Chapter

9 Political Economy and the Equity-Policy Agenda

Editor(s):
Ke-young Chu, Sanjeev Gupta, and Vito Tanzi
Published Date:
May 1999
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Author(s)
Aníbal Cavaco Silva

Introduction

Over the past twenty years, many European countries have experienced increases in income inequality, in the number of people suffering from poverty, and in social exclusion (Atkinson, 1995). Some government policies have been severely criticized for their lack of equity. In general, they are considered to have been ineffective in reducing income inequality and, perhaps, have even contributed to greater income inequality.

However, individuals’ preferences for less income inequality and for living in a fairer society have not diminished. Inquiries made in the European Union (EU) show that 80 percent of the population want the fight against poverty and social exclusion to rank among the highest government priorities. The discussion and analysis of the objectives and strategies underlying the design of government policies that, in practice, can lead to reduced income inequality and a more equitable society are issues of the greatest importance.

When designing and implementing redistributive measures, policymakers must pay attention to the international environment of increasing globalization, economic integration, and technological changes. Political factors that may influence policy choices and their implementation must also be taken into account. Economic policy advisors, whose recommendations influence politicians’ decisions, should try hard to understand the elements that determine politicians’ behavior. The focus of their advice should be on those inequality-reducing measures that politicians can embrace, rather than on those that are theoretically correct but not politically feasible.

I shall discuss the priority areas that, in my view, policymakers can be persuaded to include in their agendas, so that distributive equity will be better in the next twenty years than in the past twenty years, including equity as a policy agenda for European governments, designing and implementing policies to reduce inequality, and political and administrative concerns.

Equity Policy Agenda for European Governments

Importance of Equity

What is a politically realistic equity policy agenda for European governments? Equity is an important political issue—even in the industrialized European countries. In the EU, 55 million people (15 percent of the total population) have an income of less than half of their nation’s average; 18 million (10.7 percent of the labor force) are unemployed, of which 50 percent are long-term unemployed; and 2.5 million are homeless. This situation is a matter of growing concern to political and social actors—both at the national and EU levels—as well as to the citizenry in general.

The objectives of reducing income inequality and combating social exclusion are usually given a high priority in politicians’ electoral proposals. Political speeches generally give more emphasis to equity than to efficiency and economic growth. When political proposals put greater emphasis on economic growth, it is usual to underscore its contribution to a reduction of income inequality and to an improvement of social justice.

Electoral Proposals Versus Concrete Actions

European politicians are convinced that voters dislike large income and wealth inequalities as well as profound poverty. Politicians consider that reflecting this concern for social injustice is indispensable in winning voters’ support. Politicians are also influenced by media attention to inequality, poverty, and social exclusion. Since the 1980s, however, few European governments at either end of the political spectrum have given a high priority to reducing income inequality once in office, in contrast with the priority assigned to this goal in electoral programs.

Assuming that politicians want to be reelected, it seems strange that they would downgrade the equity objective once they take office. One explanation may be that policymakers are not very optimistic about the possibility of achieving visible improvements in equity during their terms that are large enough to offset such potential negative side effects as lower growth, higher unemployment, and higher inflation.

Generally, politicians seem to believe that redistributive policies have an adverse effect on efficiency and growth, notwithstanding the wide diffusion of the World Bank message (Chenery and others, 1974) that growth and improved equity need not be at odds. Politicians seem to think that the linkage goes mainly from growth to equity—a positive growth result is viewed as indispensable in improving income distribution in the medium term. Politicians are also convinced that the budgetary costs of a comprehensive policy designed to achieve a socially fair distribution of income would not be sustainable and would crowd out financial resources from the pursuit of other goals.

The persistence of income inequality and poverty in almost all countries leads the electorate to believe that solving the problem is an extremely long and difficult task. Voters tend to forgive incumbent politicians for weak results because they have difficulty in detecting changes in the overall state of income distribution, and increasing inequality is not always evident during a government’s term. Therefore, equity is likely to be an area where, from an electoral point of view, political speeches and promises are more important than concrete results.

When economic growth, employment, or price stability are below target, policymakers react by announcing additional measures that may have an adverse effect on equity in the short run. However, when an income distribution target is missed, policymakers do not react. This is a behavior that economists seem to accept as rational. The literature on political business cycles hypothesizes that politicians adjust economic policies to show a positive performance in economic growth, employment, and inflation as reelection nears. These theories do not view income distribution results as a determining factor for the behavior of politicians.

The downgrading of the equity objective by politicians—once in office—does not mean that policymakers do not care about taking measures to reduce income inequalities.

Designing and Implementing Policies to Reduce Inequality

Growth and Equity

Economic growth may have a positive effect on income distribution, as politicians believe. Also, without sustainable economic growth, it is difficult to achieve a significant reduction in social inequalities. This linkage, however, operates only in the long run, and some measures directed to enhance growth may have adverse equity effects in the short run.

It is well known that some redistributive measures may have a negative effect on economic growth. However, a more equitable income distribution may also have a positive effect on economic growth, as underscored by Chenery and others (1974) and as emphasized more recently by others (Persson and Tabellini, 1994; Alesina and Rodrik, 1994; Bardhan, 1996). Perotti (1996) summarizes the channels through which income distribution can affect growth.

In fact, some policy measures suit both the equity and growth objectives. Tanzi (1998) asserts that many of the policies that benefit the lowest-income groups are often those with the highest social rate of return. Programs that promote the reduction of income inequality and also benefit economic growth and employment are more likely to be chosen by politicians than those that only reduce income inequality. European politicians will not make major efforts to reduce income inequality if they are convinced that economic growth will be negatively affected.

Tax and Transfer Policies

Policymakers reveal an increasing preference for expenditure programs targeted to specific groups or situations, instead of global income redistribution policies through the tax and transfer system. Targeting society’s most vulnerable may be more popular with the electorate.

Generally, politicians believe that, as far as equity is concerned, voters are concerned mainly with specific poor groups and the programs adopted by the government to assist them. It is easier for voters to see the “beneficial” effects of targeted expenditure programs. It is thus quite normal for politicians to prefer programs that have high visibility and media impact, produce short-run results, target specific groups of voters, and fall within budgetary limits. Consequently, politicians tend to prefer social programs, such as noncash subsidies, involving paternalism toward the poor, rather than universal cash transfers.

In spite of the severe criticism by international organizations of regulatory measures that aim at the distribution of market earnings, like minimum wage and job protection legislation, such measures are also attractive to politicians. This is because these measures enjoy a high public profile, worker and trade union support, and low direct budgetary costs. Economic advisors should, however, remind politicians that market-distorting measures have a negative effect on both efficiency and equity in the long term. Although these measures are likely to benefit current workers, they are detrimental to the unemployed, the less skilled, and younger people.

It is politically unrealistic to think that an effective improvement in income distribution can be achieved through greater tax progressivity. At present, great demand is placed on the role of the tax system to achieve objectives other than equity. European decision makers have been receptive to granting various tax incentives aimed at stimulating savings, new investment, competitiveness, technological development, and other goals. Yet a significant improvement in equity could be achieved in some countries by efficient measures that reduce tax fraud and evasion.

Policymakers seem to be increasingly convinced that globalization and economic integration constrain redistributive tax policies. Governments have responded to high capital mobility by reducing capital income taxation, whereas labor, which is less mobile for cultural and linguistic reasons, is relatively burdened with taxation. Globalization helps explain the reductions seen in several European countries in corporate tax rates, the special tax concessions granted to new investments, and the cuts in the highest personal income tax rates. Fairness continues to be an important goal of tax systems, but tax policy is no longer viewed by European politicians as the key means to change the distribution of disposable income.

Tax competition in the EU is now a matter of concern to the Commission and some member states because it has led to high taxation of labor compared with more mobile factors—a situation that is unfavorable to job creation. To remedy this situation, the EU is now discussing the introduction of greater coordination—if not harmonization—of corporate taxes and savings taxes in the framework of a monetary union.

Social security transfers have made an important contribution to a fairer European society over the past forty years. In most countries, however, it is unrealistic to think that progress in income redistribution can be achieved by increasing social security benefits, which cover pensions, health insurance, and unemployment benefits. Most countries now realize that their social security systems are financially unsustainable, owing mainly to demographic changes. These systems are, to some extent, in crisis in all EU member states. Governments are under strong pressure to reform their social security systems by cutting benefits and thus the growth of public expenditure. Most EU countries also recognize that their high social security contributions strongly discourage investment and job creation.

Thus, a strategy to improve equity based on the traditional tax and transfer system does not appear politically feasible. In the near future, income inequality will probably not be reduced through radical changes in the tax system or in the state social security system. The exception lies in possible improvements in administration, which could significantly improve equity.

Employment and Human Capital Formation

If the equity goal were defined in terms of dispersion throughout the income scale, the results of government policy could be disappointing, given the difficulty of implementing a national redistribution policy. Policymakers should instead adopt a less ambitious equity goal, focusing on the lowest-income groups and social exclusion. Focusing on the poorest groups might produce better equity results and will mitigate the tension between redistribution and growth objectives. Of course, the policymaker cannot ignore distributional developments affecting nonpoor groups if income disparities above the poverty line—measured as a percentage of national median income—are socially unacceptable or jeopardize other policy goals.

Given these political, economic, and budgetary constraints, creating a more equal society in European countries requires giving priority to two interrelated areas: reducing unemployment and improving human capital. These are strategic interventions that have a good chance of being accepted by politicians and that, in the long run, should also improve growth and equity.

These areas for action are not new. On the contrary, they have been part of economists’ policy proposals for improving income distribution for the past twenty years. The environment in which these measures can now be implemented has changed, however, and some of them appear today to be much more practicable than they were in the past. Therefore, a new emphasis is justified.

In many countries, unemployment is a main factor of income inequality, and it hits poor people especially hard. The social security system does not cover all the unemployed, the benefits do not always provide an acceptable standard of living, and unemployment also negatively affects a person’s well-being, beyond the loss of income. Long-term unemployment has spread considerably during the 1990s and is a major contributor to social exclusion. Thus, the fight against unemployment should be viewed by economic and social policy advisors as a strategic step to promoting a more equitable distribution of income.

European governments are genuinely concerned about their high levels of unemployment. Moreover, pressures arising from economic globalization and monetary union are increasing the political feasibility of more effective measures to fight the structural component of unemployment. Since 1994, the Organization for Economic Cooperation and Development (OECD) has advanced a set of policy recommendations aimed at reducing unemployment—known as “the OECD Jobs Strategy”—and by the end of last year it was decided, at the highest level of the EU, to develop a strategy to coordinate employment policies with a view to increasing the employment level and to lower unemployment rates in member states.

The OECD Jobs Study (OECD, 1994) strongly recommended greater flexibility in the labor market for the EU, mainly with a view to promoting economic efficiency and competitiveness. Labor market flexibility requires not only labor-cost flexibility, but also mobility, flexibility in work time and work organization, adaptability, and less strict employment protection legislation. Because this may widen wage dispersion and, in the short run, low-skilled workers may be hit, this measure is often regarded as being adverse to equity, engendering a negative reaction from social agents.

Policy advisors should include structural reforms that create jobs in their policy proposals to improve equity. The policymakers should be persuaded to make the adjustments that are appropriate to a concern for social justice.

If equity-improvement policies are focused primarily on the poorest groups, labor market flexibility will contribute to a less unequal society. Improving labor market performance would create more employment opportunities for jobless and socially excluded individuals to work and earn wages. From this equity perspective, the employment effects of labor market flexibility are more important than the potential widening of wage distribution. However, greater flexibility must be accompanied by appropriate and well-targeted social safety nets that protect the consumption levels of those whose well-being is negatively affected. This would also help minimize any negative social reactions to labor reforms.

Although maintaining current European labor market rigidities in the new global economy might increase unemployment, social exclusion, and, consequently, create a more unfair society in the long run, a radical change in European labor markets in the direction of the U.S. model is not politically feasible.

Social partnership institutions, including government, employer associations, and trade unions, should create more favorable conditions for implementing labor reforms and take complementary actions required by an equity concern, thereby preserving social cohesion. The risk lies in the trade unions demanding compensations that benefit those workers who are and will continue to be employed, but not those who lose their jobs. Other job creation incentives should also be viewed as equity-enhancing measures, for example, reduced taxes on labor or on consumer services, a sector that makes intensive use of low-skilled labor, or even subsidies for marginal job creation, targeted to the young and long-term unemployed. Employment-promotion measures should include reinforcing entrepreneurship, reducing taxes and administrative costs for small and medium-size enterprises, and promoting local employment initiatives. In the EU, two-thirds of jobs are created by firms with fewer than 250 employees.

European policymakers have so far not been receptive to adopting expansionary macroeconomic policies to tackle unemployment. However, it is likely that future labor market reforms will be coupled with more appropriate aggregate demand management—coordinated at the EU level, as some authors have suggested (Modigliani, 1996). In some countries, strong government assistance for housing and rehabilitation for low-income families in urban areas would be equity enhancing.

To reduce income inequality in a globalizing world, a policy advisor should give special priority to the measures that improve human resources through education, vocational training, and apprenticeships—particularly measures that help those at the lower level of income distribution. Equality of opportunity, which is normally associated with access to education, is extremely important for the distribution of income or consumption.

Given rapidly changing technology, the most appropriate policies to promote greater equality of income are those that increase the income-earning capacity of the poor by promoting their human capital formation. Such policies have a positive effect on efficiency, employment, and productivity and are economically and politically recognized as key factors in enhancing competitiveness and economic growth. Therefore, governments should provide free basic education, and even secondary education; education subsidies directed toward low-income families; programs to prevent school failure or dropouts; and programs to integrate truant children. Governments should also provide training programs for the unskilled, unemployed, and socially excluded; social integration programs for single parents; and work and apprenticeship programs. Because capital market imperfections are a severe constraint on human capital investment by poor individuals, government intervention is justified. In some countries, improving access to basic health care and housing and providing for basic public infrastructure are also needed to enhance human capital.

Many recognize that the social protection schemes in some countries need to be reformed, as they are too generous, encourage a culture of dependency, and discourage work effort. Social policies should be adjusted so that individuals have an incentive to enhance their competencies and job skills and thereby improve their employability. This concept has been increasingly emphasized in the EU, where it is generally felt that passive social policies, which provide cash benefits to the unemployed and socially excluded, single parents, and other needy groups, should be replaced by a more active social policy. Under the latter, approved beneficiaries should be required to learn new skills and be advised on job search and social integration. Those who refuse to improve their skills should be penalized with a reduction in social benefits.

Reforming Public Assistance Programs

The above-mentioned priority areas for government action may lead to a less unequal European society in the long run. This does not, however, diminish the importance of specific transfer programs targeted to vulnerable groups. Special social assistance programs should be designed for those living in conditions of deep poverty and for the unemployable; for example, programs targeting poor pensioners, the homeless, drug addicts, the disabled, or ethnic minorities.

Some economists criticize the paternalism underlying noncash subsidies, but voters seem to prefer them. Because in-kind or quasi-in-kind benefits—such as housing, food, transportation, and health-care benefits—are more visible and can have an immediate impact, they may be more politically attractive than cash benefits. Moreover, in-kind benefits may produce better results in terms of well-being, as they are easier to target.

A more effective targeting of benefits toward the most disadvantaged groups seems inevitable. Some European countries are beginning to realize that they must reform their public assistance programs in order to confine the benefits to the vulnerable, and that universal benefits provided without means testing will have to be cut.

Overcoming Political and Administrative Constraints

Competitive pressures are now making European policymakers more willing to take measures to reduce social expenditures, as some of Mr. Tony Blair’s proposals illustrate. These cuts should not always be considered to be anti-equity; on the contrary, they may reduce unjustified benefits and free up money for job creation and human capital formation. Policy advisors should urge politicians to turn their efforts in that direction and put social security and welfare reform on their agendas.

Improving income distribution requires clear and strong government leadership—and the commitment of the head of government and his or her inner cabinet. Because the necessary measures have to be prepared by several ministries, the head of government will have to supply the impetus to policy action and ensure the coordination and consistency between economic policy and sectoral social policies.

An improvement in the efficiency of public service agencies responsible for the administration of redistributive programs is also indispensable. Poverty alleviation programs targeted to more vulnerable groups tend to produce better results, at a lower cost, if implemented by local authorities—with the active involvement of private social organizations.

The decentralization of social policy tends to increase local responsibility in decision making and produce more active policies. Individuals can be better oriented and encouraged to return to work and thus to escape social exclusion. At the same time, local authorities have better information on the individual situations, which can help ensure that benefits reach those who really need them, reduce fraud, and lower administrative costs. The involvement of private and voluntary institutions in the implementation of welfare programs helps improve their quality and cost-effectiveness, mainly programs targeted to children, the elderly, the disabled, and drug addicts.

Concluding Remarks

A persistent and determined action by European governments in the areas of employment and human capital formation appears to be the effort that, in practice, can lead to better results in improving equity in the long term. These two complementary areas should be addressed mainly at the national level, but also by the EU. Job creation widens the employment opportunities of those who complete training programs and acquire new skills, while their improved employability allows for a better adjustment of labor supply to market needs. Policies that stimulate income generation are more effective than unconditional cash payments to needy groups in reducing income inequality. Moreover, an increase in employment means an increase in tax revenue from the new workers and a decrease in unemployment compensation.

At the same time, social security and welfare programs will have to be reformed in several European countries. Equally important, public assistance programs should be confined to the truly vulnerable. These reforms are not necessarily anti-equity. A cut in social security expenditure may be indispensable to making budgetary room for policies that are more effective in reducing income inequality and in increasing employment.

In the context of the EU, the financing of job creation incentives and human capital investment will have to rely mainly on a change in the composition of government expenditure and in the financing system of education, health care, and other public services, allowing for an increase in user fees. The European Commission’s white paper Growth, Competitiveness, Employment (1993) suggested the introduction of an energy tax or pollution taxes. The opposition of some member states to this type of taxation has diminished, and it is possible that an agreement will be reached in the future.

An equity policy agenda such as that outlined above now has a good chance to be accepted by politicians in the EU.

References

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