This excerpt from Chapter 3 (Inequality and Social Progress) discusses the role that government policies can play in reducing inequality and improving economic opportunities for all.

Policies can affect inequality through various mechanisms. An adaptation of the assets-based approach (Attanasio and Székely, 1999; Bussolo and Lopez-Calva, 2014; and more recently, Lopez-Calva and Rodriguez-Castelan, 2016) is a useful framework to think about the different channels, and their interaction. In the short run, the income-generating capacity of individuals (and their related contribution to aggregate growth) is determined by the assets that households have and the opportunities that they have to exploit these assets, given market conditions. Indeed, inequality and growth can be conceptualized as being jointly determined (Ferreira 2010; Chenery 1974). In the long run, the ability of individuals to accumulate assets and to use those assets productively is shaped by policies—such as those related to the provision of goods and services. We can think about assets in terms of three elements: the stock of assets that people possess, the rate at which these assets are used to generate income, and their returns—such as wages or interest rates. The public provision of goods and services allows individuals to increase their stock of assets, such as in terms of human capital (for example in the form of health, education, or skills) or physical capital, (such as machinery, seeds, or land). These policies can help equalize opportunities across individuals, independently of their initial circumstances. Policies related to the provision of public health and education, policies that provide job training, or policies that encourage the supply of affordable credit and that facilitate savings can all contribute to redistribution ex-ante by enhancing the ability of poorer households to increase their stock of assets—including by influencing the decision of individuals to accumulate those assets.

Other policies have the potential to improve the distribution of economic opportunities, increasing households’ ability to exploit their assets, such as policies that implement land reform, policies that aim to improve access to markets, and policies to strengthen labor markets in order to promote employment. These policies can help equalize the opportunities of individuals to use their capital and labor to generate income—for instance, utilizing their skills to participate in the labor market, exploiting their machinery, or their land for agricultural production. Promoting an environment of investment and innovation and a stable, growing macroeconomic environment can expand access to opportunities and job creation. Minimum wage and other labor policies can affect labor market income directly and indirectly, through their effect on the amount of labor supplied, and demanded.

Policies also have an effect on the returns that households obtain for their assets, such as wages, interest rates, rents from property, or prices of land. The direct role of fiscal policy in redistributing income is discussed further below, but both it, and monetary policy also affect the returns to factors of production, which in turn have a feedback impact on the decision of individuals to use their assets more intensely or not.a

Two other elements are necessary to look at policies that can bring about a reduction in inequality. The (market) income that households generate based on their assets (their stock of assets, how intensively they are used, and the returns obtained) is complemented by the transfers that households receive, which can be privateb or—the focus of our interest—public. Public transfers include the benefits provided by the government that complement individuals’ income such as conditional cash transfer programs, pensions, unemployment insurance, or programs that provide disaster relief and other transfers to mitigate the effects of shocks.c These social protection systems can contribute to a reduction in inequality of outcomes, redistributing resources toward the most vulnerable. Finally, households’ full income generation capacity is also affected by the other side of the fiscal system, that is, taxation. Social spending necessarily requires that resources be collected in order to be redistributed. Fiscal policy in this way influences inequality ex-post through both transfers and taxes.

Countries’ fiscal systems have different redistributive capacities depending on their structure of direct and indirect taxes, transfers and subsidies. This redistributive capacity is quantifiable, by comparing the average measure of inequality (as captured by the Gini coefficient) based on the market income of individuals before the fiscal system, and after, once the effect of taxes and transfers is manifested. As shown in the sections below, the redistributive potential of fiscal redistribution in many developing countries appears to remain untapped.

As discussed in the World Bank’s World Development Report (WDR) 2017 Governance and the Law, how much countries redistribute can be understood from different viewpoints (World Bank, 2017). It may be reflecting the incentives that governments have to collect and redistribute resources—where more redistribution is associated with more checks and balances (Besley and Persson, 2011). It can be a manifestation of the preferences for redistribution of a given society. It is also a result of the relative ability of actors to influence policymaking and the allocation of resources.

a The framework also considers the set of prices of the basket of goods and services that households consume, which is also influenced by fiscal and monetary policy.
b Such as domestic and international remittances, and in-kind transfers from other households.
c In fiscal incidence analysis, the provision of public goods and services (such as education or health) and other subsidies, are also considered transfers, of the in-kind nature (see CEQ methodology, CEQ, 2016).