Fiscal Policy and Inequality: Latin American Lessons for the U.S.

As the financial and economic crisis spread internationally, governments from the United States to Europe, Latin America, China and beyond turned to fiscal policy in their scramble to save jobs, rescue banks and avoid recession or worse.

Fiscal policy — public spending, taxes and debt management — has thus returned, rather abruptly, to the heart of the public policy debate.

If fiscal policy has been policymakers’ tool of choice for responding to the crisis (many believed they, in fact, had no choice), it can also be used effectively in the longer-term fight to reduce poverty and excessive inequality.

The Obama Administration apparently aims to do precisely that — implement today's necessary fiscal policy in ways that are more attuned to reducing long-term inequality in the United States. But how much reduction in inequality can, or should, the United States expect to achieve through fiscal policy?

We can get some idea of the potential impact of fiscal policy on inequality in the United States by looking at how taxes and government spending affect income distribution in Europe and Latin America.

European countries generally have lower inequality than the United States. But in Latin America, as U.S. Secretary of State Hillary Clinton observed recently, the inequality between rich and poor is “the greatest gap of any region in the world.” What is the role of fiscal policy in these differences?

We can evaluate the impact of fiscal policy on income inequality by looking at inequality of household income before taxes and government transfer payments, and then see how much this inequality is changed through the combined effects of taxation and public spending.

Progressive taxation — taxes that take a bigger share of the income of rich families than poor families — tends to reduce income inequality, as does universal child support, pensions for lower-income workers, food stamps and other spending programs that are more important to the poor than to the rich.

On the other hand, regressive taxes (such as sales taxes) and government spending that directly or indirectly favors the better-off often fails to reduce income inequality, and can even raise it.

Inequality can be gauged by an index called the “Gini coefficient.” This index varies from zero (every household has the same income) to 100 (all the income in the land is concentrated in a single household). Typically, the effects of labor and capital markets combined are to generate before-tax-and-transfer Gini coefficients of 40 to 50, although in Latin America (and Africa) several countries have Gini indexes above 50.

For example, in Western Europe, only Portugal has a pre-tax-and-transfer Gini slightly above 50, and only the Netherlands' is (slightly) below 40. The United States' pre-tax-and-transfer Gini index is 46, fairly typical of advanced industrial countries.

These similarities dissolve when we look at inequality after taxes and public spending. In Europe, the effect of taxes and transfer spending is dramatic. Fiscal policy reduces the average Gini coefficient from 48 to 28.

In the United States, fiscal policy also reduces inequality, but much less than in Europe. Fiscal policy in the United States reduces the Gini coefficient from 46 to 38.

In Latin America, fiscal policy has a negligible effect on income distribution in most countries.

The high before-tax-and-transfer-payment inequality — Latin American countries have an average Gini of 52 before fiscal policy — remains stratospheric compared to Europe and even to the United States after taxes and public spending. After fiscal policy, income inequality in Latin America still tips the Gini scale at 50.

So fiscal policy — the combined impact of taxes and public spending — reduces income inequality in Europe by about 40% (i.e., by almost 20 Gini points), in the United States by about 17% (8 Gini points) and in Latin America by a mere 4% (2 Gini points).

Source: “Latin American Economic Outlook 2009,” OECD Development Centre (2008), and “Growing Unequal?” OECD (2008).

Why is taxation and public spending so ineffective in ameliorating income inequality in Latin America? Three facts, listed in order of decreasing importance, go far to explain this ineffectiveness:

First, in Latin America, only a privileged minority qualifies for public pensions and other “poverty alleviation” spending. Most of the population is outside the social security system. Even education and other “universal” programs are often of poor quality, and tend to be avoided by those who can afford private alternatives.

Put simply, the main problem in Latin America is that governments generate far too few benefits for most of their populations from the money they spend in terms of the quality of the public goods provided with that money — be it spent on education, health care, public safety or whatever.

This leaves the poor no better off after the government intervenes than before. And it means that an increase in public spending without fundamental changes in the way the money is spent will not even begin to solve the problem.

Second, Europe and North America rely much more on income taxes than Latin America, where sales taxes and value-added tax (VAT) are more important. Personal income taxes are 27% of government revenues in Europe and the United States, but only 4% in Latin America.

Third, the public sector is smaller in Latin America than in Europe or North America. Taxes in Europe average 38% of GDP. In the U.S. they are 27% and in Latin America they are 20%.

Trends in the United States suggest that the Latin American model of fiscal ineffectiveness is dangerously relevant. Again and again in the past few decades, U.S. voters have favored tax cuts over tax increases to support improved public services.

The erosion of popular support for public spending on education illustrates this trend, as the small proportion of U.S. children who are schooled in private academies and at home has gradually risen.

More strikingly, California voters in a May 19, 2009, referendum chose to close down public services — rather than make adjustments for the economic crisis.

Also symptomatic is the current upheaval, and apparent Democratic backpedaling, over a possible surtax on the wealthiest Americans to finance badly needed health care reform.

Looking to the future, because President Obama's stimulus package necessarily adds to the nation's already large fiscal imbalance, the United States will need to further adjust taxes and spending as the economy recovers.

The strength of pressures to avoid solutions that burden the wealthy, such as the surtax for health care reform, and the appeal of adjustments that are painless for the wealthy — privatization of Social Security, withdrawal of support to public schools, the elimination of income support programs for the indigent — constantly threaten the modest income redistribution effects of the U.S. fiscal system.

They also have perverse macroeconomic effects, and help preserve an economic system that allows some Wall Street executives to make huge under-taxed incomes through irresponsible risk taking. Too much of the burden of that risk is shifted to the public in times of major failure. And both growth and resource allocation tend to be driven, somewhat artificially, more by financial than real innovation.

President Obama’s plans to create a public health care safety net for all — and to extend public education to those aged 2-5 — may well clash with the perceived individual economic interests of older, wealthier, established voters who can easily turn against him if they feel their narrow economic interests are threatened.

Was the election of President Obama and Democratic majorities in the U.S. House and Senate truly a choice for stronger social safety nets and a stronger economy, together with more effective support for those whom the market tends to leave behind?

Or will the United States move more toward a Latin American pattern, where fiscal policy is so constrained by powerful interest groups that critical opportunities to strengthen the economy and reduce excessive inequality are lost?

The broader fiscal-policy challenge for all governments is to create a progressive tax system — and to use public spending in ways that simultaneously encourage the use of demonstrated best practices and secure the social support needed to leverage that spending for a stronger economy.

Reaping higher returns from public investment in the formation of both physical and human capital requires governments to ensure that public spending is efficient and well targeted. To do so is as important today for the United States as for Latin America.

Editor’s Note: The views expressed are those of the author and should not be attributed to the OECD, its Development Centre or their member governments.