Fiscal policy and income inequality
23 Jan 2014
EXECUTIVE SUMMARY Fiscal policy is the primary tool for governments to affect income distribution.Rising income inequality in advanced and developing economies has coincided with growing public support for income redistribution. This comes at a time when fiscal restraint is an important priority in many advanced and developing economies. In the context of the Fund’s mandate to promote growth and stability, this paper describes: (i) recent trends in the inequality of income, wealth, and opportunity in advanced and developing economies; (ii) country experience with different fiscal instruments for redistribution; (iii) options for the reform of expenditure and tax policies to help achieve distributive objectives in an efficient manner that is consistent with fiscal sustainability; and (iv) recent evidence on how fiscal policy measures can be designed to mitigate the impact of fiscal consolidation on inequality. This paper does not advocate any particular redistributive goal or policy instrument for fiscal redistribution. Both tax and expenditure policies need to be carefully designed to balance distributional and efficiency objectives, including during fiscal consolidation. The appropriate mix of instruments will depend on administrative capacity, as well as on society’s preferences for redistribution, the role envisaged for the state, and political economy considerations. Options for redistributive policies that help minimize efficiency costs, in terms of their effects on incentives to work and save, are the following: In advanced economies: (i) using means-testing, with a gradual phasing out of benefits as incomes rise to avoid adverse effects on employment; (ii) raising retirement ages in pension systems, with adequate provisions for the poor whose life expectancy could be shorter; (iii) improving the access of lower-income groups to higher education and maintaining access to health services; (iv) implementing progressive personal income tax (PIT) rate structures; and (v) reducing regressive tax exemptions. In developing economies: (i) consolidating social assistance programs and improving targeting; (ii) introducing and expanding conditional cash transfer programs as administrative capacity improves; (iii) expanding noncontributory means-tested social pensions; (iv) improving access of low-income families to education and health services; and (v) expanding coverage of the PIT. Innovative approaches, such as the greater use of taxes on property and energy (such as carbon taxes) could also be considered in both advanced and developing economies.