Wednesday, January 14, 2009

What reduces inequality - taxes or transfers?

The conventional wisdom has been that taxes are the most important instrument available with governments to reduce inequality. Accordingly, taxation systems and types of taxes have been evaluated on the basis of their ability to redistribute income as being either progressive or regressive.

Providing a fresh insight into this issue using data from across the EU and the US, in a brilliant post, Lane Kenworthy argues that taxes achieve little by way of reducton of inequality. That is achieved mostly through government transfers. Figures indicate that the US does the worst with either - taxes and transfers - in achieving reduction in inequality. However, taxes provide the money to fund the transfers and understandably countries that significantly reduce inequality using transfers tend to tax more.

Kenworthy writes, "The comparative experience thus suggests that for inequality reduction, it is the quantity of taxes rather than the progressivity of the tax system that matters most. Affluent countries that achieve substantial inequality reduction do so with tax systems that are large but no more progressive than ours." He therefore argues that Governments should consider imposing consumption taxes, which despite its regressive nature, will have limited impact on inequality, but can be used to raise substantial revenues to fund the tranfers required to reduce inequality. Kenworthy's case for higher consumption tax goes like this...

Transfers, and not taxes, are more effective at reducing inequality...

But larger the tax revenues, more the money available for transfers...

And consumption tax is a good source for raising more tax revenues.

In the context of consumption taxes, Alan Krueger floats a proposal for a deferred consumption tax, to take effect after two years, that would not only raise much needed resources but also incentivize consumers to bring forward their consumption spending, thereby boosting, or atleast sustaining, aggregate demand. He suggests that essential items be exempted from this tax, so as to ensure that it does not adversely affect the poor.

Two things related to this story. One, if the story is correct, and the figures certainly makes it appear to be so, then the US has the greatest scope for inequality reduction. Second, it will be interesting to do a similar analysis for developing countries like India where the share of direct taxes are lower than indirect taxes.

Update 1
Lane Kenworthy makes the pertinent and important observation that contrary to conventional wisdom with its emphasis on progressive taxation system, inequality reduction is achieved more by government transfers and better quality public services, both of which require higher quantity of taxes.

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