Redistribution via Taxation: The Limited Role of the Personal Income Tax in Developing Countries

In developed countries, the income tax, especially the personal income tax, has long been viewed as the primary instrument for redistributing income and wealth. This article examines whether it makes sense for developing countries to rely on the income tax for redistributive purposes. We put forth three propositions. First, the personal income tax has done little to reduce inequality in many developing countries. This failure is not surprising given that in many countries personal income taxes are neither comprehensive nor very progressive - they often amount to little more than withholding taxes on labor income in the formal sector. Moreover, the personal income tax plays such a small role in the tax systems of developing countries that it would be unrealistic to believe that this tax could have a meaningful impact on distribution. Second, it is not costless to pretend to have a progressive personal income tax system. Tax systems generate real administrative, compliance, economic efficiency and political costs. The costs associated with badly designed and badly administered personal income tax systems likely exceed the costs associated with other taxes. There are opportunity costs as well. Third, given the ineffectiveness of the personal income tax, if countries want to use the fiscal system to reduce poverty or reduce inequality, alternative approaches merit consideration. Countries need to make better use of their expenditure programs in targeting resources to the poor. Given the dominance of taxes on consumption in the tax structure of developing countries, the distributional consequences of consumption taxes are of far greater importance than those of the personal income tax. Countries can also make greater use of benefit taxation and in particular fiscal decentralization may allow for better matching of those who benefit and those who pay for government activity. Finally, countries can consider alternatives to taxing income other than the current comprehensive income approach.