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Can taxation reduce inequality?

• ODI

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Income inequality is high or worsening within many countries globally. This not only raises serious moral concerns. It also contributes to political instability and undermines inclusive economic growth.

Governments can use taxation to reduce inequality. They do this by taxing people fairly and spending a share of the revenue on social safety nets for the poor, sick, unemployed or those most impacted by negative shocks, such as Covid-19 the climate emergency, and by investing in human capital through education and health. 

But many lower income countries cannot afford comprehensive social safety nets. Their options are limited because of rising costs of borrowing and narrow tax bases. This means not enough revenue is collected and not everyone pays their fair share.

In this episode, guests examine how lower income countries can build more effective tax and transfer systems that can support fairer, more resilient and sustainable societies. 

The episode unpacks what is really meant by tax systems and social spending, why equitable taxation is critical, how governments can go about improving tax and social protection systems in practice. 

Guests 

  • Sara Pantuliano (host), Chief Executive, ODI
  • Hazel Granger ( Senior Research Fellow, ODI)
  • Professor Andrés Velasco (Dean of the School of Public Policy at the London School of Economics and Political Science, and former Minister of Finance, Chile) 
  • Alex Cobham (Chief Executive, Tax Justice Network)

Related resources

0:00:10 – Sara Pantuliano

Welcome to Think Change. I'm Sara Pantuliano. Income inequality is high and is worsening within many countries around the world. This raises serious moral concerns, but it's also contributing to political instability and undermining inclusive economic growth and living standards, and it's impacting on the poorest. One thing government can use to reduce inequality is taxation. Government can reduce inequality by taxing people fairly, by spending a share of the revenue on social safety nets for people who are sick, elderly or unemployed or for those affected by negative shocks such as the COVID-19 pandemic or the climate emergency, as well as investing in human capital through education and health. But many lower-income countries can't afford comprehensive social safety nets and their options are limited because of rising costs of borrowing and narrow tax bases. That means that not enough revenue is collected and not everyone pays their fair share. So how can lower income countries build more effective tax and transfer systems that can support a fairer, more resilient and sustainable society?  

Joining me today to explore these questions, I'm delighted to welcome Alex Cobham. Alex is the Chief Executive of the Tax Justice Network. Also with me is Professor Andres Velasco. Andres is the Dean of the School of Public Policy at the London School of Economics and Political Science and the former Minister of Finance of Chile and, last but not least, our own Hazel Granger, Senior Research Fellow here at ODI. Let's start by looking more closely at tax systems and social spending. Hazel, can you explain what we mean by tax systems and social spending generally, and to what extent can tax and social spending policies reduce inequality in lower income countries?  

0:01:58 – Hazel Granger 

I like to think of this as kind of two sides of the equation. So on the one side you have revenue and on the other side you've got spending. So on the revenue side you've got all of the taxes and fees that governments are allowed to collect. So that includes income taxes, indirect taxes like VAT and excises, customs duties on imports, and those themselves can have a redistributive effect if you design them in a way that incomes of richer households are taxed relatively more than those of the poor, for example. And then on the spending side you've got in-kind spending on social services like education and health, and then combined with direct cash benefits to vulnerable people like the long-term sick, unemployed people, people on low incomes or people affected by shocks like the Covid pandemic. And then, when you take all of those together the taxes and the social spending you can have an impact on inequality through the way that those systems redistribute incomes.  

And our work here at ODI, we've looked at all of these sort of studies that have been done across countries on the impact of taxes and transfers on inequality, and what we found was about three things really. The first one is that almost all of the countries that were studied in this way have shown that taxes and social spending do have a positive impact on reducing inequality, and that can be up to something like 25-30 percent in some countries and when you break that down by the type of policy instruments, you find that the indirect taxes, like VAT, combined with government subsidies, don't really have very much effect on inequality at all.  

And actually where you're getting the positive impact is coming from direct taxation, the direct cash benefits and the in-kind transfers like education and health. And so that's the first point. The second point is that we find a difference between global north and global south. So high income countries actually have a higher likelihood of being able to make income redistribution to reduce inequality, and that's because they tend to have broader tax bases, so there's a bigger percentage of the population actually in the tax net. So you have more opportunity to redistribute that way, and then also by being able to tax more, you have more resources to be able to spend on the social sectors, whereas in lower income countries they do struggle to mobilise revenue, and that's for a number of reasons that have been kind of well documented. I mean, they have a larger informal sector, for example, and people on lower incomes tend to be outside of the tax net.  

You have a larger agricultural sector which tends to not be taxed as much and then there are all kinds of issues around the capacities of tax administrations and non-compliance and so on so it just means that generally are sort of raising less taxes and they have less resource to be able to spend on social sectors. And then the third point is that even within countries that have similar levels of income, there's quite a lot of variation, which suggests that actually the policy choices that countries are making really matter.  

0:05:20 – Sara Pantuliano

Let's explore that with Alex. I mean, you've explained very clearly how the burden currently falls on some people more than others in low-income countries. Alex, how should tax systems redistribute income in a fair way?  

0:05:38 – Alex Cobham

I think I'd want to take a step back. I think Hazel's really set out how tax works as a tool. But perhaps what I'd add to that is the more political role of tax and what it gives us when it delivers. So what we tend to say at the Tax Justice Network is that tax is our social superpower. It isn't just a set of things that move some money from here to there. It's actually a fundamental piece of how we can choose to live together, better, longer, healthier, happier lives or, by getting it wrong, you know, to live short, nasty, solitary ones, as Thomas Hobbes might have said, not that we should quote Thomas Hobbes, but you know. But the reason tax works as our social superpower is the five R's. So redistribution is a key piece, and raising revenues, and these are the two that we tend to think of. But it also gives us the ability to reprice things like tobacco consumption or carbon emissions that have much bigger social costs than the private benefits might be. So revenues, redistribution and repricing.  

And then one we tend to overlook, perhaps the most important of all, is representation. You know, the old US cry for independence from the British. No taxation without representation. Well, the research tells us that relationship really works the other way around. There's no representation without effective taxation. It's when we are taxed, when we feel like government is taking our money, we are politically engaged, we start to hold governments to account, and so over the medium term and longer, one of the only things that's consistently associated with governments becoming more responsive and less corrupt is the share of government expenditure that's coming from taxation instead of, for example, from aid or natural resource wealth or so on. So what that means is this is kind of fundamental to the social contract, and if we want to think about states that are going to act in future, not just taking immediate decisions today, but that are, over the period of time, going to take decisions that benefit all of us, that deliver inclusive benefits, that create a state that we're all part of and, over time, reduce inequalities, then we need tax to work well, and perhaps the fifth one we introduced more recently, is more about between country inequalities.  

If you think about the scale of economic exploitation and extraction in the imperial period and to some extent still going on today. If you think about the scale of damage done by the same countries through overconsumption of planetary resources, then the kind of reparations that we'd be talking about, the kind of loss and damage funding that's needed to address the climate crisis, are too big for the economies of countries like the UK to deal with. It's estimated that the UK's reparations to India as of some years ago would total something like $44 trillion. It's not something that can be paid back, if we ever get to the stage of talking about this. So where do we have the capacity to generate the kind of long-term, high-volume funds from one country to another to address some of the damage that's done? Well in the tax system, and so tax has the potential to address both between country and within country inequalities, if we allow it, if we get it right. But that kind of brings us back to the question why don't we have this working?  

Far from reparations flowing from high income to lower income countries, we have international tax rules that systematically work in the other direction, that deny countries in the global south their fair share of taxing rights. So every year we publish what's called the State of Tax Justice Report. That looks at the scale of cross-border tax abuse by multinational companies and by wealthy individuals hiding their assets and income streams offshore. Now that tells you that the global revenue losses every year are something like half a trillion dollars $480 billion in the last review and the biggest share of those losses, in absolute terms, is felt by high income countries like the UK. But if you look at the losses as a share of current tax revenues or public expenditures, it's much higher in lower income countries. So for high and upper middle income countries in the World Bank's classification, the losses on average are about 9% of public health budgets. But for low and lower middle income countries, on average the losses are 49% of public health budgets on average. So half of the public health budget is being lost.  

Now your question about the burden. Who bears the burden of that? Well, it's all the people who can’t afford private health, all the people who are excluded from public health systems that don’t have the resources to cover them. And what are the effects? Well as the grade research organisation at the University of St. Andrews has shown very directly needless child mortality, maternal mortality, years of lost schooling and so on. The most dire and direct impacts of the failures of the international tax rules are felt in lower income countries and they translate directly into human costs. So how should tax redistribute income? Well, we need progressive taxation within country tax on profits, on personal incomes, on wealth, on capital gains. These are the taxes that deliver most strongly redistribution. They're also the taxes in lower income countries that are least effective in general, raising least revenue, except for corporate tax, and they're the ones that turn out to be most important for political representation. So if we're thinking about building effective states, these are key, but they're also the ones that are completely undermined by the failure of the international tax rules, and that's why we've had the IMF and others the International Monetary Fund for years, telling lower income countries to focus on regressive consumption taxes instead, because they are easier in some sense.  

What we're seeing now, though, finally, is a willingness to address these failures of international tax rules.  

You know, the OECD, the Group of Rich Countries, has really set those rules since they were created to do so in 1960.  

So we've had six decades during which all the evidence shows the scale of corporate tax abuse by multinationals and, at least until very recently, the scale of offshore tax abuse by wealthy individuals has grown exponentially. 

So the OECD's management of these rules really is a clear failure. What we finally have now, after more than two decades of campaigning in the tax justice movement, is the start of negotiations on a UN tax convention that would finally put these rules in a forum where every country has the ability to have a say at least, and that means, instead of the rich countries setting rules in the way that we've seen, that leaves lower income countries disproportionately denied of their taxing rights, with direct human impacts we should see over the next few years the development of a framework convention on international tax cooperation in which every country has the ability to affect those rules and where, finally, we might see a fair distribution of taxing rights and ultimately that's the only way that we will get to really use the ability of tax as our social superpower to address the very many overlapping inequalities that currently scar our societies. 

0:14:16 – Sara Pantuliano

I’d like to explore what you are saying Alex a bit more deeply because I think a lot of people are interested in this international taxation system and understanding it better and, Andres, I'd like to hear your perspective on how you think we can finally get to a really more equitable framework.  

As Alex said, this has been years and years, decades of discussions. We've made very little progress. How can we make tangible progress?  

0:14:27 – Andres Velasco 

I think, to make tangible progress, we have to focus on what the real, binding constraints of raising more tax revenue happen to be, and we haven't talked about them yet. Raising tax is not merely a matter of will. It requires one concept we have yet to introduce in this conversation that is called state capacity. So far, we've made it sound as though countries don't raise tax simply because their leaders are too busy playing golf. And it may be, and I have no problem with the notion that there are plenty of incapable leaders who are too busy playing golf. But even in countries where leaders do want to raise more tax, they run into a pretty difficult problem, which is many states don't have the capacity, don't have the infrastructure, don't have the IT systems, don't have the enforcement mechanisms, don't have the tax culture that is required to raise tax. And that is why and Hazel is right you see massive variation among developing countries in the amount of tax that is collected. Argentina raises something like 35% of GDP and in the same hemisphere, if you go to Central America, you will find countries where you know countries don't even raise 10% of GDP. And yes, some of it is a matter of political will, but some of it is a matter of state capacity. I am all for cracking down on fiscal paradises. I am all for cracking down on places in the Caribbean where the rich hide their money, but I suspect that if we do, we're not going to solve the main problem. The main problem is simply that to go from raising eight points of GDP in tax to raising 20 or 25, you need a massive investment in local state capacities, and for that you need massive political change at home. Eventually, it is national parliaments that have to decide on tax. And that takes me to the point I want to make. Tax is mostly a local matter. It's a very political matter, and that's where we tend to run into the problem.

What kinds of taxes should we be raising? Well, first of all, those that we are capable of raising. It is very easy to bash VAT or indirect taxes. Yes, they're not the most redistributive, but guess what? They raise a lot of money. If you lower VAT in most developing countries, what you will get is less money for schools, for hospitals, for pensions and for roads. And most countries rely on VAT, not because the IMF told them to rely on VAT. They do so simply because there's a one tax that they can collect.

Secondly, we need to focus a lot more on personal income tax. Very few people pay personal income tax in many countries, and I'm going to agree with Alex here that if you pay taxes, you hold the government accountable. If you don't, you don't. And as a result, we want to move quite literally from a situation in a number of countries with tens of millions in population 20,000, 30,000, 50,000 people pay personal income tax, and that means, by the way, something that is politically very difficult, which involves raising the threshold of income at which you begin to pay income tax.

One reason why in so many developing countries, not many people pay income tax is that there's you know there's evasion and abuse granted, no doubt about that. But another reason is simply that the threshold is set too high and therefore you end up with the top 10% or 8% of the income distribution paying income tax. That is not going to have the desired effect, A in terms of revenue and B in terms of involvement and accountability. So we need to do an analysis that moves away from general global level cliches and looks much more carefully at the local circumstances. In some countries, some instruments are feasible and desirable. In some countries, those same instruments are not.

0:18:40 – Sara Pantuliano

Thanks, Andres. I think a lot of what you say really resonates. As you say, it's impossible to generalize, whether it's through global south category or lower income countries. The challenge, the political challenge of redistributing the tax burden, is the same also in wealthier countries and again, every country has got a very different culture that does pay an important role in introducing taxation measures and the way in which they're introduced is critically important. We've seen recent protests and violence across Kenya in reaction to the government proposal to raise an additional 2.7 billion through taxes to reduce the budget and the borrowing. I guess what is critical is to give a sense to people that you are introducing taxation equitably. Now that is the challenge. How can you in a way, introduce taxation equitably? And also what the trade-off is between equity and efficiency. Sort of looking at you as a former minister of finance in Chile, how do you navigate that trade-off?  

0:19:55 – Andres Velasco 

Well, as I was trying to hint at earlier, that trade-off can be very steep or not steep at all, depending on where you are. If you're France and you're raising nearly half of GDP in taxation, increasing the tax burden will have an impact on efficiency and growth. If you're Guatemala and that number is 8%, there's probably plenty of room for you to do more without necessarily putting the brakes on economic growth or harming economic efficiency. So the devil here is in the details. That's the first thing that we need to remember. Secondly and this gets boring and technical exactly how you design tax systems matters a lot, and exactly which taxes we're talking about? Who bears the burden of those taxes? How are they collected? Are there offsets across taxes? That matters hugely and it's a technical discussion. It is a messy discussion, but it's one that we cannot avoid because, again, blanket statements are not going to take us very far. We need to get into the weeds. The weeds can be a little confusing and a little technical, but we need to go there.

And, if I may want to add one thing that you mentioned, Sara, in the beginning, but perhaps we didn't emphasize enough what matters for the equity of a society is the net redistributive impact of fiscal policy. And by net I mean expenditure and taxes. And in many countries you can get a very progressive combination, not so much on the tax side but on the expenditure side. That is to say, I can perfectly well imagine a country where state capacity is lacking and therefore the only available tax is, say, VAT. Okay. Well, whether that country will be equitable or not will depend on what that country does with the money that it raises through VAT. 

And I can imagine a country which uses that money very progressively on, say, primary education, and the net impact of fiscal policy is in fact very redistributive, even though the tax that they're relying on is VAT. And I can perfectly well imagine raising money through VAT and then, you know, spending it on, say, tertiary education alone, so that you're subsidizing the incomes of well-off youngsters who go to university, and therefore the net effect would be actually quite regressive. So we need to look at the whole package. If we look at the tax side alone, we are going to be misled. I am not saying, to be clear, that there's no room to redistribute via the tax system, but given that there are obvious constraints to how much you can do that, we need to think about composition of expenditure, and this is something that often gets lost in the discussion and, in fact, people end up advocating certain policies which sound progressive but which, in fact, can be quite regressive once you look at the numbers.

0:23:03 – Sara Pantuliano

Alex, what do you think about this?

0:23:08 – Alex Cobham

I mean, I certainly agree, we have to look at this in the round, and, like Andres, I can imagine a country where a VAT could be part of a progressive overall system. But on the other hand, I'm sure Andres is also familiar with the data that we know that in practice, this is almost impossibly unlikely to occur in practice, and so we need to ask ourselves why. What are the structural factors that really give us the picture we have? And one of the ones is I think the biggest piece is what I talked about earlier it's representation.

We know that in most countries, including the UK, lower income households pay a much bigger share of their income in tax, and that's through regressive taxes like VAT, but we also know that they end up feeling less politically empowered.

It's higher income households that pay more in direct taxes who feel it, and so for that reason, Andres, I'd really agree with your suggestion about extending the tax base for personal income tax.

I think everyone needs to feel that annoyance that the government's taking their money to drive greater political engagement across the spectrum, but if we're thinking about the macro effects. What we get over time, with reliance on VAT, for example, is a government that is less likely to be responsive to people than one that's more reliant on direct taxation, and so it's associated over time again with being less likely to provide inclusive public services. So, while we can imagine a state that relies on VAT and is really focused on providing inclusive services, in practice it's just less likely to happen than if we have a government that's more reliant on direct taxes. So, given that we know that, and that's really consistent in decades of data from countries all over the world, we probably should be thinking not so much about whether we can imagine in theory something nice, but actually doing what tends to have a better impact, and that's focusing more on on direct taxes.

Andres, I saw that you were reacting to what Alex was saying?

0:25:13 – Andres Velasco 

No, I mean I I I tend to agree with the thrust of what Alex was saying, but I, I would just add two caveats. Caveat number one is that and I'm just repeating something I said earlier here uh, it is feasible to imagine a country that relies on VAT and whose net effect is very progressive it just depends on what they do with money, and therefore the conversation should not be about taxation alone, but also about patterns of expenditure. The other thing I'd say is that we're sitting here in a developed country having a pleasant conversation over Zoom.

I have been there in the trenches, I have tried to raise tax, I have had debates both in my country and other countries that I have advised about the feasibility of using other instruments, and I want to emphasize something I said earlier in passing, namely this is a matter of political will, but it is also a matter of state capacity, and state capacity is not built overnight. So it has happened to me that I have flown into countries, spoken to the finance minister and said you know how come you're raising so little money via direct taxes? You should be doing more on personal income tax. And the reply is oh great, Tell me how. You know, I don't have the tax office, I don't have the tax inspectors, I don't have the IT, I don't have the enforcement capacity. Now these things can be built, but they're built over time. So my call is for a little political and practical realism here. It is very easy to call on people to do things, but when you're actually there, you realize that many of these matters are a great deal trickier than they sound. It's practically difficult, it’s politically difficult. It can be done, but it takes time. 

0:26:56 – Hazel Granger

I just wanted to come back on the VAT issue as well, because it often is seen to be a very regressive tax and so, from the equality point of view, you want to try and try and avoid it or at least kind of, as Alex was saying, to focus more on the personal income tax.

But actually some of the evidence coming from our colleagues at the IFS for example for the tax debt program that I work on is showing that in low income countries the VAT is actually more progressive and that's partly because people on very low incomes that tend to be buying their goods in informal markets or from street vendors or growing their own food and for example, so they're outside of the VAT system altogether. So actually in those countries it can be more progressive. But generally I mean even in the most equal countries they have been quite reliant on things like the VAT, as as Andres said, for raising revenue, just because it's an easier and more efficient way to do it, and then you can then have more resources to be able to put back into social spending, which is going to be more equalizing as a whole when you look at the system together.

0:28:04 - Sara Pantuliano

Well, I'm afraid that's all we have time for today. Thank you very much, Andres, Hazel and Alex for joining me on this episode of Think Change. There was an Italian economist, Tommaso Padoa Schioppa, who used to say that taxes are a beautiful thing. As you said, Alex, they can lead us to live longer, healthier, happier lives.

But we've also heard very clearly from your conversation they are a very complex political thing that is very much related to culture, to state capacity, as we've heard from Andres, and how difficult it is to implement tax systems that are fair, equitable and effective. Surely, they can help address inequality, both within and across countries. But we were loud and clear the devil is in the detail and how you design taxes is very much what matters. All the resources that you've heard about in this episode will be in the show notes, particularly around our tax dev program that we run with the Institute of Fiscal Studies that aims to do precisely that, help design taxation systems that are fairer and implementable. If you enjoyed this episode, please do like, subscribe and rate it. It helps us a lot and we hope you'll join us again next time.  

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