Can developing countries use taxation to reduce inequality?

22nd September 2015
Bruno Martorano outlines how Latin American tax policies have been successful in tackling the problem of income equality within the region.
Latin American countries have recorded important results in terms of inequality reduction during the last decade. Yet, an ignored aspect of their success is the growing emphasis placed on tax policy and the contribution of taxation in promoting an equitable distribution of income.
The region was previously influenced by neoliberal developments in tax design which saw greater emphasis on efficiency, horizontal equity and revenue adequacy (i.e. ensuring a sufficient amount of revenue is generated). As a result, governments tried to simplify and rationalize tax structures as well as to widen the tax base. In particular, VAT and other consumption taxes replaced trade taxes considered harmful in terms of domestic and international allocation of resources. In addition, personal and corporate income taxes were lowered in order to reduce as much as possible the negative consequences on labour supply and investments.
Nonetheless – contrary to the intended aims – tax policy failed to improve economic growth, contributing to macroeconomic instability and fuelling income inequality. These, together with increasing frustration with the poor results of the Washington Consensus policies and the process of democratic consolidation, saw the election success of left-wing parties in Latin America. Indeed the new left governments have followed a different strategy, focusing on more equitable growth – with taxation back to its original role of promoting development, assuring macroeconomic stabilization as well as reducing inequality.
In particular, Latin American governments have tried to mobilize revenue with a new emphasis placed on progressivity in tax design:
  • First, the vast majority of them have implemented important administrative reforms switching toward a functional rationalization of their administrative structures – i.e. focusing on tax activities (tax collection, data management etc.) – adopting a Semi-Autonomous Revenue Authorities model and establishing large taxpayer units (for those with larger receipts to pay)
  • They have enlarged their tax base, reducing numbers of exemptions and removing several forms of deductions
  • Furthermore, governments have used several unorthodox forms of taxation such as simplified tax regimes and taxes on financial transactions
  • Finally, many countries have reformed their direct tax system (especially in the late 2000s).

As a result, Vito Tanzi, former IMF Director of Fiscal Affairs explains that ‘with a closer look, it could be maintained that the changes that took place over the years, in the tax systems of many Latin American countries, have made those tax systems far better than they had been in the past in some aspects’.
These reforms have generated important consequences in terms of revenue mobilization as well as income distribution. Indeed, research colleagues and I have seen that recent tax policy changes in Latin America together with favourable external conditions have promoted an increase of the tax/GDP ratio. We have also shown that greater reliance on direct taxes and a reduction in indirect taxes has promoted the redistributive role of taxation - with the Gini coefficient of the distribution of household income improving on average by 0.4-0.8 points. The redistributive role of direct taxes was also confirmed by Lustig and colleagues in a recent work.
The Uruguayan Tax Reform of 2007, which introduced a dual tax system combining a new progressive labour income tax and a flat capital income tax, is further evidence of the possibility of harvesting more revenues whilst also enhancing the redistribution of resources. Figure 1 highlights the rise in revenue in the country since 2007, whilst recent research of mine on the Uruguayan model shows that the new tax on labour income has lowered inequality by two Gini points (Figure 2).
Figures 1 and 2

To conclude, the Latin American story provides important lessons for middle-income countries i.e. that taxation can contribute to reducing inequality. However it has real lessons for developing contexts too.
For instance:

  • Improving tax administration – reducing tax evasion and increasing tax compliance
  • Increasing the contribution of wealth and income taxes
  • Ensuring that increases in taxes meet peoples’ expectations in terms of the quantity and quality of public services.
These are general recommendations and would need to be adapted to the specific conditions of each country.