Assessing the redistributive effect of fiscal policy

How does a government’s fiscal policy, and, specifically, its tax policy, influence the distribution of economic welfare in a society? In the context of poverty and inequality, accounting for the distributional effects of public policy is essential when evaluating government intervention. One way of doing this is through expenditure and tax incidence analysis. This looks at who benefits from public spending and taxes and assesses the social desirability of the resulting distribution of benefits. A new World Bank report now looks in more detail at the basic concepts, methods and modelling approaches in fiscal incidence analysis.

The report notes that the distribution of the benefits and burdens of government intervention is the outcome of three types of decisions, the first two of which are collective while the last is individual. The decisions are:

• the size of government
• the value judgments defining the social desirability of the fiscal distributional equation
• individual reactions to fiscal decisions that aim to maximise benefits
  

In this context, the concept of progressivity is used to assess the redistributive effect of public policy, which implies that benefits and burdens of taxes and public spending must be distributed disproportionately in favour of the poor. For example, tax policies are evaluated by comparing the distribution of a living standard indicator (such as real income or expenditure) with and without the tax-benefit system. In this exercise, the interaction between collective and individual decisions makes it necessary to link a general equilibrium model to a microsimulation model to deal with both the heterogeneity and general equilibrium effects of public policies. This approach is used to assess public spending and tax policies in Australia, Chile, Ghana, Madagascar, Malawi, Malaysia, Peru, Philippines, South Africa and South Korea. 

As a result, lessons for policy design are identified including the fact that:

• individual income and wealth taxes are best for redistributing income
• institutional factors, such as the existence of a large informal sector, limit the effectiveness of income tax in developing countries
• analysis of the distribution of living standards requires going beyond economic to cover cultural and political economy factors
  

The report ends by recommending that fiscal incidence analysis broaden its scope to begin to address not just the type of living people manage to achieve from public spending out of tax revenues, but also the extent to which fiscal policy equalises opportunities for well-being among citizens.