More reports on: International Monetary Fund

IMF calls for efficient redistributive policies to bridge rising inequality

14 March 2014

The International Monetary Fund (IMF) has called for better use of redistributive tax policies and targeted public spending to bridge the rising disparity between haves and have-nots and warned that that rising income inequality is weighing on global economic growth and fuelling political instability.

To support sustainable economic growth, redistribution should be done with fiscal instruments that achieve distributional objectives at a minimum cost to economic efficiency, the global lender said.

Growing inequality in recent years has put increased pressure on fiscal policy to redistribute income.

While the question of just how much redistribution the state should do, in the end, rests with national governments, the design of the policies themselves has a critical bearing on their effects on efficiency and growth, IMF said.

IMF managing director Christine Lagarde said the issue is a high priority for the fund and warned that inequality is threatening longer-run economic prospects.

Lagarde had, last month, said the income gap risked creating ''an economy of exclusion, and a wasteland of discarded potential'' and rending ''the precious fabric that holds our society together.''

''Assessing the effect of tax and spending policies on efficiency, along with how they affect distributional goals, has long been a component of the IMF's policy advice to member countries in the context of its technical assistance. In IMF lending programmes, a common concern is how to design fiscal policy measures in a way that is consistent with the authorities' distributional objectives. The paper brings together the extensive experience of the IMF across these areas,'' the IMF staff report pointed out.

''Redistribution can help support growth because it reduces inequality,'' David Lipton, IMF first deputy managing director and a former senior White House aide, said in a speech on Thursday at the Peterson Institute for International Economics.

''When it comes to fiscal redistribution, design matters . Some redistributive fiscal policies can in fact help improve efficiency and support growth, such as those that enhance the human capital of low-income households,'' he said, adding, ''Redistribution, if poorly designed, or pushed too far, can be distortive.''

Trends in inequality
Over the last three decades, inequality has increased in most countries. While the level of inequality has declined in Latin America and sub-Saharan Africa recently, what is striking are the persistent differences across regions, with Latin America still having the highest inequality and the advanced economies having the lowest, the paper pointed out.

More recently, there has been attention to the rising share of top income earners. The paper suggests that the trends across countries appear mixed. In some economies, such as the United States and South Africa, the share of the top one per cent has increased dramatically in recent decades, but not so in continental Europe and Japan, where it has been largely unchanged (See: World's 85 richest own as much as the poorest 3.5 bn).

There are differing views of the causes of the rising share of the top one per cent. Some emphasise the impact of globalisation and new technologies, while others highlight policy choices, such as reductions in tax rates, and others the rent-seeking behaviour of executives.

While various countries follow various types of redistributive policies to deal with inequality, the IMF staff paper finds that advanced economies, on average, have been able to reduce inequality by roughly a third through a combination of social transfers (eg, welfare and pension benefits) and redistributive taxes (eg, progressive income taxes).

Other benefits, such as public spending on health, education, and housing, help reduce inequality further.

There is also evidence that an appropriate mix of measures can help offset the negative effects of fiscal adjustment on inequality. In about half of a sample of 27 advanced and emerging European economies that undertook fiscal adjustment during 20072012, inequality increased.

However, in many of these cases, the increase was muted by the design of the measures. In two-thirds of the economies, fiscal measures led to either a decrease in inequality or at least partly offset the effect of growing inequality, the paper pointed out.

In developing countries, the paper finds a moderate role by fiscal policy. ''Tax revenues are much lower (as a share of national output) in developing economies, with the exception of emerging Europe. In terms of composition, taxes on consumption account for a much larger share, which tend to be less redistributive than taxes on income. Similarly, on the expenditure side, redistributive spending is much lower than in advanced economies, particularly for social protection spending.''

The study also found that a larger share of social spending in developing economies benefits higher-income groups.

With the exception of emerging Europe, the poorest 40 per cent of the population receive less than 20 per cent of the benefits of social protection spending.

The coverage of social benefits, in terms of the percentage of poor households that receive benefits, is also low, except in emerging Europe and Latin America.

A similar situation exists for education and health spending. In many developing economies, the poorest 40 per cent receive less than 40 per cent of the total benefits.

This is because the poor often do not have access to these services, which contributes to inequality of opportunity and low intergenerational mobility.

According to the paper, key considerations in designing efficient redistributive fiscal policy are:

  • Redistributive fiscal policy should be consistent with macroeconomic policy objectives. The level of spending on redistribution, for example, should be consistent with macroeconomic stability; in addition, the benefits of additional spending on redistribution should be compared with the benefits of raising spending on other priority areas, such as infrastructure.
  • Taxes and expenditures should be evaluated jointly. For example, an increase in value added tax (VAT) revenues, used to finance higher spending in primary education, could on net be progressive.
  • The design of redistribution policies should balance redistributive and efficiency objectives. Some redistributive policies may in fact enhance efficiency, such as those that strengthen human capital. But for some instruments there may be a trade-off.
  • Design should take into account administrative capacity.

Based on these principles, a range of reform options emerge that could achieve redistribution efficiently. On the tax side, some countries could consider making their income tax systems more progressive. For example, in economies where a flat rate is used, there may be scope for more tax progression at the top. Some advanced economies could also consider relieving low-wage earners from income tax or social contributions.

Generally, consumption taxes (such as the VAT) are an inferior way to efficiently achieve redistributive goals when compared with direct taxes. Because the rich generally spend more in absolute terms on necessities such as food or energy, they enjoy considerable benefits when these items are afforded exemptions or reduced rates.

For these taxes, some governments could look at minimising exemptions and special rates, in order to efficiently raise revenues to help finance pro-poor spending.

Where capacity constraints prevent spending programmes from reaching the poor, the case for some differentiation in VAT rates (eg, for basic foods) can be strong.

On the spending side, governments could aim to improve access to education and health care services. According to the IMF paper, improving the access of low-income families to education is an efficient tool for boosting equality of opportunity, and over the long run, it can also reduce income inequality.

Along the same lines, improving the access of the poor to health care services in developing economies can help strengthen equality of opportunity in an efficient manner. In advanced economies, maintaining the access of the poor to health services during periods of constrained government spending is also consistent with efficient redistribution.

Such policies offer a ''win-win'' opportunity that can improve both equality and efficiency, the paper added.

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