Inequality, taxes and government debt

More from VoxEU, this time on the relationship between income inequality and fiscal sobriety (excerpt; emphasis added):

Income inequality, tax base, and sovereign spreads
Joshua Aizenman & Yothin Jinjarak

Might income inequality make structural adjustments more difficult? This column presents data from 50 countries in 2007, in 2009, and in 2011, and finds that higher income inequality in the country is associated with a lower tax base, less fiscal space, and higher sovereign spreads.

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…

…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 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…

…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…

…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.

I’ve taken a larger than normal excerpt because there are some important points being raised here. Quite apart from the impact income inequality has on government finances, there’s also the link between inequality and corruption, inequality and government debt, and inequality with sovereign risk. Bringing in other research strands, there’s also the link between inequality and crime, health and happiness.

The focus here on taxes goes back to another linkage with inequality – the most effective proven way to reduce inequality is higher taxation, coupled with cash transfers to lower income households. So income inequality not only reduces the power of governments to reduce the level and cost of public debt, it also constrains the most effective instrument we know of to reduce inequality itself.

Now isn’t that a bummer.

Technical Notes:

Joshua Aizenman, Yothin Jinjarak, "Income inequality, tax base, and sovereign spreads," VoxEU, June 2012