Valentina Martinez-Pabon on using fiscal policy to tackle income inequality in Latin America

June 12, 2023

This article was written by CLAIS fellow David Alzate (Jackson School) and it was originally published at the EGC site. Due to its relevance to CLAIS, we reproduce it here with their permission.

Latin America and the Caribbean (LAC) is one of the world’s most unequal regions: the wealthiest 10% of Latin Americans capture an estimated 60% of national incomes – a ratio slightly higher than in sub-Saharan Africa. Moreover, the challenge only appears to be growing: a decade of low growth and the lingering effects of the Covid-19 economic slowdown threaten to widen the gaps between rich and poor across the region.

To tackle income inequality, governments have two key fiscal policy levers: taxing wealthier households, and spending resources on programs that help lower-income ones, such as cash transfers, subsidies, education, and health. Through a combination of these types of policies, governments might, over time, decrease income inequality. 

Valentina Martinez-Pabon standing in front of the Yale Department of Economics

The net effects of such policies on income inequality and poverty in LAC are the subject of a research project by EGC postdoctoral fellow Valentina Martinez-Pabon and her coauthors Nora Lustig of Tulane University and Carola Pessino of the Inter-American Development Bank (IADB). Using extensive survey data from eighteen countries across the region, they find that fiscal policies indeed improve income equality – but that their effectiveness varies widely by country. Poverty, on the other hand, appears to be a more vexing challenge: in half the countries examined, the researchers find that poverty increases after fiscal redistribution.

This research project is part of a broader academic collaborative called the Latin America and the Caribbean Inequality Review (LACIR) – a joint effort by EGC, IADB, the International Inequalities Institute at the London School of Economics, and the Institute for Fiscal Studies. LACIR brings together top scholars working across LAC to generate new data, analyses, and discussions, with an aim to better understand the multiple dimensions of inequality and contribute to a more equal region. For Martinez-Pabon, untangling these issues has been a key focus throughout her career.

Tracking income inequality: from Colombia to EGC

Born and raised in Colombia, Martinez-Pabon studied economics at Universidad de Los Andes, and one of her first jobs after graduating was to research the impact of her country’s fiscal policies on income inequality. She worked with a research team that was part of Tulane University’s Commitment to Equity (CEQ) Institute, analyzing Colombia’s “fiscal incidence” – a measure of the impact of taxation and government spending on individual’s income. In 2017, after working as a consultant for the IADB in Washington DC, she moved to New Orleans to pursue her PhD at Tulane – where she acquainted herself with CEQ’s larger datasets on more than 50 countries.

During the Covid-19 pandemic, CEQ’s rich data enabled Martinez-Pabon and her colleagues to quickly respond by studying the potential redistributive impacts in LAC – one of the timeliest estimates of how Covid-19 lockdowns and expanded social assistance affected inequality and poverty in the region. She also used CEQ datasets to study the long-term effects of Covid-19 on education inequality in LAC and the fiscal sustainability of universal basic income schemes in Sub-Saharan Africa.

Now, as an EGC postdoctoral fellow, she is still using CEQ data to study the impacts of fiscal policy on LAC inequality. “At Yale, Valentina has done strong work developing her PhD thesis work on the redistribution effects of tax and benefit systems in different countries, focusing on that theme in Latin America,” explained Orazio Attanasio, Cowles Professor of Economics at Yale and one of the LACIR Principal Investigators. “She has contributed to LACIR both in the running of the project across institutions and with a specific research output, a paper on the role of the state in affecting inequality in several countries in the region.”

Measuring inequality accurately requires a careful understanding of individuals’ income and taxes paid, but such data is very hard to find in practice. Government data does not capture most activity in the informal economy, for instance, and household surveys often fail to capture accurate information on the wealthy. To tackle this challenge, Martinez-Pabon and coauthors Lustig and Mauricio De Rosa of Universidad de la República (Uruguay) are constructing estimated measures for inequality and income redistribution by combining surveys and tax data from a set of LAC countries.

Does fiscal policy reduce inequality and poverty in Latin America?

Leveraging CEQ’s data, Martinez-Pabon and her coauthors analyze income inequality and poverty across eighteen LAC countries. Their findings offer a detailed characterization of these challenges in the region, as well as novel insights on the potential for fiscal policy to address them.

First, they show that income inequality before taxes and government spending varies widely across the region. For instance, the Gini coefficient – a widely used measure of income inequality, with zero being perfect equality and one being perfect inequality – is above 0.5 in Brazil, Colombia, and Honduras (a level similar to Africa’s most unequal countries) and around 0.4 in El Salvador and Venezuela (similar to European countries).

Having such a rich dataset, and working with such experienced and knowledgeable mentors and coauthors, has allowed me to broaden my research on inequality and poverty and contribute to a range of academic and policy debates” – Valentina Martinez-Pabon

The effect of fiscal redistribution on inequality also varies across LAC. To analyze this, Martinez-Pabon and her coauthors compared each country’s Gini coefficient before and after taxes and government spending. In some countries, such as Guatemala, Nicaragua, and Paraguay, the effects are quite limited. In others, such as Argentina, Mexico, and Panama, fiscal redistribution reduces income inequality considerably. On average, the researchers find that fiscal redistribution does reduce inequality in LAC. But they highlight the importance of caution when considering significant redistribution: such policies may not be fiscally sustainable and could ultimately threaten economic growth.

The mix of fiscal policies matters, too. Martinez-Pabon and coauthors show that certain types of taxes and spending in LAC – such as direct taxes, direct transfers, and spending on education and health – always have equalizing effects. Indirect taxes, like a value-added tax, can in theory be regressive, meaning they may pose a disproportionate burden on lower-income individuals. But the researchers find that even these types of taxes are more frequently equalizing than not. One potential explanation for this is that lower-income individuals can avoid indirect taxes by making purchases in informal markets.

A low-income suburb of Rio de Janeiro, Brazil, is juxtaposed with high-rise luxury apartment complexes. As noted, however, the researchers also found that fiscal redistribution does not always reduce poverty. More concerningly, their analysis suggests that fiscal policies may increase poverty in several countries, including Brazil, Colombia, the Dominican Republic, Guatemala, El Salvador, Honduras, Mexico, Nicaragua, and Peru. One reason is that the poor often pay more in taxes than they receive in benefits, even in countries with generous social spending programs. While fiscal policies can help narrow income gaps overall, many poor people continue to be left behind.

Martinez-Pabon and her coauthors plan to publish their findings in the coming months as part of the new LACIR Working Paper series, which launches this summer. Studying inequality and poverty in developing countries is just one of Martinez-Pabon’s research priorities. She has also studied, for instance, the effects of policies to improve educational equality in the United States – analyzing the patterns and determinants of school closures as well the effects of test-based accountability policies like No Child Left Behind.

This fall, she will join the World Bank as a Young Professional in the Poverty and Equity Global Practice, where she plans to continue pursuing a wide-ranging research agenda – a passion bolstered during her time at EGC. “The academic environment at Yale has been fantastic, with seminars, workshops, and conferences as part of the EGC and LACIR communities,” she said. “It has inspired me to keep working on policy-impactful research about improving people’s lives, not only in Latin America but also in other developing regions across the globe.”