Changing Fiscal Contracts in the Americas?

Fiscal Policy - Public and Welfare Economics

What a difference a decade makes. Since 2000, Latin America has become less unequal, with lower levels of poverty and likely greater economic mobility, assisted in part by more progressive fiscal policy. In contrast, over a longer time frame, the United States has become more unequal, while poverty has remained relatively constant, economic mobility has likely declined, and tax and spending policies have become less effective in reducing inequality.

In Taxation, Inequality and Fiscal Contracting in the Americas, we examine how changes in levels of inequality in a country or region may influence tax and spending policies. Tax and spending patterns reflect a basic equilibrium of political interests that strongly influence the makeup of tax and spending policies. Many factors contribute to the combination of policies that constitute the “fiscal contract” in a country, but once a country adopts a particular fiscal pattern major fiscal changes are challenging.

Modern democratic societies tend to gravitate towards two distinct fiscal equilibria: big government, with redistributive expenditures but less progressive taxes—like Sweden—and small government, with more progressive taxes but less redistribution—like the United States. Although it is difficult to predict when and how a country’s fiscal balance may change, one major factor is arguably the changing economic circumstances of the middle class. In Latin America, improvements in the economic status of the middle class appear to be an important reason for recent changes. In the United States, the increased economic vulnerability of the middle class and the perceived decline in economic mobility may drive change. In both regions, the extent and nature of change may depend largely on the extent to which the middle class come to think that they may be better served with higher (or lower) taxes (on them, and on the wealthy) and more (or less) robust social spending programs.

As a region, Latin America has long led the world in terms of income inequality. Latin American fiscal policy, especially tax policy, did little to remedy this state of affairs. In contrast, over most of the 20th century income increased in the United States for all and income inequality declined. The United States has also long made heavier use of progressive income taxes than most countries. Over the last century the story of development in the Americas was broadly that regions with high inequality in the south adopted fiscal policies resulting in lower tax revenues and lower social spending levels than those in the north with lower levels of inequality. Recently, however, divergences from these broad trends have occurred.

Although experiences in Latin America are as varied as the countries of the region, the story of recent developments seems both economic and political. Economic growth has produced more and better jobs and hence a less unequal pre-tax (market- generated) distribution of income, with an expanding middle class and an increasing income tax base. While tax-to-GDP ratios in most countries (other than Argentina and, especially, Brazil) remain relatively low for the level of economic development, over the last 20 years tax burdens have been increasing faster in Latin America than in any other region in the world. Although taxes have generally not become much more progressive, in many countries transfers have, with the result that poverty has been reduced in both relative and absolute terms.

The story in the United States is very different. The pre-tax distribution of income changed dramatically over the last 30 years as incomes of the top quintile (particularly the top 1 percent) increased substantially while income growth for most of the rest of the population remained relatively flat. The result has been increased inequality, no reduction in poverty levels, and increased middle-class vulnerability.

The United States has a long tradition of small government and self-reliance with relatively low levels of taxes and social spending. Its taxes are still relatively low but the level of public spending has expanded substantially, primarily because of the rapid growth in social spending (including tax subsidies). This expansion in spending has been financed partially by increased taxes from the rapidly growing income of the wealthy but mainly by increased debt.

The dramatic increase in top incomes has allowed the share of federal tax revenues from personal income taxes to remain high. While the relative amount of the total federal income tax burden has remained relatively constant, the allocation of the tax burden among different income classes has not. Over 90 percent of the total federal income tax is now paid by the top quintile while the middle quintile’s share declined over the last 20 years to less than 3 percent in 2009.

On the other side of the budget, public social spending has increased but more goes to the elderly (without regard to need) than to the poor, and an increasing amount of indirect social spending (through tax subsidies) also goes to the upper-middle class and the wealthy. The middle class is being squeezed and many seem in recent years to have lost some of their past faith that the future will always be better.

Is the United States becoming more like Latin America? The increasing concentration of income at the top, persistent levels of poverty, declining economic mobility, and declining public services suggest that the answer is “yes.” Inequality has reached levels not seen since the 1920s, and the gap between the haves and the have-nots with respect to equality of opportunities for quality education and academic achievement continues to grow. Fiscal challenges and tax competition may, in the end, break the United States’ heavy dependence on the federal personal income tax and result in the introduction of a VAT or some other type of broad-based consumption tax.

Is Latin America likely to follow the (former) U.S. small government model with relatively low levels of public social spending? Or will different countries in the region go different ways, with some continuing to be relatively small welfare states (such as Mexico) and others moving over time to a more European approach with relatively larger welfare states (such as Brazil)? Even countries that follow the first approach may continue to expand their social spending, in part for political stability reasons. However, any such expansion of the public sector will likely be financed mainly by increased revenues from the VAT with countries following the European model increasingly supporting it by revenues from a robust income tax system. In either case, any new tax revenue will have to come from not only the wealthy but also the increasingly important middle class. In order to implement and sustain such tax changes, countries may have to strengthen the ‘Wicksellian connection’ between taxes and spending, for instance by matching tax increases with social programs applying to a larger population in contrast (or addition) to the more targeted (poverty-oriented) conditional cash programs adopted in Brazil and Mexico.


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