Fiscal Policy and Inequality in Ethiopia: A Microsimulation Analysis

: An application of ETMOD

Abstract

This paper examines the distributional impact of fiscal policy in Ethiopia, with a special focus on personal income tax (PIT) and value-added tax (VAT). The analysis makes use of the latest version of ETMOD (Tax-benefit microsimulation model for Ethiopia). The results show that increasing PIT on high-income brackets and VAT rates reduces consumption-based inequality in Ethiopia, and it is non-revenue neutral. First, with the increase in the VAT rate from the current value of 15% to 18%, inequality, as measured by the Gini coefficient, reduces by 0.08%. And a further increase in the VAT rate to 20% results in a much larger decline in inequality by 0.13%. Following these reforms, poor households suffer net losses in consumption expenditure, but this effect is quite low compared to the richest households. The possible reason is that the bottom deciles/quintiles also spend large amounts of money on food and non-food items which are subject to VAT even if it is less than the top deciles/quintiles. Second, when we increase the PIT rate on high-income brackets and decrease the PIT rate on the lower-income brackets, inequality reduces by 0.05% and 0.10% Gini coefficient for the two PIT reforms. Moreover, when the 1st and 2nd income brackets are exempted from PIT, inequality decreases by 0.11%. Moreover, the three PIT reforms generate on average Ethiopian Birr (ETB) 33, 860.14 million, and the two VAT reforms generate on average ETB 47,283.36 million in government revenue. Only 12.32 % of the government tax revenue is spent on social security transfers, and the remaining 87.68% is spent on public goods/services and other activities. More specifically, the share of education spending from the total public services spending is 12.49%. Regarding the distribution of public goods/services spending, 52% of public services benefit from government educational spending received by people in the bottom five deciles of equivalised household expenditure. On the other hand, only 28% of social security transfer benefits from pensions are received by people in the bottom five deciles of equivalised household expenditure. In contrast, these results show that the public services channel is well-targeting the poor and vulnerable segments of society than the social security transfers channel. Therefore, the microsimulation result shows that both the VAT and PIT reforms reduce consumption-based inequality better than the existing VAT & PIT policies in Ethiopia by providing essential public goods/services to the poor and vulnerable segments of society.

Date of Award	7 Sept 2023
Original language	English
Awarding Institution	University of Namur
Supervisor	Romain Houssa (Supervisor)