Income distribution and Tax and Government Social Spending Policies in Developing Countries

1. Income distribution and Tax and Government Social Spending Policies in Developing Countries Sanjeev Gupta Fiscal Affairs Department International Monetary Fund January 28, 2003

2. Introduction • Increasing economic interdependence and some evidence of widening income disparities have hightened interest in income distribution, particularly given the ongoing debate on globalization. • In this context, what should be the role of fiscal policy as a redistributive instrument in the short and long run? • What should be the role of redistributive tax and expenditure policies in developing countries? • Is expenditure policy better for affecting income distribution in developing countries?

3. This presentation: • Provides an overview of changes in income distribution in developing countries over time on the basis of available data. • Assesses the incidence of tax and government expenditures based on existing studies of individual countries.

4. Outline • Changes in Income Distribution • Survey of chages in income distribution • Distribution in industrial versus developing countries. • The role of taxes and social spending • Determinants of Income inequality • Tax incidence • Benefit incidence • Conclusions

5. I. Changes in Income Distribution • In recent decades, many developing countries have experienced an increase in income inequality. • Both in terms of before-tax (after transfer) and after-tax income (after transfer). • There are many conceptual difficulties in such an analysis. • Market income • Disposable income • Disposable income combined with government inkind transfers (eg. education and health).

6. A. Survey of changes in income distribution • Based on a sample of 19 countries for the 1970s and 1980s, the average Gini coefficient was stable, although this masks considerable changes for some countries. • For example, inequality (as measured by the Gini coefficient) increased by one point for Venezuela, but fell by the same amount in Jamaica, Panama, and Mexico.

7. Table 1. Nineteen Developing Countries: Income Distribution, 1970s-1980s (in percent unless otherwise indicated)

8. Based on a sample of 10 countries for the 1980s and 1990s, the average Gini coefficient increased by three percentage points in the 1980s, again masking larger changes for some countries. • For example, the Gini coefficient in Peru deteriorated by 2 percentage points, while in Colombia it remained constant.

9. Table 2. Ten Developing Countries: Changes in Income Distribution, 1980s-1990s (in percent unless otherwise indicated)

10. In either period, it is not evident that prolonged economic growth, in and of itself, while having a powerful impact on poverty reduction, leads to an improvement in income distribution. • For example, income distribution deteriorated even in countries with high growth (Thailand), as well as low-growth countries (Jordan, transition economies).

11. Changes in Income Distribution Possible factors underlying these changes include: • The impact on middle-income developing countries of the opening up of low-income countries (China and India) and changes in social norms. • It may, for example, for exogenous reasons, have become socially acceptable to have larger differentials within the workplace. As more people are remunerated outside the conventional norms, adherence to these norms becomes weaker, or the socially acceptable range widens. • Opening up of low-income countries may have had an adverse effect on the wages of unskilled workers in middle-income developing countries. • Worsening asset distribution in these countries.

12. Inequality and financial crises... • The evidence on countries experiencing financial crises is mixed, depending on the coverage of data. Some studies using urban data show that inequality has increased (Argentina), while other studies using urban and rural data show that inequality declined in the aftermath of a crisis (Mexico). • This result happens despite large declines in economic growth, increased unemployment, and overall increases in poverty levels.

13. Table 3. Argentina: Average per capita Urban Household (before-tax) Income by Deciles

14. Table 4. Argentina: Evolution of the Gini Coefficient – Urban Households; Panel Income Data Table 5. Mexico: Evolution of the Gini Coefficient – Urban and Rural Houshouseholds; Cross-Sectional Expenditure Data

15. B. Distribution in Industrial and Developing Countries • Without the redistributive effects of tax and transfer programmes, income inequality is lower on average in developing countries than in industrial countries. • However, industrial countries improve income distribution effectively through taxes and transfers.

16. Table 6. Income Distribution in Industrial Countries, 1970s/80s-1990s

17. Industrial Countries In the OECD, a recent study found that market income inequality has widened in 21 of the 28 member countries for which data was available. The increased dispersion of gross earnings has been the main cause with a simultaneous increase in “work-rich” and “work-poor” shares of households. Distributional effects of public transfers and taxes • The effectiveness of taxes and transfers in reducing inequality and poverty has increased. • Targeting of benefits has increased. • Non-pension transfers form an increasingly large part of the income of low-income households among the working-age population in all countries.

18. Developing countries • The before-tax (but after-transfer) Gini coefficients for developing (and transition) economies are on average lower than the “market-income” Gini coefficients for industrial countries [Deninger and Squire, 1996] • 1990s Developing countries average = 38 percent • 1990s Industrial Countries average = 44 percent. • There are indications that tax and transfer programs in developing (and transition) countries are not as effective as those in industrial countries. • The before-tax Gini averages 38 percent • The after-tax Gini averages 34 percent.

19. Table 7. Twenty Developing (and Transition) Countries: Income Distribution, 1990s 1/

20. II. The role of taxes and social spending • Taxes and transfers affect the difference between market and disposable incomes in the short and long term. • Some taxes affect work efforts of individuals. • Excessive tax rates can drive economic activity out of the formal sector or out of the country. • Social spending policies have distributional implications through immediate benefits (health and education), but also have long-term implications on earnings capactities.

21. A. Determinants of Income Inequality • A simplistic econometric estimation on the relationship between income distribution, the tax regime, secondary school enrollment, urbanization, and inflation was carried out. • The results show that other things being equal, • Inequality (measured by the Gini coefficient) declines as the ratio of direct to indirect taxes increases. However, the magnitude of this effect is small. • Inequality increases with urbanization. • Inflation does not seem to affect the long-term evolution of income inequality. • The role of secondary education is unclear.

22. B. Tax Incidence Studies • Existing studies on tax and transfer incidence suggest that the redistributive impact of these programs is limited in developing countries: • Tax structure in these countries is dominated by indirect taxes. There is a limited menu of capital and wealth taxes; • Weak tax administration, high level of evasion, poor governance, and corruption.

23. Table 8. Developing Countries: Tax Incidence

24. Tax incidence • Survey conclusions: • Regarding overall tax systems in 19 countries which were surveyed, 13 of 36 cases reviewed are progressive, 7 are proportional, 7 are regressive, and the rest have mixed or insignificant effects. • Regarding income tax systems, 12 of 14 cases are progressive, 1 is regressive, and 1 has mixed effects. • Some studies report a decline in the progressivity of direct taxes over time.

25. C. Benefit incidence of government spending Some concepts: • Benefit incidence is the analysis of who receives the benefits of government services. • Expenditure incidence is the analysis of how government spending affects private incomes. • Spending is well (poorly) targeted if the poorest quintile’s share of benefits is larger (smaller) than that of the richest quintile.

26. Benefit incidence of government spending – (cont’d.) • Spending is progressive (regressive) if the benefits to the poorest quintile are larger (smaller) than the benefits to the richest quintile relative to the respective quintile’s income or expenditure share. • If government spending is well targeted, it will be progressive. However, progressive spending may not necessarily be well targeted. • Targeting an expenditure well is more challenging than making it progressive.

27. Survey of incidence of government spending • A survey of 55 benefit incidence studies shows that education, health and transfer programs in developing countries are generally progressive, but many are not well-targeted. • 31of 55 studies for 25 developing countries find that total education spending is progressive while 33 studies find that it is poorly targeted.

28. Table 9. Developing Countries: Incidence of Education Spending

29. Education • Government spending on primary education is reasonably well-targeted in all regions – though the degree of targeting varies. • The poorest quintile in Latin America receives more than 4 times the richest quintile in terms of primary education whereas the poorest quintile in sub-Saharan African countries gets only slightly more than the richest quintile. • On average, outlays for secondary education spending are well-targeted in Asia and Latin America but poorly targeted in sub-Saharan Africa, the Middle East and in the transition economies. • Tertiary education mostly benefits the richest quintiles in all regions.

30. Table 10. Developing Countries: Incidence of Health Spending and Transfers

31. Health Spending & Transfers • 21 of 38 studies find that government spending on health care is well targeted; 30 studies find it to be progressive; although there is wide diversity across countries. • In Subsaharan Afrca and transition economies, health spending is poorly targetedl while in Asia and Latin America, the poorest quintiles receive 1½ and 3 times as much as the richest quintiles, respectively. • Other government expenditures: transfers are progressive, but poorly targeted. • The Food stamp program of Jamaica was well-targeted as was the self-targeted food subsidies program of Tunisia. Pension and social security benefits are poorly targeted in Chile, Costa Rica and Uruguay.

32. Note that the incidence of government spending programmes is not easy to assess. • For example, government expenditure on an ineffective primary education program might end up being a cash transfer to teachers, rather than a direct benefit for schoolchildren.

33. III. Conclusions • Available data and studies indicate that income inequality in developing countries is, on average, lower than that in industrial countries, before taxes and including transfers, • Due to their more effective tax systems, industrial countries are able to improve income distribution through taxes and transfers. Most developing countries do not have comparable programs to achieve post-tax post-transfer income equality as in the industrial countries. • Sound economic and social policies help either limit a deterioration, or achieve an improvement in income distribution. High economic growth alone does not appear to ensure an improvement in income distribution.

34. Conclusions • Countries that pursued sound macroeconomic and structural policies, including sound social policies, improved income distribution, in spite of the limited focus on equity in their tax reforms. • (Indonesia, Jamaica). • The use of tax instruments for redistribution remains an interesting issue that needs to be explored. • If the progressivity of the tax system is achieved at the cost of revenue (relative to a neutral tax regime), the gains in redistribution from the tax side could be more than offset by the lost opportunities to use progressive expenditure-policy instruments.

35. Conclusions • The expenditure side of the budget offers greater scope for affecting income distribution, both pre-tax and post-tax. This will, however, require improved targeting of social programs. • There is scope for further evaluation of policies using combined incidence studies: the question is what the combined effect of tax and spending policies are on income distribution.

36. Thank you.

37. Source: Förster and Pearson, “Income Distribution and Poverty in the OECD Area: Trends and Driving Forces” OECD Economic Studies. No. 34, 2001. Figure 1. OECD Poverty rates before and after taxes and transfers, working age population

38. Source: Förster and Pearson, “Income Distribution and Poverty in the OECD Area: Trends and Driving Forces” OECD Economic Studies. No. 34, 2002/1. Figure 2. OECD: Poverty percentage point changes, mid 1980s to mid-1990s.