Why Raising Taxes Won't Fix Global Inequality

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Last week, the Organization for Economic Cooperation and Development issued a report on inequality and economic growth. The OECD, based in Paris, is the official think tank for rich countries. Its analysis concluded that the income gap between the poor and the middle class contributes to declining economic growth. The United Kingdom and the United States lost 6 percentage points to 9 percentage points of gross domestic product growth over the last two decades because of rising inequality, the report suggested.

OECD economist Federico Cingano also argued that “[r]edistribution policies via taxes and transfers are a key tool to ensure the benefits of growth are more broadly distributed.” Despite such recommendations, survey data from around the world show people are suspicious of taxes as a tool for greater equality. There’s good reason for skepticism: Existing tax and transfer systems across much of the developing world, in particular, have failed to take a dent out of inequality. If governments are going to help reduce the gap between rich and poor people and spur faster income growth for all, it isn’t just about raising more taxes, but raising the right kind of taxes and spending the proceeds well.

A recent global poll (PDF) by the Pew Research Center asked “What would do more to reduce the gap between the rich and the poor in our country? High taxes on the wealthy and corporations to fund programs that help the poor or low taxes on the wealthy and corporations to encourage investment and economic growth?” In most developed countries, the most popular answer was “higher taxes.” In the U.S. and U.K., 50 percent and 49 percent respectively backed higher taxes, compared to less than 40 percent, who suggested low taxes would reduce inequality.

In a lot of countries, especially in the developing world, reducing taxes was the most popular response. It was given by more than two-thirds of respondents in Italy, six out of 10 in France, three-quarters of respondents in Brazil, and over one-half in Kenya. Worldwide, the median response was 40 percent in favor of lower taxes, compared to 32 percent backing higher taxes as the better tool to reduce inequality.

At least at first glance, those results are surprising. A relationship between a (progressive) income tax, or wealth tax, and lower income inequality seems intuitively obvious and is widely embraced by economists, not always the same thing. Not only is there a direct effect on inequality by taking more money from the rich than from the poor, but higher tax revenues can support government transfers to poorer citizens.

Take the U.S., for example: When you account for all federal, state, and local income taxes, the country’s tax system is somewhat progressive. The bottom 20 percent pay about 17 percent of their income in taxes, compared to around a 30 percent share for the top 20 percent. According to calculations (PDF) by staff at the OECD, U.S. taxes—combined with transfers such as welfare payments and the Earned Income Tax Credit—reduce inequality in the country by about 20 percent. In other rich countries, government policies are responsible for an average 25 percent reduction in inequality.

But a new dataset (PDF) put together by the International Center for Tax and Development suggests that poorer countries don’t collect as much in taxes as rich countries do, and they fare particularly badly when it comes to collecting the types of taxes that have a redistributive impact. Excluding social contributions (such as Social Security), the average tax take as a proportion of GDP was 25 percent in high-income countries in 2009, compared to a little more than 15 percent in low- and middle-income countries. And compared to rich countries (PDF), whose sales and trade taxes are about equal in size to income taxes, developing countries see sales and trade taxes worth around 11 percent of GDP, compared to direct taxes worth 6 percent and individual taxation worth just 2 percent of GDP.

This matters when it comes to inequality. Income taxes tend to be considerably more progressive, taking a larger percentage of rich people’s incomes than of poor people’s incomes. Sales taxes can even be regressive, taking a larger share of poor people’s incomes than from the income of rich people.

Nora Lustig and colleagues at the Commitment to Equity Project have worked through data (PDF) in Latin America and found that across the region, the combined impact of taxes, transfers, and subsidies has only a minor impact on inequality. The researchers use the Gini coefficient, which is a measure of inequality where scoring a 1 means one person controls all the income in a country and a zero means everyone has exactly the same income. Brazil sees its Gini drop from 0.57 to 0.54 because of the impact of taxes, transfers, and subsidies. In Mexico, a figure of 0.51, before government payments and receipts, drops to 0.48 after those transactions. Bolivia and Uruguay have such poorly designed sales taxes and subsidies that their effect is to raise inequality.

In all four countries, the overall impact is minimal. The limited effect of the tax, subsidy, and transfer system is also clear from rates of poverty in the region, before and after these financial flows to and from government. The population living on less than $2.50 a day is 15 percent in Brazil before taxes and transfers and 14 percent after them. In Mexico, it is 13 before and 10 percent after. In Bolivia, the percentage doesn’t change at all.

In most developing countries, lowering the tax take won’t, on its own, lead to greater equality. Governments everywhere need the resources to provide such public services as security, transport, education, and health, which are vital to economic growth and should benefit everyone—even though the evidence shows that such services still benefit rich more than poor (PDF)).

Simply raising taxes across the board isn’t the answer, either. Rich people across much of the developing world don’t pay much income tax, while poor people paying a lot of sales tax. If countries want the social and economic benefits of greater income equality, they are going to have to seriously reform their tax-and-transfer regimes.

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