Question

How would taxing the large corporations and giving subsidies to smaller businesses result in reduction in income inequality in the economy? Wouldn't sin taxes also hurt the poor?

Answer 1

Government policies to reduce poverty or to encourage economic equality, if carried to extremes, can injure incentives for economic output. The poverty trap, for example, defines a situation where guaranteeing a certain level of income can eliminate or reduce the incentive to work. An extremely high degree of redistribution, with very high taxes on the rich, would be likely to discourage work and entrepreneurship. Thus, it is common to draw the tradeoff between economic output and equality, as shown in Figure 1 (a). In this formulation, if society wishes a high level of economic output, like point A, it must also accept a high degree of inequality. Conversely, if society wants a high level of equality, like point B, it must accept a lower level of economic output because of reduced incentives for production.

This view of the tradeoff between economic output and equality may be too pessimistic, and Figure 1 (b) presents an alternate vision. Here, the tradeoff between economic output and equality first slopes up, in the vicinity of choice C, suggesting that certain programs might increase both output and economic equality. For example, the policy of providing free public education has an element of redistribution, since the value of the public schooling received by children of low-income families is clearly higher than what low-income families pay in taxes. A well-educated population, however, is also an enormously powerful factor in providing the skilled workers of tomorrow and helping the economy to grow and expand. In this case, equality and economic growth may complement each other.

Moreover, policies to diminish inequality and soften the hardship of poverty may sustain political support for a market economy. After all, if society does not make some effort toward reducing inequality and poverty, the alternative might be that people would rebel against market forces. Citizens might seek economic security by demanding that their legislators pass laws forbidding employers from ever laying off workers or reducing wages, or laws that would impose price floors and price ceilings and shut off international trade. From this viewpoint, policies to reduce inequality may help economic output by building social support for allowing markets to operate.

After years of quasi-neglect, economic inequality has taken center stage in the policy debate worldwide. In advanced economies, the apparent impact of globalization and technological change and the cost of counteracting these forces is raising concern. In developing economies, where inequality is higher, the issue is whether it poses a major obstacle to raising growth and reducing poverty. In both cases, the redistribution of income might achieve not only greater equality but also faster growth and, for developing economies, faster poverty reduction.

In countries where growth is satisfactory but benefits the poor much less than the non-poor, there obviously is a strong case for shifting resources from those at the top of the income scale to those at the bottom. Giving poor children access to better education and paying for it by taxing the affluent is one way to reduce inequality while also fostering future growth and poverty reduction. Redistributive policies could also help narrow the gap between rich and poor in countries with high inequality, where social and political tensions or the rise of populist regimes might prove bad for growth in the long run.

Knowing that a more equal distribution of resources may be good for development is one thing; having the right instruments to implement it is another. These instruments—from progressive taxation, cash transfers, and investment in human capital to regulation and inclusive growth strategies—do exist. But they are vastly underused in developing economies.

Straight income redistribution

Taxation and income transfers to the poorest segment of society are the most direct way to keep inequality in check and reduce poverty in the short term. These instruments are particularly appropriate when the benefits of growth fail to reach the poor. But most of the time they are too small to really make a difference. On average, taxes on personal income and cash benefits to the poor are almost 10 times lower, as a proportion of GDP, than in advanced economies.

The success of conditional cash transfer programs has demonstrated that it is possible to transfer cash efficiently to poor people in developing economies. These cash transfer programs give money to households on the condition that they comply with certain pre-defined requirements, such as up-to-date vaccinations or regular school attendance by children. The spread of such initiatives as Mexico’s Prospera or Brazil’s Bolsa Família from Latin America to other developing regions—as well as the results of several pilots in poorer sub-Saharan African countries—shows the progress made in the last 15 years or so in the field of redistribution. New methods of means testing and cash distribution have made it possible .

Such programs should continue to improve in the future, thanks to advances in information technology, particularly the use of mobile money. But their current impact on poverty and inequality is limited. Their main weakness is their size, which amounts to 0.5 percent of GDP at most in middle-income countries. In poorer countries, they are still at the pilot stage.

Expanding those programs requires more resources. A higher and more effective income tax in the upper part of the income scale could help raise the necessary funds. In this respect, the generalized use of bank accounts, credit cards, and debit cards by higher-income people in most countries should make it easier to monitor personal incomes and reduce tax evasion. Political economy issues aside, this should lead developing economies’ governments to place more emphasis on direct taxation than they presently do.

Developing economies tend to rely relatively more than advanced economies on the indirect taxation of domestic and imported goods and services. Indirect taxes are said to be regressive because they tax consumption rather than income, and wealthier people save a higher proportion of their income. But in addition, indirect taxation in developing economies may even increase poverty depending on the structure of tax rates and the consumption basket of households at various rungs of the income scale. In any case, lowering taxes on goods such as food that weigh more in the budget of poor people achieves relatively little redistribution because wealthier people also consume these goods, perhaps as a lower proportion of their budget but possibly in larger quantity. The same argument applies to subsidies for purchases of basic goods like bread or fuel. Income transfers are preferable to subsidies because they cost less and are better targeted to the truly needy, as evidenced by the pilot experiments on the replacement of food subsidies by “direct benefit transfers” in some Indian states.

There is therefore a strong case for the expansion of redistribution in developing economies when growth is satisfactory but poverty reduction is slow. There are political obstacles to doing so, however, as well as challenges related to the country’s administrative capacity. Political opposition may well remain, but modern information technology is likely to improve administrative capacity.

Policies to reduce poverty

In summary, to reduce poverty, government policies could include:

1. Means-tested welfare benefits to the poorest in society; for example, unemployment benefit, food stamps, income support and housing benefit.
2. Minimum wages. Regulation of labour markets, for example, statutory minimum wages
3. Free market policies to promote economic growth – hoping rising living standards will filter to the poorest in society.
4. Direct provision of goods/services – subsidised housing, free education and healthcare.

There are two major types of poverty:

• Absolute poverty – when people have insufficient income to afford the necessities of life, such as food, rent and clothing.
• Relative poverty – when people have income significantly less than the average income for society.

Some policies, such as promoting economic growth may be successful in reducing absolute poverty but less successful in relative poverty.

Increasing benefits to the poor

Means tested benefits involve increasing welfare benefits to those on low incomes. For example, universal tax credit, food stamps or child benefit.

Advantages of means tested benefits:

1. They allow money to be targeted to those who need it most. e.g family tax credit or pension credit.
2. It is cheaper than universal benefits and reduces the burden on the taxpayer.

However, the problem with using benefits to reduce poverty include:

• Means tested benefits are often unpopular because people are stigmatised as being poor.
• Also, it may create a disincentive to earn a higher wage because if you do get a higher paid job you will lose at least some of your benefits and pay more tax. This is known as “the benefit trap” or the “poverty trap”. The poverty trap occurs where people on low incomes are discouraged from working extra hours or getting a higher paid job because any extra income they earn will be taken away in lost benefits and higher taxes. To avoid the poverty trap the government can grade benefits so that there isn’t an immediate cut off point.
• Some relatively poor may fall just outside the qualifying limit.
• Also, not everyone entitled to means-tested benefit will collect them because of ignorance or difficulties in applying.

The government used to prefer universal benefits because it avoided the above problem, and people feel if they contribute towards taxes they deserve their benefits regardless of their wealth.

However, in recent years, the welfare state has faced increased demands due to demographic factors leading to more calls for means-tested benefits.

Policies to reduce poverty in developing economies

To reduce poverty in developing economies, the focus may be on different policies.

1. Education – greater spending on education and training can enable higher skilled workforce.
2. Foreign Aid – aid from developed countries can be used to invest in better health care and education. However, some argue aid can encourage dependency.
3. Diversification of economy away from agriculture to manufacturing. This enables greater economic development but may be difficult to do without the right skills and infrastructure.