Chapter 3. Inequality and Fiscal Redistribution in Advanced Economies
- Benedict Clements, Ruud Mooij, Sanjeev Gupta, and Michael Keen
- Published Date:
- September 2015
David Coady, Ruud de Mooij and Baoping Shang
A number of surveys have found increasing concern among populations about high inequality in their countries and revealed growing public support for more redistribution (IMF 2013a). A 2014 report released by the World Economic Forum’s Global Agenda Councils indicates that increasing inequality tops the list of the world’s most pressing threats (World Economic Forum 2014). A study by the Pew Research Center reports that a majority in all of the 44 nations it surveyed believe inequality is a big problem facing their countries (Pew Research Center 2014). There is also growing evidence that high income inequality can be detrimental to achieving macroeconomic stability and sustained growth in the long term (Easterly 2007; Ostry, Berg, and Tsangarides 2014). Others have argued that rising inequality may have been an important contributing factor to the global financial crisis (Rajan 2010; Kumhof and Rancière 2011).
Although several regulatory instruments, such as minimum wages and price controls, can be used to achieve redistributive goals, fiscal policy is the primary tool used by most governments to affect income distribution. Tax and spending policies can alter the distribution of income in both the short and medium terms. For example, in-kind benefits, such as education spending, can affect the inequality of market incomes (that is, incomes before taxes and transfers) through their impact on future earnings. Other fiscal instruments, such as income taxes and cash transfers, can directly reduce the inequality of disposable incomes (that is, incomes after direct taxes and transfers).
However, badly designed redistributive fiscal policy can have adverse implications for efficiency and growth, and can even have perverse impacts on the income distribution (IMF 2012). For example, income tax deductions, such as for mortgage interest, create distortions, and are also more likely to benefit the rich. On the transfer side, too-rapid withdrawal of means-tested benefits can involve high “tax wedges,” creating strong disincentives for labor market participation and welfare dependency. The result can be a more unequal distribution of market incomes.
This chapter focuses on the design of efficient redistributive policies in advanced economies. It first describes different concepts of inequality and their trends. It then analyzes the historical role of fiscal redistribution on inequality and presents potential tax and expenditure instruments that could help achieve efficient redistribution in advanced economies.
Trends in Inequality
Inequality can be viewed from different perspectives, each of which can provide insights into the nature, causes, and consequences of inequality and can also have different policy implications. Income inequality measures the interpersonal distribution of income, capturing how individual or household incomes are distributed across the population at a particular time. In contrast, lifetime inequality considers inequality in incomes or earnings for an individual over his or her lifetime rather than for a single year. Inequality of wealth considers the distribution of wealth across individuals or households, which reflects not only differences in income, but also savings rates as well as bequests and inheritances. Inequality of opportunity focuses on the relationship between income and social mobility, in particular the extent of mobility between income groups across generations.
Income inequality. Since 1990, inequality in the personal distribution of income has increased in most advanced economies. Figure 3.1 presents Gini coefficients for disposable incomes (that is, market incomes minus direct taxes plus cash transfers)—which embody both the inequality of market-determined incomes as well as the distributional impact of income taxes and public transfers.1 Between 1990 and 2010, the Gini for disposable income has increased in most advanced economies. More than one-third of advanced economies experienced increases in their Ginis exceeding 3 percentage points.
Figure 3.1Increase in Disposable Income Inequality, 1990–2010
Sources: Eurostat; Luxembourg Income Study database; and Organisation for Economic Co-operation and Development.
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).
More recently, the public debate has focused on inequality at the top end of the income distribution, and especially so since the global economic and financial crisis. The share of total income going to top income groups has sharply increased in some countries. Since the mid-1980s, the market income shares of the richest 1 percent of the population have increased substantially in English-speaking advanced economies (Figure 3.2). For example, in the United States, the share of market income captured by the richest 10 percent surged from about 30 percent in 1980 to 48 percent in 2012, while the share of the richest 1 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. The rise in the share of the highest income groups has varied substantially across countries. The increase in the share of the top 1 percent has been much less pronounced in the southern European and Nordic economies, and hardly any increases have been observed in continental Europe and Japan. These differences suggest that policies and institutions can play an important role in avoiding such increases in extreme inequality.
Figure 3.2Gross Income Share of Top 1 Percent in Selected Advanced Economies, 1925–2012
Source: The World Top Incomes Database (http://g-mond.parisschoolofeconomics.eu/topincomes/).
Note: Income refers to pre-tax-and-transfer gross income. See Atkinson, Piketty, and Saez 2011 for details.
Lifetime income inequality. Empirical studies suggest that lifetime inequality is usually lower than inequality in any given year. This outcome occurs for two reasons. First, in many economies, individuals experience significant fluctuations in incomes from year to year. An individual who has relatively high income in one year may not necessarily have high lifetime income relative to his or her peers of the same age. Bowlus and Robin (2012) find that because of this “earnings mobility” from one year to the next, the lifetime inequality of income is about 20–30 percent lower than annual income inequality in Canada, the United Kingdom, and the United States. In France and Germany, lifetime inequality is similar to inequality of annual income. Second, lifetime incomes also tend to be less unequal because of the age-income cycle that affects the entire population: incomes tend to be lower during early working years and peak in later years, before declining again (Paglin 1975). Taking both of these factors into account, Björklund (1993) finds that the dispersion of lifetime incomes in Sweden is about 35–40 percent lower than that of annual incomes.
Wealth inequality. In advanced economies, household net wealth—financial assets and real estate minus debt—has increased substantially since the early 1970s. Assessment of trends in this area requires caution, given the limited number of economies with comprehensive data. Internationally comparable data for eight large advanced economies show that the average ratio of net household wealth to national income grew by almost 80 percent between 1970 and 2010 (Piketty and Zucman 2013). The largest increase was observed in Italy (180 percent) and the smallest increase was in the United States (21 percent). Explanations for the rapid growth in wealth include asset price booms and a significant increase in private savings.
Wealth is more unequally distributed than income. The Gini coefficient of wealth in a sample of 13 advanced economies in the early 2000s was 0.66, compared with a Gini of 0.31 for disposable incomes (Figure 3.3). The share of wealth held by the top 10 percent ranges from slightly less than half in Italy, Japan, Spain, and the United Kingdom, to more than two-thirds in Norway, Sweden, Switzerland, and the United States. In Switzerland and the United States, where wealth is most unequally distributed, the top 1 percent alone holds more than one-third of total household wealth. The inequality of wealth has risen in recent decades in several advanced economies. For instance, between the mid-1980s and early 2000s, the growth of wealth in Canada and Sweden was all concentrated in the two upper deciles of the wealth distribution. During the same period, the Gini coefficients of wealth distribution in Finland and Italy rose from about 0.55 to greater than 0.6. In the United States, the Gini coefficient of wealth distribution rose from 0.80 in the early 1980s to almost 0.84 in 2007.
Figure 3.3Inequality of Wealth in Selected Economies, Early 2000s
Sources: Davies and others (2008); Eurostat; Luxembourg Income Study database; and Organisation for Economic Co-operation and Development.
Note: Labels in this figure use International Organization for Standardization (ISO) country codes.
Nonfinancial assets make up a large share of household wealth. Survey data suggest that nonfinancial assets—such as primary residences and other real estate—represent 70–90 percent of total household gross wealth in advanced economies. Financial wealth is generally more unequally distributed than real estate; for example, Fredriksen (2012) reports that the Gini coefficient for financial wealth (on average, 0.8 for a group of seven advanced countries) exceeds that for nonfinancial wealth (0.63).
Inequality of opportunity. Income inequality can persist across generations, reflecting differences in economic opportunity. Restricted opportunities for increasing incomes can reflect a range of factors, including lack of access to education (including early childhood and tertiary education) and lack of access to certain professions or business opportunities (OECD 2011a; Corak 2013). This lack of access is in turn reinforced by low incomes. High income inequality, therefore, is both a symptom and a cause of low economic mobility, and family background is a key factor in determining the adult outcomes of younger generations.
Intergenerational income mobility is lower in countries with higher income inequality. Intergenerational earnings mobility, as measured by the elasticity between a parent’s and an offspring’s earnings, is low in countries such as Italy, the United Kingdom, and the United States, which have high Gini coefficients for disposable income. In contrast, mobility is much higher in the more egalitarian Nordic countries (Figure 3.4). This relationship between income inequality and intergenerational mobility is often referred to as the “Great Gatsby Curve” (Krueger 2012). In low-mobility countries, about 50 percent of any economic advantage that a father has is passed on to his offspring, whereas in high-mobility countries this advantage falls to less than 20 percent. Evidence for Nordic countries shows that intergenerational income mobility is flat across much of the parental income distribution but rises at the top end.
Figure 3.4The Great Gatsby Curve: Income Inequality and Economic Mobility
Sources: Corak (2013); Eurostat; Luxembourg Income Study database; and Organisation for Economic Co-operation and Development.
Note: The intergenerational earnings elasticity estimates in the figure are the elasticity between a father’s income and a son’s income. The upward slope of the line suggests that countries with a high inequality of income around 1985 (high Gini coefficients) had high intergenerational earnings elasticities. A high elasticity suggests a strong relationship between a father’s and a son’s income and less mobility of incomes across generations. Labels in this figure use International Organization for Standardization (ISO) country codes.
Several key messages emerge from examining different aspects of inequality and their development in the past decades. First, the findings are consistent with the literature that inequality has been rising. Second, inequality of opportunity remains a major issue in advanced economies. Redistributive fiscal policies should thus first focus on addressing inequality of opportunity because such policies can potentially help reduce inequality and improve economic efficiency. Third, more attention should be paid to lifetime inequality. To the extent that market mechanisms to help households smooth income over time are absent, government could have a role in providing social insurance, which would be welfare enhancing. Fourth, the increase in wealth and inequality of wealth in many advanced economies may indicate there is more scope to increase wealth taxation, which tends to be less distortive.
Role of Fiscal Redistribution
How much has fiscal policy helped reduce income inequality? Evaluating the redistributive impact of fiscal policies requires a comparison of incomes after taxes and transfers with incomes that would exist without them. In principle, assessments of the incidence of fiscal policies should incorporate information on consumers’ and producers’ behavioral responses to taxes and transfers and their impact on market incomes.2 In practice, most studies do not incorporate this aspect, since sufficient data on behavioral responses are unavailable. In these studies, the incidence of commodity taxes is typically assumed to fall on consumers, factor taxes are assumed to fall on factor suppliers (labor and capital), and transfers to beneficiaries do not lead to changes in factor supplies.3 Despite this limitation, these studies still provide some broad picture of the redistributive role of fiscal policy by looking at the composition and overall level of taxes and spending. The evidence below is drawn from such studies.
Fiscal policy has played a significant role in reducing income inequality in advanced economies, with most of this reduction being achieved on the expenditure side through transfers. During recent decades, direct income taxes and transfers have decreased inequality in advanced economies by an average of one-third (Figure 3.5). For instance, in 2005 the average Gini for disposable income was 14 percentage points below that of the average market-income Gini. The redistributive impact of transfers accounts for about two-thirds of the decrease in the Gini. Within transfers, non-means-tested transfers (including public pensions and family benefits) account for the bulk of the redistribution (Immervoll and others 2005; Paulus and others 2009). On the tax side, personal income taxes make an important contribution to reducing inequality in a number of economies; in fact, in most economies, the redistribution achieved through income taxes is even higher than that achieved through means-tested transfers. These results are consistent with studies on poverty. Paulus and others (2009) find that fiscal policy decreases the poverty rate in 19 Organisation for Economic Co-operation and Development (OECD) countries to an average of 15 percent from an average of 30 percent, with virtually all of this decrease being achieved on the transfer side of the budget.
Figure 3.5Redistributive Impact of Fiscal Policy in Advanced Economies, Mid-2000s
Sources: Paulus and others (2009); except for Australia, Canada, the Czech Republic, Korea, Norway, Israel, Taiwan Province of China, and the United States, for which data are from Caminada, Goudswaard, and Wang (2012).
Note: The impact on inequality of disposable income does not incorporate the redistributive impact of indirect taxes and in-kind benefits. Labels in this figure use International Organization for Standardization (ISO) country codes.
Social insurance and other transfers are far less redistributive when examined from the perspective of lifetime income. Pension systems, for example, redistribute income across an individual’s own lifetime, with pension contributions being made during peak earning years, and benefits received during retirement when incomes are lower. Similarly, households receive more in transfers when they have children. The fiscal redistribution of incomes from the lifetime rich to the lifetime poor is thus smaller than that implied by a snapshot in any one year. For instance, Bovenberg, Hansen, and Sorenson (2012) show that about three-fourths of redistribution in Denmark involves redistribution over peoples’ life cycles as opposed to redistribution from lifetime rich to lifetime poor; they also report similar magnitudes for Australia, Ireland, Italy, and Sweden from other studies.
The overall redistributive impact of fiscal policy is also influenced by the distribution of indirect taxes and in-kind transfers. Empirical evidence suggests that indirect taxes tend to be regressive or proportional to incomes (O’Donoghue, Baldini, and Mantovani 2004; Cnossen 2005). While both the value-added tax (VAT) and excise duties are found to be regressive, excise taxes are especially regressive. However, the regressivity of indirect taxes is typically much smaller when assessed against lifetime income or consumption. In-kind transfers such as education and health spending are very progressively distributed (that is, their benefits are more equally distributed than disposable incomes). On average, in-kind transfers are found to decrease the Gini coefficient by 5.8 percentage points in five European economies (Belgium, Germany, Greece, Italy, and the United Kingdom), with health (3.6 points) and education (2.2 points) accounting for virtually all of this impact (Paulus, Sutherland, and Tsakloglou 2009; Figure 3.6). In addition, expansion of access at lower levels of education can decrease earnings inequality in the medium term (De Gregorio and Lee 2002).
Figure 3.6Redistributive Impact of In-Kind Spending
Design of Fiscal Redistribution
In assessing the design of fiscal redistribution, three issues are important. First, taxes and spending both matter for fiscal redistribution and should thus be evaluated jointly. For instance, an increase in regressive taxes can still be the best approach to supporting redistribution if the public expenditures they finance are highly progressive. Second, indirect effects should be taken into account. For instance, taxes and spending policies can modify market prices so that their incidence is felt elsewhere rather than by those who are directly targeted by these policies. Moreover, spending on education and health can have important dynamic effects by enhancing social mobility. Third, fiscal instruments should be compared with nonfiscal policies aimed at addressing inequality. For instance, minimum wages and rent regulations are generally designed as redistributive tools, the results of which could alternatively be achieved using fiscal instruments.
Social spending (social protection, education, and health) is the primary instrument used to achieve redistributive goals in most countries. This spending can be made more efficient by improving its targeting and reducing its adverse labor market effects. The appropriate mix of programs and design features will vary across economies to reflect differences in fiscal and administrative capacity.
Education reforms could focus on improving access by low-income groups. Although education spending as a whole is progressive, tertiary education spending tends to be regressive. This lack of access to higher levels of education results in inequality of opportunity and perpetuates inequality across generations. A range of spending reforms focused on improving access can help enhance the distributional impact of education spending:
Increasing investment in lower levels of education. The main driver behind the regressivity (or lower progressivity) of public education spending is the large share of the budget allocated to higher levels of education, which are disproportionally accessed by higher-income groups. Lack of access for lower-income groups to higher levels of education is primarily due to lack of progress through lower education levels. This situation requires improving access to, progression through, and performance in upper-secondary and tertiary education. Increasing access to early childhood education is required, especially given the substantial evidence that early education has a crucial impact on education performance at higher levels.
Improvements in the efficiency of education spending. Increased spending on education at lower levels should be complemented by efforts to get better results from existing levels of spending. Inefficiencies in spending are substantial (Gupta and others 2007; Grigoli 2014).
Increased cost recovery in tertiary education. Demand for tertiary education has increased rapidly and often faster than public financing capabilities. As a result, the quality of instruction in public institutions has declined and the number of private education institutions has risen (Woodhall 2007; OECD 2011b). 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. Income-contingent student loans to cover tuition and subsistence costs allow students to begin paying off their loans once they start earning, ensuring that higher education is free at the point of use and providing insurance against the inability to repay because of low future income (Barr 2012). Increasing private financing also allows tertiary education to expand without increasing public spending.
Targeted conditional cash assistance. As discussed above, targeting cash assistance to those with disadvantaged access to education, and conditioning this assistance on certain education outcomes, can help reduce income barriers to education and provide incentives for improved education achievement. Additional complementary reforms may also be necessary, such as targeted information campaigns and increasing the availability of shorter-term qualification options.
Maintaining access to health care services for the poor during periods of expenditure constraint is consistent with efficient redistribution. Public health care spending is a large share of total public spending and is projected to rise by almost 3 percentage points of GDP between 2013 and 2030 (Clements, Coady, and Gupta 2012; IMF 2013b). Health care reforms to curb the growth of spending will be a necessary component of many countries’ fiscal adjustment plans. Some of these reforms could take the form of an increase in cost sharing, for example, through increased copayments or a reduction in the scope of services provided by the public sector. These reforms could be designed to ensure that the poor maintain access to services, for example, by exempting them from copayments.
Reducing or eliminating user charges for low-income households. Health services outside the affordable basic package could be financed by a mix of public and private mechanisms, including insurance contributions, fees, and copayments. However, out-of-pocket costs under the typical health insurance plan may still be too high for low-income households. Further improving the affordability of health care may require the reduction or elimination of user charges for certain groups. In particular, preventive care, such as immunizations, should be offered free of charge given its large social benefits. In addition, linking use of preventive care to eligibility for other social benefits could help increase coverage among low-income households.
Addressing supply-side barriers in less developed areas. Since many low-income households reside in less developed areas or neighborhoods, availability of heath care facilities and health care professionals—of similar quality to those in more affluent areas—can be a major barrier to access. Overcoming this barrier may require public provision of health care as a last resort or additional incentives for service provision by private providers in these areas.
Improving efficiency. Between 20 percent and 40 percent of the resources spent on health are wasted, including in advanced economies (WHO 2010). The inefficiencies in health spending suggest that there is ample room to improve health care outcomes, including for the poor, by increasing the efficiency of existing spending (Coady, Francese, and Shang 2014).
Appropriately designed pension reforms can perform an effective redistributive role while ensuring fiscal sustainability. Pension benefits account for about two-thirds of social protection spending and, in the absence of reforms, average pension spending is projected to rise by an additional 1½ percent of GDP by 2030 (Clements and others 2012). Pension systems play an important lifetime consumption-smoothing role by protecting the elderly from a sharp drop in consumption during retirement. Pensions account for more than half of the total redistributive impact of social transfers. At the same time, many economies will need to contain increases in pension spending in the coming decades to support fiscal consolidation. The following reform options could safeguard the redistributive role of pensions while containing the growth of spending:
Increasing the effective retirement age. Gradual increases in the statutory retirement age reduce the need for other reforms that lower pension benefits and risk increasing old-age poverty (Shang 2014), and can also enhance employment and economic growth. Because lower-income groups tend to have shorter life expectancies than higher-income groups, an increase in the retirement age results in a proportionally larger reduction in their lifetime pension benefits. This outcome can be mitigated by linking pension eligibility to years of contribution instead of to a single statutory retirement age. Increases in the retirement age should also be accompanied by measures aimed at enhancing the earning opportunities for those approaching the statutory retirement age, especially the low skilled whose income potential can decline significantly as they approach retirement. In some economies, this may require strengthening of labor regulations protecting older workers, as well as retraining and adult education programs. Older workers should be protected fully by disability pensions where appropriate, and by social assistance programs to ensure that increases in retirement ages do not raise poverty rates. In addition, incentives and opportunities for early retirement (including through disability benefits) and disincentives to work beyond the statutory retirement age need to be reduced in many countries, for example, through concessional contribution rates and in-work benefits.
Incorporating pension incomes into a progressive income tax system. In many countries, pensions enjoy favorable tax treatment.4 In such cases, equalizing treatment across income sources by incorporating all pension benefits into the standard progressive income tax system can reduce the net fiscal cost of pension spending while protecting lower-income groups and lowering inequality.5 In addition, countries that subsidize private pensions through tax relief or matching contributions should consider scaling these subsidies back since these benefits accrue mostly to high-income groups and have little impact on national savings (European Commission 2008).
Making benefit cuts progressive. Many parametric reforms contain spending pressures by reducing replacement rates (that is, the ratio of the average pension benefit to the average wage) over time. Where possible, these reductions should be progressive to avoid increases in poverty among the elderly. However, progressive benefit cuts require larger cuts in replacement rates for higher-income groups, and thus involve a trade-off between poverty-alleviation and consumption-smoothing objectives and may exacerbate compliance problems. If benefit cuts for lower-income groups are unavoidable, these groups need to have access to other social benefits to prevent them from falling into poverty. Addressing old-age poverty concerns through a means-tested social pension financed from general revenues would also allow the earnings-related component to achieve its broader consumption-smoothing objectives more efficiently, and it could be financed by revenue instruments that are more progressive than payroll taxes.
Family benefits can be made more efficient by greater use of means testing and by strengthening incentives to return to work. On average, in 2005 family benefits decreased the disposable-income Gini by nearly 1.5 percentage points, accounting for nearly three-quarters of the redistributive impact from total social assistance spending. These benefits include a range of transfers, such as paid maternal and paternal leave, child allowances, and child-care benefits. Parental leave schemes, for example, with a guarantee to young mothers that they can return to their previous jobs within a certain period, can help keep young mothers connected to the labor market. Child benefits facilitate consumption smoothing over the life cycle by transferring resources to families with children since children increase family needs and can also reduce second-earner incomes. These objectives can be more efficiently achieved by the following:
Means testing and conditioning of child benefits. Large child allowances reduce incentives for women to enter the labor market, with detrimental effects for future earnings prospects. Linking benefits to labor force participation (including through child-care subsidies and child tax credits) can strengthen incentives to enter the labor market and decrease welfare dependency (Gong, Breunig, and King 2010; Kalb 2009; Elborgh-Woytek and others 2013). Expanding the role of means testing and including benefits in taxable income within a progressive tax schedule can make child benefits more progressive and could generate substantial savings given the very small share of these benefits that is currently means tested (Figure 3.7). Means testing also protects the consumption-smoothing role of these benefits since higher-income groups have greater consumption-smoothing opportunities.
Reducing the maximum duration of paid parental leave benefits. Reducing the maximum duration in countries where paid parental leave is very long can increase incentives to return to employment. Jaumotte (2003) finds that parental leave has a positive effect on female labor supply up to a limit (20 weeks with full replacement of earnings); above this length, the marginal effect of further leave becomes negative. Appropriately designed parental leave benefits can also reduce poverty and welfare dependency, since long spells out of the workplace can have detrimental effects on future earnings potential. Capping leave benefits where they are earnings related can also increase benefit progressivity.
Figure 3.7Means-Tested and Non-Means-Tested Family Benefits, 2010
Note: Labels in this figure use International Organization for Standardization (ISO) country codes.
Countries could intensify the use of active labor market programs (ALMPs) and in-work benefits to address the work disincentives inherent in means-tested transfers. Guaranteed minimum income programs in many advanced economies aim to fill the gap between “needs” and “means.” Although these programs may have only a small impact on inequality, reflecting low aggregate spending, they play a key role in addressing poverty. However, the withdrawal of benefits as individuals return to employment creates strong work disincentives, especially for low-wage workers and families with children. These disincentives can be reduced through the following:
Strict conditioning of eligibility for benefits on participation in ALMPs. In most advanced economies, continued eligibility for benefits is conditioned on participation in ALMPs, including personal employment services, training, job placement, and public employment schemes. Tight activation measures are especially important for containing spending and providing incentives to work. The intensity of activation requirements should increase with unemployment duration to allow an initial period for job search, followed by assistance with job placement and access to training opportunities. Although the strictness of this conditioning has increased since the early 2000s, there is still significant room for improvement in many countries (OECD 2012).
Greater use of in-work benefits. Many economies have adopted a system of in-work benefits that allows for the gradual withdrawal of benefits as earnings or employment duration increases (IMF 2012). This approach reduces the net tax on additional earnings, which can even be negative for low-income groups (Box 3.1). When combined with effective ALMPs, in-work benefits can have significant beneficial impacts on employment, inequality, and poverty. Containing the fiscal cost of in-work benefits requires that these benefits be withdrawn more rapidly as incomes increase, which may create work disincentives further up the income distribution (Box 3.1).
Box 3.1In-Work Benefits and Tax Credits
In-work benefits are used in many advanced economies to stimulate labor force participation and provide income support to low-income groups. In many countries these benefits take the form of tax credits, which constitute a net transfer to the individual when they exceed income tax liabilities. These benefits increase the net income gain from accepting a job relative to the alternative of being out of work and provide income support. In-work benefits are usually phased out as incomes rise, with the steepness of the phase out depending on the primary objective of the program. In countries that emphasize the labor force participation objective, benefits are usually gradually phased out with individual income (Belgium, Finland, Germany, the Netherlands, and Sweden). Minimum-hours-worked requirements are often used to prevent the provision of income support to high-skilled workers in part-time jobs. In countries that emphasize the income-support objective, benefits are often conditional on the presence of children in the household and generally phased out more steeply with family income to prevent leakage of benefits to higher-income families and reduce fiscal cost (Canada, France, Korea, New Zealand, the Slovak Republic, the United Kingdom, and the United States). However, the steep phasing out of benefits causes high marginal tax rates and creates strong adverse labor supply effects (de Mooij 2008).
Empirical studies suggest positive net employment effects from in-work credits. In the United Kingdom and the United States, evaluation studies find that programs have a positive net effect on employment, especially for single women with children (Hotz and Scholz 2003; Immervoll and Pearson 2009). Although negative labor supply effects have been found for those with income levels within the phase-out range, these effects were small (Eissa and Hoynes 2006). The aggregate effect on labor supply has been found to be quite small.
The use of in-work tax credits is most appropriate for countries with strong tax administrations based on the withholding of tax obligations. If most taxpayers are already filing tax returns, an effective withholding tax system is in place, and credits are provided on the same basis as the income tax (that is, individual or family based), the cost of administering in-work tax credits would be small. However, costs can be substantial if low-wage earners are currently not filing tax returns, there is no effective withholding system, or schemes are extended to the self-employed. In addition, it is important to ensure that the existence of other means-tested social benefits do not offset the positive work incentives from tax credits. If the earned income tax credit is based on self assessment, as in the United States, noncompliance and false claims (for example, regarding the number of qualifying children) can be a problem. Given the administrative capacity required to implement these programs, and their potentially large fiscal costs, in-work benefits are unlikely to be a viable option for many developing economies.
Unemployment benefits play a key role in protecting individuals from loss of income due to transitory or structural unemployment. However, these programs, if not well designed, can adversely affect employment incentives and outcomes (Meyer 2002; Abbring, van den Berg, and van Ours 2005; OECD 2006). By increasing work incentives, efficient benefit design can reduce spending while also decreasing income inequality, since unemployment benefits are typically below wages. The efficiency of unemployment benefits can be achieved through a number of design features, including the following:
Strict eligibility criteria. Tightening eligibility rules (for example, based on past employment and contributions or mandatory participation in ALMPs) reduces fiscal costs by providing incentives to return to employment or by channeling more of the unemployed to social assistance with lower benefits.
Short duration. Lowering the maximum duration of benefit eligibility can expedite the return to employment or the transition to social assistance. About a third of OECD countries have a maximum duration in excess of 12 months.
Declining benefit levels. Reducing replacement rates with unemployment duration provides strong incentives to return to employment. The desired generosity of benefits can be achieved through various combinations of benefit level and duration.
Although the primary contribution of taxation to the pursuit of equity goals is through the financing of public spending, taxes in themselves can also efficiently contribute to the achievement of redistributive goals. This depends on the progressivity of the personal income tax (PIT), the taxation of capital income and wealth concentrated among the better off, and the design of indirect taxes.
Personal Income Tax
The PIT is best equipped to tax people based on their ability to pay. Indeed, progressive PITs (usually in combination with income transfers) play a critical role in many countries in raising revenue while reflecting concerns about income inequality. The design of the PIT contains several elements:
Implementing progressive PIT rate structures can contribute to reducing inequality. The median top PIT rate (based on a large group of economies across the globe) dropped from 59 percent in the early 1980s to 30 percent more recently. Since the mid 1990s, 27 countries—especially in central and eastern Europe and central Asia—have introduced flat tax systems, usually with a low marginal rate. These regimes are typically less redistributive than those with stepwise increasing PIT rates, especially for top incomes. In these and other economies with relatively low top PIT rates—or in economies in which the top PIT bracket starts at a relatively high level of income—there may be scope for more tax progressivity at the top. Note, however, that behavioral distortions impose an upper limit on how much these top PIT rates can be increased. For instance, IMF 2013b finds that revenue-maximizing PIT rates are probably somewhere between 50 percent and 60 percent—and optimal rates are probably somewhat lower than that, depending on the welfare weights assigned to the rich.
Increasing progressivity also requires reconsideration of tax deductions. Many economies adopt various tax allowances in their PITs related to children, education, housing, health insurance, commuting, and charitable donations. Some of these allowances accrue disproportionately to the rich, such as deductions for mortgage interest: households with high incomes are more often homeowners, and tax relief is often granted in the form of deductions, which are worth more at higher marginal tax rates. Rationalizing mortgage interest deductibility could complement steps toward a more progressive tax system and also improve efficiency, since these deductions create their own distortions (IMF 2009). More generally, tax expenditures of this kind often result in significant revenue losses. In many countries, tax expenditures might not be subject to the same public scrutiny as ordinary public spending, especially when the government does not publish a tax expenditure review. Tax expenditures should undergo the same cost-benefit analysis as spending measures. Some, but not all, tax deductions might well be justified on the basis of their implications for equity and efficiency, such as deductions for charitable giving.
Reforming the PIT threshold can, in some cases, enhance tax progressivity. A threshold—either in the form of a zero tax bracket, a basic deduction, or a general tax credit—supports tax progressivity by reducing or eliminating the tax burden on people with the lowest incomes. Thresholds vary significantly across economies. In the OECD, the median threshold is approximately 25 percent of the average wage. However, the threshold should not be too high to prevent greatly reduced revenues. Note also that tax credits are, in principle, more progressive than tax deductions, since the value of a credit does not depend on the marginal tax rate faced by the taxpayer, as does a deduction.
Capital Income Tax
Taxes on capital income can strengthen the progressivity of the tax system, but high rates can have substantial efficiency costs. Taxpayers who save and invest are generally among the better off, so even a proportional tax on capital income can increase progressivity. Moreover, capital income taxation is necessary to mitigate arbitrage in the taxation of entrepreneurial income because it is often difficult (or even impossible) to distinguish labor income from capital income earned by the owner-directors of a firm. Therefore, it is important to broadly harmonize the rates of the PIT and the combined burden of the corporate income tax (CIT) and dividend and capital gains taxation. However, capital income taxes, if too high, can have high efficiency costs because of their distortionary effects on savings and investment. Moreover, it can be administratively difficult to tax capital in light of its mobility, which leads to ample evasion and avoidance opportunities. In addition, the mobility of capital allows firms to shift a large share of the burden of these taxes onto labor. To strike the right balance between equity and efficiency, governments could consider the following options:
Tax different types of capital income in a neutral way. Capital income is generally taxed at both corporate and personal levels. However, interest payments are usually deductible for the CIT (whereas returns on equity are not). In addition, some investors or investments are exempt from the PIT, and different types of capital income often face different PIT rates. As a result, interest received by individuals is often lightly taxed and dividends highly taxed, especially when compared with the taxation applied to capital gains. These differences give rise to arbitrage and lead to behavioral changes that erode the capital tax base and create economic distortions; in addition, these differences lead to horizontal inequity, that is, the unequal taxation of individuals with similar incomes and assets.
Consider implementing a lower effective rate on capital income than on labor income. Several economies impose a lower overall tax rate on capital income than on labor income. For example, in dual income tax systems, capital income is separated from labor income and taxed at a uniform and relatively low rate (Cnossen 2000; Sorensen 2005). Some economies also give targeted relief for the normal return on capital through an allowance at either the corporate level (such as Belgium and Italy) or the personal level (such as Norway).
Adopt withholding taxes, especially if administration is weak. Taxing capital income at the individual level can be administratively challenging, thus providing a rationale for withholding at the level of the firm, that is, through the CIT. In countries with weak tax administration, withholding taxes on interest and dividends can, to some extent, further circumvent administrative difficulties. Some Latin American countries also impose withholding taxes on capital gains.
Develop more effective taxation of multinational business income. Multinational corporations use a variety of tax-planning strategies to reduce their global tax liabilities, leading to profit shifting and erosion of the tax base. The Group of 20 and the OECD have an action plan on “Base Erosion and Profit Shifting,” which aims to address some of these challenges (OECD 2013). IMF (2014) explores the broader context of spillovers from the taxation of multinationals.
Automatically exchange information internationally. Information sharing has been announced by the Group of 20 as the new global standard and can enable economies to more effectively impose residence-based capital income taxes by mitigating international tax evasion and avoidance (Keen and Ligthart 2005). Some progress has been made in this regard, led by the OECD’s Global Forum on Transparency and Information Exchange. Unilateral measures are also proceeding, notably the U.S. Foreign Account Tax Compliance Act, which envisages penalties for noncompliance.
Wealth taxes, especially on immovable property, are also an option for economies seeking more progressive taxation. Wealth taxes of various kinds target the same underlying base as capital income taxes, namely assets. These taxes could thus be considered a potential source of progressive taxation, especially in countries in which taxes on capital incomes (including on real estate) are low or largely evaded. The different types of wealth taxes include recurrent taxes on property or net wealth, transaction taxes, and inheritance and gift taxes. Revenue from these taxes has not kept up with the surge in wealth as a share of GDP since the early 1970s (see earlier discussion); as a result, the effective tax rate has dropped from an average of about 0.9 percent in 1970 to approximately 0.5 percent more recently. Ways to raise additional revenue from the various types of wealth taxation include the following (and are also discussed in Chapter 7):
Property taxes are equitable and efficient, but underutilized in many economies. The average property tax yield in 65 economies (for which data are available) in the 2000s was about 1 percent of GDP. There is considerable scope to exploit this tax more fully, both as a revenue source and as a redistributive instrument, although effective implementation would require a sizable investment in administrative infrastructure (Norregaard 2013).
Recurrent taxes on net wealth generally raise little revenue. Financial wealth is mobile and taxes are hard to enforce because they are easily evaded. Few advanced economies today have recurrent taxes on broad measures of net wealth and, where they exist, revenue is typically low. More effective exchange of information across economies could help mitigate evasion and improve the prospect for net wealth taxes to increase revenue yields. If evasion can be forestalled, wealth taxes have some appeal as an instrument to reduce wealth inequality and support equality of opportunity.
Taxes on inheritances and gifts could play a useful role in limiting intergenerational inequality and strengthening equality of opportunity (Boadway, Chamberlain, and Emmerson 2010). However, where such taxes exist, rates are generally low, exemptions and special arrangements widespread, and revenue yields small. In the OECD countries, revenue has declined from 0.35 percent of GDP in 1970 to less than 0.15 percent in recent years. France and Belgium, where revenue yields are, respectively, 0.40 and 0.65 percent of GDP, illustrate that more potential from these taxes may be available.
Transaction taxes on property and financial assets are administratively appealing, since transactions can often be easily observed and administered. However, such taxes are economically distortive because they impede otherwise mutually beneficial trades. Transaction taxes on real estate can thus reduce labor mobility and raise unemployment. Financial transaction taxes (FTT) have been much discussed in the aftermath of the financial crisis, including in the European Union, where 11 member states have plans to introduce broad-based FTTs. However, FTTs can have significant social costs due to cascading effects (tax levied on tax), increased costs of capital, avoidance schemes, and the potential that they would impede socially worthwhile transactions. Moreover, their distributional impact is unclear because the incidence may be shifted onto consumers (Matheson 2012).
Consumption taxes are generally inferior for achieving redistributive objectives compared with income-related taxes and transfers. As discussed earlier in the chapter, the VAT is generally regressive in advanced economies—at least when measured as a percentage of current income rather than current consumption. Excises also tend to bear relatively more heavily on people with low incomes in advanced economies (Cnossen 2005). Regarding the design of indirect taxes, the following recommendations apply:
Minimize the use of exemptions or reduced VAT rates. Exemptions or reduced rates on necessities, such as food or energy, are often used to mitigate the regressive impact of the VAT in advanced countries, given that expenditure shares of these goods are generally higher for the poor. However, such policies are blunt redistributive instruments, because the rich generally spend more in absolute terms on these goods and thus enjoy significant benefits. Advanced economies usually have access to better instruments for helping the poor and vulnerable, such as targeted transfers and progressive PIT systems. For instance, Crawford, Keen, and Smith (2010) find that elimination of reduced VAT rates in the United Kingdom, and the use of the proceeds to increase social benefits, would significantly reduce inequality while also boosting revenue.
Set a sufficiently high VAT registration threshold. Small traders bear a significant compliance burden for the VAT, which they would likely partly pass on to consumers in the form of higher prices (Ebrill and others 2001). A threshold aims to reduce the compliance cost of the VAT for small traders, and the revenue forgone is typically not much higher (or may even be lower) than the cost of collection. A threshold can also strengthen the progressivity of the VAT by reducing the tax on small traders in rural areas where VAT compliance is particularly problematic.
Use specific excises mainly for purposes other than redistribution. Specific excises on cigarettes, alcoholic beverages, gambling, and motor fuels should be viewed as corrective tools designed to alter individual behavior in a way that is socially desirable. For example, greater taxation of energy (including through carbon taxation) can help address carbon emissions and various local pollution externalities and generate a significant amount of revenue. Although low-income groups would suffer a decline in real incomes with rising energy prices, mitigating measures targeted to lower-income groups could be introduced to offset any undesired effects on income distribution (Metcalf 2007; Clements and others 2013). Special excises on luxury goods, such as yachts, jewelry, or perfume, typically contribute little to achieving equity objectives, raise little revenue, and add to administrative costs, with the exception of taxes on motor vehicles.
In many advanced economies, inequality has been rising and this has coincided with growing public support for income redistribution. This comes at a time when many advanced economies are facing a sluggish economic recovery from the global financial crisis, taxes and social spending are already high, and public debt remains elevated. This renders it especially important that redistributive objectives be achieved at a minimum cost to economic efficiency.
While other policy instruments such as labor market regulations can also be used to achieve redistributive goals, fiscal policy is the primary tool with which governments can affect income distribution. Indeed, fiscal policy has played a significant role in reducing income inequality in advanced economies. Direct income taxes and transfers have reduced inequality by about one-third, and in-kind transfers have lowered inequality by another 15 percent.
Redistributive tax and expenditure policies need to be carefully designed to balance distributional and efficiency objectives. Priority should be given to policies that can both reduce inequality and improve efficiency. For example, improving the access of lower-income groups to higher education and maintaining their access to health services could help improve the earnings potential for children from low-income families and reduce inequality of opportunity. Such in-kind transfers could also improve economic efficiency as these children would be more productive in their lives and make larger contributions to the economy and society. Pension systems also play an important role in helping households smooth consumption over their life spans. For long-term sustainability, pension systems need to keep retirement ages in line with life expectancy, with adequate provisions for the poor whose life expectancies could be shorter. If additional redistribution is desired by society, the revenues would need to be raised with the least distortionary effect and the transfer system targeted to keep fiscal costs low while avoiding adverse effects on employment. This includes implementing progressive PIT rate structures, reducing regressive tax exemptions, and using means testing with a gradual phasing out of benefits as incomes rise. In addition, greater use of taxes on property and energy could also be considered.
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The Gini coefficient ranges between 0 (denoting complete equality) and 1 (denoting complete inequality). The 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 about 0.85.
More about incidence analysis can be found in Boadway and Keen 2000.
Although public sector support for access to finance (for example, mortgage finance and education loans) can also affect inequality, this impact is not included in these studies. Correcting market failures that strengthen access to finance can also reduce the inequality of lifetime income and of opportunity.
In most countries, pension contributions are exempt from income taxation and pension benefits receive favorable tax treatment, for example, special deductions or income tax schedules based on age (IMF 2013b). Only 10 advanced and emerging economies (Austria, China, Chile, Denmark, France, Iceland, New Zealand, Poland, Russia, and Sweden) treat pensions like any other form of income, and some (notably, several emerging economies) fully exempt pension income from taxation.
For instance, Moller (2012) shows that treating pensions like other forms of income in Colombia would reduce the Gini coefficient by 0.20 of a percentage point.