Fiscal policy and income inequality: the role of taxes and social spending

This ODI report was originally published on odi.org on 30th September 2022 here, and is reproduced with kind permission.

This report provides a comprehensive and updated survey of the available evidence on the combined impact of taxes and social spending (cash transfers and health and education in-kind transfers) on within-country income inequality and poverty. It also looks at studies of individual fiscal instruments across countries with different income levels.

A better understanding of how to design tax and social spending policies to achieve the greatest impact on income inequality and poverty within existing constraints is crucial to inform countries’ efforts to build more equitable and sustainable fiscal systems as they recover from the Covid-19 pandemic and tackle the impacts of high energy and food prices.

While inequality is often important from a political or ethical perspective, there is also an increasingly strong economic argument for addressing income inequality. The tension between equality and efficiency (and economic growth, in particular) that has underpinned arguments against progressive tax and spending systems is not supported by the empirical evidence. There is a cost to raising taxes and providing public services and social protection of course, including on incentives to save, invest and work. But it is important to assess the whole system so that the many benefits are considered together with costs to assess their net effects on societies and economies. Not all fiscal instruments have to be progressive, equalising and pro-poor; what matters the most is their combined effect on poverty and income inequality.

Our analysis shows that incomes before taxes and transfers in lower-income countries are distributed more unequally than in others. We also show that in many countries, even in richer ones that are relatively equal, inequality is rising. Yet, within income country groups and geographic regions, there are high levels of heterogeneity in income inequality and poverty outcomes, both before and after the effects of fiscal policy are assessed. This heterogeneity suggests the importance of both political and social choices, as well as the design and implementation of policy. While lower-income countries have narrower tax bases and redistribute less than richer ones, there is evidence that social spending tends to expand as fiscal capacity expands. Even if richer countries are better equipped to address income inequality through tax and social spending systems, all countries can measure and improve the performance of policies to create more equitable and efficient outcomes.

Key Messages

• Fiscal policy can reduce within-country income inequality by up to 40%. Richer countries have greater capacity to redistribute than poorer ones. Fiscal policy in low-income countries achieves only a 3% reduction in inequality on average.
• Variation in income inequality within country income groups suggests policy choices matter, beyond the level of development. While fiscal capacity needs to expand overall to achieve greater fiscal redistribution in most low-income settings, better-designed fiscal policy can also improve impact.
• Revenue mobilisation does not need to preclude more equitable policy choices since some revenue reforms can be both efficient at raising revenue and equalising, especially when combined with high-quality equitable social transfers. Lower income inequality before and after fiscal intervention can also be beneficial for economic growth and, in turn, for revenue mobilisation as the tax base expands.
• Opportunities for equitable economic growth include increasing progressivity of income tax, improving efficiency of consumption taxes, removing inefficient subsidies and tax exemptions to help finance enhanced social insurance and a mix of complementary in-kind transfers and targeted equitable cash transfers. The design and quality of cash transfers and in-kind transfers, through the delivery of health and education public services, are paramount to ensure positive net returns to fiscal intervention.
• Implementation of these reforms faces political and institutional challenges. Better analysis of net impacts of tax and spending on income inequality and poverty can inform country-specific choices, and a whole-of-government approach can help deliver them.