Do poorer countries have less capacity for redistribution? A new paper

September 28, 2009

     By Duncan Green     

When can a country end poverty by redistributing wealth from its rich people, and when must it instead rely on aid or growth? That’s a question Martin Ravallion, head of the World Bank’s research department seeks to answer in a new paper. Essentially he is trying to put precise numbers on thethe_abyss_of_inequality_307515 relatively obvious point that the richer a country becomes, the more potential it has to redistribute wealth.

Ravallion is trying to measure the capacity (rather than political will) for redistribution. He does so as follows:

He specifies that redistribution will only take place from those who would not be considered poor in the US (> $13 a day income; all $ figures are 2005 PPP)

He then calculates how much cash would need to be transferred to end absolute poverty ($1.25 a day) or to fund various basic income schemes of social protection, where the whole population receives a transfer of $1.25 a day (i.e. uniform, rather than targeted)

Make the rich payHe then converts this into a marginal tax rate on the rich – the extra tax they would have to pay on all earnings above $13 a day. An MTR above 60% (the highest rate in rich countries) is seen as an impossibly high level.

His findings?

‘Developing countries fall into two distinct groups. The first appears to have little or no scope for making a serious impact on the problem of extreme poverty through internal redistribution from those who are not poor by Western standards. The second group appears to have far more scope for such redistribution. Most of the poorest countries in terms of mean consumption fall into the first group.

The marginal tax rates needed to fill the poverty gap for the international poverty line of $1.25 a day are clearly prohibitive (marginal tax rates of 100% or more) for the majority of countries with consumption per capita under $2,000 per year. Even covering half the poverty gap would require prohibitive MTRs in the majority of poor countries.

Yet amongst better-off developing countries–over $4,000 per year (say)–the marginal tax rates needed for substantial pro-poor redistribution are very small–less than 1% on average, and under 6% in all cases.

Basic-income schemes financed by progressive income taxes also require prohibitive marginal tax rates in the poorest half of developing countries. Indeed, if the tax burden is confined to those who are not poor by developed-country standards, then providing a basic income of $1.25 a day would call for marginal tax rates of 100% or more for three-quarters of countries. Even for middle-income developing countries, this type of redistribution only starts to look feasible if one allows for a basic income appreciably less than $1.25 a day and/or significant tax burdens on the middle class [i.e. those earning less than $13 a day].’

He illustrates this in Brazil, China and India:

‘For Brazil in 2005, covering the poverty gap for $1.25 a day would only require a MTR of 1% on those who are not poor by US standards. Even for the $2 a day line, the necessary marginal rate would only be 4%. Recall that these are international lines, and they are lower than the poverty line commonly used in discussing poverty in Brazil, which is about $3 a day; filling the poverty gap for this line would call for a MTR of about 12% on those living over $13 a day.

The marginal tax on Chinese living above the US poverty line that would be needed to cover the poverty gap for $1.25 a day is 37% in 2005. China’s national poverty line is closer to $1 a day, which would only requite a MTR of 30%. However, the tax rate needed to cover the $2 a day poverty gap would require a prohibitive rate of 100%.

The capacity for redistribution in India is far more limited than in China or (especially) Brazil. Indeed, it would be impossible to raise enough revenue from a tax on Indian incomes above the US poverty line to fill India’s poverty gap relative to the $1.25 a day line; the required MTR would exceed 100%. Even at a 100% MTR, the revenue generated could fill only 20% of India’s aggregate poverty gap.’

These findings are important for a number of reasons:

They make the case for a much greater focus on redistribution and taxation in middle income countries, where tax systems are generally much less progressive than in many developed nations.

They raise serious questions about the affordability of tax-funded universal social protection

They suggest that poverty reduction in very large poor countries like India is primarily going to be achieved through economic growth, rather than aid or redistribution.

In small poor countries, the best combination is growth + aid – large scale redistribution has to wait until there is something to redistribute! However, I would add that even in poor countries, there are other reasons for strengthening a government’s tax base, such as building the social contract between citizens and state.

September 28, 2009
Duncan Green