Asia must use fiscal policy carefully for inclusive growth

Published on Wednesday, 11 May 2016

Published by Donghyun Park on Wednesday, 11 May 2016

Shanties on stilts in front of high-rise buildings in Dhaka, Bangladesh.
Shanties on stilts in front of high-rise buildings in Dhaka, Bangladesh.

Co-written by Gemma Estrada and Sang-Hyop Lee

In response to growing inequality, Asians are calling on the government to play a more activist role in bringing about a fairer society, which provides opportunities for all and distributes the fruits of growth more widely. Still, governments both rich and poor need to be careful how they go about that.

While fiscal policy can reduce inequality from either the spending or the revenue side, evidence suggests that the impact from public spending is significantly greater. As economists like Iris Claus note, the two main lessons from the broader literature for developing Asia are that fiscal expenditures, not taxation, offer the most effective means of lowering inequality and that the public spending best able to reduce inequality is on education and health care. Their analysis of data from 150 countries spanning 1970–2009 shows that, despite tax systems tending to be progressive, government expenditures are more effective at redistributing income.

Estimated marginal impact of government spending on income inequality (percentage points). Note: Minus sign indicates improved equality. Source: Government Fiscal Policies and Redistribution in Asian Countries.

Government expenditures in developing Asia are small by international standards. They are substantially less when compared with advanced countries or even against Latin America. To some extent, this reflects the region’s healthy adherence to fiscal prudence, which has served the region well. Be that as it may, developing Asia has lagged behind OECD countries and Latin America in three equity-promoting fiscal expenditures: education, health care, and social protection.

Public spending on education averages 5.3% of GDP in the advanced economies and 5.5% in Latin America but only 2.9% in Asia. The gap is more pronounced for public spending on health care, which stands at only 2.4% of GDP in developing Asia compared with 8.1% in advanced economies and 3.9% in Latin America.  On social protection, developing Asia spends about 6.2% of GDP, only half of Latin America’s 12% and less than a third of the advanced economies’ 20%. Clearly, Asian governments need to do more in fostering inclusive growth, by steering fiscal policy toward promoting greater equity.

Share of education, health care and social protection in GDP (2010). Source: ADB estimates based on data from World Bank, World Development Indicators online database.

Although government spending has a bigger impact on equity than taxation, taxation is vital for inclusive fiscal policy because it provides the resources for spending. And, developing Asia needs to raise more revenues to finance public spending.  A comparison of the trends for the 1990s and 2000s indicates that developing Asia has lagged behind other parts of the world in tax revenues. Asia’s revenues from taxes are only less than half those of the OECD. The gap between developing Asia and the OECD may be explained in part by the tendency for tax revenues to rise with per capita income. However, developing Asia also lags behind Latin America, a region with comparable income, in both tax and non-tax revenues. In 2005-2011, Asia’s tax revenues as percentage of GDP were only about three-fourths that of Latin America and barely half of the latter’s non-tax revenues. Overall, the trends suggest that there is considerable scope for boosting developing Asia‘s revenues.

Tax revenues in developing Asia, Latin America and OECD. Source: Fiscal Policy and Growth in Developing Asia.

If Asia is to use fiscal policy more actively for inclusive growth, it must do so without compromising two key strategic priorities – economic growth and fiscal sustainability. For all its success, Asia still desperately needs sustained rapid growth to raise its income level, which remains far below that of advanced economies. In addition, the region remains home to close to two thirds of the world’s poor, and further progress on the poverty front requires sustained growth. Therefore, burdensome taxation, which unduly blunts the incentives of firms and workers to engage in productive activities will ultimately hinder inclusive growth.

A long tradition of fiscal prudence has given Asia macroeconomic stability as well as adequate fiscal space, a highly valuable resource for fending off severe negative shocks—such as the global financial crisis—and addressing medium-term fiscal demands like population aging. Expanding the role of fiscal policy in fighting poverty and inequality should not come at the expense of fiscal sustainability.

Gemma Estrada is Senior Economics Officer with ADB’s Economic Research and Cooperation Department. Sang-Hyop Lee is Professor of Economics at the University of Hawaii.