FISCAL REGULATION AND INCOME INEQUALITY: THE SOCIAL FUNCTION OF TAXES

ABSTRACT

Increasing income inequality across both advanced and developing economies has fueled growing public support for income redistribution. At the same time, many of these countries are under pressure to uphold fiscal discipline. In line with its mandate to promote economic stability and growth, the paper examines four key areas: first, it outlines current trends in income, wealth, and opportunity inequality; second, it reviews how different countries have used fiscal tools to address redistribution; third, it explores reform strategies for tax and public expenditure that can achieve redistributive goals while maintaining fiscal sustainability; and fourth, it discusses how fiscal policy can be structured to mitigate the negative social effects of fiscal consolidation. While the paper provides evidence-based insights for policymakers, it does not promote any particular redistributive goal or policy instrument, maintaining a neutral stance throughout.

АННОТАЦИЯ

Рост неравенства доходов в развитых и развивающихся странах сопровождается усилением общественной поддержки политики перераспределения доходов. Это происходит на фоне необходимости соблюдения фискальной дисциплины. В соответствии со своим мандатом по обеспечению экономического роста и стабильности, данный документ рассматривает: (i) современные тенденции в неравенстве доходов, богатства и возможностей; (ii) опыт различных стран в использовании фискальных инструментов для перераспределения; (iii) варианты реформирования налоговой и расходной политики с целью достижения перераспределительных целей без ущерба для фискальной устойчивости; и (iv) способы смягчения воздействия фискальной консолидации на неравенство.

Keywords:  income, tax, fiscal, redistribution, inequality.

Ключевые слова:  доход, налог, фискальный, перераспределение.

Introduction

Although living standards have improved globally over the past decade, income and wealth inequality remain deeply entrenched both within and between countries. This ongoing disparity has kept the focus on the role of fiscal policies in addressing poverty and reducing inequality. The COVID-19 pandemic has further intensified this focus, as its social and economic impacts have disproportionately affected those with limited access to credit, public services, and secure employment. People in jobs that cannot be done remotely or without social protection have been especially vulnerable. As a result, the effect of the pandemic on income inequality varies across countries, depending on the structure of their economies, labor markets, and the strength of their social protection systems. Historical patterns from previous health crises suggest that inequality tends to rise when fiscal responses are limited. With added challenges such as rising inflation and global instability due to geopolitical conflicts, there is growing concern that long-term progress toward improving living standards and reducing poverty and inequality may be at serious risk.  [5]

Concerns regarding income inequality often extend beyond economic measures, touching on its potential effects on equal opportunities and social mobility. From a welfare economics perspective, since the marginal utility of income declines as income increases, a single dollar holds greater value for a poorer individual than for a wealthier one. This creates a rationale for income redistribution, as transferring resources from rich to poor can enhance overall societal welfare. In this light, addressing income disparities may also be driven by a sense of moral responsibility. Some argue, however, that inequality itself is not inherently problematic; the true concern lies in whether individuals have sufficient means to secure basic necessities such as food, housing, education, and healthcare. [2]

According to this view, the objective should not be to equalize incomes entirely, but to ensure a minimum standard of living for all. Reducing poverty through taxes and social transfers, and thereby narrowing income inequality, is seen as a byproduct of this broader aim. Furthermore, research suggests that localized income disparities can negatively influence individual wellbeing, reinforcing the importance of tackling within-country inequality as part of a comprehensive policy approach focused on human wellbeing. [4]

Institutions, understood as the human-designed rules and structures that guide social and economic interactions, play a foundational role in shaping the functioning of an economy. Often referred to as the "rules of the game," institutions can significantly influence both economic growth and the distribution of income, depending on whether they are inclusive—promoting participation, innovation, and fair access—or extractive, serving only a narrow elite and limiting overall development. Inclusive institutions foster economic activity and create conditions for fairer resource distribution, while extractive systems hinder progress and perpetuate inequality. The presence of good governance, strong legal frameworks, and transparency enhances economic growth and supports equitable redistribution through efficient public spending and greater economic freedom. Where governments have strong institutional capacity, fiscal policies aimed at reducing inequality become more effective. A robust legal system and low levels of corruption are essential to ensuring that social expenditures—on areas like education, healthcare, and welfare—truly benefit disadvantaged groups. [7]

Conversely, weak institutional capacity tends to worsen income disparities. When public spending is managed efficiently and transparently, it can serve as a powerful tool for redistributing wealth and expanding opportunities for the poorest segments of the population. Furthermore, strong institutions create an environment where inclusive economic planning becomes possible, allowing for more balanced income distribution. Studies across different regions have shown that when property rights are protected, corruption is minimized, and governance is effective, the income gap narrows. The quality of institutions also influences how foreign investment affects income inequality, with better institutional environments helping to reduce inequality and moderate the potential negative effects of external economic flows. [1]

Generally, the size of a government’s fiscal footprint is linked to the country's level of income—wealthier nations tend to collect and spend a higher proportion of their national income through taxation, although exceptions exist. Over time, particularly in European countries, rising domestic revenues have allowed governments to shift their focus from traditional state functions such as defense and administration toward more comprehensive social spending programs.

Taxation serves as a vital policy instrument for governments seeking to reduce inequality, though it is just one of several available tools. A comprehensive policy approach is necessary to effectively address disparities in income and wealth. Non-tax measures—such as improving access to the labour market, enforcing minimum wage standards, and providing essential public services like education and healthcare—are especially important in supporting low-income populations. In addition, policies aimed at curbing excessive market dominance can help limit the accumulation of wealth at the top. While these non-tax measures play a crucial role, tax policy can complement them by directly influencing income and wealth distribution, particularly in areas where other interventions may fall short, such as the upper segments of the population. [8]

Although inequality can be analyzed from various angles—including disparities in opportunity, ethnic background, or unfair treatment of similar individuals—the focus here, in line with much of the existing literature, remains primarily on household-level inequality measured in monetary terms such as annual income or consumption, particularly in relation to fiscal policy impacts; however, this discussion also expands the lens to include two critical but often neglected dimensions of inequality that are not captured by static, cross-sectional income comparisons—namely, the evolving nature of inequality across an individual's life cycle and persistent gender-based disparities. [3]

Fiscal policy tools can influence inequality both in the short term—such as personal income taxes that immediately reduce household disposable income—and in the long term, for example, through public investment in education that can improve individuals' future earning potential. In developed countries, fiscal policy has played a meaningful role in reducing income inequality before taxes and transfers, with average reductions in the Gini coefficient by about one-third—two-thirds of which is attributed to transfer programs and the remaining third to progressive taxation. When it comes to public spending, the effectiveness of policies depends greatly on how well they are designed to reach low-income households and avoid reinforcing poverty traps. One way to address this is by structuring benefits to limit unintended behavioral effects, such as reduced incentives to work. The degree to which taxation can reduce inequality depends largely on the progressivity of personal income taxes, as well as how capital income and wealth are taxed. In contrast, indirect taxes—when measured against income and assuming full cost pass-through to consumers—tend to be regressive and are generally less effective for redistribution than direct income taxes.  [6]

Rising income inequality has been linked to a combination of global economic shifts, including increased globalization, market liberalization, technological advancements favoring skilled workers, greater participation of low-skilled labor in the workforce, reduced top income tax rates, stronger bargaining power among top earners, and demographic changes such as the rise in high-income dual-earner households and single-parent families. While many of these changes have contributed positively to economic growth and poverty reduction at both national and global levels, recent studies suggest that excessive inequality can hinder both the pace and sustainability of economic growth. Some analysts also argue that widening inequality may have played a role in triggering the global financial crisis. Additionally, public opinion surveys from several countries show a growing demand for redistribution, particularly in those hardest hit by the crisis. These concerns emerge at a time when many advanced economies are grappling with high levels of public debt, and developing economies are facing growing fiscal vulnerabilities—both of which underscore the need to consider equity when designing fiscal consolidation strategies. As such, inequality is not only a social issue but also a macroeconomic challenge that policymakers must address. It is crucial that institutions providing economic guidance, such as international financial organizations, take into account the distributional impacts of macroeconomic and fiscal policies and ensure that these align with the broader equity objectives of national governments. [9]

Fiscal policy serves three core purposes: maintaining macroeconomic stability, supplying public goods and correcting market inefficiencies, and redistributing income. Both taxation and government expenditure can influence income distribution in the short and medium term. For instance, public investments in services like education—considered in-kind benefits—can impact future earning potential and thus affect pre-tax income inequality. Other tools, such as direct taxes and cash transfers, contribute to reducing disparities in disposable income and may also influence market income indirectly by affecting individuals’ behavior regarding work and savings.

When it comes to fiscal adjustment—especially during periods of economic tightening—its impact on inequality manifests through both market and disposable incomes. A contraction in fiscal policy can reduce output and employment, thereby lowering earnings, while also changing the structure and scale of taxation and government spending. These effects can be amplified during economic downturns, where fiscal multipliers are stronger than in periods of growth. Importantly, the specific design of fiscal consolidation matters: research indicates that spending-based adjustments tend to increase inequality more than revenue-based ones. However, evidence from recent fiscal reforms in Europe shows that consolidations—whether driven by spending cuts or revenue increases—can be structured to minimize negative impacts on inequality. This can be achieved by safeguarding the most progressive and effective spending programs and by focusing more on progressive tax instruments. In developing economies, where government capacity is generally more limited and fiscal systems less redistributive, it becomes crucial to bolster social safety nets to protect the most vulnerable groups during times of fiscal tightening. Moreover, replacing broad, untargeted subsidies with focused support measures can simultaneously reduce inequality and help control budget deficits.

Concerns about income inequality often stem from its potential to limit equal opportunities and hinder social mobility. From the perspective of welfare economics, since the value of income decreases as wealth increases, a unit of income is generally more valuable to a poorer individual than to a wealthier one. This suggests that transferring income from the rich to the poor could enhance overall societal welfare. Beyond economic reasoning, there may also be ethical justifications for addressing income disparities within a country. Some argue that the primary issue is not inequality itself, but rather that some individuals lack sufficient resources to access basic needs such as food, housing, education, and healthcare. According to this view, the goal should be to ensure that everyone can live with dignity, rather than striving to equalize incomes across the entire population. In this context, reducing poverty—and any associated decline in inequality through taxes and social transfers—is seen as a secondary benefit. Additionally, evidence suggests that localized income inequality may harm overall wellbeing, underscoring the importance of addressing domestic disparities when broader societal wellbeing is a policy objective. [3]

Methodology

It is notable that the official household income and expenditure database maintained by the State Statistical Committee of Azerbaijan does not provide any information on the Gini coefficient, a key indicator used to measure social stratification in the country. The Gini coefficient reflects how much the actual distribution of total income in an economy deviates from a perfectly equal distribution. It is calculated using a specific mathematical formula, typically based on income data categorized into quintiles—where the population is divided into five equal groups. The calculation is made using the Lorenz curve, named after American economist Max Otto Lorenz, and the coefficient ranges from 0 to 1. A value of "0" indicates perfect equality, while "1" reflects absolute inequality. The larger the income gap between the richest 20% and the poorest 20% of the population, the closer the Gini coefficient approaches 1, signaling severe income inequality and an unjust distribution of national income.

Azerbaijan has placed a strong emphasis on social priorities within its economic development agenda by enhancing labor market transparency through targeted tax incentives and fiscal measures. As part of its efforts to reduce the shadow economy, the government has implemented substantial tax reforms aimed at increasing transparency in employment practices. A key initiative introduced in 2019 exempts monthly salaries up to 8,000 manats from income tax in the private, non-oil sector for a period of seven years. This policy has produced significant fiscal benefits, including a notable rise in formal employment contracts and steady growth in the national wage fund. As a result, the number of new employment contracts in the private sector has increased by more than 80 percent, with most of the growth concentrated in industries covered by the tax exemption—highlighting the effectiveness of this reform.

Chart. Personal remittances, received (% of GDP)

Source: World Development Indicators. Retrieved from https://databank.worldbank.org/source/world-development-indicators

Above chart presents the trend of personal remittances received in Azerbaijan as a percentage of its Gross Domestic Product (GDP) from 2010 to 2023. Remittances represent a vital source of income for many Azerbaijani households, especially those with family members working abroad. Over the observed period, the share of remittances in GDP has fluctuated notably, reflecting both global economic shifts and regional dynamics. After a relatively stable start around 2.7–2.9% between 2010 and 2012, the country experienced a gradual decline, hitting a low of 1.7% in 2016. However, remittances rebounded sharply in 2017 and reached a historic peak of 5.1% in 2021—likely influenced by post-pandemic economic recovery and increased overseas support. The following year, this figure nearly halved, indicating potential changes in migration patterns, exchange rates, or domestic economic conditions. By 2023, remittances accounted for 2.8% of Azerbaijan’s GDP, signaling a modest recovery but remaining below the 2021 high.

Chart. Personal remittances, paid (current kUS$)

Source: World Development Indicators. Retrieved from https://databank.worldbank.org/source/world-development-indicators

In 2010, Azerbaijan paid approximately 950,000 thousand US dollars in personal remittances. This amount rose by 36.8% in 2011, reaching 1.3 million. The upward trend continued sharply in 2012, with a 61.5% increase to 2.1 million. However, in 2013, remittances paid dropped by 9.5% to 1.9 million, followed by a modest 7.9% rebound in 2014, climbing back to 2.05 million. Starting in 2015, there was a significant downward shift. Remittances paid fell by 34.1% to 1.35 million, and plunged again in 2016 by 40.7% to just 800,000. The decline continued in 2017 with a 25.0% drop to 600,000, and slightly decreased by 3.3% in 2018. In 2019, a small recovery of 3.4% was observed, followed by a stronger 20.0% increase in 2020 to 720,000. This upward movement continued in 2021 with an 11.1% rise to 800,000. The amount stayed flat in 2022 but declined again by 15.0% in 2023, down to 680,000 thousand US dollars.

Chart. Residual income by year

Source: Azerbaijan State Statistical Committee. (2023). Residual income statistics, 2010–2022.

Retrieved from https://www.stat.gov.az

In 2010, Azerbaijan’s residual income stood at approximately 45,000 US dollars. This figure increased by 11.1% in 2011 to reach 50,000. In 2012, it rose again by 4.0%, and continued to grow in 2013 by 7.7%, hitting 56,000. In 2014, the increase was more modest at 3.6%, bringing the total to 58,000. However, in 2015, residual income declined by 10.3%, falling back to 52,000. This was followed by a recovery in 2016 with a 9.6% rise to 57,000. The upward trend strengthened in 2017 with a 22.8% increase to 70,000, and continued in 2018 with a 12.9% growth to 79,000. In 2019, growth slowed to 1.3%, reaching 80,000. A slight decline occurred in 2020, with income decreasing by 6.3% to 75,000. In 2021, residual income rebounded sharply with a 22.7% increase to 92,000, and in 2022, it soared by 41.3%, peaking at 130,000 US dollars—the highest value in the observed period.

Chart. National income by year

Source: World Bank. (2024). World Development Indicators – National Income (US$, per capita), Azerbaijan (2010–2023).

 Retrieved from https://datacatalog.worldbank.org

In 2010, Azerbaijan's national income was approximately 15,200 US dollars per capita. This value declined slightly in 2011 by 2.0%, falling to 14,900. In 2012, it recovered with a 1.7% increase, and further rose in 2013 by 4.3% to reach 15,800. The upward trend continued into 2014, peaking at 16,200 with a 2.5% rise. However, in 2015, national income fell by 2.5% to 15,800, and in 2016 it dropped sharply by 7.6%, reaching 14,600. A modest recovery followed in 2017 with a 2.7% increase to 15,000, though it slightly declined in 2018 by 0.3%. The year 2019 saw a 3.7% rise to 15,500. Yet, 2020 experienced another drop of 5.8%, down to 14,600. In 2021, the national income increased by 4.8% to 15,300, but fell again in 2022 by 3.9% to 14,700. Finally, in 2023, it inched up by 1.0%, settling at 14,850 US dollars.

Conclusion

Taxes, when effectively designed and implemented, function not merely as a source of public revenue but as instruments of social justice. In times of national income decline, such as during the 2016 and 2020 downturns, the burden disproportionately falls on lower- and middle-income households unless fiscal buffers and redistributive mechanisms are in place. Progressive taxation—where higher income brackets are taxed at higher rates—can help absorb these shocks and fund public services essential to reducing inequality, such as healthcare, education, and social protection.

The relative stagnation in national income in the post-2015 period further emphasizes the need for fiscal reform not just aimed at economic growth, but at equitable growth. A tax system that prioritizes wealth redistribution, closes loopholes, and expands the tax base beyond extractive sectors can correct income disparities and stabilize household welfare even when macroeconomic performance wavers.

Moreover, national income trends often mask underlying disparities. While per capita income may recover on average, the benefits of growth may be unevenly distributed without corrective fiscal tools. Thus, the social function of taxation becomes essential—not only as a regulator of market failures but as a moral contract to uphold social cohesion and inclusive development.

In the Azerbaijani context, fiscal regulation must evolve beyond narrow revenue collection toward a framework that actively mitigates inequality. This involves not only tax progressivity, but transparency, efficient public spending, and a political commitment to equity. The national income trends of the past decade demonstrate that economic cycles will come and go, but it is the social architecture of taxation that determines who bears the cost—and who gets left behind.

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