The economic analysis of taxation and expenditure has influenced greatly policy debates and decisions. The analytical framework of Mirrlees (1971), which precisely balances equity and efficiency considerations, is argued to have influenced then Chancellor of the Exchequer Osborne’s decision to lower the top rate of income tax (Atkinson, 2017, pp 184–185). Similarly, reform of public expenditure is also influenced by economic analysis. For example, fuel subsidies are often argued to be fiscally unsustainable, inefficient, and inequitable. But their removal has led to what came to be termed “IMF riots”.  Consider also the “gilets jaunes” protests in France: “The diffuse interests represented in France’s National Assembly had agreed to increase gas taxes in 2014. However after farmers and their sympathizers closed down roads and took their fight to the cities, President Emmanuel Macron’s government backed down and rescinded the tax hike in 2018.” (Eichengreen, 2021).

These examples only scratch the surface of the question of social acceptability of tax and transfer schemes which pass the usual economic tests for efficiency and equity. Going beyond the calculations of actors who are rational in the conventional economic sense, are responses based on other perspectives and calculus. Our recent work (Kanbur and Levy, 2022) argues that the social acceptability of tax and transfer schemes is more culturally and contextually specific than conventional economic analysis based on efficiency and equity. We draw on a range of literatures, including behavioural public economics; carbon tax plus compensation schemes; universalism versus targeting; as well as experiences in Latin America and elsewhere of implementing conditional cash transfers and other redistributive mechanisms.

The usual rational actor way to think about the consequences of tax and transfer changes is to delineate winners and losers. An obvious answer to those opposing change on economic self-interest grounds is to compensate them accordingly, neutralising their opposition. If the losers are also at the bottom of the income distribution, such compensation is additionally beneficial from an egalitarian perspective. But within the political economy framework, the main reason for compensations is to move opponents into the supporters’ column.

The question of credibility of compensation looms large. Recipients need to believe that compensations will be paid once the policy has been introduced. In 2003 a proposal was made by Mexico’s President Fox to remove exemptions to VAT, a change requiring approval by Congress. The president pledged transfers to fully compensate households up to the fourth decile of the distribution. Critically, however, transfers would be set by presidential decree, requiring citizens to trust that future presidents would sustain them. The proposal was defeated.

Chile provides an opposite example. During the presidential elections of 2013, candidate Bachelet –who had been president before and was a trusted politician— ran on a campaign to increase taxes to fund education reform. Once elected she raised taxes by approximately 2% of GDP mostly through income taxes and, as promised, used the additional resources to expand access to higher education, without any compensations (Fairfield, 2014). The contrast between Chile and Mexico highlights two additional issues with the social acceptability of tax reforms: the source of funds and their purpose. In Chile’s case society was told that more income taxes would widen access to higher education, a concrete issue which had been the subject of social mobilizations before the presidential elections. In Mexico’s case, society was told that higher consumption taxes would fund improved social welfare, a vaguer issue where the benefits were unclear to many.

The burgeoning literature on behavioral public economics provides analytical and empirical support to these observations and highlights how the standard economic model needs to be enriched (our paper provides references to recent reviews).  A good illustration takes us back to the Gilet Jaunes protests in France. Douenne and Fabre (2022) find that: “Using a representative survey, we find that after the Yellow Vests movement, French people would largely reject a tax and dividend policy, i.e., a carbon tax whose revenues are redistributed uniformly to each adult. They overestimate their net monetary losses, wrongly think that the policy is regressive, and do not perceive it as environmentally effective.”

What is the answer to this resistance to reforms which pass standard economic tests of efficiency and equity? In our paper we draw on reform of social protection in Latin America (Levy and Cruces, 2021) to argue that a systemic approach might work better than the “scheme by scheme” approach which is the current norm.

To use the framing of political science, Ideas can change Interests. At present, middle-income groups oppose isolated reforms because they only perceive costs. They oppose eliminating fuel subsidies because compensations are usually targeted at groups with lower incomes than theirs. They oppose tax increases because they perceive that they finance social protection programs that fail to address their needs. With these perceptions, reforms are very difficult, but an overall vision may change them. A proposal for a broad redesign of social protection might allow different groups to see what is in it for them and understand that they may be winners. Even though individual components of the proposal might be undesirable, the proposal as a whole may not.

A broad proposal for systemic reform might then be more acceptable than isolated reforms. But for this to happen, individuals need to know where they are being led—what the endpoint looks like. They need to be presented with new ideas for them to consider that their interest might lie elsewhere. Systemic reform does not imply that everything needs to be reformed at the same time. But it does imply that an overall vision of the desired social protection system is required, even if individual reforms are carried out gradually.

The equity-efficiency framework usually used by economists to analyse taxation, based on the rational individual calculating costs and benefits, is incomplete because it pays little attention to the social acceptability of taxation. This is not to deny that individuals pursue their own self-interest, but it is to say that their attitudes towards taxation are more complex. They also depend on factors like trust in government, perceptions of fairness and reciprocity; and their own ideas. These factors need to be factored in when policy proposals are made to reform specific taxes or subsidies, and more so when reforming many of them at the same time.

References:

Atkinson, A.B. 2015. Inequality: What Can Be Done? Harvard University Press. ISBN: 978-0-67450-476-9

Douenne, Thomas and Adrian Fabre. 2022. American Economic Journal: Economic Policy, 14(1): 81–110.

Eichengreen, Barry. 2021. “The Logic of Effective Climate Action.” Project Syndicate, June 15.

Fairfield, Tasha. 2014. “The Political Economy of Progressive Tax Reform in Chile” in Progressive Tax Reform and Equality in Latin America, Mahon, E., Bergman, M. and Arnson, C., eds., Wilson Center, Washington, D.C., pp 30-56.

Kanbur, Ravi and Santiago Levy. 2022. “Social Acceptability of Tax and Transfer Schemes.” LSE Public Policy Review, Vol. 2 (4), pp 3-13.                         .

Levy, Santiago, and Cruces, Guillermo. 2021. “Time for a New Course: An Essay on Social Protection and Growth in Latin America”, United Nations Development Program, LAC Working Paper Series, No. 24.

Mirrlees, James. 1971. “An Exploration in the Theory of Optimum Income Taxation.” Review of Economic Studies, Vol. 38 (2), pp. 175– 208.