Fiscal Policy & Inequality in Latin America

For a long time, I have been puzzled about the effects that government policies have over the configuration of the society. In developing countries, these policies are not only constrained by the preferences of policymakers, but they also depend on structural and external factors, reducing the capacity of local governments to implement the desired policies. Fiscal policy, in particular, has important effects on the distribution of wealth across the society, directly and indirectly affecting the poor. However, in developing countries, fiscal policy depends in large degree on external factors.

For the Latin American case, I have not found a conclusive explanation on why fiscal policy has been ineffective and insufficient to reduce the high levels of income inequality that characterize the region. One cause of this is the complexity of the issue and the economic and political variations that can be found across the countries in the region, which complicates the development of conclusive arguments. This is why, this year, this topic became one of the axes of my research: I conducted a very comprehensive study of the different factors of fiscal policy that affect redistribution towards the poorer sectors of the society in the different countries in Latin America.

Looking at the graph below, it is evident that redistribution has had a limited effect on the reduction of income inequality.


These low levels of redistribution are linked to many factors. The first one is the high levels of informality that exist across the region and the revenue that gets lost in the shadow economy.


This leads to a lower tax potential that limits redistribution. Most countries across the region exert a high tax effort that allows them to tax close to their potential levels. The main exception of this is Mexico, which shows a wide gap between tax potential and actual taxation levels (this is, nevertheless, before the implementation of the fiscal reform in 2014).


(Note: the Y-axis shows the natural logarithm of the tax-to-GDP)

However, during the first decade of the new century, many countries in the region, which are net-exporters of commodities, took advantage of the international commodity boom to increase their fiscal space, reducing their debt levels (particularly, external public debt), improving their terms of trade and implementing budgetary rules that improved their budget balances. This in turn led to an amelioration of the fiscal position of countries in Latin America, which facilitated the execution of social programs aimed to reduce poverty and income inequality.


The paragon of these programs has been the conditional cash transfers programs (CCTs), which are transfers given to low-income families (or families living in low-income areas),   conditional on school attendance of the kids in the family and visits to health clinics. The program is now successfully implemented in 18 countries in the region. Nevertheless, as the terms of trade have been deteriorating in the last few years, as a result of a deceleration of the Chinese economy and a reduction of the international prices of commodities, these programs are endangered in countries that did not ameliorate their cyclically adjusted budget balance.


However, even if certain types of programs have been implemented, fiscal policy is still regressive or neutral in most countries in Latin America.  In terms of taxation, countries in the region highly depend on indirect taxes, which are considered regressive. Only Mexico and Panama rely more on direct taxes than in other sources of tax income.


This causes a low productivity of direct taxes, which is measured as the ratio of tax-to-GDP to tax rate. Guatemala and Venezuela show the lowest productivity, with rates of 0.13 and 0.14, but the region as a whole has low levels of productivity compared to those of other regions (Europe, for instance, has an average productivity rate of 0.39). This is an indication of the small tax base countries in the region have, due to the high levels of informality.  Productivity of the VAT in the region is higher, confirming that the tax base is the main factor that reduces the productivity of the income tax.

One of the causes of low collection of direct taxes seems to be the highly complex taxation system in many countries in the region. Brazil is the main example of this, as it takes an average of 2,036 hours to prepare and pay taxes in the country, whereas the world average is 250.86 hours.


On the other hand, social spending does not seem to be redistributive either. A large share of social spending is directed to social protection, which targets formal employees and thus leaves out informal workers that tend to have lower incomes.


I conducted an exercise to verify what are the explanatory variables of social spending. I did it for total social spending and for different components of it, such as health and education spending, following what Huber, Mustillo and Stephens (2016) did and using a GLS model. In general, my findings are in line with those of the authors, although I enlarged the analysis to include some variables related to fiscal space. I found that, in fact, fiscal space is an important explanatory variable for social spending. I also found that larger agglomerations in urban areas facilitate collective action to ask for more social spending. Party orientation, in this case, does not seem to be statistically significant. An interesting fact, is that while countries with more inequality spend more in social protection, they spend less in education.

Of course this analysis is still preliminary and I am still enlarging the scope of my research  to better understand this subject. What remains clear to me is that while in general the region seems to have low levels of redistribution, irrespective of the party orientation of the governments and their income levels, this situation ameliorated for net-exporters of commodities as they generated the fiscal space to implement social programs. The countries that were able establish fiscal rules seem to have the capacity to continue their social programs. However, it is also necessary to understand the differences in the economic, political and social configuration of the different countries that compose the region to discern the motivations and effects of fiscal policy in terms of poverty and income inequality reduction.


About Alma Bezares

PhD Candidate Economics and Politics. Interested in development and state capacity.
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