Despite sustained economic growth and rapid poverty reductions, income inequality remains stubbornly high in many low-income developing countries. This pattern is a concern as high levels of inequality can impair the sustainability of growth and macroeconomic stability, thereby also limiting countries’ ability to reach the Sustainable Development Goals. This underscores the importance of understanding how policies aimed at boosting economic growth affect income inequality. Using empirical and modeling techniques, the note confirms that macro-structural policies aimed at raising growth payoffs in low-income developing countries can have important distributional consequences, with the impact dependent on both the design of reforms and on country-specific economic characteristics. While there is no one-size-fits-all recipe, the note explores how governments can address adverse distributional consequences of reforms by designing reform packages to make pro-growth policies also more inclusive.

Abstract

Despite sustained economic growth and rapid poverty reductions, income inequality remains stubbornly high in many low-income developing countries. This pattern is a concern as high levels of inequality can impair the sustainability of growth and macroeconomic stability, thereby also limiting countries’ ability to reach the Sustainable Development Goals. This underscores the importance of understanding how policies aimed at boosting economic growth affect income inequality. Using empirical and modeling techniques, the note confirms that macro-structural policies aimed at raising growth payoffs in low-income developing countries can have important distributional consequences, with the impact dependent on both the design of reforms and on country-specific economic characteristics. While there is no one-size-fits-all recipe, the note explores how governments can address adverse distributional consequences of reforms by designing reform packages to make pro-growth policies also more inclusive.

Introduction

1. Income inequality in low-income developing countries (LIDCs) has remained stubbornly high over the past two decades despite sustained growth and declines in poverty levels (Figures 12).2 The experience of LIDCs mirrors that of many emerging markets (EMs), with inequality levels for both groups remaining much higher than in advanced economies (AEs) (Figure 3).3

Figure 1.
Figure 1.

Real GDP Growth and Headcount Poverty in Low-Income Developing Countries, 1996-2013

Citation: Staff Discussion Notes 2017, 001; 10.5089/9781475566222.006.A001

Sources: World Economic Outlook (WEO); PovcalNet; IMF staff calculations. Note: PPP = purchasing power parity.
Figure 2.
Figure 2.

Income Inequality across Low-Income Developing Countries, 1995-2013

Citation: Staff Discussion Notes 2017, 001; 10.5089/9781475566222.006.A001

Sources: Socio-Economic Database for Latin America and the Caribbean (SEDLAC); World Development Indicators (WDI); IMF staff calculations.Note: Calculation is based on 40 low-income developing countries.
Figure 3.
Figure 3.

Income Inequality by Country Group, 1995-2013

(Median)

Citation: Staff Discussion Notes 2017, 001; 10.5089/9781475566222.006.A001

Sources: Organisation for Economic Co-operation and Development (OECD); Luxembourg Income Study Database (LIS); Socio-Economic Database for Latin America and the Caribbean (SEDLAC); World Development Indicators (WDI); Eurostat; IMF staff calculations.Note: Calculation is based on 31 advanced economies, 48 emerging markets and 40 low-income developing countries.

2. This pattern of robust growth accompanied by little decline in inequality in LIDCs is a concern. On average, economies with lower income inequality experience longer spells of sustained growth (Ostry, Berg, and Zettelmeyer, 2012), as well as higher growth rates (Dabla-Norris and others, 2015). Widening inequality can also weaken support for growth-enhancing reforms and may spur governments to adopt populist policies, threatening economic and political stability (Rodrik, 1999). Furthermore, this pattern would limit countries’ ability to eradicate extreme poverty by 2030 (World Bank, 2016) and, more generally, to reach the Sustainable Development Goals.

3. This note examines the distributional effects of a specific set of policies and reforms aimed at raising growth in LIDCs and identifies options that governments may consider to mitigate growth-inequality trade-offs. It analyzes the channels and mechanisms through which inequality is likely to be affected by reforms given the specific economic characteristics of LIDCs and examines accompanying policy measures that can make the reforms palatable from both growth and distributional perspectives.4 It uses a two-pronged approach—empirical analysis to identify broad trends in inequality after the implementation of specific macro-structural reforms, and case studies, based on a dynamic general equilibrium framework that incorporates features common to LIDCs, to examine the mechanisms through which income distribution is affected. The two approaches are complementary. The empirical analysis has the advantage of “letting the data speak” but sheds light only on the observed historical association between major reforms and levels of inequality; it cannot be used to assess the distributional impact of specific reform packages. The case studies provide valuable insights into how reforms can affect inequality and how adverse effects might be mitigated—but the results are dependent on both the modeling methodology employed and the parameter values that are selected.

4. The note complements recent work on income inequality and growth-inequality trade-offs, including by Ostry, Berg, and Tsangarides (2014), the OECD (2015), and Ostry, Berg and Kothari (2016). It provides a more granular model-based analysis of the mechanisms through which reforms can result in growth-equality trade-offs and explores mitigating policy measures to address such trade-offs. The focus is, however, narrower: the analysis looks only at LIDCs and at a set of growth-promoting macro-structural reforms that are generally regarded as policy priorities for these countries given their stage of development (IMF, 2015a). These reforms include structural fiscal policies, such as measures to boost domestic resource mobilization and public infrastructure investment; financial sector reforms; and reforms to the agricultural sector. The choice of these policy areas does not imply that important reforms in individual countries should be exclusively focused on or limited to those areas.5 The emphasis here is more on uncovering the different channels through which such reforms can affect growth and income distribution in LIDCs and the reasons why growth-inequality trade-offs can materialize.

5. The rest of the note is structured as follows. The second section discusses the mechanisms through which these policies and reforms may affect inequality in LIDCs and how country-specific features relevant for this group—such as large differentials in productivity across sectors of economic activity, limited labor mobility across sectors, higher levels of informality, limited and inefficient infrastructure, and limited access to financial services—can influence these mechanisms. It then analyzes the distributional consequences of major reform events in LIDCs over the past three decades. The third section discusses the results from a set of individual country-case studies. Finally, the note discusses the main policy takeaways of relevance for ensuring that pro-growth policies and reforms can also be inclusive in LIDCs.

Macro-Structural Policies and Inequality: Empirical Evidence

The distributional impact of pro-growth policies and reforms is complex, depending on both the reform design and on country-specific economic characteristics as well. Empirical evidence from the past three decades suggests that specific structural fiscal policies and reforms to finance and agriculture have typically been associated with distributional changes, with the impact linked to specific economic characteristics, such as the level of informality or the efficiency of public infrastructure investment.

6. This section discusses the mechanisms through which macro-structural policies and reforms may affect inequality in LIDCs and presents new empirical evidence on the distributional consequences of major reform events over the past three decades. The analysis assesses the distributional consequences of major reforms in LIDCs using the approach in Furceri and Loungani (2016). Major reform events are identified as large changes in policy indicators—such as the indicators of the degree of agricultural and financial regulation in Ostry, Prati, and Spilimbergo (2009)—or as “unexpected” changes in public investment spending (IMF, 2014b; Furceri and Li, forthcoming).6 Reforms in taxation are identified as changes in direct and indirect tax rates. Two econometric specifications are used. The first establishes whether these major reform events or shocks are followed by significant changes to levels of income inequality. The second is used to analyze whether these effects vary with the characteristics of the economy, such as the levels of informality or financial inclusion (see Appendix 1).7

7. Structural reforms can have an impact on income distribution through a number of channels, some of which are particularly relevant for LIDCs.8

  • Reforms that tend to increase inter-sectoral productivity differentials can increase inequality, in particular in countries where the productivity gap across sectors is large and labor mobility is constrained. This is because poor individuals usually work in low productivity sectors and cannot move easily and work in higher-productivity sectors and take advantage of higher wages, exacerbating inequality across sectors.

  • Reforms that increase the relative prices of tradable to non-tradable goods can also have significant distributional effects. Since low-income individuals work mostly in the non-tradable sectors in LIDCs, reforms that reduce (or increase) the prices of non-tradable goods relative to tradable goods would affect the profits and wages of low-income workers leading to an increase in inequality.

  • Reforms that reduce the costs of borrowing can increase inequality if financial access is limited, as is the case in many LIDCs. This is because only high-income individuals and high-productivity sectors can access credit and invest in these countries. Limited labor mobility exacerbates this effect by reducing the ability of workers to take advantage of the opportunities created in higher-productivity sectors.

A. Fiscal-Structural Reforms

8. Boosting budgetary revenues is a policy priority in most LIDCs, to enable governments to provide essential public services. LIDCs still have fiscal revenues at about 20 percent of GDP, much lower than in AEs and EMs (Figure 4, Panel A), limiting their ability to finance public spending, which is a primary tool for governments to affect income distribution (Clements and others, 2015; Ostry, Berg, and Tsangarides, 2014; Figure 4, Panel B). Strengthening domestic resource mobilization is a key objective for developing countries in the Addis Ababa Action Agenda (AAAA) and further emphasized by the Group of Twenty (G20) action plan on the 2030 agenda for sustainable development. Against this backdrop, two prominent measures for resource mobilization are considered below to examine how they have typically affected income distribution in LIDCs.

Figure 4.
Figure 4.

Public Revenue and Spending

Citation: Staff Discussion Notes 2017, 001; 10.5089/9781475566222.006.A001

Sources: World Economic Outlook (WEO); Organisation for Economic Co-operation and Development (OECD); Luxembourg Income Study Database (LIS); Socio-Economic Database for Latin America and the Caribbean (SEDLAC); World Development Indicators (WDI); Eurostat; IMF staff calculations.

Policies for Domestic Resource Mobilization

Direct taxes

9. Increases in direct taxes have the potential to be progressive, but they can also introduce economic inefficiencies. Direct taxes can target the income of specific individuals and organizations and apply higher rates to those with higher incomes, thus helping redistribute income and reduce inequality. However, high marginal tax rates on income can hamper efficiency by reducing the incentives to entrepreneurship and to human and physical capital accumulation (Clements and others, 2015).

10. Empirical evidence suggests that major direct tax reforms in LIDCs have been associated, on average, with a decrease in inequality (Figure 5).9 This is consistent with the role played by redistribution policies in lowering inequality (Clements and others, 2015; Ostry, Berg, and Tsangarides, 2014). The effect, however, is not precisely estimated, suggesting that there has been wide variation in the inequality response to direct tax increases, as shown later in the case studies.

Figure 5.
Figure 5.

Impact of Personal Income Tax Reforms on Inequality

(Percentchange in Gini coefficientfor disposable income)

Citation: Staff Discussion Notes 2017, 001; 10.5089/9781475566222.006.A001

Source: IMF staff calculations.Note: t=0 is the year of the shock; solid blue lines denote the impulse responses to one-standard-deviation shock to the change of personal income tax rate, and dashed lines denote 90 percent confidence bands. See Appendix 1 for details on reforms.

11. The impact on inequality can also be affected by the presence of a large informal sector. The larger is the informal sector—as is the case in many LIDCs (Figure 6)—the smaller is the tax base, which means that tax rates have to be higher in order to attain revenue targets. Higher rates result in greater efficiency losses, through the impact on work and investment incentives. In addition, the structures that sustain a large informal sector may lead to tax avoidance in the form of a shift to the informal sector, motivating the use of indirect taxes in these economies.10

Figure 6.
Figure 6.

Size of Informal Sector by Country Group

(Median, percent)

Citation: Staff Discussion Notes 2017, 001; 10.5089/9781475566222.006.A001

Sources:International Labour Organization (ILO);IMF staff calculations.Note: Share of informality is measured by the ILO’s estimate of informalemployment as a share of total non-agricultural employment. The calculation isbased on latest available data.

Indirect taxes

12. Domestic resource mobilization in LIDCs often relies on consumption taxes, which are generally regressive. Assessing the distributional impact of an increase in taxes such as the value-added tax (VAT) requires understanding the distributional impact of the public spending that a higher rate could enable (as illustrated in the case studies). That said, to disentangle the forces at play, this section focuses on the impact of taxation in the absence of additional spending. Since the poor spend a larger share of income on consumption goods compared with better-off households, an increase in the VAT rate tends to widen consumption inequality (Stiglitz and Emran, 2007; Lustig, Pessino, and Scott, 2014). Moreover, by increasing the prices of taxed goods, a VAT hike would tend to reduce overall consumption and aggregate demand. This contraction in demand, in turn, would reduce the prices of non-tradable goods while the prices of tradable goods would remain broadly stable (the latter [before tax] are mostly determined by international markets). The decline in the relative prices of non-tradable goods translates into lower revenues for producers and reduced employment in the non-tradable sector, which typically employs low-skilled workers who have lower incomes, and thus increases income inequality across sectors.

13. The implications of a large informal sector for the distributional impact of higher consumption taxes depend on different offsetting forces. On the one hand, as for the case of direct taxation, a larger informal sector implies a lower tax base and, therefore, a need for higher tax rates to reach revenue targets. This accentuates the regressivity of an indirect tax reform. On the other hand, while higher VAT rates would reduce overall demand and everybody’s income, the demand for informal goods would contract less than for formal (taxed) goods, shielding the income of the producers of informal goods. This would reduce income inequality.11 However, this shift in demand towards non-tradable goods tends to cause a redistribution of productive resources from formal (relatively high productivity) to informal (relatively low productivity) activities, thus depressing economic growth.12,13 The overall impact of higher VAT or consumption tax rates, therefore, depends on the interaction of these various opposite effects and on the initial level of inequality, the sizes of the formal and informal sectors, and the sizes of the tradable and non-tradable sectors.14

14. Empirical evidence suggests that, on average, VAT rate increases adopted in LIDCs over the past two decades have been associated with higher inequality.15 A one-standard deviation increase in the VAT rate is associated with an increase in the Gini coefficient of about 0.2 percent one year after the tax increase. Five years after the tax increase, the increase is about 1.5 percent (Figure 7, Panel A).16 This effect tends to be greater in countries with a small share of informal sector (Figure 7, Panel B).17 This would suggest that informality could have a role in reducing the regressivity of the VAT; however, the presence of high informality can create important inequality-growth trade-offs, as discussed in the following section.

Figure 7.
Figure 7.

Impact of VAT Reforms on Inequality

(Percentchange in Gini coefficientfor disposable income)

Citation: Staff Discussion Notes 2017, 001; 10.5089/9781475566222.006.A001

Source: IMF staff calculations.Note: t=0 is the year of the reform. Solid blue lines denote the impulse responses to a one-standard-deviation shock to the change in the value-added tax (VAT) rate, and dashed lines denote 90 percent confidence bands. Solid yellow lines denote the unconditional (baseline) response presented in Panel A. Informality is measured using the informal sector employment as a share of total non-agricultural employment. See Appendix 1 for details on reforms.

Public spending in infrastructure investment

15. Deficient physical infrastructure is widely viewed as a major constraint on growth in LIDCs (IMF, 2014a). The quantity, quality, and accessibility of economic infrastructure in LIDCs lag considerably behind those in AEs and EMs, and this is seen as a binding constraint on growth (IMF, 2017).18

16. Infrastructure investment can have distributional consequences. On the one hand, increased public investment tends to reduce inequality within sectors by boosting productivity (IMF, 2014b, 2015a). It can also affect within-sector inequality by impacting demand for employment, the effect of which is larger for unskilled and low-income workers, who are more sensitive to demand fluctuations. On the other hand, it can affect inequality between sectors if the infrastructure investment has differential effects across sectors. For example, if gains are mostly captured by high productivity sectors, divergence in sectoral productivity increases, negatively affecting inequality across sectors. This occurs, in particular, when labor mobility is limited and workers cannot take advantage of higher wages in higher-productivity sectors, as is the case for many LIDCs. Policies to facilitate labor mobility can help reduce this growth-inequality trade-off in the medium-long term, as illustrated in the next section. Moreover, the benefits of higher public investment in infrastructure crucially depend on its efficiency (IMF, 2014b, 2015b).

17. On average, public investment expansions were associated with lower inequality in LIDCs over the last three decades.19 In particular, an exogenous increase in public investment of 1 percent of GDP results in a reduction of the Gini coefficient of about 0.3 percent one year after the increase and about 2.3 percent five years after the increase (Figure 8, Panel A). The effect is also economically significant, given the high persistence over time in the Gini coefficient.20 The results (not reported here) suggest that the increases in demand and employment are key factors in explaining the reduction in inequality. In addition, evidence suggests that investment efficiency matters: public investment shock do not lead to a reduction in inequality in countries with low public investment efficiency (Figure 8, Panel B).21

Figure 8.
Figure 8.

Impact of Public Investment on Inequality

(Percentchange in Gini coefficient for disposable income)

Citation: Staff Discussion Notes 2017, 001; 10.5089/9781475566222.006.A001

Source: IMF staff calculations.Note: t=0 is the year of the reform. Solid blue lines denote the response to reforms, and dashed lines denote 90 percent confidence bands. Solid yellow lines denote the unconditional (baseline) response presented in Panel A. The measure of investment efficiency is from the World Economic Forum’s Global Competitiveness Report and was also used in the April 2014 Fiscal Monitor and in the October 2014 World Economic Outlook. See Appendix 1 for details on reforms. The analysis using the Gini coefficient for market income provided similar results.

B. Financial Sector Reforms

18. Financial sector reforms have the potential to lower the cost of capital and boost growth, although they can increase inequality. Where financial access is limited, as in the case of many LIDCs (Figure 9), financial reforms that reduce the costs of capital, but do not increase access to financial services for a broader part of the population, benefit mostly the better-off households and firms, who can take advantage of cheaper credit and invest, leading to greater inequality.

Figure 9.
Figure 9.

Financial Access by Country Group

(Median)

Citation: Staff Discussion Notes 2017, 001; 10.5089/9781475566222.006.A001

Sources: Global Financial Development Database (GFDD); IMF staff calculations. Note: Financial access is measuredby bank accounts per 1,000 people. The calculation is based on 2014 or latest available data.

19. Reforms that increase access to financial services may lower inequality while boosting growth. Greater financial access can help people build buffers for smoothing out income fluctuations, reducing both income and consumption inequality. In addition, higher savings result in higher resources that can be channeled to private investment with a positive effect on growth.

20. On average, financial sector reforms implemented in LIDCs over the past three decades have not had a statistically significant effect on inequality (Figure 10, Panel A).22 Looking beyond the average effect, financial reforms appear to be associated with rising inequality in LIDCs with limited financial inclusion (Figure 10, Panel B).

Figure 10.
Figure 10.

Impact of Domestic Financial Reforms on Inequality

(Percent change in Gini coefficient for disposable income)

Citation: Staff Discussion Notes 2017, 001; 10.5089/9781475566222.006.A001

Source: IMF staff calculations.Note: t=0 is the year of the reform. Solid blue lines denote the impulse responses to a one-standard-deviation shock to the change in the domestic financial reform indicator, and dashed lines denote 90 percent confidence bands. Solid yellow lines denote the unconditional (baseline) response presented in Panel A. Financial inclusion is measured by the share of adults (age 15 and above) in the population who hold accounts at a formal financial institution. See Appendix 1 for details on reforms. The analysis using the Gini coefficient for market income provided similar results.

C. Agricultural Sector Reforms

21. Reforms to boost agricultural productivity have the potential to induce structural transformation and higher growth in many LIDCs, although they can also have distributional consequences. Reforms to agriculture can facilitate structural transformation and boost growth (Gollin, 2010), especially given their large productivity gap between agriculture and other sectors (Adamopoulos and Restuccia, 2014; Figure 11). But agriculture reforms can also have different distributional consequences. For example, increasing agricultural productivity through agricultural services or research and development (R&D) to develop and disseminate improved seed varieties would benefit agricultural workers, reducing sectoral inequality. In contrast, eliminating inefficient subsidies or price controls may improve agricultural productivity and output, but it can increase poverty and inequality if the agricultural sector employs a large number of poor and low-productivity farmers. This is because the reform would benefit mostly high-productivity farmers, who are usually better integrated into the market and able to switch crops as relative prices change. Agriculture reforms could also exacerbate inequality if labor mobility is limited: if workers cannot move to sectors with higher incomes, wages do not equalize across sectors and inequality would widen.23 Finally, the effect of agriculture reforms on inequality and growth depends importantly on complementary policies, as illustrated in the next section. For example, reforms to infrastructure through investment in electrification and irrigation can boost agricultural productivity with beneficial effects on both growth and inequality. These measures, however, can take time to bear fruit; if administrative capacity and fiscal considerations are not a constraint, governments could consider cash transfers to the rural poor as an option to help mitigate the negative distributional impact of reform during the transition.

Figure 11.
Figure 11.

Agricultural Productivity Gap by Country Group

(Median,percent)

Citation: Staff Discussion Notes 2017, 001; 10.5089/9781475566222.006.A001

Sources: World Development Indicators (WDI); IMF staff calculations. Note: Agricultural productivity gap is proxied by the ratio of labor productivity in the agricultural sector to that in the non-agricultural sector. The calculation is based on 2014 or latestavailable data.

22. Empirically, reforms aiming at reducing government interventions in the agricultural sector do not appear to be significantly correlated with inequality, but the relation differs widely across countries (Figure 12, Panel A).24 In particular, agriculture reforms tend to increase inequality in countries with a relatively large share of employment in agriculture (Figure 12, Panel B). This suggests that reforms—such as the removal of subsidies—are significantly associated with a reduction in the income of workers, who are unable to move to higher productivity sectors, increasing inequality across sectors.

Figure 12.
Figure 12.

Impact of Agriculture Reforms on Inequality

(Percentchange in Gini coefficientfor disposable income)

Citation: Staff Discussion Notes 2017, 001; 10.5089/9781475566222.006.A001

Source: IMF staff calculations.Note: t=0 is the year of the reform. Solid blue lines denote the impulse responses to a one-standard-deviation shock to the change in the agriculture reform indicator, and dashed lines denote 90 percent confidence bands. Solid yellow lines denote the unconditional (baseline) response presented in Panel A. Agricultural share is measured by the employment in agriculture (as share of total employment). See Appendix 1 for details on reforms. The analysis using the Gini coefficient for market income provided similar results.

Macro-Structural Policies and Inequality: Lessons From Case Studies

Country case studies provide granular insights on the economic and distributional impact of reform packages. They also deepen the understanding of how and to what extent policy measures can mitigate the potentially negative distributional impact of such reforms. The seven case studies discussed here tend to reinforce the message that structural policies and reforms can have significant distributional effects. They also offer options that can make reforms palatable from both a growth and a distributional perspective.

23. This section examines the macroeconomic and distributional effects of reform packages. Making use of a dynamic general equilibrium framework, this section presents the medium-term effect of structural policies and reforms that countries have recently adopted (or could adopt) to support growth, and of measures that can mitigate the possible negative distributional effects of such reforms. The reforms considered center on measures to mobilize domestic resources (Honduras, Guatemala, Uganda, and Republic of Congo);25 financial sector reforms (Ethiopia and Myanmar); and reforms to agriculture (Malawi) (Table 1). Selected economic and social indicators for these countries are reported in Table 2.

Table 1.

Macro-Structural Policies Considered in the Simulation Analysis 1

article image
Note: CIT = corporate income tax; PIT = personal income tax; R&D = research and development; VAT = value-added tax.

Honduras implemented the reform in 2013; the reform packages for other countries are potential measures not necessarily considered by the authorities.

Table 2.

Selected Economic and Social Indicators, 2015 or Latest Available

article image
Sources: World Economic Outlook (WEO); World Development Indicators (WDI); Socio-Economic Database for Latin America and the Caribbean (SEDLAC); PovcalNet; Asian Development Bank IMF staff calculations.

Poverty rate is measured by percent of population with an income of less than $1.90 per day (2011 PPP).

Guatemala and Myanmar’s poverty rates are measured by percent of population that lives below the national poverty line.

24. The dynamic general equilibrium framework applied in the case studies captures some of the key structural characteristics of LIDCs.26 The framework is based on a small and open economy model with different economic sectors (agriculture, manufacturing, services, energy, commodities for exports) and their respective productivity levels.27 It assumes different types of workers, rural and urban, and skilled and unskilled. The key parameters of the model are estimated using country-specific household level data.28 The analytical framework also incorporates other features common in LIDCs. For example, it includes activities and goods that cannot be easily monitored and therefore taxed (informal sector). It also reproduces diverse types of credit constraints so that only certain groups of people or types of firms can access credit or savings. Furthermore, it assumes that only the government has access to external capital markets.

25. The framework captures both inequality across sectors and inequality within sectors. Inequality across sectors depends on the mobility of workers across sectors. Within-sector inequality is caused by the fact that, although households of a given type and location may be ex ante identical, their individual productivity is subject to shocks over time, affecting the income households can generate in any given period.29 As a result, households end up with different incomes. Furthermore, government policies and financial sector features affect different groups of the economy differently, driving both macroeconomic performance and distributional outcomes.

A. Reforms for Enhancing Domestic Resource Mobilization

Honduras30

26. To address large macroeconomic imbalances, Honduras embarked on a reform strategy in 2013 centered on public resource mobilization. At the time, Honduras faced a difficult macroeconomic situation: growth had slowed significantly, the fiscal accounts had weakened, and the public debt-to-GDP ratio had increased by 15 percentage points over three years, reaching 45 percent of GDP in 2013. The reform package, the main elements of which are described in detail in Table 1, sought to boost tax revenues through an increase in the VAT rate and cut non-priority recurrent spending to contain the growth of public debt.31 It also included an expansion of the conditional cash transfer program Vida Mejor, aimed at protecting the most vulnerable from the potential negative effects of the tax reform while improving their labor skills. Following the reform package, sovereign spreads declined by about 400 basis points from their 2013 peak of 770 basis points, reducing domestic borrowing rates. Also, growth increased by almost 1 percent over two years, reaching 3.6 percent in 2015 (IMF, 2016a) (Table 2).

27. Simulations suggest that the reform has been associated with an increase in output (Figure 13, Panel A).32 The VAT hike is estimated to have had a direct negative impact on consumption and output, which in the case of Honduras tends to be larger because of the presence of a large informal sector (a lower tax base requires higher tax rates to reach a particular revenue target).33 The negative impact, however, was more than compensated for by the significant reduction in sovereign spreads following the fiscal consolidation. Lower borrowing costs stimulated investment and led to an overall positive output effect.34

Figure 13.
Figure 13.

Economic and Distributional Impact of Reforms for Domestic Resource Mobilization

(Cumulative change over 5 years)

Citation: Staff Discussion Notes 2017, 001; 10.5089/9781475566222.006.A001

Sources: World Economic Outlook (WEO); Socio-Economic Database for Latin America and the Caribbean (SEDLAC); World Development Indicators (WDI); IMF staff calculations.Note: VAT = value-added tax.

28. Simulations also suggest that the tax reform was overall progressive (Figure 13, Panel A). While the direct impact of the VAT hike on income inequality was neutral, once the concomitant impact of reduced sovereign spreads is incorporated, the reform impact was progressive. The direct impact of the VAT reform was neutral, because the negative impact of lower overall demand was offset by a shift in demand from tradable to non-tradable/informal (non-taxed) goods, including food, for which the prices are controlled, thus shielding the income and consumption of poor urban and rural low-income workers. Lower sovereign spreads boosted investment with the gains mostly going to high-income individuals (who have access to credit), which would exacerbate inequality. But this is more than offset by second-round effects. Higher investment resulted in a larger demand for labor in the manufacturing sector, increasing labor opportunities for the urban poor (which is a relatively large part of the urban sector in Honduras), in turn decreasing urban poverty and inequality.

29. The expansion of the cash transfer program is estimated to have boosted consumption and reduced income inequality. Cash transfers can create trade-offs between reducing poverty/inequality and economic efficiency, as they transfer income from higher-income individuals, who save a higher share, to lower-income individuals, who mostly consume and save a lower share. However, for the case of Honduras, it is estimated that such a trade-off is minimized in the medium term, as the cash transfer program is conditional on households’ enrolling their children in school, thus increasing their skills and labor productivity.

Guatemala35

30. Increasing budget revenues to finance pro-growth and pro-poor spending is a key priority for Guatemala. With tax revenues at about 10 percent of GDP in 2015, the authorities are considering options for resource mobilization. Alternative combinations of tax and spending policies analyzed in this note are summarized in Table 1.36

31. Simulations suggest that changes to the PIT rate would have smaller negative effects than VAT hikes.37 Increasing direct taxation would reduce incentives for the better-off to save and invest, with a modest negative impact on economic activity. At the same time, increasing direct taxation reduces inequality, though only marginally, reflecting the limited tax progression across income levels (Figure 13, Panel B). In contrast, VAT hikes are likely to have significant negative effects. Also, the conventional wisdom that a VAT is less distortionary in economic terms than the PIT may not apply in this case due to the presence of a large informal sector and weak controls. In fact, not only final products, but also intermediate products, could evade taxation, in part because many goods do not have multiple production stages and the issuance of VAT invoices is not enforced. At the same time, many of the goods produced by the formal and informal sectors are close substitutes. So the VAT reform would reduce the demand for formal goods with the corresponding decline in their prices and, thereby, reduce the marginal returns of formal sector firms, distorting consumption allocations and investment decisions. In contrast to Honduras, a VAT reform in Guatemala would not lead to a substantial reduction in spreads, since fiscal policy has been traditionally prudent and sovereign spreads are among the lowest in the region (the sovereign spread was 230 basis points as of October 2016). Also, unlike in Honduras, the impact of lower private demand on food prices, which are not fixed by the government, would induce a sharp reduction in the incomes of agriculture workers, increasing poverty.

32. Using the additional revenues raised by the PIT for higher infrastructure spending would more than mitigate the negative impact of the PIT reform on output and offset the progressivity of the reform; an expansion of cash transfers, in contrast, would improve inequality, but at some economic costs. Higher investment spending would boost output, because of Guatemala’s high infrastructure gap and the relatively high rate of return of public capital. At the same time, if productivity increases proportionally across sectors, higher investment spending would slightly increase inequality, offsetting the progressivity of the PIT reform. Larger cash transfers, in contrast, would help reduce inequality but also lead to a reduction in savings and investment, with a negative impact on economic activity.38

Uganda39

33. The government is considering a mix of tax policy measures and administrative reforms to achieve a targeted increase in revenue to finance additional spending on physical and human capital (IMF, 2015c).40 The tax revenue-to-GDP ratio, currently at 13 percent of GDP, is one of the lowest in the region. With the objective of boosting revenues, the analysis here considers the potential economic and distributional impacts of an increase in the rates of the VAT, the PIT, and the corporate income tax (CIT) (see Table 1).41

34. Model simulations show that increasing the VAT rate would be slightly progressive and would raise revenue with a smaller negative impact on economic activity than PIT and CIT hikes. This is because of the relatively high statutory PIT and CIT rates in Uganda as compared to other LIDCs (Figure 13, Panel C).42 Also, the presence of a large informal sector (larger than in Honduras and Guatemala) would shield the income of producers of informal goods, making the tax slightly progressive.

35. Government expenditure plays an important role in mitigating the negative impact of domestic resource mobilization. Channeling all the additional revenue to infrastructure investment would enhance productivity, albeit totally offsetting the progressive effect of the VAT hike.43 Instead, the VAT reform could reduce inequality, while still boosting growth (though to a lesser extent), if a part of spending were reallocated from additional infrastructure investment to targeted cash transfers.44

Republic of Congo

36. To maintain macroeconomic stability and support their development plans, the authorities are considering measures to boost non-oil revenues. Following the drop in oil prices that began in 2014, GDP growth more than halved to 2.3 percent in 2015 and the fiscal deficit almost doubled, reaching 18.5 percent of GDP. The authorities are contemplating various options to strengthen the country’s fiscal position, including through increased tax revenues or higher domestic energy prices, which are fixed by the government.45 The reform package considered here envisages that the additional resources would be channeled to increase infrastructure investment spending; it is also assumed that measures are taken to increase the efficiency of public investment (see Table 1).

37. Simulation results suggest that, in contrast to an increase in the VAT rate, increasing energy prices would be slightly progressive with no significant impact on economic growth. Higher energy prices would reduce the demand for energy and overall demand, with a negative impact on GDP growth. At the same time, a reallocation of resources from energy-intensive sectors to less energy-intensive activities would increase economic efficiency, broadly offsetting the negative impact of the reform on GDP growth. Since mostly higher-income households and firms consume energy, increasing energy prices would be progressive, lowering inequality (Figure 13, Panel D). Poverty would fall because the agricultural export sector, a low energy-intensive sector, would expand, increasing the demand for agricultural inputs, thus pushing up agricultural-goods prices and the incomes of rural workers. In contrast, increasing the VAT rate would reduce private consumption and demand and increase inequality.

38. Additional investment spending on infrastructure and improving its efficiency would boost growth and reduce poverty, with no significant impact on inequality. Spending the additional resources on investment in infrastructure and increasing its efficiency by 20 percent could increase GDP by almost 7 percent, while the impact of the reform package on inequality would be broadly neutral if productivity increases proportionally across sectors.

B. Financial Sector Reforms

Ethiopia46

39. The financial sector in Ethiopia is relatively underdeveloped, with policies oriented towards funding public enterprises. The government-owned Commercial Bank of Ethiopia accounts for approximately 60 percent of financial system assets, while about two-thirds of total bank credit is channeled to finance government-owned enterprises. Interest rates on deposits are negative in real terms.47 Against this backdrop, the reform considered here is expected to increase deposit rates and reduce the share of funds that banks have to channel to the public sector to 50 percent (details of the reform are reported in Table 1).

40. Simulation results suggest that the reform can boost private sector activity and economic growth.48 Higher deposit rates would increase private saving, expanding available lending resources. Private sector credit would therefore increase,49 pushing down lending rates and increasing investment—which would more than triple—contributing to economic growth. This would also boost tax revenues, allowing the government to reduce borrowing and contain the cost of public debt financing (Figure 14, Panel A).

Figure 14.
Figure 14.

Economic and Distributional Impact of Financial Sector Reforms

(Cumulative change over 5 years)

Citation: Staff Discussion Notes 2017, 001; 10.5089/9781475566222.006.A001

Sources: World Economic Outlook (WEO); World Development Indicators (WDI); IMF staff calculations.

41. The reform, however, is likely to increase inequality. Given limited financial access, the reform would benefit mostly the manufacturing and modern services sectors, increasing profitability and wages. Since rural-urban mobility is limited, agricultural workers have little opportunity to shift to higher-productivity activities and sectors, so wages would not equalize, increasing inequality across sectors. Also, inequality would increase because firms that export agricultural goods would switch to (more profitable) manufacturing goods, lowering the demand for agricultural inputs (more than offsetting higher domestic demand), thus reducing the income of small farmers.

42. Complementing the financial sector reform with measures to improve financial access and increase sectoral labor mobility would mitigate the negative distributional effect of the reform. Households with access to formal saving would have greater ability to smooth their consumption over time. Policy aimed at fostering labor mobility, such as strengthening land rights, improving infrastructure and housing, and providing accessible training and education to equip the labor force with the needed skills, would increase labor supply for the manufacturing and services sectors, inducing a narrowing of wage differentials and reducing inter-sectoral inequality. Furthermore, this mobility would make inexpensive labor available in these sectors, facilitating a structural transformation of the economy.

43. Cash transfers could help protect the most vulnerable.50 While addressing labor mobility and financial inclusion takes time and may be difficult or even infeasible from a political economy point of view, redistribution policies such as enlarging the existing cash transfer program would help mitigate the negative distributional impact of the financial reform in the short term with only a marginal negative impact on growth.

Myanmar

44. With a view to fostering inclusive growth, Myanmar’s reform strategy includes measures to enhance financial deepening, stimulate private sector activities, and increase investment in infrastructure. The financial sector in Myanmar is heavily dominated by public banks and highly regulated, with almost half of total credit channeled to the public sector. The reform package considered here includes measures to increase credit to the private sector and reduce the infrastructure gap (details are reported in Table 1).51

45. Increasing credit to the private sector would boost urban economic activity and growth and reduce poverty and inequality.52 An increase in interest rates on deposits, together with a reduction in the share of credit channeled to the public sector, would boost private sector credit, lowering borrowing costs and stimulating private investment in the industrial sector and GDP.53 Higher capital accumulation in the industrial sector would increase the demand for labor and wages, with a spillover effect on the wages in non-capital-intensive sectors, such as agricultural exports. Unlike in the case of Ethiopia, labor mobility from rural to urban areas appears to be less constrained in Myanmar, so higher urban wages would promote migration to urban areas, reducing inequality across sectors.54 Furthermore, a larger urban and richer population would increase the demand and prices for agricultural goods and, in turn, the wages and income of rural workers, resulting in a further decrease in inequality levels (Figure 14, Panel B).

46. Higher spending on infrastructure in rural areas could further strengthen the positive economic and distributional effects of the financial sector reform. Higher infrastructure investment spending to increase agricultural productivity, such as investment in rural roads, electrification, and irrigation, would boost growth while reducing inequality and rural poverty.

C. Agricultural Sector Reform

Malawi55

47. To enhance productivity and diversification in the agricultural sector, Malawi is considering a reform of its agricultural subsidies. In 2005, Malawi introduced subsidies on maize fertilizers to help support small farmers, reduce poverty, and address food security problems. However, because of its poor design and targeting, the program resulted in an overproduction of maize without addressing food security (Chibwana and others, 2010). The reform considered here centers on a reduction in the subsidy program, coupled with administrative reforms that would reduce procurement costs (Table 1 describes the reform measures in detail).

48. The reform is expected to generate some gains in efficiency and a slight rise in output, but would increase inequality.56 The reform would reduce incentives to produce maize and create a more efficient allocation of resources through a shift in production from maize to other higher-value agricultural goods, which would also stimulate exports. Inputs for exporters would be cheaper (as their supply rises), increasing the income of these agents. This would translate into a higher capital stock for the economy, higher output, and higher private consumption (Figure 15). At the same time, the reform would increase inequality. Since the subsidy system works as a cash transfer, reducing subsidies would lead to an important reduction in the income of small and poor farmers, exacerbating poverty and inequality.

Figure 15.
Figure 15.

Economic and Distributional Impact of Reform to Agriculture in Malawi

(Cumulative change over 5 years)

Citation: Staff Discussion Notes 2017, 001; 10.5089/9781475566222.006.A001

Sources: World Economic Outlook (WEO); World Development Indicators (WDI); IMF staff calculations.

49. Cash transfers to the rural poor can help mitigate the impact of the subsidy reform on poverty and inequality in the short term, while higher spending in agricultural R&D would boost agricultural productivity in the longer term. Well-targeted cash transfers would be a very efficient way to reach households most affected by the reform. At the same time, increasing spending for agricultural R&D would also increase the productivity of small farmers, boosting agricultural profitability and income. An increase in agricultural R&D, combined with an expansion of the cash transfer program, would reduce inequality. These measures would also amplify the impact of the subsidy reform on private investment and boost GDP and, in turn, bring additional revenues.

How to Make Growth More Inclusive: Policy Lessons

50. The distributional impact of macro-structural policies and reforms in LIDCs is complex. The impact depends on the policy and reform design and the interplay with country-specific economic characteristics—including inter-sectoral productivity differences, the extent of labor mobility, limited infrastructure, level of informality, and level of access to financial services. Multiple transmission channels and second-round effects are at play.

51. Pro-growth reforms that create distributional trade-offs can be complemented by policies that limit the adverse distributional effects of these reforms. While there is no one-size-fits-all recipe, governments concerned about the likely distributional impact of reforms can adjust specific features of reform design and/or introduce targeted accompanying measures to make pro-growth reforms more inclusive. Specifically:

  • On program design, reforms to boost growth or productivity can be calibrated to improve income distribution. For example, resource mobilization measures can reduce inequality if the additional resources are channeled into highly progressive spending. Infrastructure investment, if executed efficiently, can increase output and reduce inequality. Reforms to infrastructure, through investment in electrification and irrigation, and to the agricultural sector, through investment in agricultural R&D and on agricultural services, can boost productivity while reducing sectoral productivity gaps, with beneficial effects on both growth and equality. Reforms that boost financial deepening and access to financial services can foster inclusive growth.

  • On accompanying measures, the analysis underscores that, where specific growth-promoting reforms face a growth-inequality trade-off, a wider policy package can be designed to include measures that alleviate these trade-offs. Some of these complementary policies can have an immediate impact, such as conditional targeted cash transfers—which can also increase productivity in the longer term if well-designed. Other measures, such as accessible education to equip the labor force with the right skills, will clearly take time to bear fruit. Some key structural reforms, such as regulatory simplification to reduce informality or policies to enhance labor mobility, such as strengthened property rights, can be politically difficult to carry out but can boost productivity and growth for all.

Macro-Structural Policies and Income Inequality in Low-Income Developing Countries
Author: Ms. Stefania Fabrizio, Davide Furceri, Mr. Rodrigo Garcia-Verdu, Bin Grace Li, Mrs. Sandra V Lizarazo Ruiz, Ms. Marina Mendes Tavares, Mr. Futoshi Narita, and Adrian Peralta-Alva
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    Real GDP Growth and Headcount Poverty in Low-Income Developing Countries, 1996-2013

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    Income Inequality across Low-Income Developing Countries, 1995-2013

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    Income Inequality by Country Group, 1995-2013

    (Median)

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    Public Revenue and Spending

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    Impact of Personal Income Tax Reforms on Inequality

    (Percentchange in Gini coefficientfor disposable income)

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    Size of Informal Sector by Country Group

    (Median, percent)

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    Impact of VAT Reforms on Inequality

    (Percentchange in Gini coefficientfor disposable income)

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    Impact of Public Investment on Inequality

    (Percentchange in Gini coefficient for disposable income)

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    Financial Access by Country Group

    (Median)

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    Impact of Domestic Financial Reforms on Inequality

    (Percent change in Gini coefficient for disposable income)

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    Agricultural Productivity Gap by Country Group

    (Median,percent)

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    Impact of Agriculture Reforms on Inequality

    (Percentchange in Gini coefficientfor disposable income)

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    Economic and Distributional Impact of Reforms for Domestic Resource Mobilization

    (Cumulative change over 5 years)

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    Economic and Distributional Impact of Financial Sector Reforms

    (Cumulative change over 5 years)

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    Economic and Distributional Impact of Reform to Agriculture in Malawi

    (Cumulative change over 5 years)