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Economics

Tools for an equitable society

Economists study how social investment and progressive taxation combat different types of inequality, and how they can be integrated

Zé Vicente

If the poorest segment of a given population sees a gain in income of 20% during a given period, while the richest segment’s income increases by 50%, are conditions in society better or worse? The answer depends on the angle from which the question is viewed: if everyone’s income has increased, it could be claimed that the population as a whole has benefited. This view, which highlights the gains of the most impoverished, supports the arguments of those who defend the idea that if the economy grows, everyone always wins. Another perspective regards the increase in inequality as problematic, regardless of whether there are gains for everyone.

Over the past two decades, economics research has shown that the problem of inequality is not the same as the problem of poverty. The deleterious effects of cumulative inequality—which generates new inequality—are many. It undermines social mobility by reducing the opportunities available to the poorest members of society, and, in extreme cases, the middle class. As a consequence economic growth is also affected, since with reduced opportunities markets also become less dynamic. Finally, when a large percentage of wealth and income is concentrated among a limited group of people, they can control the political system and guarantee the perpetuation of their own wealth, and the poverty of others.

One fundamental question guides research on inequality: how can inequality be mitigated, or its tendency to increase reversed? To address this challenge, governments have two main tools: public spending and taxation. The role of each remains a matter of debate, but the two paths are connected, since government investment is funded, in large part, by collecting taxes.

“Everything depends on the goal,” says economist Rodrigo Orair, from the Institute of Applied Economic Research (IPEA). “To reach the low-income population, social investment is clearly the best path, using cash transfers such as those done through the Bolsa Família. If the goal is to create a more equitable society, in the sense of opportunities and access to public assets benefiting not only the poor, but also the middle class, the path is to invest in health, education, and transportation. If the problem is an excess of income concentrated at the top, in particular wealth that arises from capital, the instrument par excellence is taxation,” he observes. Progressive taxes with higher rates for those with larger incomes and more assets make it possible to offset the concentration of wealth at the top.

The Brazilian case
If inequality is something to be opposed not only for ethical and social reasons, but also for economic reasons, then Brazil, recognized as one of the most unequal countries in the world, is a special case. After two decades of decline, inequality in Brazil began to increase during the recession of 2015–16. Measured by the Gini coefficient (see glossary), the concentration of income, which according to the World Bank had improved from 0.633 to 0.519 between 1989 and 2015, rose again to 0.539 in 2018.

However, even during the period when the Gini coefficient was lower, the reduction in inequality did not occur across the entire range of income distribution. Research using income-tax data, such as a study by IPEA sociologist Pedro Herculano Ferreira de Souza, show that among the richest 1% of the Brazilian population—i.e., the top of the pyramid—the income concentration has not only remained stable, but is some of the most extreme in the world. The data were published in his book Uma história da desigualdade: A concentração de renda entre os ricos no Brasil – 1926–2013 (A history of inequality: The concentration of income among the rich in Brazil – 1926–2013).

The fight against inequality must be accomplished by taxing exactly that portion of the population, in Orair’s view. However, “researchers have highlighted the high degree of regressivity of our tax structure, especially due to the small share of direct taxation, that is, on income and wealth, but also due to a series of idiosyncrasies, exemptions, and special tax schemes that distort the progressive profile of direct taxation,” says economist Débora Freire, a researcher and professor at the Center for Development and Regional Planning at the Federal University of Minas Gerais (CEDEPLAR-UFMG).

In short, the wealthiest portion of the population spends a smaller proportion of their income than the poorest. Since tax rates on consumption are the same for everyone, the poor pay proportionately more taxes than the rich. At the same time, taxes on services are lower, benefiting the wealthy, who consume proportionately more services. Furthermore, the investment income common to wealthier taxpayers is taxed less than wages, reinforcing the system’s injustice.

An article by former Central Bank president Armínio Fraga, published in the December 2019 issue of Novos Estudos CEBRAP, provided new fuel for the debate on the relationship between inequality, public spending, and the tax system in Brazil. Fraga defends the idea that government needs to be able to invest much more in social causes and infrastructure. To obtain funds for these areas, he proposes an attack on three fronts: spending less on civil servants, reducing social security expenditures, and reforming the tax system by making it progressive and eliminating subsidies to the rich.

“This is how Brazil can get its fiscal house in order. It would also be possible to establish lower interest levels. There would be a lot of money left for improving investment in social areas like education, sanitation, and health, including strengthening the SUS [Unified Health System]. It would also be possible to supplement the private sector with what it can’t do, in terms of infrastructure,” notes Fraga.

“Our tax system has become a generator of inequality, not the other way around. Our direct taxes are not very progressive, so the regressivity of indirect taxation is not sufficiently compensated for,” Freire adds. “For reforms to truly act on the inequities of the tax system, making it redistributive, they would need to increase the percentage of direct taxation [in the total taxes collected] and improve the progressive makeup of those taxes.”

The UFMG economist believes it would be necessary to “resume taxing profits and dividends, raise inheritance taxes, levy a tax on large fortunes, create higher tax brackets to include ultra-high incomes in the personal income tax, and improve the design of property taxes such as the IPTU [Property and Urban Land Tax], IPVA [Motor Vehicle Property Tax], and ITR [Rural Land Tax].”

Therefore, the most direct measure to combat the concentration of income and wealth would be the direct taxation of these types of riches. However, the tax-reform proposals under discussion in Congress deal exclusively with indirect taxation. Both Proposed Constitutional Amendment (PEC) 45, in the Brazilian House of Representatives, and PEC 110, in the Senate, seek to merge several taxes into one, creating the Goods and Services Tax (IBS) or Value Added Tax (VAT).

Reform is focused primarily on indirect taxes due to the complexity of the current goods and services taxes in Brazil. The system contains a myriad of tax benefits, special schemes, and differing rates, and what are called “cascade” taxes, where each successive stage of the production process is taxed on top of the previous stages. Thus, “in addition to the impact on efficiency, there would also be a certain distributive impact, because standardizing tax rates and ending the compounded taxes would generate lower rates, on average,” Freire explains. PEC 45 also provides for the creation of a tax refund system for the poorest families and equalizing the goods and services taxes.

“A good tax system limits growth as little as possible and is progressive at the same time, so that the wealthier strata contribute proportionally more,” says economist Bernard Appy, director of the Center for Tax Citizenship (CCIF). “Changing how consumption is taxed in Brazil is important in eliminating distortions that hinder the country’s growth. It would increase the potential GDP [Gross Domestic Product] by more than 20% within 15 years,” he estimates. Appy also points out that reforming both indirect taxes and direct taxes are compatible goals. “They are complementary agendas, not competing,” he notes.

In countries where accelerated growth does not lift people out of poverty, the increase in inequality does not translate into any improvement in living conditions.

When systematizing the collection of taxes on income and wealth, one difficulty for legislators is avoiding accounting schemes that allow higher-income earners to pay lower than average rates. This is what happens today in Brazil. Contracting employees as though they were separate companies or independent contractors in order to avoid taxes and other legally mandated employment costs is a common strategy. It is a phenomenon known as pejotização (a term derived from pessoa jurídica [legal entity]) in labor relations. Compensation pay such as housing per diems can also constitute “disguised wages,” which are untaxed, notes Orair. Several types of financial investments, such as real estate funds, are tax exempt.

“Individuals who own one rental property pay 27.5% income tax on rents received. If they own ten properties, they can set up a company on the estimated profit basis and pay 11.3% to 14.5%, using the company’s corporate status. Dividends distributed to the owner as an individual taxpayer will be exempt. And if they have more than 100 properties, they can get together with other people and set up a real estate investment fund, and pay zero income tax,” explains Appy. “In Brazil, the more real estate a person owns and the more complex the model through which rent is received, the less tax they pay,” he summarizes.

“We need an income tax system that treats earnings from capital more or less the same way those earned by working are treated,” says Orair. “Otherwise, people will continue to treat their capital gains as labor earnings or vice versa, depending on which is taxed less,” he adds. In Brazil, pejotização and similar phenomena are examples of income from labor being treated as capital earnings: since it is possible to pay less income tax as a company than as an individual, many choose to receive professional remuneration as if they were companies receiving profits. If revenues from capital and labor were taxed equally, this wouldn’t happen.

In her thesis Capital e trabalho no Brasil do século XXI: O impacto de políticas de transferência e de tributação sobre desigualdade, consumo e estrutura produtiva [Capital and work in Brazil in the 21st century: The impact of cash transfers and taxation policies on inequality, consumption, and the structure of production], Freire argues that reducing asymmetries between the taxation of labor income and capital would contribute to growth and a reduction in inequality. “If there were a concurrent increase in the percentage of direct taxation the reduction in inequality would be significant,” she adds. In a 2016 survey conducted in partnership with economist Sérgio Gobetti, Orair estimated that Brazilian inequality, as measured by the Gini index, would be reduced by 4.31% if the individual tax rate for income above R$325,000 per year were set at 35%. The reduction also assumes dividends would be taxed according to the same table. Approximately 1.2 million people would be affected, and the Federal Revenue Service would see increased revenues of R$72 billion. The results were published in the discussion text “Progressividade tributária: A agenda negligenciada” (Tax progressivity: The neglected agenda).

An unequal world
These concerns revolve around a traditional economic principle: that remuneration stimulates productivity and innovation. This means that a certain degree of inequality is acceptable, because if everyone is equal, known as “equality of outcome,” there is no reason for greater effort, or to produce more. On the other hand, extremely unequal societies are also less efficient because they waste talent by concentrating the chances for success within a restricted group of people who already belong to the upper classes, making “equality of opportunity” impossible.

How much inequality is desirable? “There is no way to calculate or determine an optimal amount of inequality,” Fraga says. “The relationship between growth and inequality isn’t universal and doesn’t occur in all countries through the same mechanisms.” Therefore, it’s necessary to differentiate inequality caused by the dynamics of the competitive economy from other factors such as “rent seeking,” or in other words, the capture of the mechanisms for generating wealth by economic power groups. The problem of determining how much a society will fight inequality, or if it will promote it, is mainly one of a political nature. “In my article I defend the thesis that, in Brazil, fighting inequality would help accelerate growth,” he adds.

Both aspects of inequality are readily apparent in countries that are undergoing rapid economic development, such as China. Before the reforms of the 1970s, China was agrarian and there was little inequality. With industrialization and rapid growth, concentration of income increased, while at the same time the population on the whole became wealthier. “But there are also examples in China of billion-dollar fortunes,” which Fraga estimates could lead to a tightening economy. As in the West, such wealth concentration may be a factor in the loss of dynamism in the Asian giant.

In countries where accelerated growth does not lift people out of poverty, the increase in inequality does not translate into any improvement in living conditions. On the contrary, it endangers democracy and the economic system by blocking social mobility. In his book Capitalism, Alone, released in 2019, Serbian economist Branko Milanovic, a professor at City University of New York (CUNY) and a former employee of the World Bank Research Department, argues that both Western capitalism, which he describes as “liberal meritocratic,” and Asian capitalism, which he describes as “political,” are moving towards becoming plutocracies, i.e., systems in which political and economic elites become “one self-sustaining elite.”

“Two myths dear to economists have crashed and burned. The first is that inequality will tend to decrease with development. The second is that inequality is beneficial for everyone, especially the most impoverished,” says economist Celia Kerstenetzky, director of the Center for Studies on Inequality and Development (CEDE) of the Institute of Economics at the Federal University of Rio de Janeiro (UFRJ). “The persistent increase in inequality in the world over the past 30 years, with this element of extreme and increasing wealth concentration at the top, and the insight that the fate of the richest ‘1%’ and the remaining ‘99%’ are linked—in a detrimental way for the latter group—was responsible for the decline of these beliefs,” she observes.

In his book Capital in the Twenty-First Century, published in 2013, French economist Thomas Piketty argues that the economic system has an inherent tendency to concentrate wealth. He expressed the idea with a simple formula, (r>g), that is, earnings on capital (r) grow faster than the economy as a whole (g) and, therefore, than income from labor. To avoid returning to an oligarchic society, in which only the heirs of wealthy families have a chance of success, Piketty defends the need for not only progressive taxation, but also taxes that compensate for the innate tendency of the system to concentrate gains in income among the wealthiest class.

For Freire, a large part of the inequality in Brazil is explained by the production structure, in which the sectors that export commodities are heavyweights. “Deindustrialization, which has been going on since the 1990s, reinforces the wealth-concentrating structure, because it has favored an increase of the commodity-exporting sectors’ share of production,” she argues. In her thesis, Freire explains that these sectors have an unequal pay structure, which means they generate more income from capital than income from work as compared with industry. As a result, the greater their weight in the economy and in exports, the greater the tendency is to reinforce income concentration.

Distribution models
In the United States, Democratic Representatives like Alexandria Ocasio-Cortez defend initiatives to reinforce the role of government funding in guaranteeing full employment and transitioning the American economy towards sustainability through the “Green New Deal.” The name is a reference to Franklin D. Roosevelt’s (1882–1945) economic recovery program during the Great Depression of the 1930s, the New Deal.

The Green New Deal proposals are based on the ideas of a recent economic school of thought called Modern Monetary Theory (MMT), in which public spending is not limited by government capacity for funding, and taxation serves mainly as an instrument to manage the economy. For MMT economists, “the role of taxation is not to fund government spending, but to manage the total level of spending in the economy, which includes spending by families, business, government, and the external sector, so as to avoid both unemployment and inflation,” says economist Simone Deos, from the Institute of Economics at the University of Campinas (IE-UNICAMP).

Managing spending in the economy involves choosing which segments of the economy to tax and which social groups to serve through public investment, which has distributional effects. However, “as long as there are real resources available in the economy, especially labor, it’s possible and desirable to expand investments aimed at the poorest segment, without any equivalent increase in tax revenues, with the effect of reducing inequality,” argues Deos. This means that it’s not necessary to explicitly use taxation of the upper classes in order to fund investments in health, education, and job creation, when there are idle resources available such as people without work, unused machinery, and infrastructure operating below capacity. Taxation and funding are two independent initiatives, except in the case of an economy at full employment, when the withdrawal of resources on one side should compensate for investment on the other.

In the book Consenso e contrassenso (Consensus and nonsense), economist André Lara Resende uses the history of theories of currency and monetary policy to defend the idea that balancing public accounts is not an obstacle to social spending. In other words, there is no formal impediment to increasing public investments with the goal of reducing inequality. “The restriction on primary issuance [of government bonds] is purely administrative. It is a measure based on a political decision to set limits on public spending,” he writes.

Throughout history, public spending and progressive taxation have been used extensively to ensure more equal societies and similar opportunities for all. An example is the model adopted by social-democratic regimes, mainly in Europe after the Second World War (1939–1945), during the period that became known as the “30 glorious years of capitalism.” Large public investments in education, transportation, and healthcare have led to the expansion of the middle class and economic recovery in European countries destroyed by the war.

“The research in Piketty’s latest book, Capital and Ideology [published in 2019], shows that the role of taxation is greater than previously thought. Progressive taxation, in effect between the First World War [1914–1918] and the late 1970s and early 1980s, was one of the main causes of the reduction of inequality in advanced economies during the twentieth century,” says Kerstenetzky. “Taxation was important not only for financing post-war reconstruction and urgent social policies. It was also a mechanism for directly reducing inequality by, for example, discouraging very high salaries and reducing net financial gains,” she argues.

“Social democracy uses the market for what the market can do, that is, for creating wealth. But it also corrects market failures, creating an environment with more opportunities for people, more social mobility, and a safety net,” Fraga observes.

Miniglossary

Primary deficit
Government accounts have a primary deficit if spending exceeds tax revenue before interest payments on the public debt, and a primary surplus if revenue exceeds spending. When debt interest is included in the equation, it is called total deficit or total surplus.

Gini Index
Developed in 1912 by the Italian statistician Corrado Gini (1884–1965), the Gini coefficient, or Gini index, is a statistical measure of wealth distribution, today used mainly to calculate income inequality in a society. It ranges from 0 (zero) to 1. A distribution index of “0” would mean perfect equality, while “1” corresponds to absolute concentration.

Income and wealth
Income is the generic term that includes earnings from work (salaried and self-employed) and returns on property (stocks, companies, real estate, bonds). While all incomes are flows of money, property (or wealth) is a stock of assets. As an example, when making individual income tax declarations taxpayers pay on their net flow (how much money they received that year). When individuals acquire wealth during the same period, this is declared as an asset, which shows their stock of wealth, how much they own as of that date.

Progressive/Regressive taxation
A tax system is said to be progressive when the portion of the population that receives more income pays proportionally more taxes. When the tax burden is heavier on those who earn less, the system is said to be regressive.

Direct and indirect taxation
A tax is “direct” when it is levied on individuals and companies directly, that is, on their assets and sources of income. Examples are income tax (for individuals or legal entities), IPVA, IPTU, ITR, and inheritance tax.
“Indirect” taxes are those embedded in production and consumption, such as the sales and services tax (ICMS), the Industrialized Products Tax (IPI), and the Tax on Credit, Exchange, and Insurance Operations (IOF).

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