CGD Podcast: Fiscal Policies for Equality

Sanjeev Gupta: Good day. I'm Sanjeev Gupta, senior fellow emeritus at the Center for Global Development. Before joining CGD, I spent over 31 years at the International Monetary Fund, some 22 of which were in leadership positions across its key departments. In today's podcast, I will discuss how fiscal and monetary policies can be reformed to promote inclusive and sustainable growth. Discussion is based on a guidance note that my colleagues and I prepared at the requests of the United Nations. The note explores how the UN member states can strengthen fiscal and monetary policies and governance to achieve the Sustainable Development Goals by 2030.

Joining me today is Benedict Clements, a visiting professor at the La Universidad de las Américas in Ecuador. Before that, Ben spent 29 years at the IMF, where he served as a mission chief for Kenya at the time of his retirement. Ben and I have a long history of collaboration. Since 1994, we have worked together on numerous projects, engaged with several policymakers, and co-edited six books published by the IMF. I would like to turn to Ben to give us an overview of the recent trends in income and wealth inequality, and key policies available to influence.

Benedict Clements: Thanks, Sanjeev. First, on a global scale, inequality has declined, propelled by the rapid growth of emerging market and developing economies, and notably in China and India. This has resulted in income convergence between developing countries and advanced economies. This is good news. However, one looks at inequality within countries, it has increased in the advanced countries, just in the United States and Europe for the past 20 years, mostly because of rising disparities in market incomes, that is the incomes households get from wages and the assets failing. In emerging market and developing economies for the past 20 years, inequality has remained about the same, but still with noticeable differences in trends across regions.

For example, inequality has gone up in Sub-Saharan Africa, but it's gone down in Latin America. Really, what's most striking in the data is that inequality remains much higher in the emerging and developing economies than advanced economies. One of the reasons that inequality is so high in these countries is that government taxation and spending programs really don't result in much shifting income from the rich to the middle class and poor compared with the advanced economies. The advanced economies, these programs have a big effect. They reduce inequality by about a third.

In contrast, when we look at tax and spending policies in emerging and developing economies, that only reduces inequality by a tenth. The relatively poor performance of taxes and spending to improve income distribution is really one of the reasons that we wanted to dig into the reasons for this poor performance and see what kind of policy reforms would lead to that outcome.

Before I conclude, I would like to highlight one really worrisome trend of the past 20 years. That worrisome trend is a high and rising degree of inequality in the distribution of wealth, which has really reversed the decline that was observed for most of the post-World War era until the 1970s. Household wealth exhibits a much greater level of inequality compared to income. This is primarily due to the higher savings rates amongst high-income individuals, which leads to faster wealth accumulation compared with poorer households. More research is needed, but the preliminary data we have suggests that wealth inequality went up even further since the COVID pandemic.

In the wake of the pandemic, many countries implemented fiscal stimulus and easy monetary policies with low interest rates, and that contributed to rapid increases in stock markets and real estate prices. Since these are owned more heavily by upper-income groups, wealth inequality has risen really contributing to the social discontent in the sense that the economy is unfair.

Sanjeev: I would now like to turn to the considerations that influence the design of sound monetary and fiscal policies. Here, I would like to emphasize the state of the economy, which influences the effectiveness of monetary and fiscal policies. In periods of recession or of low growth, the ability of central banks to influence interest rates is reduced, as we found out during Great Recession and immediately after the COVID pandemic. During these periods, interest rates are already low. As a result, central banks find it difficult to lower them further to stimulate borrowing and investment.

In such instances, central banks have resorted to unconventional measures, like quantitative easing, that is, buying assets such as government bonds or private sector financial assets to promote economic activity. However, the effectiveness of these two diminishes over time and can have side effects on wealth inequality, as noted by Ben earlier. The efficacy of fiscal policies is shared by countries' prevailing fiscal space, which is defined as its ability to engage in discretionary increases in expenditure or reduction in taxes while maintaining access to financial markets and meeting all payment obligations without default.

At the same time, strong economic growth plays a crucial role in expanding space by generating higher revenues. This, in turn, empowers a country to invest more in social sectors' infrastructure and climate transitions. Given that developing countries generally possess a smaller capital base, they stand to gain a greater growth dividend from productive capital investments.

I would like to stress that the efficient use of public expenditure is essential for maximizing the impact of fiscal policies and getting the most out of limited fiscal space. Unproductive spending funded solely through borrowing limits the country's fiscal space by adding burden of repaying loans and necessary interest. Rising debt-to-GDP ratios that we have witnessed in all country groups in recent years pose a major constraint on fiscal policy choices by limiting the government's ability to finance additional spending.

Ben, I would now like to turn to the role of monetary policy in supporting equitable growth agenda. Would you please elaborate?

Benedict: With respect to monetary policy, it's really traditionally been viewed as less important than fiscal policy in achieving equity objectives. There's a good reason for this because monetary policy instruments, such as the interest rates set by a central bank, can't be targeted to a specific population segment. That said, monetary policy still can play a crucial role in supporting equitable growth by containing inflation at lower moderate levels.

Now, why is inflation so bad for inequality? The reason is that high inflation rates are tax on the poor. Poor people hold more of their assets in cash rather than in short-term interest-bearing assets, where depositors can demand higher interest rates to compensate for inflation. Empirical studies, some done at the IMF, suggest the inflation rate above 5% to 6% per year can have a deleterious effect on income distribution.

We also find that countries that pursue low to moderate inflation really don't end up sacrificing other macroeconomic objectives such as economic growth, real wages, or unemployment over the medium to long term. While this suggests that maintaining low inflation is compatible with a broader strategy for equitable growth. At the same time it's important to recognize that in the short run, raising interest rates to reduce inflation can worsen income inequality by slowing economic activity. This underscores that countries need to have social safety nets in place to protect the poor during these episodes of monetary policy tightening. Now with these safety nets in place, such as unemployment insurance, monetary policy can focus on the inflation objective while avoiding large-scale increases in poverty and inequality during periods of monetary tightening.

Sanjeev: This brings me to the design of fiscal policy needed for this process. Fiscal policy is government's main instrument for achieving redistribution. Fiscal policy affects inequality primarily through taxes and expenditures that redistribute income. If these taxes or expenditures affect some income groups more than others, for example, the income taxes are paid more by upper-income groups, they affect income inequality. In a similar way, government transfer payments can affect inequality if they benefit lower-income groups more than others. Thus, the size of these taxes and transfers determines their aggregate effect on income inequality. Government provision on health and education labeled as in-kind benefits further affects inequality. This spending positively affects the formation of [00:10:22] full amount capital.

As Ben remarked earlier, advanced economies achieve a much greater degree of fiscal redistribution than emerging and developing economies. This redistribution resulted in a decline in inequality in advanced economies by about a third as opposed to a tenth in emerging and developing economies. About three-fourths of the reduction in inequality in advanced economies is achieved through transfers such as public pensions and family benefits, and the rest comes from personal income taxes. Let me explain at this point why fiscal policy is less redistributed in emerging and developing countries.

First, these countries have a smaller share of tax revenues that come from direct taxes. Here I'm referring to income and wealth taxes, which are more progressive than indirect taxes, including those on consumption such as the value-added tax or the sales tax. Second, tax systems in emerging and developing economies generate a lower level of revenue as a share of total economic output. This limits the amount that governments can spend while maintaining macroeconomic stability, including social benefits that help achieve redistribution.

Third, pension systems in this country typically cover workers in the former sector, that is, people who are paying taxes and thus miss a large share of workforce employed in what we call informal sector. This results in both low contribution of revenues for pension system and ultimately a low number of pension beneficiaries. It also makes it difficult to extend coverage to those in the informal sector without large transfers from the government. Fourth, reflecting administrative challenges and scarcity of fiscal resources, social assistance program do not reach all low-income households in these countries. In Latin America, for example, about two-thirds of those in the bottom fifth of the income distribution are covered while developing Asia, less than half are covered.

Finally, a sizable share of social benefits goes to middle-income households rather than to those that are relatively poor. This limits how much redistribution is achieved with these programs. In other words, how well these benefits are targeted makes a big difference to the outcomes. Before passing it on to you, Ben, let me elaborate a bit on the importance of tax reforms in emerging and developing economies to help finance higher levels of expenditure as well as to reduce income inequality.

The track record on these reforms has been mixed, and their impact on income distribution has not always been favorable. The best outcomes have been observed for improvements in revenue administration and for personal income tax. Not all regions, however, have had positive outcomes from personal income tax reforms in Sub-Saharan Africa, and fragile countries in particular, inequality was exacerbated because of shortcomings in the reform design.

Could you please elaborate on reforms that are needed in monetary policy to better serve equity goals?

Benedict: Let's first discuss this issue for the case of the advanced economies. For this group, countries that have credible monetary policy frameworks can focus on achieving inflation targets over the medium term. When inflation expectations are well anchored, monetary policy can really focus on supporting economic activity and employment through low interest rates and quantitative easing, as we saw in the COVID-19 pandemic. In cases where very low interest rates are necessary to stimulate economic activity, it is essentially recognize and address some of the adverse effects this will have on wealth inequality through fiscal policy instruments. This might involve, for example, measures to increase taxation of assets or higher taxes on high-income earners.

Now for the emerging and developing economies, the main task of monetary policies to avoid high inflation and the resulting adverse effects on inequality, monetary policy frameworks really aim at keeping inflation at a moderate level, let's say no more than 5% to 10% per year. Now, in cases where inflation exceeds its target but country has well anchored inflation expectations, they can engage in a more gradual monetary tightening to attenuate any adverse effects on output and employment. Countries that don't have such credibility don't really possess this flexibility. EMDE should expand their fiscal toolkit to make sure they can protect the incomes of the unemployed and therefore offsetting any short-term effects of monetary tightening on poverty and inequality.

Sanjeev: I would now like to turn to the kind of reforms that are needed in fiscal policy to address the equity agenda. I believe that reform agenda will differ between advanced and emerging, and developing economies. Let me start by taking the case of advanced economies. In advanced economies, steps can be taken to reform the composition of taxes. Here, I would suggest raising top marginal rates for personal income tax, reducing tax exemptions for income taxes, which often benefit upper income groups widely adopting the globally agreed minimal corporate tax rate, which can help safeguard revenues and mitigate tax competition between countries, introducing or increasing taxes on net wealth and raising property taxes.

Regarding expenditures, the reform agenda in advanced economies should focus on enhancing the quality of public education spending to low income households, especially considering the pandemic's adverse impact on learning among poor students who have limited access to work and learning tools, and also, then improving the quality and accessibility of public health services for low income households. Finally, adjusting social assistance payments to levels sufficient for poverty elimination while incorporating worker requirements to mitigate adverse effects on labor supply.

Now turning to emerging and developing economies, they would need to increase revenues as a share of GDP. The revenues are relatively low to be able to support the equity agenda of the governments and then prioritize spending to create space for financing higher levels of distributive spending. It has been estimated that low-income developing countries, many of which are in Africa, could raise tax-to-GDP ratio over time by an additional eight percentage points through tax system and institutional reforms. While emerging market economies could achieve a 5% point increase. The revenue measures that this country should implement should enhance the effectiveness of the value-added tax by reducing exemptions and extending its coverage to the import of digital services and online purchased parcels.

Second, they could curb the use of tax expenditures and in the tax system, including for value added tax, raising excise duties on petroleum products, alcoholic beverages, tobacco, unhealthy foods such as sugary drinks and plastic waste, and then improving the design of personal income taxes to boost revenues but also to introduce high rates for capital income such as interest, dividends and capital gains. Adjusting the threshold for personal income tax can be instrumental. In many countries, a relatively small percentage of workers are subject to income tax because of a very high threshold for paying taxes. These countries should focus on making it more efficient.

In education health, for example, Sub-Saharan African countries spend 20% to 30% more resources than needed to achieve comparable outcomes to more efficient countries. Subsidies on fossil fuels primarily benefited upper-income households and should be replaced with gas assistance for low-income households to prevent increases in poverty. Many countries will need to increase spending on health to achieve universal healthcare. While some countries may need to raise education spending, depending on their demographics, improving its composition and efficiency is crucial. Reallocation away from public universities towards primary and secondary schools can make education spending more progressive. The mix of spending inputs, such as wages and medicines, could be improved to deliver better quality services.

Could you please discuss the kind of institutional reforms that are needed to promote equity agenda?

Benedict: Why don't I start first, then, with the monetary policy institutions? For this, there are really three pillars for sound governance of central bank practices on monetary policy. One is the independence and accountability of the central bank. This really should be established by law. A particularly important part of this operational independence is that central bank is not compelled to finance government deficits and has sufficient financial strength to carry out its mandate. On accountability, this implies that the central bank must provide clear objectives for monetary policy and report on its performance to the public.

Another pillar then, is to have solid policy and operational strategies. This entails clarity with respect to the objectives for monetary policy with regard to, say, numerical targets and the data that define these targets and whether the central bank has reached them or not, the time horizon to achieve these targets, the setting of these targets for inflation over a median term, and describing the conditions under which these targets can be modified. The third pillar, then, is transparent communication practices. This involves, for example, following a clear cycle of communication to the public, explaining the policy stance, following the conclusion of monetary policy meetings, and publishing a regular monetary policy report.

Now, if we look then at fiscal policy institutions, there are a number of them that are important. One is good budgeting practices. The budget really should comprehensively cover all revenues and expenditures. Countries can often benefit from having also what are called fiscal rules, which limit government debt or how much governments get increased spending in any one year. It can also be helpful to provide budget plans over more than one year in what is called a medium-term fiscal framework.

Number two, there should be transparent reporting on the budget. Transparent budgeting ensures that budget formulation, execution, and reporting processes are open and accessible to the public. This involves publishing comprehensive budget documents, conducting public consultations, and providing timely updates on budget execution. Third is there should be independent fiscal institutions. These provide an independent assessment of government policy that can help the public hold the government accountable. Examples are the Congressional Budget Office in the United States and the audit institutions in many countries.

One thing I'd like to emphasize is that these strong fiscal institutions are necessary for reducing corruption. Corruption increases inequality by diminishing the amount of resources available for redistribution. It also erodes public trust in government institutions, rendering the implementation of social policies more challenging and thus widening the gap between the rich and the poor.

Sanjeev: While this agenda is undoubtedly challenging, we must acknowledge the political constraints shape the pace and design of reforms in this area. Nevertheless, gradual policy changes in taxes and expenditures can make a significant difference in achieving more equitable outcomes. Now, before we close out, there are two questions that we ask every guest on CGD Podcast. The first question that I would like to ask is, what's one weird and funny, memorable thing that has happened to you on the job?

Benedict: I have many stories. One involves a visit to a country in the former Soviet Union in the early days of 1993. When I arrived at the airport with the rest of the IMF team, we were told that our visas were not valid. We couldn't leave the airport, and no one spoke English in the airport. There was no way to contact an embassy or anyone else on the outside. How did we ever leave and finish the mission? After six hours, we finally found someone that could speak English. Of all places, it was a nice woman who was working at the Hertz rental car company at the airport. We were finally able to find a way to negotiate our exit with her help. This shows that when you travel, there are always kind people to help you out, even in the most unexpected places.

Sanjeev: If you could instantly change any one policy in the world, what change do you think would do the most good?

Benedict: If I had a magic wand, I think I would change education policy, really ensuring that all children, regardless of their economic circumstances, were provided with the academic or practical skills needed to earn an adequate wage. I really think that would really do a lot to reduce inequality.

Sanjeev: Let me turn to my weird and funny experiences on the job. It so happens that my experience is also from the same region as Ben's. In 1990s, I also had the opportunity to travel extensively across the former Soviet Union. It was common in those days to be hosted for dinner by the country's Minister of Finance several times during one's stay in a country. Since many of us were unfamiliar with drinking vodka, I once asked the minister which vodka he considered the best. He looked puzzled and replied, "All vodkas are good, but some are very good." I really got the message. I remember this so vividly, how he told me his response, and thought I would like to share that response with you, guys.

As regards one policy change that I would like to implement, which could do most good, it would be taxes. In many countries experiencing rising income and wealth inequality, taxes on income and wealth have been gradually lowered. One policy change I would advocate for is a gradual increase in these taxes. This would not only help reduce inequality but also generate resources to support the less fortunate in the society.

Before concluding, I would like to point out that the guidance note on which this podcast is drawn from is available on CGD's website for those who are interested in delving into the details of what we discussed during the podcast. Thank you all for tuning in into the podcast. Thank you, Ben.

Benedict: Thanks.