The Impact of Taxes and Social Spending on Income Distribution and Poverty in Latin America. An Application of the Commitment to Equity (CEQ) Methodology

Using standard fiscal incidence analysis and the new methodological developments by the Commitment to Equity (CEQ) Institute, this paper estimates the impact of fiscal policy on inequality and poverty in sixteen countries in Latin America around 2010. With information on incomes, consumption, and other dimensions available in household surveys, and knowledge about the characteristics of the fiscal system, the CEQ method consists in allocating to each individual the burden of personal income and consumption taxes, and the benefits from cash transfers, consumption subsidies, and government spending on education and health. This process yields the pre-fiscal and post-fiscal income concepts of interest. These income concepts, in turn, are used to calculate the corresponding indicators of inequality and poverty. Thus, one can estimate, for each country, the impact of the fiscal system and each of its components on inequality and poverty. Since the methodology that was applied is the same, results are comparable across countries. The countries that redistribute the most are Argentina, Brazil, Costa Rica, and Uruguay. Guatemala, Honduras, and Peru are the countries that redistribute the least. Fiscal policy reduces extreme (income) poverty in twelve out of the sixteen countries. The incidence of poverty after taxes, subsidies, and cash transfers, however, is higher than market income poverty in Bolivia, Guatemala, Honduras, and Nicaragua, even though fiscal policy reduces inequality in these four countries. Contributory pensions have a heterogeneous effect on inequality and, contrary to some expectations, their impact is equalizing in nine of the countries. In the sixteen countries, spending on pre-school and primary education is equalizing and pro-poor (per capita benefits decline with income per capita). Spending on secondary education is always equalizing; it is also pro-poor in some of the countries. Spending on tertiary education is never pro-poor but it is equalizing in all the countries except for Guatemala. Spending on health is always equalizing but pro-poor only in some countries. Latin America presents a great deal of heterogeneity in the size of the state and the countries’ capacity to use their fiscal power to reduce inequality and poverty. A higher share of social spending (to GDP) is associated with a larger redistributive effect but countries with similar, or even lower, shares of social spending show heterogeneous redistributive effects implying that other factors beyond size such as the composition and targeting of social spending (and taxes) are at play. It is important to emphasize that a higher redistributive effect is not necessarily a desirable outcome since in this article there is no estimation of the impact of redistributive policy on fiscal sustainability and efficiency. In some countries, the burden of consumption taxes is such that a portion of the poor are net payers into the fiscal system (before receiving "in kind" transfers in education and health). Governments should examine whether this undesirable effect could be avoided, or at least reduced, through an expansion of targeted cash transfers and/or reduction in the consumption taxes that are particularly burdensome for the poor.