Economic outlook, analysis and forecasts

The equity implications of fiscal consolidation


The overall redistributive impact of taxes and transfers depends on the progressivity of each instrument, the weight of each instrument in the tax and transfer system and the overall size of the tax and transfer system. Thus, governments can exercise a certain degree of discretion about the redistributive impact of their consolidation strategies by choosing particular combinations of spending reductions and revenue increases, or by changing the progressivity and size mix of transfers and taxes. This is illustrated by the redistributive impact of two polar consolidation strategies. For both strategies it is assumed that the government targets a deficit reduction of 3% of GDP. The first strategy relies entirely on raising direct household taxes and the second on cutting cash transfers to households. The exercise is based on the size and progressivity of taxes and transfers as of the late 2000s (see Joumard et al., 2012). It is assumed that the change in taxes and transfers is proportional across all deciles in each of the two calculations and that market income is not affected. More generally, no behavioural response is considered. As the example shows (see figure below), the required tax increases reduce income inequality, measured by the Gini coefficient, in all OECD countries, although to varying degrees. Similarly, if the same consolidation outcome is to be achieved via reductions in transfers, inequality increases in all countries, to different degrees and with absolute changes in inequality usually higher than in the case of tax increases. Crosscountry differences in impacts reflect pre-existing differences in the progressivity of individual instruments and in their relative size. Any combination of changes in taxes on the one hand and transfers on the other hand would moderate the redistributive impact of consolidation in comparison with exclusive changes in either taxes or transfers, respectively. Changes in progressivity of particular instruments would also change the redistributive impact of the consolidation package.


Fiscal consolidation

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In some cases, cuts in transfers can be designed and supplemented by structural measures in a way that minimises adverse distributive impacts or even avoids them entirely, though possibly at the price of a delay in consolidation. In particular, raising the effective retirement age would be a preferential consolidation measure, as it will increase labour force participation and thus boost income for some persons who otherwise would have received a pension instead, but will produce budgetary savings only very gradually. Reform in the education and health care systems should also rank high on the policy agenda in that it can produce large consolidation gains without compromising equity or service quality. However, such reform would require meticulous programme planning and implementation to be effective and avoid disadvantaging the less well-off. Cuts in unemployment-related benefits and disability benefits would likely hit poorer people in the first place, especially if weak economic activity prevents an offsetting rise in employment. However, if designed properly and supplemented with coherent activation strategies, such adverse effects can be offset by higher employment once the economy adjusts.

On the revenue side, cutting certain tax expenditures can increase both equity and economic growth and should be given high priority. Higher taxation of immovable property, which is taxed at a lower rate than other assets in most countries, appears broadly consistent with equity objectives and belongs to the tax increases that are least harmful to long-term growth. However, to be effective, additional measures might be needed that could increase near-term administrative costs, such as proper valuation of property. Raising other property taxes would be beneficial for equity, although potentially at the cost of negative growth effects. Increasing consumption taxes would be regressive from the perspective of the static income distribution, although much less so from a lifetime perspective as over their lifetime people spend more of what they earn. If increases are broadly based, little damage might be done to lifetime income equity and growth. Higher capital income taxes would be positive for equity. They can be distortive with respect to growth, but are more worth considering when capital income is taxed at a significantly lower rate than labour income. Raising labour income taxes can enhance equity in the short run, but would likely reduce growth in the long run.

Further reading

  Rawdanowicz, L., E. Wurzel and A. Christensen (2013), "The Equity Implications of Fiscal Consolidation", OECD Economics Department Working Papers, No. 1013, OECD Publishing.
doi: 10.1787/5k4dlvx2wjq0-en

OECD Economic Outlook, Volume 2012 Issue 2 | OECD Free preview | Powered by Keepeek Digital Asset Management Solution

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Global Economic Outlook, June 2017

OECD (2012), OECD Economic Outlook, Vol. 2012/2, OECD Publishing.
doi: 10.1787/eco_outlook-v2012-2-en


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