Why taxes are important to reduce poverty and inequality?

Free market conservatives oppose big government and favor reduction in taxes as the preferred route to the achievement of economic growth. They argue that governments are inherently ineffective in efficiently allocating resources and therefore should give way and facilitate private enterprise to achieve the same objective.

They claim that economic growth, thus achieved, will "trickle down" to benefit everyone by way of more jobs, higher wages, and better living standards. They therefore advocate that government's role should be confined to unshackling the restraints to private enterprise and providing everyone with the basic opportunities - health care, education, and skills - to compete in the market.

However, as Lane Kenworthy (see also this earlier) points out with empirical evidence, reality is not as simple. In fact, examining the trends in income levels among those at the lower end of the income ladder in the advanced economies since the 19760s, he finds that it was not trickle down but direct transfers that kept incomes growing. He writes,

"In almost all of these countries (Ireland and the Netherlands are exceptions) the earnings of low-end households increased little, if at all, over time. Instead, increases in net government transfers — transfers received minus taxes paid — tended to drive increases in incomes when they occurred."

The graphic below captures the average household income in the bottom decile of the posttransfer-posttax income distribution. Group 1 is Denmark, Finland, Ireland, Netherlands, Norway, Sweden, and United Kingdom, while Group 2 includes Australia, Canada, Germany, Switzerland, and United States.



Clearly, incomes have increased substantially after transfers for those in Group 1. In fact, Kenworthy goes further and argues that jobs and higher wages cannot produce the same trickle down effect on those at the bottom end. He writes,

"At higher points in the income distribution, they do play more of a role. But for the bottom 10 percent there are limits to what employment can accomplish. Some people have psychological, cognitive, or physical conditions that limit their earnings capability. Others are constrained by family circumstances. At any given point in time, some will be out of work due to structural or cyclical unemployment. And in all rich countries, a large and growing number of households are headed by retirees. We surely can do better at helping able adults get into (or back into) employment, but we shouldn’t pretend that paid work is a realistic route to guaranteeing rising incomes for everyone."

He also points to the importance of keeping income transfers dynamic enough to ensure that its share of incomes do not fall appreciably with time. He draws attention to the fact that in most affluent nations, including the Scandinavian ones, while transfers have increased, it has not done so at the rate required to keep its share of the GDP from falling. He writes,

"In most of these affluent nations... increases in the share of GDP allocated to public transfers largely stopped after the 1970s. In recent decades, the distinction has been between countries that kept transfers rising in line with GDP versus those that did not. Sometimes doing so requires no explicit policy change, as benefit levels tend to rise automatically as the economy grows. This happens when, for instance, pensions, unemployment compensation, and related benefits are indexed to average wages. Increases in other transfers, such as social assistance, typically require periodic policy updates. That’s true also of tax reductions for low-income households."

In particular about the US, his suggestion is,

"What the income data tell us is that the United States has done less well by its poor than many other affluent nations, because we’ve failed to keep government supports for the least well-off rising in sync with our GDP... Modest, regularized increases in the inflation-adjusted benefit levels of existing social programs — the Earned Income Tax Credit, unemployment compensation, social assistance (TANF and SNAP), housing assistance, and disability benefits — would yield significant improvements in the incomes of America’s least well-off."

Kenworthy's findings carry important lessons for policy makers in India. It clearly establishes that economic growth alone cannot address the problems of poverty and inequality, all the more so in regulated and under-developed markets like India. Government transfers are more important in achieving poverty reduction objective, especially for those at the bottom of the income ladder. However, there are two points of qualification.

One, transfers can be meaningful only when the the fiscal balance is in order and governments have the resources to carry out such transfers. Robust economic growth is the only route to keeping public finances in good strength. Two, it is important to ensure that these resources are utilized to deliver bang for the buck. The most effective strategy to optimize public spending is to channel it towards those activities which address market failures and enables equality of opportunity to all citizens in accessing the market. This requires a very scarce commodity - far-sightedness in public policy making.