid-1990s .........................13

6. Levels and Composition of Tax Revenues and Social Spending ........................................16

7. Benefit Incidence of Education and Health Public Spending ..............................................18

8. Unemployment Rate Before, During, and After Large Fiscal Adjustments,

Advanced Economies...........................................................................................................20

9. Unemployment Rate Before, During, and After Large Fiscal Adjustments,

Developing Economies ........................................................................................................21

Box

1. Fiscal Policy and Income Inequality in Latin America .......................................................16

Appendix

1. Construction of the International Gini Database .................................................................24

Appendix Table

1. Gini Coefficients for Advanced and Developing Economies, 1980–2010 ..........................25

EXECUTIVE SUMMARY

Income inequality has increased in most advanced and many developing economies over

recent decades, reflecting a range of factors including globalization and technological

change. Even more striking is the large variation in average disposable (post-tax-and-

transfer) income inequality across regions, much of which can be accounted for by

differences in the level and progressivity of tax and spending policies. In advanced

economies, fiscal policy has played a significant role in reducing income inequality,

especially on the expenditure side but also through progressive income taxation. However,

reforms since the mid-1990s have lessened the generosity of social benefits and the

progressivity of income tax systems in these economies making fiscal policy less

redistributive.

In the context of fiscal consolidation in many economies, tax and spending measures should

enhance or maintain the distributive effects of fiscal policy while supporting economic

efficiency. Such measures include reducing opportunities for tax evasion and avoidance,

increasing the progressivity of income taxes over higher income brackets, cutting

unproductive expenditures, and expanding means-tested programs. Enhancing the

distributive impact of fiscal policy in developing economies will require improving their

capacity to raise tax revenues and to spend those resources more efficiently and equitably.

Resource mobilization should focus on broadening income and consumption tax bases and

expanding corporate and personal income taxes by reducing tax exemptions and improving

compliance. Expenditure reforms should focus on reducing universal price subsidies,

improving the capacity to implement better targeted transfers, and gradually expanding social

insurance systems.

This is a revised version of SDN/12/08 (published on June 28, 2012), which incorporates

updated data on international Gini coefficients. Figure 1, Table 1, and Appendix Table 1

have been updated to include the new data.

I. INTRODUCTION

Rising income inequality is a growing concern for policymakers in many economies.

These concerns have recently been heightened by social unrest in the Middle East, high

unemployment in many advanced economies in the aftermath of the financial crisis, rapid

income growth among the very rich in the past three decades in relation to other income

groups, and the possible adverse impact of fiscal consolidations on low-income groups in a

number of advanced and emerging economies. Income inequality has been increasing in

many advanced economies since 1980 owing to a range of factors, including:

 widening inter-regional inequality within economies;

 globalization, which has exerted downward pressure on the wages of low-skilled

workers;

 technological change, which has favored high-skilled workers;

 institutional and regulatory reforms that have increased competition in product and factor

markets and decreased the bargaining power of labor;

 increases in labor force participation by low-skilled workers; and

 the growing importance of high-income couples and single-parent households.

At the same time, high economic growth in many developing economies has also been

accompanied by rising income inequality, including in China and India.

Many policymakers view a more equal income distribution as a desirable goal, although

the underlying motivations may differ. Lower income inequality is often viewed as

important for achieving greater equality of opportunities to access economic, social, and

political resources. Others view it as intrinsically desirable because the existing income

inequality is perceived to be the outcome of unfair access to resources and thus detrimental to

social cohesion. Although some inequality is deemed necessary to provide incentives for

investment and economic growth (Barro, 2000; Forbes, 2000), there is also evidence that

high inequality may retard growth, especially if it reflects credit market imperfections or

political corruption or if it causes political instability (Berg and Ostry, 2011). Some have

On the broader economic policy implications of income inequality, see Atkinson (1997), Tanzi and Chu

(1998), and Tanzi, Chu, and Gupta (1999).

argued that rising income inequality was an important contributing factor to the recent

financial crisis.

This staff discussion note focuses on how fiscal policy can address income inequality in

both advanced and developing economies.

It reviews the relevant literature and assembles

a comprehensive database on disposable (i.e., post-tax-and-transfer) income inequality for

22 advanced and 128 developing economies. Fiscal policy can influence income distribution

both directly through its effect on current disposable incomes and indirectly through its effect

on the future earnings capacities—and therefore on market (i.e., pre-tax-and-transfer)

incomes—of individuals. Its role is likely to vary across economies, reflecting differences

both in available fiscal instruments and in social preferences regarding equity and the role of

government. The paper therefore focuses on what has been, rather than what should be, the

redistributive impact of fiscal policy and how this can be enhanced if seen as desirable. When

designing redistributive policies, it is also important to recognize that redistributive tax-

benefit systems can introduce economic inefficiencies, since individuals and firms change

their behaviors to avoid paying taxes or to maximize the transfers they receive, reducing the

overall size of the ―income pie‖ being redistributed. This efficiency cost of redistribution

typically increases with the extent of redistribution. In practice, therefore, there is a limit to

redistribution, reflecting both these inefficiencies and the recognition that not all income

inequality is unfair or undesirable. It is also important to focus on the overall tax and transfer

system (as opposed to its individual components) when designing fiscal policies to address

income inequality.

The following sections review the evolution of income inequality over recent decades in

advanced and developing economies and discuss how fiscal policy has influenced these

outcomes. The focus is on the direct impact of fiscal policy on income inequality, that is, on

how the inequality of disposable income compares to the inequality of market incomes. The

note starts by describing recent regional trends in disposable income inequality both over

time and across a large sample of advanced and developing economies. Changes in income

inequality after the onset of the financial crisis are also discussed. The note then examines the

contributions of both tax and expenditure policies in reducing income inequality in advanced

and developing economies, highlighting fiscal policy’s declining redistributive impact in

advanced economies over the last decade as well as its relatively low redistributive impact in

Fitoussi and Saraceno (2009) argue that increasing inequality has depressed aggregate demand, resulting in a

monetary policy that has maintained low interest rates, thus fuelling a debt spiral among households. This was

exacerbated by investor behavior, which created an asset bubble as investors searched for higher returns. Rajan

(2010) argues that rising inequality led to political pressure for more housing credit, which distorted lending in

the financial sector. Kumhof and Rancière (2010) show that in the United States, the Great Depression starting

in 1929 and the Great Recession starting in 2007 were both preceded by a sharp increase in income and wealth

inequality and by a rapid rise in debt-to-income ratios among lower- and middle-income households.

In this note, the category ―developing economies‖ covers emerging and low-income economies.

developing economies. This is followed by a discussion of how fiscal consolidation strategies

can be designed to address distributive concerns. Finally, lessons for the design of fiscal

policy are summarized.

II. TRENDS IN INCOME INEQUALITY

Trends in income inequality often depend on the inequality indicator being used. The

most widely used and widely available inequality measure is the Gini coefficient.

Although

the Gini is sensitive to what happens to income shares in the tails of the income distribution,

it is more sensitive to changes in shares in the middle of the distribution. For this reason, it is

common to supplement the Gini with an analysis of inequality at the extremes of the income

distribution, such as the share of the top income quintile divided by the share of the bottom

quintile. The discussion below focuses primarily on the Gini coefficient but makes reference

to other inequality measures whenever observed trends differ in a substantive manner—

Appendix 1 provides details on the construction of the international Gini database used. The

discussion below focuses initially on long-term trends up to immediately prior to the recent

financial crisis, and then on what has happened since the crisis.

Differences in disposable income inequality across regions are considerably greater

than changes in regional averages over time. Figure 1 presents trends in the Gini

coefficient for disposable income (i.e., market incomes minus direct taxes plus cash

transfers) across regions over recent decades. Between 1990 and 2005, average inequality in

each region changed by less than 4.5 percentage points. In contrast, while average inequality

in the two most unequal regions (Sub-Saharan Africa and Latin America) exceeded a Gini of

0.45 every year, average inequality in the two most equal regions (emerging Europe and

advanced economies) was less than 0.34, a difference of 11 percentage points. Measures that

capture inequality at the extremes of the distribution display a similar pattern. For instance,

the correlation between extreme inequality measures (including the 90/10 and 80/20 income

percentiles and income-share ratios) and the Gini exceeds 0.9.

The Gini coefficient ranges between 0 (complete equality, with everyone having the same income) and 1

(complete inequality, with one person having all the income). For example, a Gini of 0.3 (or 30 percent)

indicates that if two persons were chosen at random from the population, the expected difference between their

incomes would be 60 percent of the mean income.

Figure 1. Trends in Disposable Income Inequality, 1980–2010

Source: Appendix 1 provides details on the underlying country-specific database.

These averages hide substantial variation in trends within some regions. Inequality

increased in nearly all advanced and emerging European economies. Between 1990 and

2005, one-third of advanced economies and two-thirds of emerging Europe experienced

increases exceeding 3 percentage points (Table 1). Inequality increased by more than

5 percentage points in half of emerging Europe, with most of these increases occurring

between 1990 and 1995. Although inequality also increased in over half of the economies in

Latin America during the same period, it has recently started to decline there, with decreases

observed in nearly all economies since 2000. Inequality increased in most economies in Asia

and the Pacific as well, yet two economies there witnessed decreases in excess of

3 percentage points. In Sub-Saharan Africa, although the region’s average inequality has

fallen, inequality has increased by more than 3 percentage points in seven countries. And

while inequality in the Middle East and North Africa has increased by over 3 percentage

points in over one-third of countries, it decreased by over 5 points in two countries.

Table 1. Changes in Disposable Income Inequality Across Regions, 1990–2005

(Percentage-point change in Gini coefficient)

Source: Appendix 1 provides details of the underlying country-specific database; 1980 data are only available for

advanced economies.

More recently, the focus has been on the sharp increase in the share of total income of

the top income groups. Over the last three decades, the pre-tax-and-transfer income (i.e.,

market income) shares of the richest have increased substantially in English-speaking

advanced economies, as well as in India and China, but much less so in Southern European

and Nordic economies, and hardly at all in continental Europe and Japan (Figure 2).

For

This concentration of income is also mirrored in the unequal distribution of global wealth, with the wealthiest

0.5 percent of the global population accounting for more than 35 percent of total global wealth (Credit Suisse

Research Institute, 2010).

example, in the United States, the share of market income captured by the richest 10 percent

surged from around 30 percent in 1980 to 48 percent by 2008, while the share of the richest

1 percent increased from 8 percent to 18 percent.

More striking, the income share of the

richest 0.1 percent increased fourfold, from 2.6 percent to 10.4 percent.

Figure 2. Gross Income Share of Top One-Percent in Selected Advanced

and Developing Economies, 1925–2010

Source: The World Top Incomes Database. Available at: http://g-mond.parisschoolofeconomics.eu/topincomes/.

Note: Income typically refers to pre-tax-and-transfer gross income (see Atkinson, Piketty, and Saez, 2011, for details).

There does not as yet appear to be any discernible pattern to changes in income

inequality in the aftermath of the financial crisis (Jenkins and others, 2011). In Ireland,

where the macroeconomic shock was relatively large, inequality declined early in the crisis

because of a relatively large fall in top incomes (especially capital incomes), increases in

taxes, and an expansion of redistributive social transfers (Nolan, Callan, and Maitre, 2011).

However, as the crisis in Ireland deepened and fiscal consolidation efforts intensified,

inequality started to increase, with the Gini coefficient increasing by nearly 2 percentage

points by end-2010 (Figure 3). In contrast, in Italy, the Gini coefficient increased by

1 percentage point initially (as income losses from unemployment were only partially

compensated for by the transfer system) but eventually showed a decrease as the crisis

evolved. Changes in inequality have also varied among those worst hit by the crisis—with

the Gini increasing in Latvia and Lithuania but falling in Estonia, Greece, and Iceland—as

well as among those economies that experienced smaller macroeconomic impacts (the Gini

increased in France and Spain but fell in Portugal and the Netherlands). In the United States,

Note that these shares are likely to underestimate the income share of the rich, since they are typically based on

tax return data and often exclude non-realized capital gains and non-reported incomes. For example, for the

United States, estimates of the true share of the top 1 percent show that they received in excess of 20 percent of

total income in 2007 (U.S., Congressional Budget Office, 2011). The concentration of wealth is even higher,

with the top 1 percent accounting for nearly 35 percent of total wealth (Dumhoff, 2011).

Percent

United Kingdom

Australia

Canada

South Africa

India

United States

Percent

France

Germany

Japan

Netherlands

Sweden

the Gini changed little, with the expansion of public transfers offsetting the inequality impact

of high unemployment during the crisis (Thompson and Smeeding, 2011). Experience with

past crises suggests that the distributional effects of such a crisis can take many years to work

their way through the system (Atkinson and Morelli, 2011).

Figure 3. Disposable Income Inequality Trends Since the Financial Crisis,

2007–2010

Source: Staff estimates. Gini coefficients are taken from Eurostat for all countries except the United

States, for which they are taken from Thompson and Smeeding (2011).

III. FISCAL POLICY AND INCOME INEQUALITY

Evaluating the impact of fiscal policies on the distribution of income requires

comparing incomes in the presence of tax and transfer policies with those in the absence

of such policies. This comparison is complicated by the fact that the actual incidence of tax

and transfer policies may differ from their statutory incidence. In principle, determining the

actual incidence of fiscal policies requires specifying the structure of the economy (including

the competitiveness of various sectors and the openness of the economy) and having

information on the magnitude of consumers’ and producers’ behavioral responses to taxes

and transfers. In practice, however, most studies focus on statutory incidence, since sufficient

data on market structure and behavioral responses are often unavailable. In these studies, the

incidence of commodity taxes is typically assumed to fall on consumers, that of factor taxes

is assumed to fall on factor suppliers, and transfers to beneficiaries do not adjust their factor

supplies. Virtually all studies reviewed below make such assumptions.

Belgium

Bulgaria

Czech Republic

Denmark

Germany

Estonia

Ireland

Greece

Spain

France

Italy

Cyprus

Latvia

Lithuania

Luxembourg

Hungary

Malta

Netherlands

Austria

Poland

Portugal

Romania

Slovenia

Slovakia

Finland

Sweden

United Kingdom

Iceland

Norway

Croatia

United States

-5

-4

-3

-2

-1

-8 -6 -4 -2 0 2 4

Absolute change in Gini coefficient (percentage points)

Average annual percentage change in real GDP from 2007 and 2010

A. Advanced Economies

Fiscal policy has played a significant role in reducing income inequality in advanced

economies, especially in economies with high initial pre-tax and transfer inequality. In

every year between 1985 and 2005, fiscal policy (i.e., direct income taxes and transfers)

decreased the average Gini in 25 OECD countries by about one-third, that is, by around

15 percentage points (OECD, 2008, 2011a).

In 2005, for example, fiscal policy reduced

income inequality by around 20 or more points in seven economies (Belgium, Denmark,

Germany, Italy, Luxembourg, Poland, and the Slovak Republic) and by less than 10 points in

five economies (Korea, Iceland, Ireland, Switzerland, and the United States). On average, the

decrease in inequality brought about by tax and transfer policies was greater in economies

with higher inequality of market income, so that differences across economies in inequality

of disposable income are much smaller than differences in market income inequality. The

distributive impact is even higher when indirect taxes and in-kind benefits are allowed for

(see below).

Most of the redistributive impact of fiscal policy is achieved through the expenditure

side of the budget, especially non-means-tested transfers, although income taxes are

also important in many economies. On average, the redistribution achieved by public cash

transfers is twice as large as that achieved through taxes (Figure 4)—only in the United

States are taxes more redistributive than transfers (OECD, 2008).

This is in spite of the fact

that the magnitude of direct taxes is typically substantially larger than that of public transfers.

Non-means-tested transfers (including public pensions and universal child benefits) account

for the bulk of the redistribution on the expenditure side, especially in the Nordic economies,

Austria, Belgium, Poland, and Hungary (Immervoll and others, 2005; Paulus and others,

2009). On the tax side, income taxes achieve the greatest amount of redistribution—in fact,

in most economies, the redistribution achieved through income taxes is even higher than for

means-tested transfers.

Both the United Kingdom and Ireland stand out as the only

economies where means-tested benefits are responsible for most of the redistribution.

This finding is also confirmed by Brandolini and Smeeding (2009) and Atta-Darkua and Barnard (2010) using

different data sets.

OECD (2008) also finds that, with the exception of the United States, transfers are responsible for most of the

redistribution towards the bottom of the income distribution.

The United States is an exception in that the income tax system plays a relatively strong role in redistributing

income towards low-income families (OECD, 2008).

Figure 4. Redistributive Impact of Income Taxes and Transfers in the EU for

Early 2000s

Source: Based on Table 5 in Paulus and others (2009).

Note: Lines show the increase in the Gini coefficient of disposable income due to the removal of each tax

and transfer. Policies simulated reflect those existing between 2000 and 2005, depending on the country.

However, the redistributive impact of fiscal policy has decreased since the mid-1990s.

Between the mid-1980s and mid-1990s, the Gini coefficient for market income increased by

3 percentage points, while that for disposable income increased by only 0.8 points (Figure 5).

Over the same period, the decrease in inequality due to fiscal policy (i.e., the difference

between the market income Gini and the disposable income Gini) increased by

2.2 percentage points, from 9.5 in the mid-1980s to 11.7 in the mid-1990s. As a result, fiscal

policy offset 73 percent of the 3 percentage-point increase in market income inequality.

Although the inequality of market income increased by less over the subsequent decade, the

distributive impact of fiscal policy actually diminished. As a result, during the two decades

from the mid-1980s to the mid-2000s, fiscal policy offset a much lower 53 percent of this

increase, and market income inequality still grew by twice as much as redistribution.

This fall in the redistributive impact of fiscal policy reflected policy reforms that

reduced the overall progressivity of the tax-benefit system. In the absence of policy

reforms, the distributive impact of progressive tax-benefit systems tends to automatically

increase as market income inequality increases (e.g., due to higher unemployment or

increasing incomes of higher income groups). However, in many economies, reforms since

the mid-1990s have reduced the generosity of social benefits, particularly unemployment and

social assistance benefits, and have also reduced income tax rates, especially at higher

income levels (OECD, 2011a).

0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14

0.16

Change in Gini coefficient

social insurance

contributions

personal

taxes

means-tested

benefits

non means-tested

benefits

Figure 5. Diminishing Redistributive Impact of Fiscal Policy Since Mid-1990s

Source: Authors’ calculations based on OECD (2011a, Table 7.2).

Note: Fiscal distribution is defined as the ratio of the change in distributional impact of fiscal policy between two

points of time (e.g., between mid-1980s and mid-1990s) to the change in market income inequality over the

same periods, and therefore captures the percent of the increase in market income inequality that was offset by

an increase in the distributive impact of fiscal policy. In both cases, changes are relative to the mid-1980s base.

A key fiscal policy challenge is the need to balance often competing redistributive and

efficiency objectives. However, although redistribution through tax and benefit systems can

dilute work incentives across the income distribution, improved design can reduce this

equity-efficiency trade-off.

A large part of the efficiency cost arises from the use of means tested social benefits, that is,

where benefits are withdrawn as earnings increase. This has provided large disincentives for

low-skilled workers to take up employment opportunities (OECD, 2011b). In a study of

European economies, Immervoll and others (2007) find that transferring an additional euro

from high- to low-income individuals through traditional means-tested transfer programs

results in a reduction in the welfare of high-income individuals by 2 to 4 euros in most

economies. To reduce this equity-efficiency trade-off, many countries have introduced ―in-

kind benefits‖ that link receipt of benefits to employment. Countries have also expanded the

use of active labor market programs aimed at tightening rules for continued eligibility for

unemployment benefits, including more intensive job search requirements and participation

in training. However, designing and implementing such policies requires substantial

administrative capacity.

Progressive income tax schedules can have similar disincentive effects among higher income

groups. Such concerns motivated the reduction in top income tax rates in many economies

during the 1980s, which was followed by relatively high income growth at the top of the

36.2

26.7

39.2

27.4

39.8

28.3

Market Income

(left)

Disposable Income

(left)

Gini coefficient

mid-1980s

mid-1990s

mid-2000s

73.2

52.5

Fiscal Redistribution

(right)

Percent

income distribution (Saez, 2004; Atkinson and Leigh, 2010; Roine, Vlachos, and

Waldenstrom, 2009). But recent research has argued that the efficiency cost of progressive

taxation may be much smaller than previously thought. For instance, Piketty, Saez, and

Stantcheva (2011) have argued that the absence of any correlation between rising top

incomes and per capita GDP growth indicates that increases in top incomes primarily reflect

rent-seeking behavior (i.e., income increases are achieved at the expense of other income

groups) as opposed to productivity increases. This has led to calls for more progressive

taxation on higher income groups, especially higher taxation of ―high net wealth‖ individuals

(Tanzi, 2011). However, existing opportunities for tax evasion and avoidance, which are

typically greater for higher income groups, also need to be removed, since these can heavily

distort the structure of remuneration in response to more progressive income taxation (e.g.,

through the shifting of remuneration toward stock options and capital gains) and also reduce

the revenue potential and redistributive impact of income taxes (Gruber and Saez, 2002).

The overall redistributive impact of fiscal policy is also influenced by both indirect

taxes and in-kind transfers. The above studies focused only on the impact of direct income

taxes and transfers. Empirical evidence suggests that although indirect taxes tend to increase

inequality, in-kind transfers (such as education and health spending) are highly redistributive.

 Indirect taxes: In an analysis of 12 European Union economies, the effective indirect tax

rate, calculated as the share of consumption taxes in total household income, is on

average three times higher for the bottom income decile than for the top decile

(O’Donoaghue, Baldini and Mantovani, 2004). While both the value-added tax (VAT)

and excise duties are regressive in all economies, excise taxes are especially regressive,

their share in total income being four times higher in the bottom income decile than in the

top decile.

 In-kind transfers: A high share of public spending is allocated to the provision of

education, health care, housing, and food transfers to the population (Garfinkel,

Rainwater, and Smeeding, 2006; Brandolini and Smeeding, 2009; Aaberge and others,

2010).

Each component of in-kind transfers tends to reduce inequality: public housing

benefits tend to be targeted at low-income households, while public education and health

services are disproportionately used by households with children and elderly who are

typically concentrated in the lower parts of the disposable income distribution. On

average, in-kind transfers decreased the Gini coefficient by 5.8 percentage points in five

Similar results were found by Decoster and others (2009) for five economies (Belgium, Greece, Hungary,

Ireland, and the United Kingdom) and in a review of studies of OECD economies by Warren (2008).

As noted earlier, such spending can also have an important longer-term impact on the distribution of market

incomes. For example, higher education spending can increase education outcomes in general, contribute to

higher growth, and lead to a more equal distribution of income growth over time (Roll and Talbott, 2002;

Harberger, 2003).

European economies (Belgium, Germany, Greece, Italy, and the United Kingdom), with

health (3.6 points) and education (2.2 points) accounting for virtually all of this impact

(Paulus, Sutherland, and Tsakloglou, 2009).

In addition, very few incidence studies include corporate income taxes, partly reflecting

the difficulty associated with establishing where incidence lies. In theory, the impact of

corporate taxes on wages and capital income over the long run depends on the relative

mobility of capital and labor across both sectors and economies (Auerbach, 2006). Where

capital is more internationally mobile, the incidence of corporate taxes will tend to fall on

wages to the extent that labor is immobile, with this impact being reduced when the home

country is large enough to affect the international rate of return on capital. However, the

taxation of ―rents‖ (i.e., above normal profits) is still likely to fall on owners of capital.

Recent empirical evidence on the long-run incidence of corporate taxes suggests that between

45 and 75 percent of the corporate tax burden falls on wages (Gentry, 2007; Arulampalam,

Devereux and Maffini, 2010). Since wage earners typically have lower mean incomes than

those with capital income, corporate income taxes may not be as progressive as would appear

at first sight. But progressivity could be higher to the extent that low-skilled labor is a good

substitute for capital.

B. Developing Economies

The redistributive impact of fiscal policy in developing economies is severely restricted

by lower overall levels of both taxes and transfers. While average tax ratios for advanced

economies exceed 30 percent of GDP, ratios in developing economies (excluding emerging

Europe) generally fall in the range 15–20 percent of GDP (Figure 6). As a result, spending is

also substantially lower in developing economies, but especially in Asia and the Pacific and

in Sub-Saharan Africa, with low transfer spending explaining most of the difference. This

substantially reduces the redistributive potential of fiscal policy in developing economies.

For instance, almost three-quarters of the difference in disposable income inequality between

Latin American economies and advanced economies can be explained by fiscal policy

(Box 1).

Figure 6. Levels and Composition of Tax Revenues and Social Spending

Source: IMF database.

Box 1. Fiscal Policy and Income Inequality in Latin America

Fiscal policy has been much less effective at decreasing income inequality in Latin America

than in advanced economies. Goñi, López and Servén (2008) find that, in the mid-2000s, the tax

and transfer system decreased the average Gini (i.e., the difference between the Ginis for market

and disposable incomes) in six Latin American economies (Argentina, Brazil, Chile, Colombia,

Mexico, and Peru) by only about 2 percentage points, from 0.52 to 0.50—similar magnitudes are

reported by Lustig and others (2011) using more recent data. This compares to a decrease of

around 20 percentage points in 15 European economies, from 0.46 to 0.27. Almost three-quarters

of the difference in the Ginis for disposable income between these Latin America and European

countries (18 out of the 23 points) can therefore be explained by different fiscal policies.

The ineffectiveness of fiscal policy in reducing income inequality reflects both low tax and

spending levels and a less progressive tax and spending mix. In spite of recent increases in the

tax-to-GDP ratio, tax collections in the region are below the levels achieved in economies with

similar levels of income, with the median being 4 percentage points lower (Goñi, López and

Servén, 2008). Increases in the tax ratio have also been achieved through a greater reliance on

regressive indirect taxes and a decreasing share of more progressive income taxation. The low tax

ratio reflects narrow tax bases (due to tax evasion, numerous loopholes, a large informal sector

and weak tax administrations) rather than low tax rates. These limitations also tend to decrease

the redistributive impact of taxes. On the expenditure side, most Latin American economies

spend substantially less on social transfers than advanced economies do (Lindert, Skoufias, and

Shapiro, 2006); 7.6 percent of GDP in the above six economies compared to 16.3 percent in the

15 European economies. In addition, whereas social spending in Europe is distributed evenly

across the income distribution, in Latin America the richest 40 percent of the income distribution

capture over 70 percent of such spending.

Advanced

Emerging

Europe

Latin

America

Middle East

and North

Africa

Asia and

Pacific

Sub-Saharan

Africa

Percent of GDP

Social Spending,

2010 or latest

Transfers

Health

Education

Advanced

Emerging

Europe

Latin

America

Middle East

and North

Africa

Asia and

Pacific

Sub-Saharan

Africa

Percent of GDP

Tax,

2010 or latest

Indirect

Income

Corporate

Property

Low tax and spending levels are compounded by a heavy reliance on regressive tax

instruments as well as by the low coverage and benefit levels of transfer programs.

 Indirect Taxes: The redistributive potential of taxes in developing economies is limited

by greater reliance on indirect taxes and narrower tax bases. Taxes have been found to

have only a small impact on income inequality in developing economies, with the

average Gini for disposable income of 0.34 being only slightly below the pre-tax income

inequality of 0.38 (Chu, Davoodi, and Gupta, 2004). Taxes on imports, which continue to

be important in low-income economies, often appear to be among the most regressive,

while excise taxes—such as fuel, alcohol, and tobacco excises—tend to be progressive.

Although the distributive impact of value-added taxes has been found to be mixed, there

is strong evidence that the exemption of small businesses (including agriculture and the

informal sector) can result in a progressive incidence (Jenkins, Jenkins, and Kuo, 2006).

 Direct taxes: In general, personal income and property taxes in developing economies are

progressive. However, high levels of tax noncompliance combined with narrow tax

bases—due to widespread exemptions and the preferential treatment of capital and other

income—contribute to low income tax ratios, low income tax progressivity, and the

overall regressivity of tax systems.

Resource taxation can be progressive as well as

efficient, though it is applied mostly to foreign incomes.

 Expenditures: Both low spending and poor targeting limit the redistributive capacity of

transfer programs. The existence of a large informal sector further complicates the

development of such programs. In most developing economies, participation in social

insurance schemes is restricted to high-income workers in the formal sector and to public

sector employees. For example, in the early 2000s, the share of the population above the

legal retirement age in receipt of a pension in developing economies was, on average,

around 40 percent, as compared to 90 percent in European economies (ILO, 2010).

Expenditure on social assistance programs is also often low and poorly targeted (Coady,

Grosh, and Hoddinott, 2004; Weigand and Grosh, 2008). In many developing economies,

the fiscal space for expanding more distributive social transfers is constrained by large

expenditures on regressive universal price subsidies, especially energy price subsidies

(Coady and others, 2010; Arze del Granado, Coady, and Gillingham, 2010).

In-kind public spending has been found to be regressive in many developing economies,

although individual components can be progressive. In many economies, this regressivity

reflects lack of access by low-income households to key public services such as education

Existing reviews of the distributional impact of taxes and transfers in developing economies include:

Immervoll and others (2006), Gemmell and Morrissey (2005), Cubero and Hollar (2010), and Coady (2006).

Although corporate income taxes are often progressive, they can be horizontally inequitable when levied only

on large enterprises, allowing profitable medium-sized firms to escape the corporate tax net.

and health. Aggregate education and health spending is regressive in many developing

economies, especially in low-income countries (Figure 7). In health, the progressivity of

primary health care spending is dominated by the regressivity of higher-level health

spending. In education, the progressivity of primary education spending is dominated by the

regressivity of secondary and tertiary education spending. However, increases in in-kind

spending to finance the expansion of basic education and health services are likely to be

much more progressively distributed than existing spending (van de Walle, 1995).

Figure 7. Benefit Incidence of Education and Health Public Spending

(Percent of Public Spending Going to Poorest 40 Percent of Households)

Source: Davoodi, Tiongson, and Asawanuchit (2010), Lustig and others (2011), and data provided by the World Bank.

The recent expansion of “conditional cash transfer” programs provides a promising

approach for enhancing the distributive power of public spending in developing

economies. These programs target income transfers at poor households and condition the

continued receipt of the transfer on households investing in the education and health of

family members. Such programs have been adopted in many developing economies,

including some low-income African economies, albeit on a smaller scale (Fiszbein and

Shady, 2009; Garcia and Moore, 2012). In Latin America, 17 economies are currently

operating conditional cash transfer programs, with program expenditures typically falling

below 1 percent of GDP. It has been estimated that the largest programs, in Brazil and

Mexico, have reduced the Gini for disposable income by 2.7 percentage points, accounting

for about a fifth of the decrease in the Gini coefficient between the mid-1990s and the mid-

2000s (Soares and others, 2007). However, these programs are most cost-effective when

targeted at the poorest households, which tend to be most disadvantaged in terms of human

capital, so expansions need to be carefully designed in order to generate human capital

impacts and avoid labor supply disincentives.

Argentina 2009

South Africa 2000

Brazil 2009

Bolivia 2007

Egypt 2005

Belarus 2002

Honduras 2004

Mexico 2008

Mongolia 1995

Bangladesh 2000

Turkey 2003

Mozambique 1997

Bulgaria 1995

Romania 1997

Ghana 1998

India 1996

Ecuador 1998

Guatemala 2006

Health

Namibia 2003

Lesotho 2002

South Africa 2000

Argentina 2009

Brazil 2009

Peru 2009

Mexico 2008

Albania 2002

Bosnia&Herz 2001

Kenya 2006

Costa Rica 2001

Cambodia 2002

Turkey 2001

Azerbaijan 2001

Kosovo 2000

Nepal 2004

Bolivia 2007

Uzbekistan 2000

Benin 2003

Mozambique 2003

Egypt 2005

Uganda 2006

Bangladesh 2000

Education

IV. FISCAL CONSOLIDATION AND INCOME INEQUALITY

Fiscal consolidation affects income inequality in two ways. First, consolidation reduces

output and increases unemployment in the short run (Blanchard and Perotti 2002; IMF

2010a, 2012), and this has typically been associated with a declining wage share. The

declining wage share tends to increase inequality, given the relatively higher wage share in

the total income of lower income groups (Rotemberg and Woodford, 1999; Jenkins and

others, 2011). Increasing unemployment also tends to widen wage inequality, since low-wage

workers are typically hit harder as employers hoard skilled labor and unskilled wages fall

relative to skilled wages (Agenor, 2002; Mukoyama and Sahin, 2006). The duration and

magnitude of these effects depends on the growth response and the employment intensity of

this growth. Second, both the level and composition of tax and spending can be affected by

fiscal consolidation. Income inequality will tend to increase the more fiscal adjustment relies

on increasing regressive taxes (such as consumption taxes) or on cut-backs in progressive

spending. The discussion below focuses on large fiscal consolidations, given that the

inequality effects are likely to be more pronounced and many advanced countries will require

sizeable fiscal adjustments over the coming decade.

A. Advanced Economies

Episodes of large fiscal adjustment in advanced economies have been associated with

sizeable increases in unemployment in the short term (Figure 8).

In these cases, the

distributive impact on household incomes in the short term depends on the size of automatic

stabilizers, whether they are allowed to operate, and how quickly and strongly exports and

private demand respond to reduced government demand. Increased expenditures on

unemployment benefits help to contain the widening of income inequality, through their

effect both in cushioning demand and in replacing lost wage incomes. But cut-backs in

government services could worsen income distribution, given the heavy reliance of low-

income households on these services. The effects of fiscal consolidation on unemployment

have tended to reverse over the longer term (Clinton and others, 2010), although this may be

muted to the extent that there is a permanent downward shift in potential output.

The mix of tax and spending measures during fiscal adjustment has also been an

important determinant of the impact of consolidation on income inequality. Large and

durable fiscal adjustments have typically been associated with significant expenditure cuts,

including in redistributive social transfers (Alesina and Perotti 1995; Alesina and Ardagna,

2009). Consistent with this, adjustments biased towards expenditure cuts have tended to

exacerbate income inequality (Agnello and Sousa, 2012). However, protecting the most

A large fiscal consolidation is defined as one that lasts at least three years, where the cyclically adjusted

primary balance (CAPB) improves by at least 5 percent of GDP, and where the cumulative change in the CAPB

is not reversed by more than 1 percentage point from one year to the next.

progressive social benefits and improving targeting can minimize the impact of expenditure

cuts on income inequality, as the experiences of Denmark, Germany, Iceland, and Sweden

have demonstrated (OECD, 2008; IMF, 2001; IMF, 2012). This can be accomplished in a

number of ways. First, greater reliance on progressive revenue measures can obviate the need

for large cuts in social transfers, although the extent to which adjustment can be achieved

through revenue measures is limited if taxes are already high (Baldacci, Gupta and Mulas-

Granados, 2012). Second, removing opportunities for tax avoidance and evasion, practices

that typically disproprtionately benefit higher-income groups, can simultaneously improve

both the efficiency and the distributional impact of the tax system, as can a greater reliance

on progressive wealth and property taxes than is currently the case (Norregaard,

forthcoming). Third, broadening the scope of expenditure reforms to include military

spending, subsidies (including tax expenditures), and public-sector wages, can also reduce

the need for cuts in social transfers (IMF, 2010a). Finally, expanding active labor market

programs (such as job-search support, targeted wage subsidies, and training programs) can

help accelerate the fall in unemployment as economic growth resumes and avoid persistently

high unemployment.

Figure 8. Unemployment Rate Before, During, and After Large Fiscal

Adjustments, Advanced Economies

(Percent)

Source: IMF Fiscal Monitor, November 2010.

B. Developing Economies

In developing economies, large fiscal adjustments have had relatively significant

impacts on the real economy and unemployment (Figure 9). However, reflecting the

shorter duration of consolidation episodes in developing economies as compared to

advanced economies, the increase in unemployment has also been of shorter duration. This

contributes to better income distribution outcomes in the post-adjustment period. In addition,

fiscal consolidation is often essential to reduce high inflation, which typically has adverse

4.0

4.5

5.0

5.5

6.0

6.5

7.0

7.5

Before (3y average)

During adjustment

After (3y average)

Unweighted average

Weighted average (by size of adjustment)

effects on inequality (Agenor, 2004; Easterly and Fisher, 2001) and can help to address

macroeconomic imbalances leading to improved employment prospects in the long term.

Fiscal consolidation in developing economies can be designed to mitigate its adverse

impact on inequality if it is accompanied by improvements in the progressivity of the

overall tax and transfer system economies. Since a large share of government spending in

developing economies is not progressive (as discussed earlier), expenditure reductions

implemented during fiscal adjustment can actually improve equity, depending on where

consolidation is concentrated. Similarly, strengthening social safety nets can greatly enhance

the capability of governments to protect vulnerable households during adjustment. However,

to be sustainable, fiscal adjustment in developing economies is also likely to require revenue

measures (Bevan, 2010; Gupta and others, 2005). Any adverse impact of tax measures on

inequality can be mitigated if they are accompanied by tax reforms that enhance the

efficiency and equity of the tax system, such as a greater reliance on progressive income

taxation combined with the removal of opportunities for tax avoidance and evasion.

Figure 9. Unemployment Rate Before, During, and After Large Fiscal

Adjustments, Developing Economies

(Percent)

Source: IMF Fiscal Monitor, November 2010.

V. SUMMARY AND CONCLUSIONS

Although fiscal policy has played a key role in reducing income inequality in advanced

economies over recent decades, its redistributive impact has diminished since the mid-

1990s. The combination of progressive income taxes and highly redistributive transfers has

decreased income inequality by about one third. The decrease is even greater when in-kind

transfers, such as education and health spending, are included. However, since the mid-

1990s, disposable-income inequality has increased more than market-income inequality due

to the reduced generosity of redistributive social benefits and the diminished progressivity of

8.5

9.5

10.5

11.5

Before (3y average)

During adjustment

After (3y average)

Unweighted average

Weighted average (by size of adjustment)

income taxes. Addressing this decline in the redistributive impact of fiscal policy in the

context of rising market-income inequality will require a combination of tax and expenditure

policy measures, with due recognition of potential equity-efficiency trade-offs.

 On the tax side, a key issue will be the potential for increasing the redistributive impact

of direct income taxes. Priority should be given to reducing opportunities for tax

avoidance and evasion, practices that typically disproportionately benefit those at the top

end of the income distribution. In addition, there may be scope for raising average and

marginal tax rates in economies with relatively low rates. However, increasing the top

marginal income tax rates applied to the richest one-percent of the population may

require greater international cooperation to be effective.

 On the expenditure side, countries will need to avoid the continued decline in the most

redistributive cash and in-kind transfers. While reforms aimed at enhancing the

redistributive impact of transfers (e.g., through greater use of means-tested and in-work

benefits) can help, the redistributive power of these transfers is limited by the work

disincentives they can create.

The measures described above will also contribute to reducing income inequality in

advanced economies needing to implement fiscal consolidation over the medium term.

Over the short term, protecting the most redistributive social benefits (including

unemployment benefits) until the economy recovers and unemployment starts to decline can

help to cushion aggregate demand and mitigate adverse impacts on income inequality. In

addition, expanding active labor market programs (such as job-search support, targeted wage

subsidies, and training programs) can help to accelerate the decrease in unemployment as

economic growth resumes and can help avoid persistently high unemployment levels. Over

the medium term, somewhat greater reliance on tax measures, as well as broadening the

coverage of expenditure reforms to include such items as military spending and subsidies,

would obviate the need for large cuts in redistributive transfers.

Enhancing the capability of fiscal policy to address income inequality in developing

economies will require strengthening both their resource mobilization capacity as well

as their capacity to use more progressive tax and spending instruments. A significant

proportion of the higher income inequality in developing economies, as compared to

advanced economies, can be explained by the lower levels of taxation and public spending in

developing economies, as well as their greater reliance on less progressive tax and spending

instruments. Addressing these challenges will require raising tax revenues and spending them

more efficiently and equitably.

 On the tax side, much can be done to improve the distributional impact of fiscal policy. In

the short-term, resource mobilization efforts should focus on broadening income and

consumption tax bases. Expanding corporate and personal income tax bases by reducing

tax exemptions, closing loopholes, and improving tax compliance would raise revenues

to finance progressive transfers. Expanding the consumption tax base (e.g., through

broader adoption of the value-added tax) would increase tax revenues, and these

consumption taxes can also be designed to mitigate adverse distributional impacts (e.g.,

through appropriate treatment of small businesses and the application of excises to luxury

goods).

 On the expenditure side, revenue constraints will require greater reliance on targeted (as

opposed to universal) social expenditures aimed at protecting households from poverty

and improving education and health outcomes among disadvantaged households.

Eliminating fiscally costly and inefficient universal price subsidies (including tax

expenditures) can generate substantial resources in the short term in many economies.

The recent success of conditional cash transfer programs in many economies suggests

that these programs should play a greater role in the social protection strategies in

developing economies. Broadening the coverage of public pension systems would also

have an important role in reducing inequality. Where expansion is constrained over the

short term by administrative capacity and fiscal constraints, greater use of targeted social

pensions may be warranted.

Appendix 1. Construction of the International Gini Database

The inequality database assembled for this note covers 150 advanced and developing

economies (see Appendix Table 1 below). Whereas data on disposable income inequality

exists from 1980 for many advanced economies, for other regions estimates exist mostly

from 1990 onwards. Furthermore, data limitations mean that assembling a panel of inequality

estimates across regions and time requires combining estimates from different sources based

on different underlying data. The Gini estimates presented below are drawn from five data

sources. Priority was given to reporting estimates based on disposable income, otherwise

estimates based on consumption or expenditure are used. Estimates for any one country are

always for a single base, i.e., income, consumption and expenditure inequality are never

mixed for a single country. All estimates reported are drawn from household surveys. For

advanced, emerging Europe, and Latin America and the Caribbean economies, the Gini

coefficients are based on disposable per capita income data. For the majority of other

economies, estimates are based on per capita consumption or expenditures.

In Appendix Table 1, the ―Source‖ column reports the sources from which the Gini estimates

are obtained. The data sources used are: European Union Statistics on Income and Living

Conditions (EU-SILC); Luxembourg Income Study (LIS); Organisation for Economic

Cooperation and Development (OECD); Socio-Economic Database for Latin America and

the Caribbean (SEDLAC); and the World Bank, World Development Indicators (WDI). For

the majority of economies, a single data source is used for different years. For economies

where the ―Source‖ column indicates two sources, this reflects Gini estimates being drawn

from separate sources for different years to allow for coverage of more recent years. For

example, the main source of data for most advanced economies is LIS. However, at the time

of writing, LIS only goes up to 2007, so to get Ginis for more recent years the absolute

changes in the disposable income Gini coefficient according to EU-SILC (which only starts

around 2006) is added to the Gini for 2007 from LIS. Validation tests were carried out to

ensure comparability in the underlying data sources; these tests show that both the level and

changes in Ginis in both databases are highly correlated.

The constructed Gini database is unbalanced in that Ginis do not exist for all economies over

all years. Appendix Table 1 reports Ginis for 5-year windows, starting in 1980 and ending in

2010. This is constructed as follows: if the Gini for the reference year (e.g., 1990 or 1995) is

available it is reported; otherwise the reported Gini is based on the nearest year (first below

then above) to the reference year if available; otherwise it is based on the second years below

or above.

Appendix Table 1. Gini Coefficients for Advanced and Developing Economies,

1980–2010

Appendix Table 1. (Continued)

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