Please cite this paper as:

OECD 2012, Income inequality and growth:

The role of taxes and transfers, OECD
Economics Department Policy Notes, No. 9.
January 2012.

ECONOMICS DEPARTMENT POLICY NOTE No. 9

INCOME INEQUALITY AND

GROWTH: THE ROLE OF
TAXES AND TRANSFERS

Economics Department
Organisation for Economic Co-operation and Development

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INCOME INEQUALITY AND GROWTH: THE ROLE OF TAXES AND TRANSFERS

Inequality of income before taxes and transfers is mainly driven by the dispersion of labour
income and the prevalence of part-time employment and inactivity. Despite their wider
dispersion, self-employment and capital income play a smaller role.
Tax and transfer systems reduce overall income inequality in all countries. On average across
the OECD, three quarters of the reduction in inequality is due to transfers, the rest to direct
household taxation.
In some countries, cash transfers are small in size but highly targeted on those in need. In
others, large transfers redistribute income mainly over the life-cycle rather than across
individuals.
The personal income tax tends to be progressive, while consumption taxes and real estate
taxes often absorb a larger share of the current income of the less well-off.
Some reforms of tax and transfer systems entail a double dividend in terms of reducing
inequality and raising GDP per capita. In particular, reducing tax expenditures, which mostly
benefit the well-off, contributes to equity objectives while also allowing for a growth-friendly cut
in marginal tax rates.
Other reforms may entail trade-offs between these two policy objectives. Shifting the tax mix
to less-distorting taxes in particular away from labour towards consumption would improve
incentives to work and save, but raise inequality at least at a given point in time.

Understanding inequality
1.
What ultimately matters for people is their income after taxes and transfers, which largely
frames their consumption possibilities. The best and most comprehensive available income measure is
household disposable income that has been adjusted for household size and for publicly-provided
in-kind transfers, such as public spending on education and health care. This income concept, which
should ideally be further adjusted to take indirect taxes into account, is shaped by various factors,
which are summarised in Figure 1. Income distribution measures are discussed in Box 1.
2.
This Policy Note covers two of these five income concepts household market income and
household disposable income, as they are the most relevant in shaping income inequality. It focuses on
inequality at a given point in time. Concerns with different aspects of inequality may be less acute,
when looked at over people's entire lifetime, as fluctuations of income over time are not considered.
For example, consumption and real estate taxes tend to be less regressive from a lifetime than from a
current income distribution perspective. An analysis of lifetime income inequality is not possible, due
to the absence of harmonised cross-country datasets.

Figure 1. From individual labour earnings to adjusted household disposable income

Family
formation
and
composition

Income
concept

Relevant
policy
instrument

Individual
labour
income

Capital
income

Household
market
income

Household
labour
income

Family policies
Labour ,
(child and
education,
elderly care)
migration and
gender policies

Tax policies
(wealth, capital
income)

Taxes &
cash
transfers

Individual
consumption
of public
goods

Household
disposable
income

Cash transfers
and tax policies

Household
adjusted
disposable
income

Education,
health and
housing
policies

Box 1. Income distribution measures

Income inequality measures fall into two categories: one-number summary statistics, such as the Gini index,
and information about the income distribution at various points, such as shares of income or percentile ratios.
One-number summary statistics measure the income distribution throughout the entire distribution. The Gini index
ranges from zero (perfect equality) to one (one individual or household receives all the income and the others
receive none). The concentration coefficient is a variant of the Gini index, with the only difference being that
individuals are not ranked by the values of the income concept for which inequality is computed, but by their
disposable income. Shares of income or percentile ratios provide a picture of inequality at specific points in the
th
th
income distribution, by comparing, for instance, the income of the 90 percentile to that of the 10 percentile.
These inequality measures are applied to standardised household surveys, which are assembled in the
OECD Income Distribution and Poverty Database. Despite harmonisation, the database has limitations: i) The
richest often fail to respond and, when they do, they tend to under-report their income, while the poorest may be
too marginalised to respond; ii) Non-response rates and misreporting varies across countries; iii) The income data
do not include some components such as home production and imputed rent; iv) Household income and property
taxes as well as social security contributions paid by employees are included, but social security contributions
paid by employers, indirect and corporate income taxes are not, making it difficult to draw cross-country
comparisons on the size and redistributive impact of tax systems based on household surveys.

Before taxes and transfers, income dispersion mainly reflects labour market outcomes
3.
Countries differ widely with respect to the level of labour income inequality. Labour income
inequality is largely shaped by differences in wage rates, hours worked and inactivity. Total market
income, which also includes capital and self-employment income, is more concentrated than labour
earnings. Even so, given their generally small size, capital income and self-employment income is not
a major determinant of total household market income dispersion in most OECD countries. Labour
market income accounts for around 75% of the dispersion on average in the OECD, as compared with
just 25% for self-employment and capital income combined (Figure 2).

Figure 2.

Labour income inequality is the main contributor to the dispersion in household market income

Contributions to the concentration coefficient of market income, working age population, in the late 2000s
Wages and salaries

Self -employment income

Capital income

0.6

0.5

0.4

0.3

0.2

0.1

Note:

Contributions to overall household market income inequality are derived by multiplying the concentration coefficients of
each income source by their weight in total market income. The data for Greece, Hungary, Mexico and Turkey are net of
taxes. Data for France and Ireland refer to the mid-2000s. The concentration coefficient of market income is computed
as the Gini index with individuals ranked by household disposable income.

Source: OECD Income Distribution and Poverty, OECD Social Expenditure Statistics (database).

What drives inequality in household disposable income?

Taxes and transfers reduce inequality in all OECD countries
4.
OECD-wide inequality in income after taxes and transfers, as measured by the Gini index,
was about 25% lower than for income before taxes and transfers in the late 2000s. That said, the
distribution of income after taxes and transfers still varies widely across countries (Figure 3). Indeed,
after taxes and transfers, the Gini index ranged from below 0.25 in Slovenia (little inequality) to 0.5 in
Chile (high inequality). The most unequal countries before taxes and transfers usually remain so after
taxes and transfers, even though they tend to redistribute more. Percentiles, which rank individuals by
income level in an ascending order, provide an intuitive way to gauge the width of the income
distribution. In the late 2000s, the income of the 90th centile, which includes rich households, was
three times higher than the income of the 10th centile, which includes poor households, in several
Eastern European and Nordic countries. But this ratio stood above 6 for Chile, Israel, Mexico and
Turkey. Also, cross-country differences in the share of top income earners (99th centile) in total
income are very wide, ranging from 4.5% for Sweden to 18.1% for the United States.

Figure 3. The divide between the rich and the poor is quite pronounced in some countries
Household disposable income: Gap between the 10th and the 90th centile
and the Gini index in the late 2000s
Centile ratio
10.0

Gini index

Centile ratio (left scale)

Gini Index (right scale)

0.6

9.0
0.5

8.0
7.0

0.4

6.0
5.0

0.3

4.0
0.2

3.0
2.0

0.1

1.0
0.0

0.0

Note: The Gini index ranges from zero (perfect equality) to one (one individual or household receives all the income and the
others receive none). Data for France and Ireland refer to the mid-2000s instead of the late 2000s.
Source: OECD Income Distribution and Poverty Database, OECD Social Expenditure Statistics (database).

Some countries rely heavily on taxes and transfers to influence distributional outcomes
5.
Cash transfers such as pensions, unemployment and child benefits account for more than
three quarters of the overall redistributive impact in the OECD on average and taxes for the remaining
part. There are large differences across the OECD in the size, composition and progressivity of taxes
and cash transfers. On the transfer side, pensions account for the bulk of total transfers in most, but not
all, countries (Figure 4). They primarily aim at redistributing income over the lifetime of individuals
those with higher incomes contribute more but will also receive higher pensions. Thus, pensions often
redistribute little across individuals, but mainly redistribute over their entire lifetime. Other transfers
are usually more progressive, although how much depends on their design, e.g. the relative role of flat
versus income-related benefits. In most countries, family and housing benefits are either universal or
means-tested, thus involving more redistribution across individuals than benefits based on the
insurance principle, which aims at preserving the income level experienced in the past (e.g. pensions
and unemployment benefits).

Figure 4. Cash transfers vary greatly across countries,

but less redistributive old age transfers often account for the largest share
1

Public cash transfers to households: level and composition, 2007

Old age

Incapacity

Family

Unemployment

Other social policy areas

%GDP

20
18
16
14
12
10
8
6
4
2
0

1. The data shown here exclude private mandatory spending which accounts for an important share of total social spending in
some countries (in particular Chile, Germany and Switzerland). In addition, public cash transfers shown here may not fully
account for those programmes and services provided, or co-financed, by local governments. Measurement gaps may be
high, notably in federal countries such as Canada.
2. Incapacity-related spending covers expenditure on disability pensions and sick leave schemes (occupational injury and other
sickness daily allowances).
Source: OECD Social Expenditure Statistics (database).

6.
The redistributive impact of taxes varies less across countries than the large differences in
tax-to-GDP ratios would suggest. Indeed some high-tax countries show little progressivity, either
because: i) the tax mix favours consumption taxes and social security contributions over more
progressive personal income taxes; ii) the progressivity of tax schedules is limited; or iii) statutory
progressivity is weakened by tax expenditures that benefit high-income groups most. In the late 2000s,
the redistributive impact of household taxes was the highest in Germany, Israel and Italy (Figure 5,
Panel A) and by far the lowest in Switzerland, followed by Chile, Iceland and Korea. Some of the
countries with the highest inequality in market income tend to redistribute more through household
taxes than less unequal countries.
7.
The progressivity of household taxes varies little across countries despite large cross-country
differences in the size of taxes. As an illustration, household taxes absorbed more than 35% of
household disposable income in Austria, Denmark and Sweden in the late 2000s, but their
redistributive impact was lower than in Australia, Israel and the United States, all characterised by a
much lower tax-to-income ratio. In many high-tax countries, taxes embody little progressivity
(Figure 5, Panel B) this is particularly the case in Denmark, Iceland and the Netherlands. And
household taxes are more progressive in the United States than in most EU countries. However, some
countries (including Chile, Korea and Japan) combine a relatively low tax take with very little
progressivity.

Figure 5. The redistributive impact, size and progressivity of household taxes

In the late 2000s
Panel A. Unequal countries tend to redistribute more through household taxes
Redistributive impact of taxes

0.05
SVN
DNK

0.04

ITA

DEU
IRL
CAN

FIN

GBR

NOR
CZE
BEL
AUT
SWE

0.03

ISR
USA

AUS
PRT

NLD
LUX OECD-30
EST

NZL

FRA

0.02

SVK
ISL

0.01

POL

ESP
JPN

CHL

KOR

0.00
CHE
-0.01
0.25

0.30

0.35

0.40

0.45

0.50

Gini of household market income plus transfers

Panel B. High tax countries tend to have less progressive household taxes
Progressivity index of household taxes

0.25
AUS

IRL
0.20

ISR
USA
CAN
PRT
GBR

CZE

0.15

EST
0.10

KOR

0.05

OECD-30

SVK
ESP

FRA
CHL

ITA
SVN

LUX
NZL

JPN

FIN
NOR
BEL

DEU

AUT
SWE

DNK
NLD

POL
ISL

0.00
CHE
-0.05
0

10

20

30

40

50

60

Household taxes as a share of household disposable income

Note: The redistributive impact of household taxes is measured as the difference between the concentration coefficient of
income after transfers but before taxes and that of disposable income (i.e. after taxes and transfers). The progressivity
index of household taxes is the Kakwani index computed as the concentration coefficient for taxes less the concentration
coefficient for income after transfers and before taxes. Data for France and Ireland refer to the mid-2000s. In Panel A, the
trend line excludes Chile. Data for Greece, Hungary, Mexico and Turkey are not available.
Source: OECD Income Distribution and Poverty Database.

Classifying countries by their inequality patterns

8.
Countries can be grouped according to their inequality patterns (Figure 6). This allows the
identification of what inequality dimensions distinguish these groups and provides a guide towards the
available policy options for reducing inequality. Five groups have been identified:
i) The Nordic countries and Switzerland are characterised by below-average disposable
income inequality thanks to little dispersion in wages, in particular at the upper end,
combined with a high employment rate. However, the share of part-time employment is
above average in all these countries (except Sweden), contributing to inequality in labour
income. Cash transfers are often universal and household taxes tend to be largely
proportional to household income, implying only moderate redistribution.
ii) In eight continental European countries (Belgium, the Czech Republic, Estonia, Finland,
France, Italy, the Slovak Republic and Slovenia), inequality originating from the labour
market is slightly below the OECD average. Wages are little dispersed in international
comparison but inequality in labour earnings is driven by a low employment rate (in
particular for Belgium, France, Italy and the Slovak Republic). The high concentration of
self-employment or capital income brings inequality in household market income close
to the OECD average (except in the Slovak Republic and Slovenia). However, the share
of taxes and cash transfers in GDP is high, reducing household disposable income
inequality to or below the OECD average.
iii) In seven other continental European countries (Austria, Germany, Greece, Hungary,
Luxembourg, Poland and Spain) and Japan and Korea, inequality originating from the
labour market is at or above the OECD average. However, the underlying causes vary.
The wage rate dispersion is wide in all these countries, but the employment rate is low in
Greece, Hungary, Korea, Luxembourg, Poland and Spain, while the share of part-time
employment is high in Austria and Japan. Cash transfers tend to have little redistributive
impact since they are small in size (Korea) or largely insurance-based and thus not
highly progressive (Austria, Germany, Greece, Hungary, Japan, Poland and Spain).
Overall, both the dispersion in household disposable income and the poverty rate are
close to the OECD average.
iv) Five English-speaking countries (Australia, Canada, Ireland, New Zealand and the
United Kingdom) and the Netherlands all have a large share of part-time employment,
driving inequality in labour earnings. On the other hand, the employment rate is above
the OECD average in all these countries except Ireland, which reduces inequality. While
small in size (for all countries except the Netherlands), cash transfers tend to be more
targeted and taxes more progressive than in the other OECD countries, and therefore
have a sizable redistributive impact. Household disposable income inequality is,
however, above the OECD average in all these countries except for the Netherlands.
v) Chile, Israel, Mexico, Portugal, Turkey and the United States are characterised by above
average inequality originating from the labour market. This reflects a very wide wage
dispersion coupled with a low employment rate (though here the United States is an
exception). Capital and self-employment income also tend to benefit a small group of
households. Cash transfers have little redistributive impact because they are small in size
and often largely insurance-based. The size of tax systems is also small in most of these
countries, although progressivity is above the OECD average in some countries. Overall,
both inequality in household disposable income and the poverty rate are well above the
OECD average.
9

Growth and inequality: Trade-offs and complementarities associated with tax and transfer
system reforms
9.
Despite a vast theoretical literature on the link between inequality and growth, no consensus
has emerged and the empirical evidence is inconclusive. Still, specific structural reforms that aim at
raising living standards also influence the distribution of income. Taxes and transfers, for instance, do
not only affect the distribution of income; they also impinge on GDP per capita by influencing labour
use and productivity. Some tax reforms appear to be win-win options improving growth prospects
while narrowing the distribution of income. Others, however, may imply a trade-off between these
objectives.
Closing tax loopholes, while cutting marginal rates on labour, would foster equitable growth
10.
Some policy options could promote growth and reduce inequality. Cutting back tax
expenditures, which mainly benefit high-income groups, is likely to be beneficial both for long-term
GDP per capita, allowing a reduction in marginal tax rates and for a more equitable distribution of
income. Tax relief often distorts resource allocation. Moreover, scaling back tax expenditures would
reduce the complexity of the tax system, and thus improve tax compliance and lower collection costs.
Specific tax expenditures that should be reconsidered include tax relief on mortgage interest in
countries that do not tax imputed rent, tax incentives to promote pension savings or reduced taxation
of capital gains from the sale of a principal or secondary residence. Other tax reliefs may provide tax
avoidance instruments for top-income earners. In particular, there is little justification for tax breaks
for stock options and carried interest. Raising such taxes would increase equity and allow a
growth-enhancing cut in marginal labour income tax rates.
Shifting revenues away from progressive taxes could raise inequality, but promote growth
11.
Some taxes have a greater adverse effect on economic activity than others. Personal and
corporate income taxes are the most distortive taxes as they have sizable negative effects on labour
use, productivity and capital accumulation. Shifting the tax mix away from such taxes and towards
recurrent taxes on immovable property (the least distortive) and consumption taxes should thus raise
living standards. However, there is likely to be a trade-off with the income distribution objective since
personal income taxes are progressive while real estate and consumption taxes are at best neutral in a
lifetime perspective. Targeted transfers, however, can reduce the severity of this trade-off.
The effect of transfers on income inequality and growth depends on their design
12.
Transfers are usually progressive, although their degree of progressivity depends on their
features, e.g. on the relative importance of flat versus income-related benefits. Effects on GDP per
capita depend on whether transfers undermine work incentives with adverse effects on hours worked
and income levels. This need not be the case if they are properly designed or accompanied by
offsetting measures. For instance, high, but degressive, unemployment benefits may have only limited
adverse effects on work incentives when a coherent activation strategy is in place. Likewise, high oldage pension benefit replacement rates may not affect labour force participation of older workers much,
if the system is actuarially neutral. Targeted transfers are likely to have adverse incentive effects for
those individuals approaching the income level at which benefits are being withdrawn. Adverse
incentive effects can be mitigated by avoiding thresholds and the associated spikes in marginal
effective tax rates. Universal benefits are likely to have comparatively lower incentive effects, but a
higher tax take which itself entails economic distortions is needed to finance them.

10

Figure 6. Country groups with similar patterns of inequality

Lower inequality in household disposable income

Higher inequality in household disposable income

Denmark
Iceland
Norway
Sweden
Switzerland

Belgium
Czech Republic
Estonia
Finland
France2
Italy
Slovak Republic
Slovenia

Austria
Germany
Greece
Hungary
Japan
Korea
Luxembourg
Poland
Spain

Low dispersion in labour income

(high employment rate and little
wage dispersion). Cash transfers
tend to be universal and taxes are
not highly progressive.

Average dispersion in labour income

(little wage variation but low
employment or high part-time rate).
Highly concentrated capital and selfemployment income. Cash transfers
(largely insurance-based) and taxes
are not highly progressive.

Individual labour income is concentrated, reflecting above average

dispersion in wages and a low
employment or high part-time rate.
Taxes and transfers are not highly
progressive.

Australia
Canada
Ireland2
Netherlands
New Zealand
United Kingdom

Above average wage dispersion

coupled with a high part-time rate.
Cash transfers are targeted and
taxes are progressive.

Chile
Israel
Mexico
Portugal
Turkey
United States

High concentration of labour, capital

and self-employment income. The
poverty rate is high.

1. Country groups are derived from a cluster analysis of a set of 12 core income inequality indicators, with standardised values and unsquared Euclidean distance to measure differences between groups. Various alternative scenarios have been
run. They suggest that the two groups to the right are very stable. The dividing lines between the three groups to the left are less sharp.
2. For France and Ireland, mid-2000s (instead of end-2000s) data have been used for the cluster analysis.
Source: Hoeller, P. et al. (2012), Less Income Inequality and More Growth Are they Compatible? Part 1. Mapping Income Inequality Across the OECD, OECD Economics Department Working Paper, No. 924.

11

Suggested further reading

The main papers providing background to this note are:
Hoeller, P., I. Joumard, M. Pisu and D. Bloch (2012), Less Income Inequality and More Growth Are
They Compatible? Part 1. Mapping Income Inequality Across the OECD, OECD Economics
Department Working Paper, No. 924.
Joumard, I., M. Pisu and D. Bloch (2012), Less Income Inequality and More Growth Are They
Compatible? Part 3. Income Redistribution via Taxes and Transfers across OECD Countries,
OECD Economics Department Working Paper, No. 926.
OECD (2012), Inequality in Labour Income What are its Drivers and how Can it Be Reduced?, OECD
Economics Department Policy Note, No. 8.
Additional related papers include:
Fournier, J-M. and I. Koske (2012), Less Income Inequality and More Growth Are They Compatible?
Part 7. The Drivers of Labour Earnings Inequality An Analysis Based on Conditional and
Unconditional Quantile Regressions, OECD Economics Department Working Paper, No. 930.
Fredriksen, K. (2012), Less Income Inequality and More Growth Are They Compatible? Part 6. The
Distribution of Wealth, OECD Economics Department Working Paper, No. 929.
Hoeller, P. (2012), Less Income Inequality and More Growth Are They Compatible? Part 4. Top
Incomes, OECD Economics Department Working Paper, No. 927.
Kierzenkowski, R. and I. Koske (2012), Less Income Inequality and More Growth Are They
Compatible? Part 8. The Drivers of Labour Income Inequality A Review of the Recent Literature,
OECD Economics Department Working Paper, No. 931.
Koske, I., J-M. Fournier and I. Wanner (2012), Less Income Inequality and More Growth Are They
Compatible? Part 2. The Distribution of Labour Income, OECD Economics Department Working
Paper, No. 925.
OECD (2011), Divided We Stand: Why Inequality Keeps Rising, OECD Publishing.
Pisu, M. (2012), Less Income Inequality and More Growth Are They Compatible? Part 5. Poverty in
OECD Countries, OECD Economics Department Working Paper, No. 928.

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13

ECONOMICS DEPARTMENT POLICY NOTES

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to a wider readership, selected studies which the
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sent to OECD Economics Department, 2 rue Andr
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