The growing public debt in many nations has brought fiscal rebalancing to the top of policy agendas. This means raising taxes, or cutting expenditure. Recent US experience in the US and other nations suggest the presence of structural factors accounting for resistance to tax reforms.
One obstacle to tax changes may be polarised distribution of incomes.
- If all agents are identical, equal burden sharing would be the norm;
- With great income inequality, however, tax reforms usually get tangled in inequity debates, hindering, for example, efforts to broaden the tax base.
A mechanism explaining the resistance was proposed by Bénabou (2000). More inequality, he argues, may result in less government spending on redistribution because the consensus for ex ante efficient redistributive policies breaks down.
- As a broader tax base is a necessary condition for greater redistribution, opponents of redistribution oppose broadening.
- In this way, a high Gini coefficient could impair tax collection and thus reduce the fiscal space at a given public debt level.
This result was confirmed by the findings that more unequal societies do spend less on redistribution (de Mello and Tiongson 2006).
In recent research (Aizenman and Jinjarak 2012), we investigate the association between income inequalities and the tax base across countries in the 2000s, and link it to the pricing of sovereign debt. We find strong negative association between the two, and that higher inequality is associated with lower tax base, lower de facto fiscal space, and with a higher sovereign spreads.1
Our de facto fiscal space follows on from previous research (Aizenman and Jinjarak 2011), and is defined as the public debt relative to the de facto tax base, where the latter measures the realised tax collection, averaged across several years to smooth for business cycle fluctuations. Thus, the de facto fiscal space is inversely related to the tax-years it would take to repay the public debt. In practice, the average tax revenue provides a good measure of the de facto taxing capacity, being the outcome of the tax code and its effective enforcement. While the public debt-to-GDP ratio may increase rapidly at times of peril [see Ireland in the recent crisis, more than doubling its public debt/GDP in one year], the de facto taxing capacity changes slowly at times of peril, as parties tend to be locked in a war of attrition, attempting to minimise their adjustment burden (Alesina and Drazen 1991). Consequently, the ratio of the outstanding public debt to the de facto tax base, or the tax-years needed to repay the public debt, provide information about the relative fiscal tightness of countries. For a given similar unanticipated adverse fiscal shock, a country with lower public debt/average tax revenue may have more room to adjust by reallocating its priorities of using the relatively high tax base.
Figure 1. Tax Base, Inequality, and Corruption in 50 countries, 2007-11
Figures 1a and 1b are scatterplots of the data for 2007 and 2011, respectively, of the tax base and income inequality relationship. A look at Figures 1a and 1b reveals that developed countries are clustered mainly to the left, while emerging markets are clustered to the right. This suggests a significant association between the quality of institutions and the tax base. Indeed, Figures 1c and 1d support the negative relationship between tax base and the corruption index. We base our econometric analysis on the 50 countries that have comprehensive records of the key variables; Gini coefficient, tax base, fiscal space, and market pricing of sovereign risk, up to year 2011. We find that higher inequality is associated with a lower tax base over the sample period; and that the inequality effect has increased from 2007 to 2011. The influence of inequality on fiscal space operates through the tax base, and is large: a one standard deviation increase of Gini, 10 in a scale of 0-100, is associated with a lower average tax base by 21% GDP in 2011.
Next, we estimate the association between sovereign risk and fiscal space with the two-stage least square estimation, evaluating the impact of inequality effect on both the fiscal space and the sovereign risk.2 We summarise the economic significance of our econometric findings in Figure 2. For each variable, the corresponding bar in the figure is the estimated impact of one standard deviation of the viable of interest. Our key factors of interest, the fiscal space variables (tax base and public debt) – together account for about 350 basis points of sovereign risk as measured by the CDS prices, which is about a third of sovereign risk in 2011. This estimate indicates that sovereign risk is responsive to the tax base, and hence the Gini coefficient, though this association is estimated using changes over the period, so it is a medium-run relationship. Other macroeconomic variables, including growth, volatility, and inflation are also economically large and significant in the sovereign risk equation. Overall, the estimation suggests that increased inequality, and thus decreased tax base and fiscal space, is associated with a significant worsening impact on sovereign risk, at least in the medium run. A one standard deviation increase of the Gini coefficient is associated with a rise of 470 basis points of the sovereign spread in 2011.
Figure 2. Economic Significance on Sovereign Risk, in basis points of CDS prices
Notes: This figure reports the economic significance of each variable based on the estimation results of Table 2, column (iv). The height of each bar is equal to the coefficient estimate multiplied by the 2011 sample standard deviation of the variable.
The de facto tax base is hard to change overnight, as it reflects a social contract. This contract depends on the tax enforcement capacities of a country, which are anchored in the public’s perception of tax fairness and the gains from public sector expenditure, factors that are hard to change at times of crisis.
This view is consistent with recent empirical literature finding that tax compliance and the individual’s willingness to pay taxes are affected by perceptions about the fairness of the tax structure. An individual taxpayer is influenced strongly by his perception of the behaviour of other taxpayers (Alm and Torgler 2006).
If taxpayers perceive that their preferences are adequately represented and they are supplied with public goods, their identification with the state increases, and thus the willingness to pay taxes rises (Frey and Torgler 2007). Thereby, greater income inequality limits the ability to conduct a counter fiscal policy, and increases the downside risk of a given debt-to-GDP ratio.
Confirming this logic, our empirical results suggest that more polarised societies find it harder to adjust to crises by raising taxes at times of peril.
The uniform fiscal guidelines of the Maastricht treaty (debt-to-GDP below 60%) were too lenient for peripheral countries with a low tax base. The focus of the discussions on the Eurozone crisis has been on the inequality between rich and poor member states, and whether it has contributed to the crisis.
Our analysis suggests that another income inequality – within countries – explains the challenges of adjustment.
The Maastricht Criteria should have encouraged countries with a low tax base to broaden their tax base and adopt policies aiming at reducing income inequality.
The combination of the two would increase overtime the fairness perception of the tax structure, reduce polarisation, improve the adjustment capacity at times of peril, and reduce the sovereign risk associated with a given public debt/GDP.
Accomplishing these tasks is challenging, yet the history of Brazil during the last two decades illustrates vividly the feasibility of these reforms. The tax revenue in Brazil as a percentage of the GDP rose from 25% to 37% between 1993 and 2005. Intriguingly, Brazil’s GINI coefficient in 2001, 60, has decreased to 54 in 2009. While Brazil remains challenged by inequality and fiscal deficiencies (see Melo et al. 2010), the reforms of the last two decades provide useful lessons for all emerging markets, including Europe’s periphery countries.3
The authors are grateful for the comments of Alfons Weichenrieder and anonymous referees. Any views presented are those of the authors and not the NBER
Aizenman, Joshua and Yothin Jinjarak (2011), “The fiscal stimulus of 2009-10: Trade openness, fiscal space and exchange rate adjustment”, NBER Working Paper No. 17427, forthcoming, NBER International Seminar on Macroeconomics 2011.
Aizenman, Joshua and Yothin Jinjarak (2012) “Income inequality, tax base and sovereign spreads”, NBER Working Paper No. 18176
Alesina, Alberto, and Allan Drazen (1991), "Why are Stabilizations Delayed?", American Economic Review, 82:1170-1188.
Alm, J and B Torgler (2006), “Culture differences and tax morale in the US and in Europe”, Journal of Economic Psychology, 27:224-246.
Bénabou, Roland (2000), “Unequal societies: Income distribution and the social contract”, American Economic Review, 90:96-129.
De Mello, Luiz and Erwin R Tiongson (2006), “Income inequality and redistributive government spending”, Public Finance Review, 34(3):282-305.
Frey SB and B Torgler (2007), “Tax morale and conditional cooperation”, Journal of Comparative Economics, 35:136-159.
Heller, SP (2005), “Back to Basics – Fiscal Space: What It Is and How to Get It”, Finance and Development, 42(2), June.
Melo, M, C Pereria, and S Souza (2010), “The political economy of fiscal reform in Brazil”, IDB Working Paper 117.
1 Heller (2005) defined fiscal space “as room in a government’s budget that allows it to provide resources for a desired purpose without jeopardising the sustainability of its financial position or the stability of the economy.” Yet, measuring ‘fiscal space’ tightly remains a challenge.
2 As long as the income inequality does not have a direct effect on the sovereign risk, the Gini coefficient is a potential instrumental variable that is relevant for estimating the impact of fiscal space on sovereign spreads.
3 The record of the Euro Periphery has been mixed: the GINI coefficients of Greece was overall stable, 33 in 1999 and 32.9 in 2009, while its tax/GDP dropped from 35.4% in 1999 to 32.8% in 2009; for Portugal, the GINI declined from 36 in 1999 to 33.7 in 2009, while its tax/GDP increased from 33.4% in 1999 to 34.4% in 2009; for Spain, the GINI went from 32 in 1999 to 33.9 in 2009, while its tax/GDP dropped from 34.8% in 1999 to 31.6% in 2009; for Italy, the GINI went from 29 in 1999 to 31.2 in 2009, while its tax/GDP increased from 42.4% in 1999 to 43.1% in 2009; for Ireland, the GINI went from 30 in 1999 to 33.2 in 2009, while its tax/GDP dropped from 32.8% in 1999 to 29.8% in 2009.