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©2014 International Monetary Fund IMF POLICY PAPER FISCAL POLICY AND INCOME INEQUALITY IMF staff regularly produces papers proposing new IMF policies, exploring options for reform, or reviewing existing IMF policies and operations. The following document(s) have been released and are included in this package:  The Staff Report on Fiscal Policy and Income Inequality, prepared by IMF staff and completed on January 22, 2014 to brief the Executive Board on February 7, 2014. The Executive Directors met in an informal session, and no decisions were taken at this meeting. The policy considerations in this paper should be attributed to IMF staff and not to the IMF or its Executive Board. The analysis was prepared by the staff of the Fiscal Affairs Department and has benefited from comments and suggestions by staff from other IMF departments, as well as by Executive Directors following their discussion of the report on February 7, 2014. The policy of publication of staff reports and other documents allows for the deletion of market-sensitive information. Electronic copies of IMF Policy Papers are available to the public from http://www.imf.org/external/pp/ppindex.aspx International Monetary Fund Washington, D.C. January 23, 2014 FISCAL POLICY AND INCOME INEQUALITY EXECUTIVE SUMMARY Fiscal policy is the primary tool for governments to affect income distribution. Rising income inequality in advanced and developing economies has coincided with growing public support for income redistribution. This comes at a time when fiscal restraint is an important priority in many advanced and developing economies. In the context of the Fund’s mandate to promote growth and stability, this paper describes: (i) recent trends in the inequality of income, wealth, and opportunity in advanced and developing economies; (ii) country experience with different fiscal instruments for redistribution; (iii) options for the reform of expenditure and tax policies to help achieve distributive objectives in an efficient manner that is consistent with fiscal sustainability; and (iv) recent evidence on how fiscal policy measures can be designed to mitigate the impact of fiscal consolidation on inequality. This paper does not advocate any particular redistributive goal or policy instrument for fiscal redistribution. Both tax and expenditure policies need to be carefully designed to balance distributional and efficiency objectives, including during fiscal consolidation. The appropriate mix of instruments will depend on administrative capacity, as well as on society’s preferences for redistribution, the role envisaged for the state, and political economy considerations. Options for redistributive policies that help minimize efficiency costs, in terms of their effects on incentives to work and save, are the following:  In advanced economies: (i) using means-testing, with a gradual phasing out of benefits as incomes rise to avoid adverse effects on employment; (ii) raising retirement ages in pension systems, with adequate provisions for the poor whose life expectancy could be shorter; (iii) improving the access of lower-income groups to higher education and maintaining access to health services; (iv) implementing progressive personal income tax (PIT) rate structures; and (v) reducing regressive tax exemptions.  In developing economies: (i) consolidating social assistance programs and improving targeting; (ii) introducing and expanding conditional cash transfer programs as administrative capacity improves; (iii) expanding noncontributory means-tested social pensions; (iv) improving access of low-income families to education and health services; and (v) expanding coverage of the PIT. Innovative approaches, such as the greater use of taxes on property and energy (such as carbon taxes) could also be considered in both advanced and developing economies. January 22, 2014 FISCAL POLICY AND INCOME INEQUALITY 2 INTERNATIONAL MONETARY FUND Approved By Sanjeev Gupta Prepared by staff from Fiscal Affairs Department supervised by Sanjeev Gupta and Michael Keen, and comprising Benedict Clements, Victoria Perry, David Coady, Ruud De Mooij, Stefania Fabrizio, Baoping Shang, Allan Dizioli, Luc Eyraud, Csaba Feher, Valentina Flamini, Alvar Kangur, Javier Kapsoli, Carlos Mulas-Granados, Peter Mullins, Philippe Wingender, Dora Benedek, Ryan Espiritu, and Louis Sears. Production assistance was provided by Pierre Jean Albert, Jeffrey Pichocki, and Mileva Radisavljević. CONTENTS INTRODUCTION __________________________________________________________________________________ 4 TRENDS IN INEQUALITY__________________________________________________________________________ 7 A. Inequality of Income ____________________________________________________________________________ 7 B. Inequality of Wealth ___________________________________________________________________________ 11 C. Lifetime Inequality _____________________________________________________________________________ 13 D. Inequality of Opportunity _____________________________________________________________________ 13 FISCAL REDISTRIBUTION _______________________________________________________________________ 14 A. Advanced Economies__________________________________________________________________________ 15 B. Developing Economies ________________________________________________________________________ 18 DESIGN OF EFFICIENT REDISTRIBUTIVE FISCAL POLICY ______________________________________ 21 A. Conceptual Framework ________________________________________________________________________ 21 B. Social Spending _______________________________________________________________________________ 25 C. Tax Design _____________________________________________________________________________________ 36 D. Summary ______________________________________________________________________________________ 42 FISCAL CONSOLIDATION AND INEQUALITY __________________________________________________ 43 A. Advanced Economies__________________________________________________________________________ 44 B. Developing Economies ________________________________________________________________________ 48 Appendix I. Who Benefits from Tax Incentives for Charitable Giving?____________________________ 50 BOXES 1. Efficiency and Fiscal Redistribution ______________________________________________________________ 6 2. Rising Public Support for Redistribution _________________________________________________________ 9 3. Redistributive Fiscal Policy: Evidence from Regression Analysis _______________________________ 15 4. Fiscal Policy and Income Inequality in Latin America __________________________________________ 19 5. What is the Shape of the Optimal Income Tax Schedule? _____________________________________ 23 FISCAL POLICY AND INCOME INEQUALITY INTERNATIONAL MONETARY FUND 3 6. In-Work Benefits and Credits _________________________________________________________________ 25 7. Conditional Cash Transfer Programs __________________________________________________________ 32 FIGURES 1. Trends in Disposable Income Inequality, 1980–2010 ____________________________________________ 8 2. Gross Income Share of Top One-Percent in Selected Advanced and Developing Economies, 1925–2012 ___________________________________________________________ 10 3. Poverty Rates in Developing Economies, 1980–2010 __________________________________________ 11 4. Inequality of Wealth and Incomes in Selected Economies, early-2000s _______________________ 12 5. The Great Gatsby Curve: Income Inequality and Economic Mobility , mid-1980s _____________ 14 6. Redistributive Impact of Fiscal Policy in Advanced Economies, mid-2000s ____________________ 16 7. Diminishing Fiscal Redistribution, 1985–2005 _________________________________________________ 17 8. Tax Revenues and Social Spending in Advanced and Developing Economies _________________ 19 9. Social Protection Coverage and Incidence in Developing Economies, late-2000s _____________ 20 10. Benefit Incidence of Education and Health Public Spending _________________________________ 21 11. Means-tested and Non-means-tested Family Benefits, 2010 ________________________________ 28 12. Top PIT Rates, 1980–2012 ____________________________________________________________________ 37 13. Redistributive Effect of Fiscal Adjustments, 2007–2012 ______________________________________ 45 14. Cumulative Change in Households Disposable Income due to Simulated Fiscal Consolidation Measures, 2008–12 ___________________________________________________________ 47 15. Simulated Impact of Fiscal Consolidation (FC) Measures on Gini Index, 2012 ________________ 47 16. Unemployment Rates and Gini Coefficients During Large Fiscal Adjustments in Developing Economies _______________________________________________________________________ 48 TABLES 1. Summary: Fiscal Reform Options for Efficient Redistribution in Advanced and Developing Economies _________________________________________________________________________ 43 APPENDICES I. Who Benefits from Tax Incentives for Charitable Giving? ______________________________________ 50 II. Recent Fiscal Consolidations and Income Inequality __________________________________________ 51 APPENDIX FIGURES 1. Aggregate Effect and Composition of Simulated Fiscal Consolidation Measures, 2008–12 ___ 51 2. Change in Household Disposable Income by Type of Measure and Income Group, 2007–12 ________________________________________________________________________________________ 53 REFERENCES______________________________________________________________________________________54 FISCAL POLICY AND INCOME INEQUALITY 4 INTERNATIONAL MONETARY FUND INTRODUCTION 1. Income inequality has increased in both advanced and developing economies in recent decades.1 Increasing inequality has been attributed to a range of factors, including the globalization and liberalization of factor and product markets; skill-biased technological change; increases in labor force participation by low-skilled workers; declining top marginal income tax rates; increasing bargaining power of high earners; and the growing share of high-income couples and single-parent households (OECD, 2008; Alvaredo and others, 2013; Hoeller, Joumard, and Koske, 2014). Many of these developments have had beneficial effects on growth and poverty reduction both nationally and globally (Chen and Ravallion, 2010; Milanovic, 2012). 2. There is growing evidence that high income inequality can be detrimental to achieving macroeconomic stability and growth. Recent empirical work finds that high levels of inequality are harmful for the pace and sustainability of growth (Ostry, Berg, and Tsangarides, forthcoming). Others have argued that rising inequality may have been an important contributing factor to the global financial crisis.2 Moreover, evidence from public surveys in various countries indicates that widening income inequality has been accompanied by growing public demand for income redistribution, especially in countries most strongly affected by the crisis. This comes at a time when high public debt ratios in the advanced economies, and emerging vulnerabilities in the developing economies, have made fiscal restraint an important priority, and point to the importance of sensitivity to distributional concerns in designing consolidation packages. In this light, income inequality can be of macroeconomic concern for country authorities, and the Fund should accordingly seek to understand the macroeconomic effects of inequality. In addition, in its policy advice, the Fund should be mindful of how macroeconomic policies (including fiscal policies) affect income distribution and their consistency with the distributional goals of country authorities. 3. Fiscal policy is the primary tool for governments to affect income distribution.3 Fiscal policy has three main objectives—to support macroeconomic stability, provide public goods and correct market failures, and redistribute income. Both tax and spending policies can alter the distribution of income, both over the short and medium term. For example, in-kind benefits, such as education spending, can affect the inequality of market incomes (i.e., incomes before taxes and transfers) through their impact on future earnings. Other fiscal instruments, such as income taxes and cash transfers, can reduce the inequality of disposable incomes (i.e., incomes after direct taxes 1In this paper, the category “developing economies†covers both emerging and low-income economies. These are merged together because they face similar issues, and data availability for both groups of economies is similar. 2Rajan (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. 3Other tools to influence income distribution include labor market, product market, and institutional reforms, as well as asset redistribution. These can have an influence on inequality directly or through their effects on growth. FISCAL POLICY AND INCOME INEQUALITY INTERNATIONAL MONETARY FUND 5 and transfers), including indirectly via their impact on market incomes due to work and savings responses. 4. The Fund has long recognized the nexus between income distribution and fiscal policy. In the late 1980s there was growing recognition and discussion of the potential effects of macroeconomic and structural adjustment programs on poverty and inequality, including by the IMF’s Executive Board (IMF, 1995). These discussions highlighted the importance of social safety nets to protect the poor and safeguard their access to essential public services, such as primary education and healthcare. Guidance notes from management on how income distribution and social expenditures should be addressed by staff, in the context of the Fund’s mandate, were issued in the mid-1990s (IMF, 1996, 1997). The Fund also expanded its analytical work in this area, drawing on contributions from leading academics (Tanzi and Chu, 1998; Tanzi, Chu, and Gupta, 1999). The growing attention of the Fund to the impact of fiscal policy on the poor was also reflected in the creation of the Poverty Reduction and Growth Facility (later PRGT) in the late 1990s, which emphasized the importance of pro-poor government budgets. More recently, the work on fiscal policy and equity was revived (Bastagli, Coady, and Gupta, 2012) and subsequently broadened to cover jobs and growth; a guidance note on the latter was issued to Fund staff (IMF, 2013a). The macroeconomic gains from greater gender equity, and fiscal policies to help achieve this, have also been addressed in recent work (Elborgh-Woytek and others, 2013). 5. Against the background of recent trends in income distribution and experience with the use of redistributive fiscal instruments in both advanced and developing economies, this paper explores how a society’s distributional objectives can be achieved in the most efficient manner. Redistributive fiscal policies can affect private decisions in various ways, including decisions to seek employment, to increase labor effort, and to save and invest. These, in turn, can potentially affect both the level and growth of economic activity, either positively and negatively. Given the Fund’s mandate to promote growth and stability, it is important that the potential tradeoffs or complementarities between fiscal redistribution and growth are well understood. In particular, there is a need to identify fiscal instruments that achieve distributional objectives at a minimum cost to economic efficiency (Box 1). In doing so, the paper draws extensively on country experience, as discussed in the literature,4 as well as in IMF technical assistance reports.5 The paper also discusses how fiscal policies can protect households from poverty. 4See, for example, World Bank (2006); OECD (2011a, 2012); Asian Development Bank (2012); and Joumard, Pisu, and Bloch (2012). 5The paper has also benefited from consultation with Civil Society Organizations and labor unions on its principal conclusions and policy recommendations. In their comments, they emphasized the limited capacity of developing economies to target social spending and protect the poor from spending cuts; the need to protect low-income workers, who may have short life expectancies, during pension reforms that raise retirement ages; the need to strengthen information sharing on corporate taxation; and concerns that value added taxes, in practice, were regressive. FISCAL POLICY AND INCOME INEQUALITY 6 INTERNATIONAL MONETARY FUND 6. This paper does not advocate any particular redistributive goal or policy instrument for fiscal redistribution. The motivation for the paper is to provide guidance to policymakers on options to achieve their desired level of redistribution in the most efficient manner. The paper does not provide guidance on the optimal degree of fiscal redistribution, which is country-specific and depends, among other factors, on preferences for the role of the state and the costs involved in meeting goals for redistribution. Box 1. Efficiency and Fiscal Redistribution The term “efficiency†in economics is often used loosely. At the most precise level, it means Pareto efficiency—a situation in which no individual can be made better off without making some other individual worse off. An efficiency-improving reform in this sense would then be one that makes someone better off and no one worse off. But this is a very demanding test, both in assessing well-being and removing any possibility that someone may be adversely affected by change. Reflecting this, the term “efficiency gain†is often used more loosely to refer to increase in the aggregate level or growth of income; and this is the interpretation in mind here. A closely related concept is deadweight loss (or excess burden), which measures the inefficiency associated with economic distortions. For example, the welfare loss of a distortionary tax is measured by the burden imposed on individuals in excess of the revenue generated by the tax—and conversely, for a subsidy, the burden in excess of the revenue loss. Importantly, there may be instances of reform that improve both efficiency—in any of these senses—and equity (Boadway and Keen, 2000). For example, when the rich are altruistically inclined towards the poor, redistribution can be obviously Pareto improving. Also, the provision of social insurance can encourage risk-taking and increase investment returns, thus also potentially improving efficiency. Fiscal redistribution can also relax credit constraints facing poor households and allow them to invest in education, boosting human capital and enhancing efficiency. Interestingly, these examples show that redistribution may yield efficiency gains which are also reflected in higher economic growth. Identifying instances in which both equity and efficiency can be improved is a primary concern of this paper, though some trade-off between them becomes inevitable once these have been fully exploited. 7. The structure of the paper is as follows. The next section describes trends in inequality across advanced and developing economies. The discussion covers inequality of incomes and wealth. It also examines the evidence on the persistence of income inequality across generations, an indicator of equality of opportunity. This is followed by a review of empirical evidence on the redistributive impact of fiscal policies and the extent to which fiscal policy can explain differences in inequality across countries and over time. The paper next focuses on the overall design of redistributive fiscal policy as well as of specific tax and spending instruments, and how these can be designed to minimize the efficiency costs of redistribution. The final section discusses the redistributive impact of fiscal consolidation, which can affect inequality both in the long run through channels explained in earlier sections and through its short-run effects on output and employment. FISCAL POLICY AND INCOME INEQUALITY INTERNATIONAL MONETARY FUND 7 TRENDS IN INEQUALITY 8. Economic inequality can be viewed from different perspectives. Each of these can provide insights into the nature, causes, and consequences of economic inequality.  Inequality of income: This focuses on the inter-personal distribution of income, which captures how individual or household incomes are distributed across the population at a point in time.  Inequality of wealth: Here the focus is on the distribution of wealth across individuals or households, which reflects differences in savings as well as bequests and inheritances.  Lifetime inequality: This focuses on measuring inequality in incomes or earnings for an individual over his or her lifetime, rather than for a single year.  Inequality of opportunity: This focuses on the relationship between income inequality and social mobility, in particular the extent of mobility between income groups across generations. A. Inequality of Income 9. Over the last three decades, inequality in the personal distribution of income has increased in most economies. Figure 1 presents trends in the average (unweighted) Gini coefficient for disposable incomes (i.e., market incomes minus direct taxes plus cash transfers) across regions over recent decades—which reflects both the inequality of market-determined incomes as well as the distributional impact of income taxes and public transfers.6 The Gini coefficient ranges between 0 (denoting complete equality) and 1 (denoting complete inequality).7 Between 1990 and 2010, the Gini for disposable income has increased in nearly all advanced and emerging European economies. Over one-third of advanced economies and half of emerging Europe experienced increases in their Ginis exceeding 3 percentage points, with most of the increases in emerging Europe occurring between 1990 and 1995 during the early years of their transition to market-based systems. Inequality also rose in most economies in Asia and the Pacific and in Middle East and North Africa. While average inequality fell in sub-Saharan Africa over this period, it still rose by more than 3 percentage points in more than one-fourth of these economies. Inequality also increased in over one-third of the economies in Latin America, although on average there was a slight decline. However, since 2000 there has been a substantial decline in the Gini in nearly all countries in this 6Data on the inequality of market incomes is much more limited, being available mostly for advanced economies and for a shorter time period. For country specific data on Ginis for disposable income, see Bastagli, Coady, and Gupta (2012). For a discussion of the issues that arise when comparing income inequality measures across countries and time, see Atkinson and Bourguignon (2000), Atkinson and Brandolini (2001), and Deaton and Zaidi (2002). 7The Gini is less sensitive to inequality at the extremes of the income distribution than many other commonly used measures. However, other inequality measures show a similar trend in overall income inequality. For instance, the ratio of the income share of the top 20 percent of the income distribution to the share of the bottom 20 percent has a correlation coefficient with the Gini of around 0.85. FISCAL POLICY AND INCOME INEQUALITY 8 INTERNATIONAL MONETARY FUND region. This increase in inequality across the globe has also been accompanied by a widespread rise in public support for redistribution (Box 2). Figure 1. Trends in Disposable Income Inequality, 1980–2010 Sources: OECD; Luxembourg Income Study Database; Socio-Economic Database for Latin America and the Caribbean (SEDLAC); World Bank; Eurostat. Note: Disposable income is income available to finance consumption once income taxes and public transfers have been netted out. Therefore, the distributional impacts of indirect taxes and in-kind transfers are not included. The Gini coefficient ranges between 0 (complete equality) and 1 (complete inequality). Number of countries in parentheses. 10. More striking than changes in inequality within regions are the persistent differences across regions. For instance, between 1990 and 2010, average inequality in each region changed by less than 3¼ percentage points. In contrast, average inequality in the two most unequal regions (sub-Saharan Africa and Latin America) remained 12 percentage points higher than the two most equal regions (emerging Europe and advanced economies). As the following section shows, a large proportion of the differences in regional average disposable income inequalities can be explained by differences in fiscal policies, especially in the levels and composition of taxes and spending. 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55 1980 1985 1990 1995 2000 2005 2010 G in i c oe ff ic ie nt Advanced (21) Asia and Pacific (14) Emerging Europe (21) Latin America and Caribbean (19) Middle East and North Africa (12) Sub-Saharan Africa (22) FISCAL POLICY AND INCOME INEQUALITY INTERNATIONAL MONETARY FUND 9 11. More recently, the public debate has focused on the sharp increase in the share of total income going to top income groups. Over the last three decades the market income shares of the richest one-percent of the population have increased substantially in English-speaking advanced economies, as well as in China and India (Figure 2). For 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 2012, while the share of the richest one-percent increased from 8 percent to 19 percent. Even more striking is the fourfold increase in the income share of the richest 0.1 percent, from 2.6 percent to 10.4 percent. There has been substantial variation across countries in how much the share of the highest income groups has risen. The increase in the share of the top one-percent has been much less pronounced in Southern European and Nordic economies, and hardly any increases have been observed in continental Europe and Japan. While there is broad consensus Box 2. Rising Public Support for Redistribution International public surveys monitor public support for redistributive policy in both advanced and developing economies. These surveys, which include the World Value Surveys (WVS), Regional Barometers, and International Social Surveys, ask citizens whether they favor more or less redistribution. In the WVS, respondents are asked to indicate, on a scale from 1 to 10, whether “incomes should be made more equal†(1) or whether the country “needs larger income differences as incentive†(10). For our purposes, we divide these responses in two categories: answers 1 to 5 indicate that the respondents prefer more redistribution, and answers 6 to 10 indicate preference for less redistribution. A similar approach is applied to other surveys to find the share of the population that supports more redistribution. The evidence indicates that public support for redistributive policies has grown in recent decades. Between the late-1990s and the late-2000s, public support for redistribution increased in almost 70 percent of the advanced and developing economies surveyed. For instance, support increased substantially in Finland, Germany, and Sweden, and also in China and India (see Figure). In the late-1990s, results for only 15 economies out of the 57 in the sample (26 percent) indicate majority support for more redistribution. By the late-2000s, the percentage of countries where a majority supported more redistribution grew to 56 percent. These findings are consistent with other surveys of public opinion (e.g., OECD, 2008; ADB, 2012). Support for redistribution grew more in countries where inequality increased and, more recently, in advanced economies where the crisis hit hardest. For instance, public support between the late-1990s and the late-2000s grew by more than 30 percentage points in China, Finland, Germany and several Eastern European countries, where the income Gini increased by over 20 percent. At the same time, support declined in countries where the Gini decreased, including in Bulgaria, Mexico, Peru, and Ukraine. Rising inequality thus seems to partly explain the increased public support for redistribution. Between 2008 and 2011, among advanced economies, public opinion changed more in favor of redistributive policies in countries that experienced large declines in GDP, such as Portugal, Ireland, and Slovenia. ALB ARG ARM AUS AUT AZE BLR BEL BIH BRA BGR CAN CHL CHN HRV DNK EST FIN FRA GEO DEU HUN ISL IND IRL ITA JPN KOR LVA LTU MKD MLT MEX MDA MNE NLD NGA NOR PER POL PRT ROM RUS SRB SVK SVN ZAF ESP SWE CHE TPE TUR UKR GBR USA URY 0.1 0.3 0.5 0.7 0.9 0.1 0.3 0.5 0.7 0.9 La te 2 00 0s Late 1990s Figure. Public Support for Redistribution Source: Integrated Values Survey 1981–2008
