Income Inequality, Fiscal Policy and Institutional Development: On the Redistributive Effects of IncomeTax Progressivity

1. Income Inequality, Fiscal Policy and Institutional Development:On the Redistributive Effects of IncomeTax Progressivity and Corruption. Elisa Baroni UK Department of Work and Pensions* Cathal O’Donoghue National University of Ireland Galway ICER,DWP * Disclaimer: the views expressed in this paper are those of the authors only

2. Our model aims to show that: • A “pro-poor” expenditure system is not the only mechanism to reduce inequality. The progressivity of the tax system also matters. • The effect of tax progressivity on inequality however is non-linear. Possibly this is because higher tax progressivity leads to more tax evasion. • Corruption increases inequality directly, and indirectly, by reducing the redistributive effectiveness of tax progressivity.  The effectiveness of redistributive policies on income inequality depends on the institutional context  Could tackling corruption (e.g. tax evasion) get us around the classic equity / efficiency trade-off in taxation ?

3. Why Inequality Matters • Empirical Evidence - Income inequality has increased both across and within several countries since 1970s, but no clear trend and large variance within countries. • Theory - Equity and Efficiency are non-separable goals in a market characterised by imperfect information/imperfect credit markets. - Inequality can have efficiency implications  lower investment in human/physical capital by poor  poverty traps.

4. Why Tax Progressivity Matters • Tax progressivity lowers inequality. • However it has efficiency costs because it distorts behaviour: • Tax progressivity reduces labour supply (Mirrlees, 1971). • Tax progressivity reduces investments hence growth (Persson and Tabellini, 1994) • Tax progressivity encourages tax evasion (Hindriks Keen Muthoo, 1998) • Progressive tax systems are harder + costlier to administer. • The net redistributive effect of tax progressivity is what matters: More Tax Progressivity  Less Inequality ?

5. Why Corruption Matters • Corruption : “the abuse of public office for private gain”; “ the enjoyment by some of a larger share of public benefits and a lower share of the costs “ (Kauffman, 1997; Tanzi, 1997). • Most common forms: tax evasion, illicit exemptions, siphoning of public funds  usually in favour of higher income groups. • Has a negative distributional impact; • Distorts the allocation of public expenditures (e.g. less on education, Mauro 1998). • Reduces the progressivity of the tax system (Tanzi and Davoodi, 2000; Gupta, Davoodi and Alonso Terme, 1998). • Lowers the tax base available for redistribution More Corruption  Higher Inequality

6. What others say (to our knowledge) and what we add to it: • The effect of tax progressivity on inequality is measured indirectly e.g. through the direct/indirect tax composition ratio (Chu, Davoodi, Gupta)  our model measures tax progressivity directly. • The effect of corruption on tax progressivity / inequality is measured indirectly (Gupta, Davoodi, Alonso-Terme) e.g. through its differential effect on pre- and post-tax gini  our model measures this effect directly.

7. Our Data • Cross-country dataset, 47 countries (OECD and Developing), 1980-1997 • Inequality  Av. Gini (Deininger- Squire 80-95) • Higher Gini  higher inequality • Tax progressivity index (Source: IMF) • Ratio t (3*GDPpc) to t (0.5*GDPpc) • Higher Index  greater progressivity. • Expenditure progressivity  • primary ed.exp per pupil as %GDP, • social expenditures as %GDP. • Corruption  composite index (Av. 80-95) (Gupta, Davoodi). • Higher index  lower corruption. • Other explanatory variables include: • education inequality, • human capital endowment, land inequality, • GDP per capita, • tax composition ratio.

8. Our Econometric Model • Basic OLS regression: Yi=  + 1Ti + 2Ei + 3Ci + 4Zi + 5CORRi + 6(Ti)2 + ui • We control for endogeneity between tax progressivity T and inequality Y by lagging T to the 1st year of Gini data available. • We interact CORR*T and CORR*E • We control for post-tax Gini • We run separate regressions for developed and developing countries

9. Our Results • Increasing income tax progressivity by 1 s.d. lowers inequality by approx. 6 Gini points, both post-tax and pre-tax (negative and significant 1). • Tax composition matters only when we control for tax progressivity, but “wrong” sign (positive and mildly significant 3). • The relationship between income tax progressivity and income inequality is non-linear (positive and significant β6). • Corruption worsens income inequality directly (negative and significant β5 ) • It also worsens inequality indirectly by reducing the impact of tax progressivity (positive and significant interaction term with T). • Reducing corruption has equity implications + efficiency costs lower than raising tax progressivity.

10. Future Work • Measurement error: in both dependent and independent variables  try different measures of inequality, remodelling tax progressivity index • Identification problems: (i) endogeneity of corruption  try to use IV (ii) endogeneity of tax progressivity and pre-tax inequality (iii) omitted variable bias e.g. measure of openness to trade, lagged inequality, size of the formal sector/GDP etc. • Small sample size – Add extra countries • Static model: need to introduce dynamic dimension eg. Impact of Tax Reform or Institutional Reform (=change in corruption levels) on changes in inequality.