How tax can reduce income inequality in Africa?

The rapid growth of emerging economies in the past decade has lifted hundreds of millions of people out of absolute poverty and reduced income disparities across the world. At the same time, until the financial and economic crisis of 2008, most other economies were expanding too. However, within the OECD and emerging economies not all regions or people benefitted equally from the growth years. On the contrary, the distribution of income tended to become more unequal.

  Since the onset of the crisis, these trends have increased the salience of “fairness” in political debate in many countries, in terms of both equality of opportunity and of outcomes for household incomes and consumption. While few doubt that fairness is important, interpretations of what is fair differ and may in part reflect historical norms for the distribution of income, which can differ widely between countries. That said, over the longer term too much inequality may be inimical to growth.

   Tax policy can play a major role in making the post-tax income distribution less unequal and is very crucial for raising revenues to finance public expenditure on transfers, health and education that tend to favour low-income households, as well as on growth-enabling infrastructure that can also increase social equity.

   Inequality tends to be less pronounced in OECD countries than elsewhere in the world, though in recent decades the distribution of disposable incomes has tended to become more unequal. In the mid-1980s the Gini coefficient, whereby 0 is perfectly equal (and the higher the coefficient, the more unequal is a distribution) stood at 0.28 among the working-age population, on average, in OECD countries. By the mid-2000s it had become more unequal, increasing to 0.31.

The effects of taxation on income distribution needs to be seen in the context of the trade-offs between growth and equity and not just at whether individual taxes are progressive or regressive. This is because the distribution of disposable incomes depends on both taxes and benefits. Raising indirect taxes, for instance, is often regressive where these taxes fall on the consumption of goods and services that make up a larger share of the budgets of poorer than richer households. But the overall impact of a fiscal reform can still be progressive, if these effects are offset by other tax and benefit changes. Income-related benefits are a much more efficient way of increasing the disposable income of poorer households than reduced rates of VAT.

  There is clear in the case of developing countries, where the relatively greater reliance on indirect taxes may make their tax systems more regressive. On the other hand, consumption taxes such as VAT may be the only way to finance (more) strongly progressive spending. However, as some countries lack the administrative capacity to make welfare transfers to households, there may be a case for differentiating VAT rate structures to tax “necessities” at a lower rate, if at all.

Most developed countries already have well-developed tax regimes that raise, on average, tax revenues equivalent to some 35% of GDP. The scale of tax revenues is capable of achieving a significant amount of redistribution. However, it is also capable, if structural tax policies are poorly designed, of becoming detrimental to economic performance.

During the 1980s a number of countries became concerned that high marginal tax rates were one of the factors that had contributed to the slowdown in economic growth in many countries in the 1970s. Moreover, high tax rates were encouraging the development of selective tax reliefs, which distorted investment decisions, and extensive (even aggressive) tax planning through the exploitation of loopholes that narrowed the tax base. Reformers decided to adopt a “broad base-low rate” approach instead, which meant pushing down statutory rates of both corporate and personal income taxes, and recovering potentially lost revenue by applying these tax rates to a broader base.

The apparent success of such reforms encouraged others to emulate them. Moreover, competitive pressures arising from the effects of liberalizing trade and financial flows (notably growing international integration and globalization) also put downward pressures on tax rates. Top marginal statutory rates of personal tax, in particular, have been cut quite substantially in many cases, from an OECD average of 66.8% in 1981 to 41.7% in 2010.

   Faced with the challenge of how to restore sustainable public finances and the growth of output and employment following the post-2008 recession, what tax policies should OECD countries pursue now? Can tax policies be devised that will be perceived to be “fair” and help maintain the social cohesion, while supporting growth too? Where additional tax revenues have to be raised as part of fiscal consolidation plans, can this be achieved by broadening tax bases to make more of the income of better-off individuals taxable, or should marginal statutory tax rates be raised too?

  Simply raising marginal personal income tax rates on high earners will not necessarily bring in much additional revenue, because of effects on work intensity, career decisions, tax avoidance and other behavioural responses. Where tax increases are necessary, the most growth-friendly approach would be to reduce tax-induced distortions that harm growth, including closing loopholes, and to raise more revenues from recurrent taxes on residential property, while setting taxes to reduce environmental damage and correct other externalities.

As ever, the devil is in the detail, but there are a number of ways in which such reforms could contribute to social equity. For instance, many tax breaks favour higher income individuals disproportionately. The case for reviewing their effectiveness is clearly compelling.

Good tax administration also matters. New IT systems in use in revenue administrations increasingly include tools such as sophisticated risk engines to identify potential missing revenues. Efforts to curb offshore non-compliance by making the exchange of information among tax authorities more effective have been given a new impetus. Tax evaders, who are often wealthy, have fewer places to hide their money. These initiatives also bolster international efforts by the IMF, OECD, UN and World Bank to help low-income countries to develop more effective tax systems.

In short, tax reform can promote more equity while unblocking growth, so that the next rising tide lifts more boats together.