Economic News

How can public finance reforms boost economic growth and enhance income equality?

by Boris Cournede, Head of Public Finance Workstream, OECD Economics Department

Most OECD countries have very large government sectors: publicexpenditure amounts to 43% of economic activity, measured by GDP, on averageacross OECD countries. This proportion exceeds 50% in four OECD countries. Theprogrammes on which governments spend have thus deep implications for people’swell-being and a country’s economic fortunes. Similarly, the choice and designof taxes that fund expenditure will also shape economic decisions and influencepeople’s  choices to work, invest and consume.

New OECD empirical work has identified lessons provided by the
experience of OECD countries over the past three decades. These empirical
investigations shed light on the effects of public finance on economic activity
as well as on the distribution of income across households.

First, large governments can be compatible with high levels of
economic activity: the condition is that governments provide their services
very efficiently. The Nordic countries display the levels of government
effectiveness at which governments can be large without weighing on growth.
Where governments are less effective, reducing their size can be expected to lead
to higher growth; however, reducing the size of government typically entails a
rise in income inequality, because public expenditure, and especially
transfers, are a powerful equaliser of incomes.

Second, leaving aside questions about government size, many
public finance reforms that change the composition of spending or the mix of
taxes offer the potential to boost economic activity and household incomes:

  • Some reforms can boost overall economic activity
    while reducing income gaps:

    • One important reform of this nature is to reduce
      the effective tax that low-income workers face (taking into account the
      withdrawal of benefits) and funding this change through proportional increases
      in other taxes.
    • Another reform that belongs in this win-win
      category for higher activity and less inequality is to increase inheritance
      taxes and use the proceeds to reduce other taxes proportionally.
  • A number of public finance reforms can increase
    activity without altering income differentials, thereby “lifting all boats”
    roughly equally. They include:

    • Higher public investment, while reducing other
      spending programmes by the same amount;
    • Higher recurrent property taxes, while lowering
      other taxes by as much;
    • Lower effective rates of corporate income tax,
      while increasing other taxes.
  • One public finance change that benefits the poor
    with no substantial effect on overall activity is to expand spending on family
    policy while reducing other spending programmes by the same amount.
  • Finally, a number of changes to the structure of
    public finance can be expected to boost economic activity but widen relative
    income gaps yet leave no income group worse of in absolute terms. Such reforms

    • Lowering public subsidies, while increasing
      other expenditure categories by as much, giving priority to the most favourable
      for growth such as investment and education;
    • Lowering net wealth taxes while raising other
      taxes by the same amount;
    • Easing the tax burden on workers earning
      above-average wages while increasing other taxes to make up for the revenue
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The empirical work shows that reforms of sizes that correspond to
changes that have been observed in OECD countries in the past three decades can
have substantial effects on economic activity (Figure). This work can help
select reform priorities in the light of their expected overall economic
benefits and their distributional consequences, which will determine how
inclusive, and therefore acceptable in political terms, they are likely to be.
Importantly, the exact choice and design of the reforms will also have to
reflect country specificities in terms of institutions and preferences.

Read more:

  • Cournède, B., J.-M. Fournier and P. Hoeller
    (2018), “-Public Finance Structure and Inclusive Growth, “  OECD Economic
    Policy Paper,
    No. 25. [INSERT
  • Akgun, O., D. Bartolini and B. Cournède (2017),
    “The Capacity of Governments to Raise Taxes”, OECD Economics Department Working
    Papers, No. 1407, OECD Publishing, Paris,
  • Akgun, O., B. Cournède and J. Fournier (2017),
    “Effects of the Tax Mix on Inequality and Growth”, OECD Economics Department
    Working Papers, No. 1447, OECD Publishing, Paris,
  • Fournier, J. (2016), “The Positive Effect of
    Public Investment on Potential Growth”, OECD Economics Department Working Papers,
    No. 1347, OECD Publishing, Paris,
  • Fournier, J. and Å. Johansson (2016), “The
    Effect of the Size and the Mix of Public Spending on Growth and Inequality”,
    OECD Economics Department Working Papers, No. 1344, OECD Publishing, Paris,
  • Hagemann, R. (2018), “Tax Policies for Inclusive
    Growth: Prescription versus Practice,” OECD
    Economic Policy Paper,
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