©2014 International Monetary Fund

IMF POLICY PAPER
FISCAL POLICY AND INCOME INEQUALITY
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or reviewing existing IMF policies and operations. The following document(s) have been
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ï‚· The Staff Report on Fiscal Policy and Income Inequality, prepared by IMF staff and
completed on January 22, 2014 to brief the Executive Board on February 7, 2014.
The Executive Directors met in an informal session, and no decisions were taken at this
meeting.

The policy considerations in this paper should be attributed to IMF staff and not to the IMF
or its Executive Board. The analysis was prepared by the staff of the Fiscal Affairs Department
and has benefited from comments and suggestions by staff from other IMF departments, as
well as by Executive Directors following their discussion of the report on February 7, 2014.

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Electronic copies of IMF Policy Papers
are available to the public from
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International Monetary Fund
Washington, D.C.
January 23, 2014



FISCAL POLICY AND INCOME INEQUALITY


EXECUTIVE SUMMARY
Fiscal policy is the primary tool for governments to affect income distribution.
Rising income inequality in advanced and developing economies has coincided with
growing public support for income redistribution. This comes at a time when fiscal
restraint is an important priority in many advanced and developing economies. In the
context of the Fund’s mandate to promote growth and stability, this paper describes:
(i) recent trends in the inequality of income, wealth, and opportunity in advanced and
developing economies; (ii) country experience with different fiscal instruments for
redistribution; (iii) options for the reform of expenditure and tax policies to help achieve
distributive objectives in an efficient manner that is consistent with fiscal sustainability;
and (iv) recent evidence on how fiscal policy measures can be designed to mitigate the
impact of fiscal consolidation on inequality. This paper does not advocate any particular
redistributive goal or policy instrument for fiscal redistribution.

Both tax and expenditure policies need to be carefully designed to balance
distributional and efficiency objectives, including during fiscal consolidation. The
appropriate mix of instruments will depend on administrative capacity, as well as on
society’s preferences for redistribution, the role envisaged for the state, and political
economy considerations. Options for redistributive policies that help minimize
efficiency costs, in terms of their effects on incentives to work and save, are the
following:
ï‚·
In advanced economies: (i) using means-testing, with a gradual phasing out of
benefits as incomes rise to avoid adverse effects on employment; (ii) raising retirement
ages in pension systems, with adequate provisions for the poor whose life expectancy
could be shorter; (iii) improving the access of lower-income groups to higher education
and maintaining access to health services; (iv) implementing progressive personal
income tax (PIT) rate structures; and (v) reducing regressive tax exemptions.
ï‚·
In developing economies: (i) consolidating social assistance programs and
improving targeting; (ii) introducing and expanding conditional cash transfer programs
as administrative capacity improves; (iii) expanding noncontributory means-tested
social pensions; (iv) improving access of low-income families to education and health
services; and (v) expanding coverage of the PIT.
Innovative approaches, such as the greater use of taxes on property and energy (such
as carbon taxes) could also be considered in both advanced and developing economies.
January 22, 2014
FISCAL POLICY AND INCOME INEQUALITY
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Approved By
Sanjeev Gupta
Prepared by staff from Fiscal Affairs Department supervised by
Sanjeev Gupta and Michael Keen, and comprising Benedict Clements,
Victoria Perry, David Coady, Ruud De Mooij, Stefania Fabrizio, Baoping
Shang, Allan Dizioli, Luc Eyraud, Csaba Feher, Valentina Flamini,
Alvar Kangur, Javier Kapsoli, Carlos Mulas-Granados, Peter Mullins,
Philippe Wingender, Dora Benedek, Ryan Espiritu, and Louis Sears.
Production assistance was provided by Pierre Jean Albert, Jeffrey
Pichocki, and Mileva Radisavljević.

CONTENTS
INTRODUCTION __________________________________________________________________________________ 4 
TRENDS IN INEQUALITY__________________________________________________________________________ 7 
A. Inequality of Income ____________________________________________________________________________ 7 
B. Inequality of Wealth ___________________________________________________________________________ 11 
C. Lifetime Inequality _____________________________________________________________________________ 13 
D. Inequality of Opportunity _____________________________________________________________________ 13 
FISCAL REDISTRIBUTION _______________________________________________________________________ 14 
A. Advanced Economies__________________________________________________________________________ 15 
B. Developing Economies ________________________________________________________________________ 18 
DESIGN OF EFFICIENT REDISTRIBUTIVE FISCAL POLICY ______________________________________ 21 
A. Conceptual Framework ________________________________________________________________________ 21 
B. Social Spending _______________________________________________________________________________ 25 
C. Tax Design _____________________________________________________________________________________ 36 
D. Summary ______________________________________________________________________________________ 42 
FISCAL CONSOLIDATION AND INEQUALITY __________________________________________________ 43 
A. Advanced Economies__________________________________________________________________________ 44 
B. Developing Economies ________________________________________________________________________ 48 
Appendix I. Who Benefits from Tax Incentives for Charitable Giving?____________________________ 50 

BOXES
1. Efficiency and Fiscal Redistribution ______________________________________________________________ 6 
2. Rising Public Support for Redistribution _________________________________________________________ 9 
3. Redistributive Fiscal Policy: Evidence from Regression Analysis _______________________________ 15 
4. Fiscal Policy and Income Inequality in Latin America __________________________________________ 19 
5. What is the Shape of the Optimal Income Tax Schedule? _____________________________________ 23 
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6. In-Work Benefits and Credits _________________________________________________________________ 25 
7. Conditional Cash Transfer Programs __________________________________________________________ 32

FIGURES
1. Trends in Disposable Income Inequality, 1980–2010 ____________________________________________ 8 
2. Gross Income Share of Top One-Percent in Selected Advanced and
Developing Economies, 1925–2012 ___________________________________________________________ 10 
3. Poverty Rates in Developing Economies, 1980–2010 __________________________________________ 11 
4. Inequality of Wealth and Incomes in Selected Economies, early-2000s _______________________ 12 
5. The Great Gatsby Curve: Income Inequality and Economic Mobility , mid-1980s _____________ 14 
6. Redistributive Impact of Fiscal Policy in Advanced Economies, mid-2000s ____________________ 16 
7. Diminishing Fiscal Redistribution, 1985–2005 _________________________________________________ 17 
8. Tax Revenues and Social Spending in Advanced and Developing Economies _________________ 19 
9. Social Protection Coverage and Incidence in Developing Economies, late-2000s _____________ 20 
10. Benefit Incidence of Education and Health Public Spending _________________________________ 21 
11. Means-tested and Non-means-tested Family Benefits, 2010 ________________________________ 28 
12. Top PIT Rates, 1980–2012 ____________________________________________________________________ 37 
13. Redistributive Effect of Fiscal Adjustments, 2007–2012 ______________________________________ 45 
14. Cumulative Change in Households Disposable Income due to Simulated Fiscal
Consolidation Measures, 2008–12 ___________________________________________________________ 47 
15. Simulated Impact of Fiscal Consolidation (FC) Measures on Gini Index, 2012 ________________ 47 
16. Unemployment Rates and Gini Coefficients During Large Fiscal Adjustments in
Developing Economies _______________________________________________________________________ 48 

TABLES
1. Summary: Fiscal Reform Options for Efficient Redistribution in Advanced and
Developing Economies _________________________________________________________________________ 43 

APPENDICES
I. Who Benefits from Tax Incentives for Charitable Giving? ______________________________________ 50 
II. Recent Fiscal Consolidations and Income Inequality __________________________________________ 51 

APPENDIX FIGURES
1. Aggregate Effect and Composition of Simulated Fiscal Consolidation Measures, 2008–12 ___ 51 
2. Change in Household Disposable Income by Type of Measure and Income Group,
2007–12 ________________________________________________________________________________________ 53 

REFERENCES______________________________________________________________________________________54




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INTRODUCTION
1.
Income inequality has increased in both advanced and developing economies in recent
decades.1 Increasing inequality has been attributed to a range of factors, including the globalization
and liberalization of factor and product markets; skill-biased technological change; increases in labor
force participation by low-skilled workers; declining top marginal income tax rates; increasing
bargaining power of high earners; and the growing share of high-income couples and single-parent
households (OECD, 2008; Alvaredo and others, 2013; Hoeller, Joumard, and Koske, 2014). Many of
these developments have had beneficial effects on growth and poverty reduction both nationally
and globally (Chen and Ravallion, 2010; Milanovic, 2012).
2.
There is growing evidence that high income inequality can be detrimental to
achieving macroeconomic stability and growth. Recent empirical work finds that high levels of
inequality are harmful for the pace and sustainability of growth (Ostry, Berg, and Tsangarides,
forthcoming). Others have argued that rising inequality may have been an important contributing
factor to the global financial crisis.2 Moreover, evidence from public surveys in various countries
indicates that widening income inequality has been accompanied by growing public demand for
income redistribution, especially in countries most strongly affected by the crisis. This comes at a
time when high public debt ratios in the advanced economies, and emerging vulnerabilities in the
developing economies, have made fiscal restraint an important priority, and point to the importance
of sensitivity to distributional concerns in designing consolidation packages. In this light, income
inequality can be of macroeconomic concern for country authorities, and the Fund should
accordingly seek to understand the macroeconomic effects of inequality. In addition, in its policy
advice, the Fund should be mindful of how macroeconomic policies (including fiscal policies) affect
income distribution and their consistency with the distributional goals of country authorities.
3. Fiscal policy is the primary tool for governments to affect income distribution.3 Fiscal
policy has three main objectives—to support macroeconomic stability, provide public goods and
correct market failures, and redistribute income. Both tax and spending policies can alter the
distribution of income, both over the short and medium term. For example, in-kind benefits, such as
education spending, can affect the inequality of market incomes (i.e., incomes before taxes and
transfers) through their impact on future earnings. Other fiscal instruments, such as income taxes
and cash transfers, can reduce the inequality of disposable incomes (i.e., incomes after direct taxes

1In this paper, the category “developing economies” covers both emerging and low-income economies. These are
merged together because they face similar issues, and data availability for both groups of economies is similar.
2Rajan (2010) argues that rising inequality led to political pressure for more housing credit, which distorted lending in
the financial sector. Kumhof and Rancière (2010) show that in the United States, the Great Depression starting in
1929 and the Great Recession starting in 2007 were both preceded by a sharp increase in income and wealth
inequality and by a rapid rise in debt-to-income ratios among lower- and middle-income households.
3Other tools to influence income distribution include labor market, product market, and institutional reforms, as well
as asset redistribution. These can have an influence on inequality directly or through their effects on growth.
FISCAL POLICY AND INCOME INEQUALITY
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and transfers), including indirectly via their impact on market incomes due to work and savings
responses.
4. The Fund has long recognized the nexus between income distribution and fiscal policy.
In the late 1980s there was growing recognition and discussion of the potential effects of
macroeconomic and structural adjustment programs on poverty and inequality, including by the
IMF’s Executive Board (IMF, 1995). These discussions highlighted the importance of social safety nets
to protect the poor and safeguard their access to essential public services, such as primary
education and healthcare. Guidance notes from management on how income distribution and social
expenditures should be addressed by staff, in the context of the Fund’s mandate, were issued in the
mid-1990s (IMF, 1996, 1997). The Fund also expanded its analytical work in this area, drawing on
contributions from leading academics (Tanzi and Chu, 1998; Tanzi, Chu, and Gupta, 1999). The
growing attention of the Fund to the impact of fiscal policy on the poor was also reflected in the
creation of the Poverty Reduction and Growth Facility (later PRGT) in the late 1990s, which
emphasized the importance of pro-poor government budgets. More recently, the work on fiscal
policy and equity was revived (Bastagli, Coady, and Gupta, 2012) and subsequently broadened to
cover jobs and growth; a guidance note on the latter was issued to Fund staff (IMF, 2013a). The
macroeconomic gains from greater gender equity, and fiscal policies to help achieve this, have also
been addressed in recent work (Elborgh-Woytek and others, 2013).
5. Against the background of recent trends in income distribution and experience with
the use of redistributive fiscal instruments in both advanced and developing economies, this
paper explores how a society’s distributional objectives can be achieved in the most efficient
manner. Redistributive fiscal policies can affect private decisions in various ways, including decisions
to seek employment, to increase labor effort, and to save and invest. These, in turn, can potentially
affect both the level and growth of economic activity, either positively and negatively. Given the
Fund’s mandate to promote growth and stability, it is important that the potential tradeoffs or
complementarities between fiscal redistribution and growth are well understood. In particular, there
is a need to identify fiscal instruments that achieve distributional objectives at a minimum cost to
economic efficiency (Box 1). In doing so, the paper draws extensively on country experience, as
discussed in the literature,4 as well as in IMF technical assistance reports.5 The paper also discusses
how fiscal policies can protect households from poverty.


4See, for example, World Bank (2006); OECD (2011a, 2012); Asian Development Bank (2012); and Joumard, Pisu, and
Bloch (2012).
5The paper has also benefited from consultation with Civil Society Organizations and labor unions on its principal
conclusions and policy recommendations. In their comments, they emphasized the limited capacity of developing
economies to target social spending and protect the poor from spending cuts; the need to protect low-income
workers, who may have short life expectancies, during pension reforms that raise retirement ages; the need to
strengthen information sharing on corporate taxation; and concerns that value added taxes, in practice, were
regressive.
FISCAL POLICY AND INCOME INEQUALITY
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6. This paper does not advocate any particular redistributive goal or policy instrument
for fiscal redistribution. The motivation for the paper is to provide guidance to policymakers on
options to achieve their desired level of redistribution in the most efficient manner. The paper does
not provide guidance on the optimal degree of fiscal redistribution, which is country-specific and
depends, among other factors, on preferences for the role of the state and the costs involved in
meeting goals for redistribution.
Box 1. Efficiency and Fiscal Redistribution
The term “efficiency” in economics is often used loosely. At the most precise level, it means Pareto
efficiency—a situation in which no individual can be made better off without making some other individual
worse off. An efficiency-improving reform in this sense would then be one that makes someone better off
and no one worse off. But this is a very demanding test, both in assessing well-being and removing any
possibility that someone may be adversely affected by change. Reflecting this, the term “efficiency gain” is
often used more loosely to refer to increase in the aggregate level or growth of income; and this is the
interpretation in mind here.
A closely related concept is deadweight loss (or excess burden), which measures the inefficiency associated
with economic distortions. For example, the welfare loss of a distortionary tax is measured by the burden
imposed on individuals in excess of the revenue generated by the tax—and conversely, for a subsidy, the
burden in excess of the revenue loss.
Importantly, there may be instances of reform that improve both efficiency—in any of these senses—and
equity (Boadway and Keen, 2000). For example, when the rich are altruistically inclined towards the poor,
redistribution can be obviously Pareto improving. Also, the provision of social insurance can encourage
risk-taking and increase investment returns, thus also potentially improving efficiency. Fiscal redistribution
can also relax credit constraints facing poor households and allow them to invest in education, boosting
human capital and enhancing efficiency. Interestingly, these examples show that redistribution may yield
efficiency gains which are also reflected in higher economic growth.
Identifying instances in which both equity and efficiency can be improved is a primary concern of this paper,
though some trade-off between them becomes inevitable once these have been fully exploited.
7. The structure of the paper is as follows. The next section describes trends in inequality
across advanced and developing economies. The discussion covers inequality of incomes and
wealth. It also examines the evidence on the persistence of income inequality across generations, an
indicator of equality of opportunity. This is followed by a review of empirical evidence on the
redistributive impact of fiscal policies and the extent to which fiscal policy can explain differences in
inequality across countries and over time. The paper next focuses on the overall design of
redistributive fiscal policy as well as of specific tax and spending instruments, and how these can be
designed to minimize the efficiency costs of redistribution. The final section discusses the
redistributive impact of fiscal consolidation, which can affect inequality both in the long run through
channels explained in earlier sections and through its short-run effects on output and employment.


FISCAL POLICY AND INCOME INEQUALITY
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TRENDS IN INEQUALITY
8. Economic inequality can be viewed from different perspectives. Each of these can
provide insights into the nature, causes, and consequences of economic inequality.
ï‚·
Inequality of income: This focuses on the inter-personal distribution of income, which captures
how individual or household incomes are distributed across the population at a point in time.
ï‚·
Inequality of wealth: Here the focus is on the distribution of wealth across individuals or
households, which reflects differences in savings as well as bequests and inheritances.
ï‚· Lifetime inequality: This focuses on measuring inequality in incomes or earnings for an individual
over his or her lifetime, rather than for a single year.
ï‚·
Inequality of opportunity: This focuses on the relationship between income inequality and social
mobility, in particular the extent of mobility between income groups across generations.
A. Inequality of Income
9. Over the last three decades, inequality in the personal distribution of income has
increased in most economies. Figure 1 presents trends in the average (unweighted) Gini coefficient
for disposable incomes (i.e., market incomes minus direct taxes plus cash transfers) across regions
over recent decades—which reflects both the inequality of market-determined incomes as well as
the distributional impact of income taxes and public transfers.6 The Gini coefficient ranges between
0 (denoting complete equality) and 1 (denoting complete inequality).7 Between 1990 and 2010, the
Gini for disposable income has increased in nearly all advanced and emerging European economies.
Over one-third of advanced economies and half of emerging Europe experienced increases in their
Ginis exceeding 3 percentage points, with most of the increases in emerging Europe occurring
between 1990 and 1995 during the early years of their transition to market-based systems.
Inequality also rose in most economies in Asia and the Pacific and in Middle East and North Africa.
While average inequality fell in sub-Saharan Africa over this period, it still rose by more than
3 percentage points in more than one-fourth of these economies. Inequality also increased in over
one-third of the economies in Latin America, although on average there was a slight decline.
However, since 2000 there has been a substantial decline in the Gini in nearly all countries in this

6Data on the inequality of market incomes is much more limited, being available mostly for advanced economies and
for a shorter time period. For country specific data on Ginis for disposable income, see Bastagli, Coady, and Gupta
(2012). For a discussion of the issues that arise when comparing income inequality measures across countries and
time, see Atkinson and Bourguignon (2000), Atkinson and Brandolini (2001), and Deaton and Zaidi (2002).
7The Gini is less sensitive to inequality at the extremes of the income distribution than many other commonly used
measures. However, other inequality measures show a similar trend in overall income inequality. For instance, the
ratio of the income share of the top 20 percent of the income distribution to the share of the bottom 20 percent has
a correlation coefficient with the Gini of around 0.85.
FISCAL POLICY AND INCOME INEQUALITY
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region. This increase in inequality across the globe has also been accompanied by a widespread rise
in public support for redistribution (Box 2).
Figure 1. Trends in Disposable Income Inequality, 1980–2010
Sources: OECD; Luxembourg Income Study Database; Socio-Economic Database for Latin America and
the Caribbean (SEDLAC); World Bank; Eurostat.

Note: Disposable income is income available to finance consumption once income taxes and public
transfers have been netted out. Therefore, the distributional impacts of indirect taxes and in-kind
transfers are not included. The Gini coefficient ranges between 0 (complete equality) and 1 (complete
inequality). Number of countries in parentheses.

10. More striking than changes in inequality within regions are the persistent differences
across regions. For instance, between 1990 and 2010, average inequality in each region changed by
less than 3¼ percentage points. In contrast, average inequality in the two most unequal regions
(sub-Saharan Africa and Latin America) remained 12 percentage points higher than the two most
equal regions (emerging Europe and advanced economies). As the following section shows, a large
proportion of the differences in regional average disposable income inequalities can be explained
by differences in fiscal policies, especially in the levels and composition of taxes and spending.





0.2
0.25
0.3
0.35
0.4
0.45
0.5
0.55
1980
1985
1990
1995
2000
2005
2010
G
in
i c
oe
ff
ic
ie
nt
Advanced (21)
Asia and Pacific (14)
Emerging Europe (21)
Latin America and Caribbean (19)
Middle East and North Africa (12)
Sub-Saharan Africa (22)
FISCAL POLICY AND INCOME INEQUALITY
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11. More recently, the public debate has focused on the sharp increase in the share of
total income going to top income groups. Over the last three decades the market income shares
of the richest one-percent of the population have increased substantially in English-speaking
advanced economies, as well as in China and India (Figure 2). For example, in the United States, the
share of market income captured by the richest 10 percent surged from around 30 percent in 1980
to 48 percent by 2012, while the share of the richest one-percent increased from 8 percent to
19 percent. Even more striking is the fourfold increase in the income share of the richest 0.1 percent,
from 2.6 percent to 10.4 percent. There has been substantial variation across countries in how much
the share of the highest income groups has risen. The increase in the share of the top one-percent
has been much less pronounced in Southern European and Nordic economies, and hardly any
increases have been observed in continental Europe and Japan. While there is broad consensus
Box 2. Rising Public Support for Redistribution
International public surveys monitor public support for redistributive policy in both advanced and
developing economies. These surveys, which include the World Value Surveys (WVS), Regional
Barometers, and International Social Surveys, ask citizens whether they favor more or less redistribution. In
the WVS, respondents are asked to indicate, on a scale from 1 to 10, whether “incomes should be made
more equal” (1) or whether the country “needs larger income differences as incentive” (10). For our
purposes, we divide these responses in two categories: answers 1 to 5 indicate that the respondents prefer
more redistribution, and answers 6 to 10 indicate preference for less redistribution. A similar approach is
applied to other surveys to find the share of the population that supports more redistribution.
The evidence indicates that public support for redistributive policies has grown in recent decades.
Between the late-1990s and the late-2000s, public support for redistribution increased in almost 70 percent
of the advanced and developing economies surveyed. For instance, support increased substantially in
Finland, Germany, and Sweden, and also in China and India (see Figure). In the late-1990s, results for only
15 economies out of the 57 in the sample (26 percent) indicate majority support for more redistribution.
By the late-2000s, the percentage of countries where a majority supported more redistribution grew to
56 percent. These findings are consistent with other surveys of public opinion (e.g., OECD, 2008; ADB,
2012).

Support for redistribution grew more in
countries where inequality increased and,
more recently, in advanced economies
where the crisis hit hardest. For instance,
public support between the late-1990s and
the late-2000s grew by more than
30 percentage points in China, Finland,
Germany and several Eastern European
countries, where the income Gini increased
by over 20 percent. At the same time,
support declined in countries where the Gini
decreased, including in Bulgaria, Mexico,
Peru, and Ukraine. Rising inequality thus
seems to partly explain the increased public support for redistribution. Between 2008 and 2011, among
advanced economies, public opinion changed more in favor of redistributive policies in countries that
experienced large declines in GDP, such as Portugal, Ireland, and Slovenia.
ALB
ARG
ARM
AUS
AUT
AZE
BLR
BEL
BIH
BRA
BGR
CAN
CHL
CHN
HRV
DNK
EST
FIN
FRA
GEO
DEU
HUN
ISL
IND
IRL
ITA
JPN
KOR
LVA
LTU
MKD
MLT
MEX
MDA
MNE
NLD
NGA
NOR
PER
POL
PRT
ROM
RUS
SRB
SVK
SVN
ZAF
ESP
SWE
CHE
TPE
TUR
UKR
GBR
USA
URY
0.1
0.3
0.5
0.7
0.9
0.1
0.3
0.5
0.7
0.9
La
te
2
00
0s
Late 1990s
Figure. Public Support for Redistribution
Source: Integrated Values Survey 1981–2008