University International Studies Program Working Paper 01-10 August 2001 The Impact of Budgets on the Poor: Tax and Benefit Incidence Jorge Martinez-Vazquez Georgia State University Andrew Young School of Policy Studies The Impact of Budgets on the Poor: Tax and Benefit Incidence Working Paper 01-10 Jorge Martinez-Vazquez August 2001 International Studies Program Andrew Young School of Policy Studies Georgia State University Atlanta, Georgia 30303 United States of America Phone: (404) 651-1144 Fax: (404) 651-3996 Email: [email protected] Internet: http://isp-aysps.gsu.edu Copyright 2001, the Andrew Young School of Policy Studies, Georgia State University. No part of the material protected by this copyright notice may be reproduced or utilized in any form or by any means without prior written permission from the copyright owner. International Studies Program Andrew Young School of Policy Studies The Andrew Young School of Policy Studies was established at Georgia State University with the objective of promoting excellence in the design, implementation, and evaluation of public policy. In addition to two academic departments (economics and public administration), the Andrew Young School houses seven leading research centers and policy programs, including the International Studies Program. The mission of the International Studies Program is to provide academic and professional training, applied research, and technical assistance in support of sound public policy and sustainable economic growth in developing and transitional economies. The International Studies Program at the Andrew Young School of Policy Studies is recognized worldwide for its efforts in support of economic and public policy reforms through technical assistance and training around the world. This reputation has been built serving a diverse client base, including the World Bank, the U.S. Agency for International Development (USAID), the United Nations Development Programme (UNDP), finance ministries, government organizations, legislative bodies and private sector institutions. The success of the International Studies Program reflects the breadth and depth of the in-house technical expertise that the International Studies Program can draw upon. The Andrew Young School's faculty are leading experts in economics and public policy and have authored books, published in major academic and technical journals, and have extensive experience in designing and implementing technical assistance and training programs. Andrew Young School faculty have been active in policy reform in over 40countries around the world. Our technical assistance strategy is not to merely provide technical prescriptions for policy reform, but to engage in a collaborative effort with the host government and donor agency to identify and analyze the issues at hand, arrive at policy solutions and implement reforms. The International Studies Program specializes in four broad policy areas: Fiscal policy, including tax reforms, public expenditure reviews, tax administration reform Fiscal decentralization, including fiscal decentralization reforms, design of intergovernmental transfer systems, urban government finance Budgeting and fiscal management, including local government budgeting, performance-based budgeting, capital budgeting, multi-year budgeting Economic analysis and revenue forecasting, including micro-simulation, time series forecasting, For more information about our technical assistance activities and training programs, please visit our website at http://isp-aysps.gsu.edu or contact us by email at [email protected]. Table of Contents I. Policy Significance of the Distributional Impact of Fiscal Systems ..........................................1 II. Concepts of Welfare and Equity and their Measurement .........................................................2 Horizontal and Vertical Equity .......................................................................................2 Measuring Individual Welfare: Utility, Income and Capabilities ....................................3 Specifying Fiscal Criteria for Equal Treatment ...............................................................3 Two Fiscal Principles: Benefit Versus Ability to Pay .....................................................4 Defining Equity through Redistribution and the Use of Social Welfare Functions ...........5 Theories of Distributive Justice and their Representation in Social Welfare Functions ....6 III. Measurement Issues: Changes in the Distribution of Income and Progressivity ....................7 Measuring Changes in Income Distribution ....................................................................7 Measuring Progressivity ...............................................................................................10 Other measurement issues .............................................................................................12 IV. Tax Incidence Analysis ......................................................................................................13 Statutory (Legal) Incidence Versus Economic Incidence: Tax Shifting ........................14 Tax Burdens and Excess Burdens .................................................................................15 The Counterfactual .......................................................................................................16 Conventional Models of Tax Incidence .........................................................................16 Assumptions Used in Conventional Models of Tax Incidence .......................................17 General Equilibrium Approaches to Tax Incidence .......................................................20 Conventional Versus General Equilibrium Approaches: Advantages and Disadvantages ............................................................................................................21 Lifetime Versus Annual Tax Incidence .........................................................................22 Tax Expenditures ..........................................................................................................23 The Incidence of Negative Taxes ..................................................................................24 The Impact of the Institutional Setting on Tax Incidence ..............................................24 Tax Incidence and Fiscal Decentralization ....................................................................25 Tax Evasion and the Incidence of Tax Evasion .............................................................26 The Impact of Other Government Policies on Income Distribution ...............................27 Country Examples of Tax Incidence .............................................................................28 V. Estimating the Incidence of Public Expenditures .................................................................30 The Basic Measurement Issue .......................................................................................31 The Traditional Approach: Benefit Incidence ................................................................32 The Behavioral Approach: Marginal Willingness to Pay ...............................................34 Advantages and Limitations of the Benefit Incidence and the Behavioral Approaches ................................................................................................................35 Combining the Benefit Incidence and Behavioral Approaches ......................................37 Country Examples of Expenditure Incidence ................................................................38 VI. Net Fiscal Incidence: Combining Tax and Expenditure Incidence ......................................40 VII. Conclusion ........................................................................................................................42 Appendices I: The Conventional Estimation of Tax Incidence: Methodology and Case Study ...................44 II. Conducting Benefit Incidence Analysis ...............................................................................56 List of Tables I-1 Tax Burden by Income Decile: Base Scenario .....................................................................53 I-2 Tax Burden by Income Decile: Alternative Scenario ...........................................................53 I-3 Income Distribution of Net (After-Tax Income) ..................................................................54 I-4 Income Distribution of Gross (Pre-Tax Income): Base Scenario ..........................................54 I-5 Income Distribution of Gross (Pre-Tax Income): Alternative Scenario.................................55 List of Figures Figure 1 ......................................................................................................................................8 Figure 2 ......................................................................................................................................8 References ...............................................................................................................................59 I. Policy Significance of the Distributional Impact of Fiscal Systems One of the most important goals of government policy is to address inequalities in the distribution of income and to try to improve the welfare of the poor. An important part of the theory and practice of public finance is dedicated to conceptualizing and measuring how the revenue and expenditure sides of government budgets affect the distribution