There’s No Magic Bullet, But We Have the Tools to Reduce Inequality

Reducing inequality is front and center of the current economic policy agenda. Multilateral institutions like the IMF and the World Bank have accepted that high inequality leads to macroeconomic instability and lowers growth and that lower inequality helps make growth sustainable in the long run.

But there is no magic bullet. Reducing inequality requires a long hard slog of building institutions for better tax and expenditure policies, improving the efficiency of redistribution, ensuring fairness, and increasing accountability. There is also no substitute for a strong state that designs effective fiscal policies and protects the interests of those who struggle to provide economic stability and security for their families, both in the developed and the developing world.

These are some of the key messages from a lively panel discussion (video available) organized by CGD and IMF to launch a new publication on inequality and fiscal policy. The IMF viewpoint, presented by the deputy managing director Min Zhu, signals a shift in the policy advice that the IMF provides to member countries — inequality is a macro issue that needs to be addressed through effective tax policies that are progressive, supported by expenditure policies that enhance redistribution and equity.

Inequality trending down?

Concerns about inequality seem to be on the rise, but the news is not all doom and gloom. Nora Lustig presented evidence that nearly half of the 78 countries included in the Commitment to Equity project have shown a decline in inequality, led by a stellar performance in Latin America over the last 15 years (see the figure below). Public investment in education has led to an expansion in tertiary education which reduced wage inequality in countries such as Brazil. At the same time, moving from general subsidies to cash transfers improved the targeting and increased the efficiency of redistributive policies.

In fact, data shows that developing countries are spending much more on redistribution of tax based resources today than developed countries did when they were at the same level of income. The message is that policymakers have the tools to reduce inequality if they have the will to do so. As I pointed out on the panel, however, this will require addressing legacy issues of past fiscal adjustment policies that focused on the decreasing public expenditure, especially in education and health. (To hear more from Nora Lustig on inequality, listen to her related podcast.)

It’s easier to prevent than cure

The emerging policy agenda is clear. As Nancy Birdsall summarized in her remarks, building effective fiscal institutions is the key to reducing inequality in the long run. It is better to prevent inequality from reaching high levels by implementing an efficient and progressive taxation regime. Identifying the rich and ensuring their compliance improves tax collection, ensures fairness and increases accountability. Countries should reduce their dependence on value-added tax and other indirect tariffs that impose disproportionate costs on the poor. Fiscal policies should address “strugglers,” those who are one income shock away from falling into poverty.

Whether inequality will continue to trend downward will depend in large part on whether countries are able to build effective institutions that give their people a stable economic future.