How could fiscal policies be designed to reduce inequality given the often-limited fiscal space? How does COVID-19 affect policy design options?
How are German reform partner countries faring, and what could the German development cooperation do to further help fiscal policy reforms to recover forward?
These questions are taken up by the study “Fiscal Policies to Reduce Inequality”. It focusses on personal income taxes (PIT), corporate income taxes (CIT), wealth taxes including property tax, consumption taxes, digital services taxes, and carbon pricing on the revenue side. On the expenditure side, it examines spending for social protection as well as conditional and unconditional cash transfer programmes.
Fiscal policies on the revenue and on the expenditure side impact inequality differently. Therefore, both sides need to be considered jointly in order to have the biggest impact on the reduction of inequality. Progressive taxation and other targeted tax policies can ensure that taxpayers are taxed effectively and according to their ability to pay, meaning that, overall, the richest persons or entities pay more taxes than the less wealthy or micro or small businesses. By contrast, the expenditure side can grant access to important basic services that increase the chances of less wealthy people to generate higher income or wealth in the future.
When designing fiscal policies, existing trade-offs between competing objectives as well as administrability need to be considered and balanced against each other. With regards to design options on the revenue side, a well-designed progressive PIT takes the taxpayer’s ability to pay into account and can act as a counterbalance to often regressive taxes, such as a value-added tax (VAT). However, due to a large informal sector as well as tax evasion by wealthy individuals, implementing PIT is challenging for developing countries. Corporate taxation is an effective revenue generator, also in developing countries, and can help reduce inequality because company ownership is extremely unequally distributed. Wealth taxes including property taxes target the wealthy and can thus contribute to decreasing inequality within a country.
In addition to different design options for income and wealth taxes, it is generally important to close loopholes in existing laws and ensure enforcement to make sure that the wealthy contribute their fair share to public revenues. Consumption taxes such as VAT are excellent revenue generators and are relatively easy to implement, but they are not per se inequality-reducing. To counter their regressive effect, countries use lower or zero rates for certain products that are considered essential for “basic needs”. However, zero-rating products for consumption taxes is not actually progressive unless the product or service is consumed almost entirely by people in poverty. Similarly, carbon taxes have their biggest impact on inequality by providing the government with revenue for pro-poor spending and deterring undesired behaviour.
Moreover, the expenditure side is equally important for reducing inequality. Health and education spending, for example, promotes growth and productivity, and reduces inequalities as well as disparities in human capital. Spending on social protection reduces poverty and ensures income security across the lifecycle of a beneficiary, specifically in emergencies, such as the current global health and energy crisis or climate change. The COVID-19 pandemic and its consequences are felt most severely by the most vulnerable members of society, such as children, the elderly, women and other marginalised groups. Public spending is therefore also crucial to reduce specific inequalities such as gender inequality.
Cash transfer programmes are one measure to support the reduction of inequality by providing regular cash assistance to people in poverty and other vulnerable groups, and do not require any monetary contribution from the beneficiary. They can be categorised as either conditional (CCTs) or unconditional (UCTs), depending on whether the beneficiary needs to comply with specific behavioural requirements to be eligible for the transfer. Examples include poverty-targeted cash transfers, child grants, and social pensions for the elderly. In many countries, cash transfer programmes were used especially during the COVID-19 pandemic.
The ability of the German reform partner countries, namely Côte d’Ivoire, Ethiopia, Ghana, Morocco, Senegal, Tunisia, and Togo, to reduce inequality is limited by their relatively low level of tax revenue as well as common concerns such as high levels of informality and expensive and often regressive subsidies. The German development cooperation (GDC) is well placed to help its partner countries, especially the reform partner countries, design inequality-reducing fiscal policies. GDC can build on its track record of supporting partner countries in their GFG reforms, with regards to tax policy and administration as well as public budgeting.