Can Policymakers Stem Rising Income Inequality?

By David Coady and Sanjeev Gupta

The issue of rising income inequality is now at the forefront of public debate. There is growing concern as to the economic and social consequences of the steady, and often sharp, increase in the share of income captured by higher income groups.

While much of the discussion focuses on the factors driving the rise in inequality—including globalization, labor market reforms, and technological changes that favor higher-skilled workers—a more pressing issue is what can be done about it.

In our recent study we find that public spending and taxation policies have had, and are likely to continue to have, a crucial impact on income inequality in both advanced and developing economies.

In advanced economies, this is especially important given that the ongoing fiscal adjustment needs to be continued for many years to reduce public debt to sustainable levels. But it is equally important in developing economies where inequality is relatively high.

Income inequality in recent decades

Our database on inequality trends in 150 advanced and developing countries shows that disposable income inequality (that is, after taxes and transfers)  has increased in most advanced and many developing economies over recent decades (Chart 1).  Inequality is measured by the Gini coefficient (which ranges from 0, when everyone has exactly the same income, to 1 when a single individual receives all the income of a society).

Even more striking is the large variation in average income inequality across regions.

Another striking trend has been the sharp increase in the share of income captured by the highest income groups since the early 1980s.

For example, in the United States, the share of market (that is, before taxes and transfers) income captured by the richest 10 percent surged from around 30 percent in 1980 to 48 percent by 2008. Similar trends have occurred in other advanced and also some developing economies.

Some experts have argued that such increases have been a major contributor to the recent financial crisis.

So what role has fiscal policy played in determining these trends?

A look at advanced economies

The good news is that taxes and public transfers have played a significant role in offsetting the increase in inequality.

Over the past two decades, fiscal policy decreased inequality by about one-third in OECD countries, with two-thirds of this decrease achieved through transfers such as child benefit and public pensions. The redistributive impact is even higher when in-kind transfers such as education and health are included.

The worrying news is that the distributive impact of fiscal policy has diminished since the mid-1990s.

Chart 2 shows how market- and disposable-income inequality for working-age households have changed since the mid-1980s, with the difference between these capturing the redistributive impact of fiscal policy in each time period.

Whereas fiscal policy offset 73 percent of the 3 percentage point increase in market-income inequality up to the mid-1990s, it offset a much lower 53 percent of the increase up to the mid-2000s. Over the whole period, market-income inequality grew by twice as much as redistribution!

What’s responsible for the decreasing impact of fiscal policy?

We find that the reduction in the generosity of social benefits (particularly unemployment and social assistance benefits) and lower income tax rates, especially at higher income levels, have contributed most to the reduced impact of fiscal policy since 1990s.

This development is worrisome given the need for substantial fiscal consolidation in advanced economies in the coming years.

Indeed, in some countries, income distribution has already worsened since 2007 (for example, Ireland and Spain). However, fiscal policy can be used to mitigate the adverse impacts of consolidation by allowing automatic stabilizers (such as unemployment benefits) to work, protecting the most progressive social benefits, removing opportunities for tax avoidance and evasion, and increasing reliance on wealth and property taxes.

Role of fiscal policy in developing countries

The increase in inequality in advanced countries pales into insignificance when compared to the gap in inequality between developing and advanced economies. Much of this higher income inequality can be explained by lower levels of taxation and public spending (Chart 3), as well as their greater reliance on less progressive tax and spending instruments.

So what can be done to change this?

On the tax side, the focus should be more on broadening tax bases rather than increasing tax rates, through reduced tax exemptions, closing loopholes and improving compliance.

However, continued tight revenue constraints and the large demands on these resources to finance development objectives means that greater emphasis will need to be placed on improving the progressivity of public spending through, for example, eliminating general price subsidies and better targeting of poverty programs to the most vulnerable.

10 Responses

  1. [...] or whether there are tax policy reforms that achieve both. In the “related links” is a blog post that notes that the impact of fiscal policy on income distribution in OECD countries has diminished [...]

  2. Great post. I believe the way to capture the public’s attention is illustrating the connection between high inequality and economic stability, as you’ve accomplished in your paper. The impacts on social harmony, as well as the moral and philosophical reasonings for greater equality are equally compelling. Yet, it seems decision-makers and publics may be more responsive to the hard economic fact that inequality dampens growth and raises vulnerabilities. I am trying to argue very similar things over here:
    http://www.topplinginequality.wordpress.com

  3. When you have unemployment, underemployment of educated/skilled/experienced and “non skilled” people, it goes on to create poverty wages/welfare by paying the minimum wage to low income groups, which is the majority of the workforce. But then you have minorities on very high to excessive wages in the millions which tends to push up the average wage to a level that amounts to a “lie” and so the cost of living such as bills and housing is pushed so high that most just live off credit.

    If people don’t spend money due to the fact they don’t have it because of low wages, then businesses ranging from small enterprises to corporations don’t get the money and money does not go around and so it is on the government “welfare” to keep it all flowing; but then that creates debt for both sides as in the people and government.

    The only ones that come out on top is the employer/business owner because they still make money either by people spending or governments stimulating and bailing out and because Extreme Capitalism is still worshiped, governments see no other way of doing it.

  4. The pillars of the global economy are crumbling
    So far, the U.S. economy has been a stabilizing factor for the global recovery, and surveys have reflected that.

    But a surprise contraction in U.S. manufacturing activity in June has raised the prospects of a worsening slowdown in the U.S.

    The fear is growing that the world’s largest economy could be in a weaker condition than previously thought. The chances that the U.S. Federal Reserve will announce in the coming months a new round of monetary easing are growing.

  5. This problem of rising income inequality is well explained by David and Gupta especially in terms of broadening the tax base instead of increasing the tax rate. In Pakistan, tax potential given by some economic experts is close to Rs 7.00 trillion whereas actual collection is hardly Rs 2.00 trillion. Other policy options like public transfers and unemployment benefits for the most vulnerable do reduce the gap between the haves and the have nots to an appreciable extent. The rich should learn the lesson of equity and demonstrate in practical terms.

    This is a good suggestion by Angus that the IMF should highlight laggard policymakers on a country by country basis. Like in Pakistan, most of the feudals and agriculturists, because of their political influence, do not pay the required amount of agricultural tax.

    Adam Smith’s wisdom has passed the test of time and should be applied in reducing the income gap.

  6. Now that the IMF has shown that policymakers CAN not only stem rising income inequality, but also to turn the tide, the question arises, despite the fact that governments in the advanced economies are almost all facing serious deficits, as to why policymakers are not doing more to return income inequalities to the years before the Chicago School of Simplistic Mathematical Economics fired up billionnaires and their lobbyists?

    Is it not now time for the IMF to highlight laggard policymakers, at least on a country-by-country basis? Adam Smith’s “Theory of Moral Sentiments” warned us, 250 years ago, of the dangers arising from admiring the rich and the great more than the wise and the virtuous, so if the IMF were to be so bold as to publish a league of social equity building policymakers, it would certainly have the 250-year-old authority of the father of economic philosophy to back such a move.

  7. Absolutely! The Haves and the Have Nots are closely correlated with the not-risky and the risky, and so the first thing policymakers can do is to stop bank regulators from, by means of capital requirements based on perceived risks, causing additional discrimination of those perceived as risky, and who are already sufficiently discriminated by the banks in terms of interest rates, amounts of bank credit and other terms.

    And that represents, perhaps unwittingly, effective interest rate manipulations (like Barclays?)… something which can only increases inequality in society and reduce the opportunities for the poorer to rise… for absolutely no purpose at all… since those perceived ex ante as risky have never ever caused a bank crisis.

    My simple calculations have shown that a not-rated bank client, exclusively on account of this odious regulatory discrimination, has to pay about 270 bp (2.7%) more in interest rates when compared to an AAA rated bank client, or, like now, in times of extremely scarce bank capital, suffer the consequences of being totally excluded from access to bank credit.

    Besides, in a land that begins to value history, what it has got more than future, what it can get, sets itself on a downward path for all.

    • “Besides, in a land that begins to value history, what it has got more than future, what it can get, sets itself on a downward path for all.”

      I don’t comprehend what you intend to convey by that, Per. Perhaps if I put it in terms I can understand, you will correct me if I have gotten your point wrong.

      ***
      When I invest, i.e. make a financial bet on the future, I will analyze the past but I will retain in mind the reality that the future is not necessarily a simple extension of the past. This means that I will be intelligent if I apply a modification of the trends found in my analysis that reflects everything else I know that I could not explain by simple trends. If, however, someone else who has (a) a louder voice than I have and (b) the social mandate to supervise me — both of which circumstances characterize people making investment decisions for institutions supervised by financial authorities subscribing to the capital requirements recommendations of the Basel Committee on Banking Supervision (BCBS), tells me and everyone else that the future will be thus and so, then, recognizing that my own perspective on the future has been rendered redundant, I stop putting effort into thinking about the future and rely, like the many others in the same situation, on that someone else’s view. So, under the BCBS capital requirements framework arrangement, the only people doing thinking about the risks of assets rated by official rating agencies are the agencies themselves and people outside supervised financial institutions who are not accepting the advice of supervised financial institutions.

      How then does the BCBS capital requirements framework arrangement affect the allocation of debt capital? It renders it monolthic, i.e. herd like, and thus inordinately subject to booms and busts. Not only that, it tends to make the cost of pre-investment due diligence of investing in well-established assets, such as government bonds, lower than in an arrangement in which capital requirements are not predicated on the BCBS recommendations; and that has the effect of shifting financial institutions allocation of debt capital away from the high cost of pre-investment due diligence associated with loans to small enterprises, and toward the government and large corporate establishments.

      Perhaps that too widens the level of income inequality?
      ***

      Is that what you intend to convey to this blog’s audience, Per?

      • Angus… what you have written is absolutely correct and is a fundamental part of what I have been arguing for more than a decade now.

        But, in this particular case, I was referring to the need for a society to be willing to risk part of its history, what it has already got, in order to gain the new results that can sustain its future.

        And so when regulators, as current bank regulators have done, add on another layer of risk adverseness, on top of the society’s (and bankers’) natural risk-adverseness, then there will be too much defense of history, and too little promotion of the future… and the bicycle’s forward motion will stall, and the bike-rider (the nation) fall.

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