Lecture 9.

Assessing tax progressivity

Assessing the effect of tax policy requires identification of winners and losers from such a
policy. Progressive tax policy favors the poor relative to the non-poor. The opposite is true in the
case of regressive tax policy. Sources of the information to assess the redistributive effect of
taxes include tax laws and statutes, data on tax collected by categories (direct and indirect taxes)
from tax administration, and household survey data. Depending on type, taxes affect either the
sources (earnings) or the uses (expenditure) side of the household account. 

The criteria to assess tax progressivity and redistributive effect is based on comparing the
distribution of tax payments with a reference distribution such as income or expenditures per
capita. In this unit, we will consider several measures to make that assessment, highlighted in the
image below.
 1. Simple method of comparing ratios: compare tax ratio to income shares, as highlighted in
the table below. 

 Progressive tax: the ratio of tax to income rises (column 5) as income rises (column 2)

 Proportional tax: the ratio of tax to income (column 8) remains unchanged as income rises

 Regressive tax: the ratio of tax to income declines (column 11) as income rises

2. Tax concentration curve and concentration coefficient (CT)

Common measures of tax progressivity rely on the Gini index of income inequality and measures
of tax concentration. 
 Tax Concentration Index (Quasi Gini)
Tax concentration index (also called quasi-Gini) is similar to the Gini index, measuring how
shares of taxes paid relate to shares of population, with taxpayers ranked by pre-tax income.

Like the Gini index:

o Tax concentration index plots the cumulative percentage of tax paid (by deciles, percentiles,
etc.). Note that the individuals are still sorted by income (and not by tax per capita).

o Tax concentration index of zero: means the lowest income 10 percent of the population pays
10 percent of the taxes, the lowest 20 percent pays 20 percent of taxes, etc.

o Tax concentration index of 1: means all taxes are paid by the single highest earner.
Unlike the Gini index:

o The cumulative distribution of the tax is plotted against the cumulative distribution of the
population ranked by original income and not the tax.

o The tax concentration index could be negative if one paid a disproportionately higher share
of taxes the lower one’s income
3. Concentration and Lorenz curves

 Tax is equalizing when the post-tax income Lorenz curve lies everywhere above the pretax
income Lorenz curve, as indicated below. In other words, incomes are less unequal after a tax
than before the tax if and only if the tax is distributed more unequally than the income to which it
applies. 
 Lorenz Curve of Pre-Tax Income and Post Tax Income and Concentration Curve of Tax

 Tax is un-equalizing when the post-tax income Lorenz curve lies everywhere below the pretax
income Lorenz curve. Incomes become more unequal after a tax than before the tax if and only if
the tax is distributed more equally than the income to which it applies. 

 Tax is neither equalizing nor un-equalizing when the post-tax income Lorenz curve coincides
with the pretax income Lorenz curve. A proportional tax will have the same distribution as the
pretax income and leave the distribution of income unchanged. 
 1. Kakwani Index (K): the difference between the tax concentration
coefficient (CT) of the tax and the Gini coefficient of pre-tax income
(GY): 

 If taxes are progressive: the tax concentration index is greater than the Gini index (that is, taxes
are more concentrated than income at the top of the income distribution) -> Kakwani index
is positive.

 If taxes are proportional: the tax concentration index mirrors the Gini index -> Kakwani index
is zero. 

 If taxes are regressive: the tax concentration index is less than the Gini index (that is, taxes are
more concentrated than income at the bottom of the income distribution) -> Kakwani index
is negative.

2. Reynolds-Smolensky index: the difference between the Gini index for before-tax
income and the Gini index for after-tax income. The Reynolds-Smolensky index
reflects the aggregate amount of taxes as well as their concentration.
 Tax is progressive: if pre-tax Gini index is > after-tax Gini -> Reynolds-Smolensky index
is positive

Tax is proportional: if after-tax Gini = pre-tax Gini -> Reynolds-Smolensky index is zero

Tax is regressive: if pre-tax Gini index is < after-tax Gini -> Reynolds-Smolensky index
is negative

6. Simple plots

Plotting the average tax rate against values (or quantiles) of pretax income (see figure below)
will be enough to determine whether a tax system is:

 Everywhere progressive: tax rates rise with income 

 Neutral: tax rates are the same for all incomes—a flat (proportional) tax 

 Regressive: tax rates decrease with income

Average Tax Rate by Pretax Income: A Progressive, Neutral, and Regressive Tax
 Fiscal incidence analysis measures who bears the burden of taxes and who receives the
benefits of government spending—in particular, of social spending—and who are the gainers
and losers of tax reforms or changes to welfare programs. 

 In practice, fiscal incidence analysis is utilized to allocate taxes and public spending to

households to compare incomes before taxes and transfers with incomes after them and
calculate the relevant indicators of pre-fiscal and post-fiscal inequality and poverty. 

Net Fiscal Incidence 

Net fiscal incidence is the relevant equity measure that government authorities need to use in
judging certain policies. For instance: 

 An increase in value-added tax (VAT) may be rejected on equity grounds as being regressive.
But it may be desirable from an equity standpoint if the resulting revenues are used to finance
primary-school services in poor neighborhoods. 

 Taxes may be progressive, but if transfers to the poor are not large enough, they may worsen
poverty.

Usually, fiscal incidence analysis looks only at what is paid and what is received without
assessing the behavioral responses that taxes and public spending may trigger on individuals or
households. This is referred to as the “accounting” approach. The accounting approach consists
of starting from an income concept depending on the fiscal intervention under study, allocating
the proper amount of a tax or a transfer to each household or individual. If the fiscal intervention
is a direct tax (transfer) and one starts the analysis from pretax (pre-transfer) income, the post-tax
(post-transfer) income is calculated by subtracting (adding) the tax paid (transfer received).

Note:
 Comprehensive fiscal incidence analysis assesses the impact of the revenue and spending sides
simultaneously. 

 Incidence analysis can use income or consumption to measure household welfare. 

 There is point-in-time versus lifetime fiscal incidence analysis.

 The analysis can assess a current system or estimate the potential or actual effects of
reforms. 

 It can use the statutory incidence or the actual one (for example, include tax evasion or less
than full take-up of a cash transfer).

Unit 5.4: Fiscal Incidence Analysis: Allocating Taxes and Transfers to Individuals
Allocating Taxes and Transfers to Individuals 

Starting from pre-fiscal income, Market Income (income from labor and capital and private
transfers), each new income concept is constructed by adding another element of the fiscal
system to the previous one. 
For example, Disposable Income subtracts direct personal income taxes and adds cash transfers
to Market Income. Consumable Income subtracts indirect taxes and adds subsidies to
Disposable Income. And, Final Income adds government spending on education and health to
Consumable Income. 
 The Case of a Single Transfer: We will use the words “transfer” and “benefit” interchangeably.
Transfers encompass a wide spectrum of benefits provided by the government such as:

 Cash transfers

 School food programs

 Consumption subsidies

 Access to free public services 

Progressive Transfers: Incomes are less unequal after transfers than before if and only if
transfers are distributed more equally than the income to which they apply. In other words, if the
average transfer rate decreases with income everywhere, then transfers are distributed more
equally than pre-transfer income. This scenario is shown below.

A Progressive Transfer: Lorenz Curve of Pre-Transfer Income, Concentration Curve of an

Equalizing Transfer, and Lorenz Curve of Post-Transfer Income
Equalizing and Pro-poor Transfers: If the relative size of the transfer declines with income, a
transfer will be equalizing. However, equalizing transfers may not be pro-poor. To be pro-poor,
the absolute size of the transfer also needs to decline with income. The share of a transfer going
to the rich can be higher than the share accruing to the poor even if a transfer is equalizing (or
progressive). The figure below shows the concentration curve for a transfer that is both
equalizing and pro-poor.

A Pro-Poor Transfer: Lorenz Curve of Pre-Transfer Income, Concentration Curve of an

Equalizing Transfer, and Lorenz Curve of Post-Transfer Income
 The following steps can be undertaken by the government to address political and social
challenges when implementing fiscal policy changes:

A. Ensure Strong Political Commitment and Leadership

 Ministers of Finance are usually responsible for the management of the fiscal policy. They
should have clear and unconditional leadership over the reform efforts. 

 In many countries, a permanent or temporary committee chaired by the Minister of Finance and
supported by technical working groups, brings together all stakeholders from the public sector to
reflect the different interests. 

B. Build Consensus and Garner Public Support 

 It is essential to hold extensive political consultations with multiple stakeholders in society, such
as businesses, civil society, local governments, legislators, academics, and think tanks. 

 Consultative discussions might not create unanimous support but will instill in society a sense
of country-wide ownership. 

 A participatory process will help identify areas of resistance or support for change.

 Experience shows that involving a broader spectrum of society in the design of reform—along
with a readiness to respond to concerns to the extent of modifying reform proposals—
also fosters a sense of ownership for reform and can help hold back future opposition. 

C. Build Coalitions 

 Building coalitions is imperative for successful reform: fiscal reform inevitably entails
distributional consequences: losses for some—particularly those with vested interest in the status
quo —in the short term, while generating broad benefits to the wider population in the longer
term. 

 Gaining traction for reform—and ultimately succeeding in implementing it—depends on a

government’s ability to build coalitions in support of change while addressing opponents’
concerns about its distributional impact.

D. Develop a Clear Communication Strategy

 Effective communications are imperative during the fiscal reform process. Given the increasing
importance of social media, it is important for governments to utilize these platforms as a means
of effective communications when making their case for reform. 

 The communication campaign should develop a narrative that positions fiscal reforms as a

government-led and country-owned strategy that supports inclusive growth, emphasizing the
benefits to society at large. 

 The government should mobilize representatives from the public sector, the private sector,
business associations, religious leaders, community representatives and the mass media, to signal
broad consensus across the wider community and involve them in the communication.
 In order to improve the redistributive impacts of fiscal policy, recommended guidance includes
the following: 

A. Emphasizing the Joint Impact of Taxes and Expenditures 

 It is difficult to pursue a revenue-raising structural tax reform due to opposition from those who
will be taxed more. Sometimes, this is due to a narrow focus on the tax burden, without looking
at the broader implications on the spending side. 

 To convince the public on the desirability of revenue-raising tax reform, it is critical to

emphasize the additional expenditures (e.g. on health, education, or infrastructure) they help
finance. 

 This joint impact of tax and spending can be progressive and supportive of inclusive growth,
even if some of the taxes are regressive. 

 Earmarking of taxes for specific expenditures should be avoided since it can lead to inefficient
spending decisions. 

B. Quantifying the Impact of the Reform 

An evidence-based quantitative impact assessment is essential for several reasons:

 Quantification will help structure the debate and rationalizes discussions among stakeholders—
which might otherwise be dominated by vague statements or loose beliefs. 

 Analysis of the impact on revenue, spending, the income distribution, and the economy helps
policy makers design the reform in the best possible manner. This enables the government to
convince stakeholders that the reform is both inclusive and growth friendly. 
 Quantitative analysis also supports the transparency and accountability of the reform process and
helps build trust in government. 

In order to mitigate the impacts on fiscal reforms on inclusive growth, recommended guidance
includes the following: 

A. Sequence Reforms Carefully 

 A strong economic rationale drives political support for the fiscal reforms, which are expected to
improve economic opportunities for the majority of the population. Careful timing and
sequencing of fiscal reforms are required. 

 Policymakers may focus on low-hanging fruit or use small-step approaches, such as launching

reforms on a limited scale and assessing them before expanding them. Examples include
accepting a gradual approach to a tax increase or linking electricity tariff increases to
improvements in service provision coverage.

 In a challenging the sociopolitical environment, it may be necessary to move ahead with those
measures that can garner enough support and to postpone others: some progress is better
than none. In this sense, it will be important to accept deviations in timing and sequencing from
technically or economically “optimal” reform paths, subject to considerations of macroeconomic
stability.

 The sustainability of any reform—and support for the whole reform process—could be
jeopardized by the lack of early and visible economic improvements. To counter this risk, show
commitment to reform and improve confidence, policymakers should include in their reform
programs initiatives that have a rapid impact, and consider compensating in advance
vulnerable groups that stand to lose from the reforms.

B. Use Opportunities During Good Times 

 Fiscal reforms have been most successful when undertaken during good times, when fiscal
savings from reforms can be used to compensate losers of reforms. 

 While some reforms are growth friendly, not all are inclusive, and some may have inevitably
increased income inequality. 

C. Use Opportunities During Bad Times

 During or after a crisis, policy makers under pressure may rush into measures that risk damaging
inclusive growth, e.g. through quick fixes such as tax rate increases or the introduction of new
distortive taxes or expenditure. 
 However, in some countries a crisis paved the way for the introduction of long-lasting structural
reforms that support inclusive growth. Crisis times may offer an opportunity for reform as the
urgency facilitates political agreement among different actors. 

To address institutional challenges, recommended guidance includes: 

A. Recognize Institutional Constraints 

Reform champions, together with well-functioning and credible institutions, are needed to
sustain change. Reform-minded individuals are indispensable for the reform effort, but without
strong institutions, policies cannot be implemented or can be quickly reversed. For example:

 In the case of energy subsidies, successful and durable reforms typically require the introduction
of a depoliticized and rules-based mechanism for setting energy prices, which can help reduce
the chances of reversal.

 Revenue agencies responsible for the implementation of the tax system should participate in the
reform process, e.g. as members of the tax reform committee. This ensures that concerns about
enforcement of a reformed tax system are recognized and accounted for in the reform strategy. 

 Legal drafting experts are essential for the reform process to ensure that tax laws are clear and
unambiguous and that they ensure tax certainty. 

 In some countries, decentralized fiscal powers (states, provinces, or municipalities) can create

obstacles to the reform process or for its implementation and their interests should also be
integrated into the reform management process. 

 Budgetary institutions with rules that govern budget formulation, execution, reporting, and
disclosure, along with capable external oversight bodies, are necessary to support sound fiscal
policy and financial accountability. 
 B. Build Administrative Capacity 

Reforms may also be constrained by limited administrative capacity to design and administer
them. Agents of change, needed to champion reform, could be at risk of becoming overloaded
and losing the ability to focus on delivering on priority items. 

Complex reforms, therefore, may not be feasible in the short term and would require careful
sequencing that includes investment in building the capacity to implement them. For instance:

 Capacity constraints in tax and custom administrations are often obstacles to revenue

mobilization in developing countries. These considerations should play a role in the design of tax
reform. 

 Reforming the tax administration to deal with new or modified tax laws usually takes time to
bear fruit, especially if they require major changes in how people work and administrative
processes. 

While simple tax instruments that rely on withholding from a limited number of large taxpayers
may have preference over more complex taxes that rely on filing, revenue agencies should build
capacity by establishing access to information on individual incomes and the administrative
capacity to process this information and collect the taxes. This can be accomplished through
digitalization and information technology. 

In this module, we explained how fiscal policy could be used to make growth more inclusive.
Specifically, we discussed the link between fiscal policy and inclusive growth and the tradeoffs
between growth and equity. We analyzed how fiscal policy tools—expenditure programs and tax
measures—could foster or hinder inclusive growth. In each case, we presented a conceptual
framework, described tools for assessing how much redistribution can be achieved, and provided
practical measures for fostering inclusiveness. Finally, we discussed challenges caused by
 political economy considerations and proposed mitigating measures based on international best
practices.

The main takeaways from the discussions in this module can be summarized as follows:

1. Fiscal policy can help address distributional disparities while promoting equal opportunities. 

2. Fiscal policy measures often entail tradeoffs between growth and equity. Not all fiscal policy
measures can promote growth and reduce inequality. Often, measures supporting growth
exacerbate inequality and vice versa.

3. Fiscal policy cannot be inclusive unless it leads to macroeconomic stability and fiscal
sustainability.  

4. Public expenditure programs have the largest scope for making growth more inclusive through
three channels: social protection, human capital formation, and investment in public
infrastructure.

5. Taxes affect inequality or ‘inclusiveness,’ mainly through the progressivity of the tax system
—meaning a tax burden that rises with a taxpayer’s income or wealth—and affecting other
dimensions of equality, such as equal treatment by gender, equality of opportunity,
intergenerational equity and by treating people in similar circumstances the same. 

6. Both the level and composition of taxes matter for inclusive growth. 

7. Many countries have scope to promote inclusive growth through tax reforms. 

 In advanced and some emerging market economies, options include more progressive
personal income tax systems, more neutral taxation of capital and corporate income, a broader
VAT base, and more/better use of carbon taxes, property taxes and inheritance taxes. 

 Developing countries should continue to build their administrative capacity to better enforce

existing taxes. They can improve and simplify their VAT and excises, protect their income taxes
better against avoidance and evasion, reduce discretionary tax incentives, enhance fiscal regimes
for extractive industries, and better exploit taxes on property and pollution. Tax increases that are
not progressive—such as higher consumption taxes—might be desirable for inclusive growth if
the revenues finance spending on for example, social programs, education, health, and
infrastructure, which pursue better standards of living. 

8. Taxes are a means to an end—to finance public spending. Those expenditures affect inclusive
growth. For instance, productive spending on education and infrastructure are important for
economic growth; and redistributive transfers in cash or in kind are vital for inclusion. Any
analysis of inclusive growth should look at the joint impact of taxes and public expenditures.

9. Government authorities need to use net fiscal incidence in judging certain policies. For
instance, an increase in value-added tax (VAT) may be rejected on equity grounds as being
regressive. But it may be desirable from an equity standpoint if the resulting revenues are used to
finance primary-school services in poor neighborhoods. On the other hand, taxes may be
progressive, but if transfers to the poor are not large enough, they may worsen poverty.

10. Experience gleaned from the work of the IMF and other institutions, as well as the political
economy literature, points to several considerations that policymakers may find useful when
designing and implementing reforms in support of inclusive growth. These considerations
include addressing political, and social challenges, focusing on net redistributive impact of fiscal
policy, mitigating the impact of fiscal reforms on inclusive growth, and addressing institutional
challenges.