Inequality and Fiscal Policy
Chapter

Chapter 4. Fiscal Redistribution in Developing Countries: Overview of Policy Issues and Options

Author(s):
Benedict Clements, Ruud Mooij, Sanjeev Gupta, and Michael Keen
Published Date:
September 2015
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Author(s)
Francesca Bastagli, David Coady and Sanjeev Gupta 

Introduction

The developing world has experienced sustained economic growth and poverty reduction during the past two decades. Globally, income inequality has also been on a steady downward trend driven by relatively high growth in developing countries and a decline in between-country income inequality (Pinkovskiy and Sala-i-Martin 2009). However, the persistence of high, and often rising, income inequality in many developing countries is a growing concern for policymakers and the public. In a survey of policymakers in Asia, about 70 percent of respondents answered that concerns about income inequality had increased during the past decade, and more than half disagreed with the statement that rising income inequality is acceptable so long as poverty is declining (Kanbur, Rhee, and Zhuang 2014). A public opinion survey in Latin America found that about 90 percent of the population regarded the existing income distribution in their country as unfair or very unfair (Latinobarómetro 2003). Evidence from public surveys also indicates that widening income inequality has been accompanied by growing public demand for income redistribution across the developing world (IMF 2014a).

This chapter discusses the role of fiscal policy in reducing income inequality in developing countries. The objective is to provide an overview of issues that arise in the context of designing redistributive fiscal policies rather than to provide an exhaustive review of country studies. It adds to the existing literature on fiscal redistribution in developing economies by taking a global (as opposed to regional) developing-country perspective of fiscal redistribution.1 It discusses how tax and spending policies can be designed to minimize the trade-off between efficiency and equity objectives, emphasizing the importance of taking a comprehensive approach that considers the combined redistributive and efficiency impacts of taxes and spending, and of encompassing both design and administration issues. In practice, since existing tax and spending policies in many developing economies suffer from numerous design and implementation inefficiencies, fiscal reforms that improve the redistributive impact of fiscal policy can actually be efficiency enhancing.

The chapter is structured as follows: The available empirical evidence on the level and trends in income inequality in developing countries over recent decades is reviewed. The extent of fiscal redistribution in developing countries is discussed. How the redistributive role of fiscal policy can be enhanced in developing countries while containing any efficiency-equity trade-offs is then addressed, followed by a summary of the findings.

Income Inequality in Developing Countries

Over recent decades, inequality in the distribution of per capita income has increased in many countries across the developing world. Table 4.1 reports the percentage point change in the Gini coefficient between 1990 and 2010 by country and shows that 46 countries out of the 89 developing countries for which data over this time span are available experienced an increase in inequality.2 Some 20 countries, including large developing countries such as China, Indonesia, and South Africa, experienced increases of more than 5 percentage points. Inequality rose in most countries in Asia and the Pacific and in the Middle East and North Africa. Although average inequality fell in sub-Saharan Africa during this period, it still rose by more than 3 percentage points in more than one-fourth of these economies. Inequality also increased in more than one-third of countries in Latin American and the Caribbean, although, on average, it declined slightly. However, since 2000, the Gini coefficient has steadily declined in nearly all countries in Latin American and the Caribbean.

Table 4.1Changes in Disposable Income Inequality, 1990–2010(Percentage point change in Gini coefficient)
Large Increase (Change ≥ 5)Medium Increase (3 ≤ Change < 5)Small Increase (0 < Change < 3)Small Decrease (-3 < Change ≤ 0)Medium Decrease (-5 < Change ≤ -3)Large Decrease (Change ≤ -5)
Latin America and the CaribbeanParaguayCosta Rica, ColombiaUruguay, Honduras, Jamaica, GuatemalaDominican Republic, ArgentinaVenezuela, Mexico, PanamaChile, Peru, El Salvador, Brazil, Ecuador, Bolivia, Nicaragua
Sub-Saharan AfricaRwanda, Ghana, South AfricaCôte d’Ivoire, Nigeria, TanzaniaZambia, MozambiqueBurundi, Uganda, Madagascar, Niger, CameroonCentral African Republic, Lesotho, Ethiopia, Guinea, Kenya, Swaziland, Burkina Faso, Senegal, Mali
Asia and the PacificChina, Sri Lanka, Lao P.D.R., IndonesiaMongolia, Taiwan Province of China, BangladeshIndia, NepalCambodia, Malaysia, Vietnam, PhilippinesThailand
Middle East and North AfricaTurkmenistan, Kyrgyz Republic, Uzbekistan, IsraelTajikistan, Morocco, TunisiaMauritania, EgyptPakistanJordan, Iran
Emerging EuropeLithuania, Croatia, Latvia, FYR Macedonia, Slovak Republic, Czech Republic, Albania, PolandMoldova, Belarus, Georgia, KazakhstanBulgaria, Ukraine, SloveniaAzerbaijan, HungaryTurkeySerbia, Estonia, Armenia

More striking are the persistent differences across regions. Figure 4.1 presents the most recent data available on income inequality for advanced and developing countries, clearly showing a large gap. These regional differences are much more significant than the increase in average income inequality in recent decades. Based on the data in Table 4.1, between 1990 and 2010 the average inequality in each region changed by less than 3.25 percentage points. In contrast, average inequality in the two most unequal regions (sub-Saharan Africa and Latin America and the Caribbean) remained 12 percentage points higher than the two most equal regions (emerging Europe and the advanced economies).

Figure 4.1Disposable Income Inequality in Advanced and Developing Countries

Source: Authors’ calculations based on data from Bastagli, Coady, and Gupta (2012).

Note: PPP = purchasing power parity.

Redistributive Fiscal Policy in Developing Countries

The redistributive impact of fiscal policy depends not only on the magnitude of tax and spending but also on the composition of tax and spending (for example, the relative balance between indirect and direct taxes or between universal or means-tested transfers). If the combined redistributive impact of tax and spending is progressive, then the higher the level of tax and spending in a country the larger is the redistributive impact. Similarly, for a given level of tax and spending, the more that revenue collection is concentrated in redistributive taxes (for example, progressive income taxes) and the more that spending is concentrated in redistributive transfers (for example, well-targeted social transfers), the greater the redistributive impact of fiscal policy.

The evidence presented in the previous chapter clearly shows that fiscal policy has played a significant redistributive role in advanced countries, with direct income taxes and transfers reducing the income Gini coefficient by an average of about one-third, with the transfer side accounting for two-thirds of this. The potential redistributive impact of fiscal policies in developing countries is substantially reduced compared with advanced economies, reflecting differences in both the levels and the composition of tax and spending. Figure 4.2 presents the magnitude of tax and social spending in advanced and developing countries. Whereas average tax ratios for advanced economies exceed 30 percent of GDP, ratios in developing economies generally fall in the range 15–20 percent of GDP.3 As a result, social spending, which includes social protection spending as well as education and health spending, is also substantially lower in developing economies, but especially in Asia and the Pacific and in sub-Saharan Africa.

Figure 4.2Levels and Composition of Tax Revenues and Social Spending, 2010

Source: IMF database.

Note: Numbers in brackets refer to number of countries in the {tax; spending} country samples.

The redistributive implications of lower tax and spending can be seen by comparing the redistributive impact of fiscal policy in Latin America (the region with the highest average level of income inequality, and higher tax and spending levels compared with other developing countries) with the impact in advanced economies (the region with the lowest average level of income inequality).4 The average Gini coefficients of market income for a sample of advanced and Latin American economies were 0.46 and 0.53, respectively (Figure 4.3). The corresponding coefficients for disposable income were 0.29 and 0.49, respectively. Therefore, whereas income taxes and transfers reduced the Gini by 0.17 in the sample of advanced economies, it decreased it by only 0.04 in the sample of Latin American economies. In other words, about two-thirds (0.13 out of 0.20) of the difference in average inequality of disposable income between advanced and Latin American countries is explained by differences in the redistributive impact of taxes and transfers.

Figure 4.3Redistributive Impact of Income Taxes and Transfers in Advanced and Developing Countries, Mid-2000s

Sources: Lustig, Pessino, and Scott (2014); Goñi, López, and Servén (2011).

Note: Diamonds denote developing countries and circles advanced economies. Data labels in the figure use International Organization for Standardization (ISO) country codes.

The composition of tax and social spending in developing economies also reduces the redistributive impact of fiscal policy. On the tax side, the redistributive impact is limited by greater reliance on indirect taxes (Figure 4.4). Overall, indirect taxes tend to be either slightly progressive or slightly regressive, and therefore have only a small impact on income distribution (Chu, Davoodi, and Gupta 2004; Gemmell and Morrissey 2005; Coady 2006). Income taxes, however, have been found to be progressive (Gemmell and Morrissey 2005). Within indirect taxes, trade (mainly import) taxes also have a relatively high share, especially in low-income countries, although this share has been decreasing in recent decades. Incidence studies have typically found that import taxes are regressive,5 while excise taxes—such as fuel, alcohol, and tobacco excises—tend to be progressive. The distributive impact of value-added taxes has been found to be mixed (Bird and Zolt 2005; Coady 2006); while Sahn and Younger (1999) find that the value-added tax is progressive in some African countries, other studies have found that it can be less progressive than the consumption taxes it has replaced, so that such reforms can be on net regressive (Munoz and Cho 2003; Hossain 1995, 2003; Tareq and others 2005). However, these studies also find that the progressivity of a value-added tax can be enhanced through the adoption of lower rates for basic goods or by setting the registration threshold high enough to exclude most small-scale enterprises, which tend to be used more intensively by lower-income groups (Jenkins, Jenkins, and Kuo 2006).6

Figure 4.4Composition of Tax Revenues, Late 2000s

(Percent)

Source: IMF database.

Note: Numbers in brackets denote country sample size.

Although spending on education and health can decrease income inequality and poverty in the medium term by increasing the future incomes of lower-income groups (De Gregorio and Lee 2002), it does not decrease current disposable income inequality (it may, however, free up resources for other consumption). Thus, the high share allocated to education and health spending can introduce a trade-off between lower current income inequality and lower future income inequality. However, existing benefit-incidence studies show that the redistributive impact of education and health spending in the medium term is compromised by the regressivity of this spending in many developing countries, but especially in low-income countries where access levels are much lower for poor households (Figure 4.5).7 But 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 so that the average progressivity of spending should increase over time (van de Walle 1995).

Figure 4.5Average Benefit Incidence for Education and Health Spending

(Percent of public spending going to poorest 40 percent of households)

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

Note: Data labels in the figure use International Organization for Standardization (ISO) country codes.

The much lower coverage of social insurance (mainly pensions) in developing countries, especially among lower-income groups, is a key factor behind the lower redistributive impact of social spending. In most developing economies, participation in social insurance schemes is restricted to workers in the formal sector and to public sector employees. Data for the early 2000s show that the share of the population older than the legal retirement age in receipt of a pension in developing economies was, on average, about 40 percent in the Middle East and North Africa and in Latin America and the Caribbean, and about 25 percent in Asia and the Pacific and in sub-Saharan Africa, as compared with 90 percent in European economies (ILO 2010). With coverage heavily skewed toward higher-income groups, lower-income groups receive a very small share of the benefits—in more than half of a sample of developing countries with data, fewer than 10 percent of the poorest 40 percent of households received a social insurance benefit, and these households received less than 10 percent of total social insurance spending (Figure 4.6, panel 1).

Figure 4.6Social Protection: Coverage and Benefit Shares

(Percent)

Source: World Bank Aspire database.

Note: For presentational purposes, Mexico (79, 0) and Thailand (99,1) are excluded from the social insurance figure.

Low social assistance spending in most developing economies results in low coverage of the poor and substantial leakage of benefits to the non-poor—in more than half of the countries for which data are available, fewer than half of the poorest 20 percent of households received some social assistance, and these households received less than a quarter of total assistance spending (Figure 4.6, panel 2). At the same time, many developing countries allocate large sums to energy subsidies by setting consumer prices below cost-recovery levels (known as pretax subsidies), although these subsidies are often not recorded in the budget (in oil producers, for example). Posttax energy subsidies, which arise when energy prices are below levels that reflect cost recovery plus an optimal tax to reflect revenue needs and the environmental cost of energy consumption, are significantly larger. Recent estimates show that subsidies are especially large in oil-exporting countries but are also large in many other developing countries (Clements and others 2013). Most of the benefit from such universal subsidies accrues to higher-income groups; a recent review of country studies finds that the top income decile receives seven times more in subsidies than the bottom decile (Arze del Granado, Coady, and Gillingham 2010). Therefore, these subsidies reinforce rather than reduce income inequality and crowd out more redistributive social spending

Options for Enhancing Efficient Fiscal Redistribution in Developing Countries

Enhancing the capability of fiscal policy to address income inequality in developing economies will require strengthening both their resource mobilization capacity their capacity to use more progressive tax and spending instruments. While many low-income countries may prioritize reducing poverty over reducing broader inequality, many middle- and lower-middle-income countries, where poverty rates have decreased substantially with economic growth, are increasingly emphasizing the need for a more inclusive growth process. At the same time, most developing economies are constrained by low tax ratios while facing increasing demand for public investments in education, health, and physical infrastructure to help stimulate or sustain economic growth. Strategies for enhancing the redistributive impact of fiscal policy therefore need to recognize these competing objectives.

The theoretical literature on the design of efficient redistributive fiscal policies in developing economies provides some basic guiding principles (Newbery and Stern 1987). First, income-based instruments, such as direct income taxation and means-tested transfers, are more efficient at achieving redistributive goals than are other policy instruments (Atkinson and Stiglitz 1976). Second, where access to such direct tax and transfer instruments is restricted (for example, because of administrative or political constraints), it may be desirable to replace these instruments with instruments that link taxes and transfers to household characteristics that are highly correlated with income (so-called tagging) such as whether a member has a disability, whether the household is headed by a female or a widow, and the number of children and elderly in the household (Akerlof 1978). Third, consumption-based indirect taxes or subsidies do not redistribute income efficiently since higher-income households typically account for a substantially greater proportion of consumption than do lower-income households (Sah 1983). However, where governments do not have access to efficient direct income-based tax and transfer instruments, consumption taxes may have a distributive role. However, because the amount of redistribution that can be achieved through differential consumption taxes and subsidies is limited, and because such taxes and subsidies distort consumption patterns, there is a high return to the development of more effective direct transfer instruments that allow indirect taxes to focus more on raising revenue to finance more efficient redistributive transfers. Fourth, corrective Pigouvian consumption taxes levied on consumption goods that generate negative social externalities (for example, reflecting pollution from the consumption of fossil fuels, or the adverse health or social impacts from alcohol or tobacco consumption) can provide a “win-win” opportunity for efficient redistribution when their consumption is highly concentrated among higher-income groups.

In summary, where administrative constraints limit the range of direct tax and transfer instruments available to a government, a mix of direct and indirect instruments is often desirable. The corollary is that there are typically substantial efficiency and equity gains to be had from the development of greater administrative capacity to effectively implement direct tax and transfer instruments. In addition, as noted earlier, the design of efficient redistribution should focus on the combined redistributive impact of taxes and spending.

Tax Reform Options

Increasing tax ratios in developing economies is a key component of any strategy for enhancing fiscal redistribution while addressing competing public spending needs.8 Low tax ratios in developing countries have been attributed to the greater importance of sectors (such as small-scale agriculture and small-scale or informal enterprises) for which information gathering is extremely difficult since literacy is low, record-keeping is poor or nonexistent, and administrative systems are often weak (Musgrave 1969; Goode 1984).9 As economies develop, the number of formal market transactions tends to increase, population literacy improves, and government administrative systems become more effective. These advances, in turn, enable a widening of the tax base and an expansion of the set of feasible tax instruments (Gillis 1989). These trends are reinforced by increasing demand for publicly provided goods and services.

In practice, tax structures in many developing economies have evolved in an ad hoc manner in response to various internal and external pressures, and reflect a host of historical, social, political, and economic factors. The resulting inefficiencies and inequities, reflecting both design and administration shortcomings, mean that “win-win” opportunities for increasing tax revenues while improving the efficiency and equity of the system are likely to be available. Realizing these efficiency and equity gains will require improvements in both the design and the administration of tax policy focused on broadening income and consumption tax bases by reducing exemptions and loopholes and strengthening compliance.10 Continued reliance on a small base of compliant taxpayers to increase tax ratios is likely to exacerbate the distortionary impact of taxes and the existing inequities without raising much extra revenue.

During the past decade, many developing economies have managed significant increases in tax ratios. The median change in the tax ratio during 2000–10 ranged from slightly more than 3 percent of GDP in Asia and Pacific and Latin American and Caribbean countries to less than 2 percent in sub-Saharan Africa and about 1 percent in the Middle East (Figure 4.7). Most of the increase reflects increases in revenues from indirect taxes and corporate taxes. Tax ratios actually fell in more than half the countries in the Middle East and North Africa, a third of countries in Asia and Pacific, and in a quarter of countries in sub-Saharan Africa. However, the high degree of variation in tax ratios across developing economies at similar levels of development suggests that there is ample scope to increase tax revenues in many countries.

Figure 4.7Increases in Tax Ratios in Developing Economies, 2000–10

Source: IMF staff calculations.

Note: Samples only include countries in which tax ratios increased. Numbers in brackets refer to number of countries {where tax ratio increases, in full sample}.

Personal Income Taxation

A key challenge in developing economies is to develop more effective progressive personal income tax (PIT) systems. The median income tax ratio is 7.9 percent of GDP in advanced economies, but substantially lower in developing economies, ranging from 1.9 percent in the Middle East and North Africa to about 1.6 percent in other regions. Although PIT systems in developing economies often use progressive tax schedules, narrow tax bases—due to high income tax thresholds, widespread exemptions, and the preferential treatment of capital and other income—contribute to low effective income tax progressivity.11 In many countries, PIT revenues come mainly from wage tax withholding on large enterprises and public sector employees (Peter, Buttrick, and Duncan 2010). This situation is exacerbated by administrative systems that suffer from weak detection and enforcement capacity, thereby resulting in high levels of tax evasion, especially by high-income groups. Although distributional and administrative considerations point to the desirability of relatively high income thresholds for income tax liability, these thresholds may still be too high in some countries. For example, whereas in the OECD the median threshold is about 25 percent of per capita income, in 16 developing economies the threshold exceeds twice per capita income (Peter, Buttrick, and Duncan 2010).12 At the same time, some developing countries do not allow for any threshold—all income groups are liable for income tax (USAID 2013).

Therefore, to increase income tax ratios, improvements will be required in both the design and implementation of income tax regimes, primarily with a focus on broadening the income tax base rather than increasing tax rates (Crandall and Bodin 2005; Kloeden 2011; Zake 2011; IMF 2011). On the design side, broadening the base will require lowering the thresholds for tax liability and for top-income tax rates where these are high, and reducing exemptions, privileges and loopholes so that all income is taxed in the same manner regardless of source to avoid distorting economic activities. On the administrative side, more active segmentation of income-tax-payers (for example, high- and middle-income groups, self-employed earners, and agriculture) will be required to address the challenges associated with collecting income taxes from these groups—many countries have already created large-taxpayer offices as part of this strategy.

Corporate Income Taxation

As a share of total revenues, corporate tax revenue is even more important in developing economies than in advanced. Despite decreasing tax rates worldwide, corporate tax revenues have actually increased as a share of GDP in developing economies since the early 1990s. However, international tax competition will present increasing challenges to developing countries in protecting corporate tax revenues (IMF 2014b).13

Ensuring sufficient corporate income tax revenues is desirable for raising revenue efficiently and equitably. In the short term, corporate taxation tends to be highly progressive since recipients of capital income tend to be higher-income groups. However, in the long term, the incidence of corporate taxes on wages and capital income depends on the relative mobility of capital and labor across both sectors and countries (Auerbach 2006). If capital is more internationally mobile, the incidence of corporate taxes will tend to fall more on wages to the extent that labor is immobile.14 Empirical evidence on the long-term 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), reducing its redistributive impact since wage earners typically have lower mean incomes than do those with capital income.

As with personal income taxation, increasing (or protecting) corporate income tax ratios will require improvements in both the design and implementation of corporate tax regimes with a focus on broadening the income tax base rather than increasing tax rates. Given administrative constraints in implementing PITs, corporate taxation can work like an income withholding tax in developing economies by taxing income before it gets distributed to corporate owners. Therefore, for efficiency reasons, it is important to harmonize PIT rates across different sources of capital income. Although the growing international mobility of capital and associated evasion and avoidance opportunities present increasing administrative difficulties for developing countries, the associated efficiency costs can be contained by setting corporate income tax rates lower than PIT rates, having a common tax treatment of different types of capital income (including reducing tax exemptions),15 increasing the use of withholding taxes (especially where administration is weak), and strengthening the taxation of multinational businesses that use a variety of tax-planning strategies to reduce their global tax liabilities.

Indirect Taxation

Efficiency considerations suggest that indirect taxes should fall on final consumption (and not intermediate consumption to avoid distorting production decisions), with higher rates on goods that are less price elastic. In general, then, there is a trade-off between efficiency and equity objectives when designing indirect taxes since necessities tend to have relatively low elasticities but account for a larger share of the budgets of lower-income households. When countries have access to effective redistributive spending instruments, the design of indirect taxes should focus mainly on raising revenue efficiently, although tax administration considerations suggest that the number of rates should be minimized. However, where administrative constraints also limit the availability of effective redistributive spending instruments, lower tax rates on goods that are relatively important in the budgets of low-income households (for example, basic foods) may be warranted on distributional grounds. But, again, administrative constraints on the tax side also suggest that the number of rates should be minimized.16 Specific excises on such goods as cigarettes, alcoholic beverages, gambling, motor fuels, and luxury goods can also raise significant revenue and increase tax progressivity while also helping to internalize consumption externalities and to promote socially desirable consumption patterns.

The gradual shift from trade taxes to broader consumption taxes in developing countries in recent decades has improved the efficiency and equity of indirect tax systems (Newbery and Stern 1987; Keen and Simone 2004).17 As trade taxes have decreased in importance, more broad-based consumption taxes have increased. A more contentious issue has been the equity implications of replacing sales taxes with a value-added tax (VAT), which has happened in most developing countries. As seen earlier, the equity implications will depend on how the VAT is designed. Although some studies find that the VAT has been less progressive than the sales taxes they replaced, other evidence shows that the progressivity of a VAT can be enhanced by adopting lower rates for basic goods or by setting the registration threshold high enough to exclude most small-scale businesses. The relatively large administrative and compliance costs associated with the VAT, especially for small traders, also make it desirable to adopt VAT registration thresholds that exclude small businesses. Given that the standard VAT rate is already high in many countries, emphasis should be placed on reducing the use of exemptions and reduced rates by restricting them to goods that are particularly important in the budgets of lower-income households (for example, basic foods).

Social Spending

Although higher levels of social spending can enhance the redistributive impact of fiscal policy in developing economies, there is also substantial scope for improving the redistributive impact of existing spending in many countries. The importance of such improvements is further reinforced to the extent that countries find it difficult to increase tax ratios to finance higher spending in the short term. In addition, countries need to make difficult choices between increasing education and health spending as a way of addressing income inequality and poverty in the medium term, and increasing social protection spending to address current inequality and poverty.

The relatively small redistributive impact of public transfers in most developing economies is due in large part to the limited coverage of public pension systems of lower-income groups. In addition, these pension systems often require significant financing from general government revenues, thus crowding out more redistributive social spending. Given that the primary focus of these programs is social insurance, from a redistribution perspective it is desirable to prioritize parametric reforms that put existing systems on a sound financial footing and reduce the need for financing from general revenues before scaling up program coverage. Doing so could free up resources to finance, for example, an expansion of noncontributory “social pensions” that provide a flat pension aimed at poverty reduction (Holzmann, Robalino, and Takayama 2009). Social pensions exist in a number of developing countries, including low-income countries (for example, Bangladesh, Brazil, Chile, Costa Rica, Ethiopia, India, Nepal, Madagascar, South Africa, and Thailand). Setting these pensions at a level sufficient to alleviate poverty can help reduce incentives to remain outside the formal pension system and also contain their fiscal cost.18 If sufficient administrative capacity exists, then means testing can further contribute to containing the fiscal cost.

Many developing economies could also enhance the effectiveness of their social assistance programs by addressing key design and implementation shortcomings. Most developing economies rely on a diverse set of poverty alleviation programs, including cash transfers, food or other in-kind transfers, public workfare, fee waivers (for example, for education and health services), and price subsidies (especially for food and energy). These programs often fall short of their redistributive objectives, and their cost-effectiveness could be greatly improved by reforms to address the following shortcomings (Grosh and others 2008):

  • Fragmentation and duplication—Many countries have a myriad of small programs with overlapping objectives spread across various ministries with little or no coordination. This increases the fixed administrative costs associated with program implementation.

  • Bad targeting—Many of the targeting approaches used are badly designed (for example, based on weak or loosely specified tagging that is not well correlated with poverty), resulting in substantial leakage of benefits to non-poor households and increasing the fiscal cost of these programs.

  • Low coverage and benefits—The low level of spending spread across numerous small programs with high leakage leads to low coverage of the poor and low benefit levels.

  • Reliance on costly in-kind benefits—Some countries spend significant amounts on food distribution programs that are prone to large leakages (including from theft and wastage) and involve large overhead costs. Overhead costs can be as much as 50 percent higher than the value of the in-kind benefit to beneficiaries.

  • Reliance on universal price subsidies—Many countries spend substantial amounts on universal price subsidies. Reflecting the overall inequality of consumption, most of the benefit from these subsidies accrues to higher-income households.

Consolidation of benefits into a smaller number of programs with clearly established objectives can help reduce the cost of these programs and improve efficiency. Together with improved targeting and the scaling down of price subsidies, consolidation will enhance the poverty impact of existing spending and create the fiscal space to finance the development of more effective safety net programs with expanded coverage and adequate benefit levels.19

Many low- and middle-income developing countries have extensive public works programs that play an important role in addressing persistent or seasonal poverty as well as protecting households from income shocks. These programs have been successfully implemented in a range of settings, including in the wake of natural disasters and economic crises as well as in postconflict states, although the precise design needs to reflect the differing administrative capacity in emerging and low-income countries (Subbarao, del Ninno, and Rodriguez-Alas 2013). Public works programs can be designed to encourage self-selection of the poor, which can reduce the fiscal costs and avoid crowding out private sector jobs. This self-selection can be achieved by setting wages below those prevailing in the market for unskilled labor so that programs will only attract those without other opportunities. This design also allows for the automatic scaling down of programs in the aftermath of a crisis as higher-wage job opportunities expand. If timed to avoid coinciding with peak employment seasons (for example, during agricultural harvests) this can prevent crowding out of private sector jobs. However, these cost-effective design features can make public works programs ineffective (or even counterproductive) at addressing severe shocks such as prolonged drought when those affected may be too weak to work (Bastagli and Holmes 2014). Even in normal times, the work requirement may exclude those incapable of work such as the physically or mentally disabled. In both these circumstances, unconditional transfers are likely to be more effective. Countries with greater administrative capacity can also enhance the developmental role of these programs by putting greater emphasis on the infrastructure and training components of these programs (these programs are often referred to as “social funds”). However, the need to allocate a greater share of resources in these programs to capital and administrative costs introduces a trade-off between addressing current poverty (through wages) and future poverty (through infrastructure development).

Turning to education and health spending, enhancing its progressivity requires that expansion be focused on increasing the access of low-income groups to quality education and health services. For education, this requires expanding enrollment and progression rates in primary and secondary education, which will eventually also help improve the progressivity of spending on higher levels of education as average education attainment increases for lower-income groups relative to the population average. But sufficient attention needs to be given to ensuring that quality education services are delivered, which will enhance future earnings capacity. At the tertiary level, increasing demand in the context of tight public finances has often resulted in a decline in the quality of instruction in public institutions and growth in private education institutions (Woodhall 2007; Hanushek and Woessmann 2011; Pritchett 2013). Since much of the benefit from tertiary education accrues to graduates in the form of higher earnings and other nonmonetary benefits, a strong case can be made for financing more of this cost from tuition fees. However, means-tested income support is still required to ensure lower-income groups can also access tertiary education services. Increasing private financing also allows tertiary education to expand in response to growing demand for skilled labor without increasing public spending.

For health, there is a growing consensus that ensuring universal access to a fiscally sustainable, publicly financed basic package of health services is required to generate substantial improvements in health outcomes and to enhance the progressivity of public health spending (Jamison and others 2013). Access to a broad package of essential health services (including primary care) is still incomplete in many developing economies. As a consequence, the poor often forgo or delay necessary care at an early stage of illness when treatment is more cost-effective. Many households fall into poverty because of high out-of-pocket spending and many others are just one major illness away from poverty. In particular, preventive care, such as immunizations, should be offered free of charge given their large social benefits.

The recent expansion of “conditional cash transfer” programs provides a promising approach to enhancing the distributive power of public spending in developing economies while also addressing the trade-off between using income transfers to reduce current poverty and in-kind transfers (that is, education and health) to reduce future poverty. These programs typically target the poorest households, link benefits to the number of children, and condition continued eligibility on attendance of children at health clinics and school. In many countries conditional cash transfers have been used to consolidate a number of existing programs to reduce administrative costs and improve effectiveness.20 The use of proxy means testing has helped reduce the fiscal cost of these programs without generating any significant work disincentives. The largest such programs are in Brazil (Bolsa Familia) and Mexico (Oportunidades), which in 2012 cost 0.5 percent of GDP and 0.8 percent of GDP, and covered one-quarter and one-fifth of the population, respectively.21 These programs have had substantial impacts on poverty and inequality, as well as education and health outcomes, and can help increase investment by alleviating credit constraints (Fiszbein and Schady 2009). In addition, they indirectly affect the inequality of market incomes over time by decreasing the inequality of education outcomes.22 However, since they require adequate administrative capacity to implement means-testing and monitor conditionality, as well as ensuring that the targeted poor populations have access to basic education and health services, they are more challenging for economies with limited administrative capacity.23

Conclusion

This chapter highlights the important role of fiscal policy in achieving distributional objectives in developing economies. Evidence from advanced countries shows that fiscal policy reduces income inequality by about one-third, and that the extent of fiscal redistribution is substantially higher if in-kind spending is included. However, the extent of fiscal redistribution is much more limited in developing economies because of their lower tax and spending levels as well as the composition of this tax and spending. Comparing average inequality levels in Latin America and the Caribbean (the region with the highest level of income inequality) with levels in advanced economies (the region with the lowest income inequality), the chapter shows that differences in the extent of fiscal redistribution can explain two-thirds of the difference in average income inequality after taxes and transfers between these regions. On the tax side, fiscal redistribution is limited by the heavy reliance on indirect taxes, which have little impact on income distribution. On the spending side, the high share of education and health spending (which only affect income distribution in the medium term) in total social spending, and the high share of social insurance (mainly pensions) that benefits mainly higher-income groups, limit the impact of fiscal policy on income inequality. In addition, low coverage of social assistance spending with substantial leakages to higher-income groups further reduces the extent of fiscal redistribution.

Increasing tax ratios in developing economies is a key component of any strategy for enhancing fiscal redistribution while addressing competing public spending needs. Improvements in both the design and administration of tax policy, focused on broadening income and consumption tax bases by reducing exemptions and strengthening compliance, will be required to increase tax ratios. Although the primary role of taxes is to raise revenue efficiently to finance redistributive transfers, taxes can also be progressively designed to directly contribute to the achievement of equity goals. From a design perspective, this can be accomplished by expanding personal income taxation by lowering the tax-exempt income threshold and possibly the top-income tax threshold, better integrating the corporate income tax system with the personal income tax system (with possibly a lower rate for corporate income tax), and reducing tax exemptions and preferential tax rates. On the administrative side, tax compliance can be improved by more active segmentation of income-tax-payer groups to address the different challenges associated with collecting income taxes from these groups. The limited potential for redistribution through differential consumption taxes combined with administrative considerations points to minimizing the use of exemptions and reduced rates and adoption of a registration threshold that excludes small traders. These measures will both enhance the efficiency and progressivity of taxes and increase income tax ratios to help finance greater redistributive and other public spending.

Although higher levels of social spending can enhance the redistributive impact of fiscal policy in developing economies, there is also substantial scope for improving the redistributive impact of existing spending in many countries. Competing development needs for spending and the challenges faced in increasing tax ratios mean that many developing countries will need to give priority to designing well-targeted transfer programs and avoid the use of fiscally expensive universal price subsidy schemes. With social insurance, which currently disproportionately benefits higher-income groups, priority could be given to parametric reforms that put existing systems on a sound financial footing and reduce the need for financing from general revenues. To the extent that social pensions are expanded, benefit levels can be kept low enough to reduce disincentives for contributing to formal social insurance schemes and means tested to contain fiscal costs.

The effectiveness of social assistance can be enhanced by reducing fragmentation and duplication, improving targeting and expanding coverage, and reducing universal price subsidies. The effectiveness of public works programs can be improved by the appropriate use of wage-setting practices to encourage self-selection; an emphasis on labor-intensive projects in countries in which administrative capacity is weak; and the incorporation of development objectives when administrative capacity is higher, which allows greater emphasis to be put on the infrastructure and training components of these programs. Enhancing the redistributive impact of education and health spending requires that expansion be focused on increasing access for low-income groups to quality education and health services. In this respect, the expansion of “conditional cash transfer” programs, which target the poorest households and condition transfers on accessing education and health services, provides a promising approach to enhancing the distributive power of public spending in developing economies while also addressing the trade-off between using income transfers to reduce current poverty and in-kind transfers (that is, education and health) to reduce future poverty.

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For a regional perspective, see Claus, Martinez-Vazquez, and Vulovic 2014 for Asia; Cubero and Hollar 2011 for Central America; and Breceda, Rigolini, and Saavedra 2009 and Lustig, Pessino, and Scott 2014 for Latin America and the Caribbean.

In this chapter, the term “developing” countries includes emerging market European countries.

Although total revenue (which includes nontax revenues and external grants) is higher in all regions, the pattern across regions is similar with the exception of countries in the Middle East and North Africa, where total revenues are, on average, closer to the higher levels observed in many advanced and emerging European economies.

Such a comparison is not possible for other regions given the absence of comprehensive country studies of the redistributive impact of taxes and transfers.

However, studies using general equilibrium models tend to find that import taxes on unskilled-labor-intensive goods (for example, food) are highly progressive because of large increases in unskilled wages (Hertel and Reimer 2005). However, these taxes are also extremely inefficient since they distort production and consumption decisions. In addition, they are extremely blunt redistributive instruments because they tend to benefit some poor households while hurting other poor households (Coady, Dorosh, and Minten 2009).

The results from computable general equilibrium models also support the findings that excise taxes are progressive and that the distributional implications of the value-added tax depend on how basic foods are treated (see Coady 2006 for a review).

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. See Demery 2000 for more details.

This section draws on IMF 2011, which provides a detailed discussion of tax administration and design challenges in developing countries. The focus of this chapter is tax revenues. Although in some developing economies nontax revenues (primarily resource-based taxes) are important, the design of efficient fiscal regimes for taxing resource revenues is outside the scope of this chapter. For a detailed discussion of resource tax regimes, see Daniel, Keen, and McPherson 2010. For a discussion of the trade-offs faced in using resource revenues for redistribution, see Gupta, Segura Ubiergo, and Flores 2014.

There is a substantial literature on the reasons behind low tax ratios in developing economies, including Ahmad and Stern 1989, Burgess and Stern 1993, Heady 2002, Keen and Simone 2004, and Gordon and Li 2009.

Although taxation of wealth is typically considered to be both efficient and equitable, it is not widely used, and the effective tax rate has dropped from an average of about 0.9 percent in 1970 to about 0.5 percent in 2010. Among developing countries, only Colombia, Namibia, South Africa, and Uruguay collect more than 1 percent of GDP through recurrent property taxes. Wealth taxes include a range of options such as recurrent taxes on property or net wealth, transaction taxes, and inheritance and gift taxes. IMF 2013 discusses the scope for increasing revenues from wealth taxes. In the context of developing countries, the most promising revenue source is probably property taxes, which average about half a percent of GDP in developing countries compared with more than 1 percent in advanced economies (Bahl, Martínez-Vázquez, and Youngman 2008). However, since implementing property taxes would require a significant investment in administrative infrastructure, it is probably only feasible in the medium term (Norregaard 2013).

A study by Modi (1987) finds that, on average, less than 5 percent of the population in developing countries pays PIT (compared with 50 percent in advanced countries) and less than 15 percent of the income is taxable (compared with 57 percent in advanced countries).

With respect to the upper end of the PIT schedule, Peter, Buttrick and Duncan (2010) find that top PIT rates start at about 18 times per capita income in upper-middle-income countries and at 83 times in low-income countries.

The impact on wages is reduced where the home country is large enough to affect the international rate of return on capital. Also, the taxation of “rents” (that is, above normal profits) is still likely to fall on owners of capital.

Preferential tax treatment for certain types of investment has become pervasive in many developing economies, but especially in low-income countries (IMF 2013). In 1980 about 40 percent of low-income countries (LICs) in sub-Saharan Africa offered tax holidays, but this figure increased to about 80 percent by 2005. Especially pronounced has been the increase in the number of countries providing holidays through free trade zones. A number of studies have estimated the fiscal cost of corporate income tax (CIT) incentives, although care needs to be taken when comparing and interpreting these studies because of methodological differences and data limitations. Cubeddu and others (2008) put the revenue cost of CIT incentives in 15 Caribbean countries at an average of about 5.5 percent of GDP. Villela, Lemgruber, and Jorratt (2010) estimate the cost of preferential treatment under the income tax at 0.5–6.0 percent of GDP in Latin America. Raising “CIT-productivity” in LICs to the LIC median for those countries below the median was estimated by IMF 2011 to increase revenue by about 0.7 percent of GDP.

Attempts to focus lower tax rates (or even subsidies) on a narrower set of often low-quality consumption items that are consumed mainly by lower-income groups are likely to give rise to large inefficiencies and be self-defeating. Since their budget shares will be low, the tax differentials required to provide income support will be large, giving rise to large substitution effects.

Trade taxes, which are essentially a subsidy to domestic producers financed by a tax on domestic consumers, are an inefficient revenue-raising instrument since they distort both production and consumption decisions. They are also a very blunt redistributive instrument, benefiting some poor households but hurting others.

The cost of these social pensions can be substantial. For example, spending on social pensions ranges from ½ to ¾ percent of GDP in many developing economies (Holzmann, Robalino, and Takayama 2009; Bosch, Melguizo, and Pagés 2013). South Africa’s Social Grants Program includes a means-tested social pension program costing 1.3 percent of GDP. Based on a pension set at 70 percent of country-specific poverty lines, Kakwani and Subbarao (2005) estimate the cost of a universal pension for everyone older than 65 years in 15 sub-Saharan African countries to range from 0.7 percent of GDP in Madagascar to 2.4 percent of GDP in Ethiopia. Limiting the pension to only the elderly poor would approximately halve this cost for most countries.

A review of safety nets in Africa, for instance, finds that they have expanded in a number of countries (for example, Ghana, Kenya, Mozambique, Rwanda, and Tanzania) in the wake of recent economic crises and are evolving from fragmented programs to a more integrated social safety net (Monchuk 2014).

In Mexico, for instance, the conditional cash transfer program was financed by eliminating food subsidies. Coady and Harris (2004) estimate that, in addition to the gains from better targeting, the elimination of price subsides generated substantial efficiency gains equivalent to MEX$38 for MEX$100 pesos spent on the program.

The direct impact of such transfers in Brazil and Mexico accounted for one-fifth of the decrease in the Gini between 1995 and 2004 in these two countries (Soares and others 2007).

Recent studies have found that improved education outcomes, as reflected in the increase in the education level of the working population, has been the dominant factor behind decreasing income inequality in Latin America, followed by the growth in public transfers in terms of importance (Azevedo, Inchauste, and Sanfelice 2013).

Many countries in sub-Saharan Africa (for example, Burkina Faso, Liberia, Madagascar, Malawi, Niger, and Tanzania) and Asia (for example, Bangladesh, Cambodia, India, Indonesia, Pakistan, and the Philippines) are first adopting these programs on a pilot basis before gradually expanding them nationwide (Fiszbein and Schady 2009; Garcia and Moore 2012; Monchuk 2014).

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