Essay 7: What Does the Distribution of Taxes Imply about the Distribution of Transfers?

Targeting within Universal Social Protection | 55

A second instrumental reason to focus on reducing inequality is because of the toll it can take on growth. Ostry, Berg, and Tsangarides (2014) review the growing literature on the theme and extend it, showing that lower net inequality is robustly correlated with faster and more durable growth, for a given level of redistribution. They show that it appears that redistribution has a generally benign impact on growth; only in extreme cases is there some evidence that redistribution may have direct negative effects on growth. Dabla-Norris et al. (2015) further support the case for redistribution, such as that achieved by progressive tax-transfer policies. They find that if the income share of the top 20 percent increases by 1 percentage point, gross domestic product (GDP) growth is actually 0.08 percentage point lower in the following five years, suggesting that the benefits do not trickle down. In contrast, a similar increase in the income share of the bottom 20 percent (the poor) is associated with 0.38 percentage point higher growth.

While a broad spectrum of structural policies can help reduce inequality in the long run—competition policies; equity in the provision of water, sanitation, transport, power, communications services, education, and health care; minimum wage and other labor market regulations; and so forth—the tax-transfer system has a more direct effect, with impacts possible in a short period rather than gradually over decades. Therefore, social protection programs are an important part of the toolkit to build equitable societies. Moreover, income inequality is linked to inequality of opportunity (IMF 2021), so well-focused, short-run actions to reduce income inequality can support structural efforts as well.

Essay 7: What Does the Distribution of Taxes Imply about the Distribution of Transfers?

Because the objectives of social protection include reducing poverty and/or inequality, the distribution of transfers and the taxes that support them must be considered together. Governments can achieve redistribution with flat (uniform) benefits if the taxes that support them collect (absolutely) more from those with higher welfare than those with lower welfare.11 To achieve a given level of redistribution, the more sharply progressive taxes are, the flatter may be the benefits and vice versa. Although this point is conceptually obvious, because data have been scarce, joint consideration of the empirics of tax and transfer systems was not done as a matter of course. In advanced economies, direct taxes and transfers reduce income inequality on average by about one-third (from a Gini of 0.49 to 0.31), with three-quarters of this reduction achieved through transfers,12 which reduce inequality more at the bottom while taxes do so more at the top. IMF (2017)

56 | Revisiting Targeting in Social Assistance

notes that in recent years in some advanced economies, redistributive efforts have lessened despite increased inequality in labor incomes, confirming a trend noted by Bastagli, Coady, and Gupta (2012). The lessening of progressive taxation is a theme picked up in Bussolo et al.’s (2018) study of the social contract in Europe (both Western and Eastern). They show that from the early 1980s until prior to the global recession, the share of top incomes grew, while the top personal income tax and corporate tax rates fell sharply. In the United States, tax rates on the highest income earners (95th percentile and above) fell enormously and more or less steadily from 1950 to 2018, while remaining relatively flat and constant for the rest of the distribution. By 2018, tax rates were relatively flat overall, and indeed slightly lower for the very top earners than for the lowest decile (Saez and Zucman 2019). In the OECD, the top rates for personal income taxes, dividend income, interest earnings, and corporate income have each fallen on the order of 20 percentage points (IMF 2021).

In developing economies, fiscal redistribution is much more limited, reflecting lower revenues as well as a less progressive taxation mix (Fuchs, Sosa, and Wai-Poi 2021). Total tax revenues determine how much public spending, including on redistributive policies, can be done. As figure 1.3 shows, advanced economies raise tax revenues equivalent to around 25 percent of GDP. This falls significantly for developing countries, with non-high-income countries averaging considerably less than 20 percent. Moreover, within these lower levels of tax revenues, the mix of taxes on which developing countries rely is often less progressive than in advanced economies, where over a third of all revenue is from personal income taxes, which are the most progressive, and over half is from other progressive direct taxes, such as property, payroll, and corporate income taxes. Instead, indirect taxes on consumption (such as value added and excise taxes) make up the majority of the tax revenue base in developing countries as well as non-OECD high-income countries. Such taxes, which usually impose the same rate for all purchasers of goods, are more regressive than income taxes.13 Even when exemptions and lower rates are placed on staples consumed more by the poor, richer households enjoy more of the savings due to their higher consumption.

Evidence for jointly considering the tax and transfer impacts in developing countries has been boosted by the Commitment to Equity project in recent years, as well as its inclusion as a Sustainable Development Goal indicator in March 2020, and shows a variable and cautionary picture. Inchauste and Lustig (2017) initially compiled comparative evidence from 17 low- and middle-income countries. For the years studied, the effect of taxes and transfers on the Gini was limited, at less than 4 points in all countries, with only South Africa (7.7) as an exception.14 Rodriguez and Wai-Poi (2020) include a wider comparison of fiscal redistribution in 42 developing