total government spending and comprise the key categories with potential non-neutral distributional effects.<sup>3</sup> This is more or less in line with coverage of components of fiscal policy in other countries.<sup>4</sup> The CEQ analysis usually excludes some categories of taxes and spending such as corporate income taxes, defense, spending on infrastructure, and other public goods due to the difficulty of assigning the benefits or burdens to individual households. This is more likely to be true for the poverty analysis, which depends on absolute incomes, than inequality, which depends on relative incomes.

**Our findings show that the fiscal system in Albania plays a positive role in reducing inequality, while it has a poverty-increasing effect** . The fiscal system contributes to reducing inequality from a Gini coefficient of 0.35 at market income (pre-fiscal income) to 0.32 after all taxes and transfers are considered. However, in the baseline scenario of pensions treated as pure deferred income, it also contributes to increasing poverty, going from 7.5 percent to 8.1 percent ($2.5-day poverty line). Specifically, while direct and indirect taxes and social contributions have a role in reducing inequality, they also have a povertyincreasing effect; indirect taxes, particularly the VAT, account for the largest increases in poverty. This effect is somewhat compensated by direct transfers (with programs such as the _Ndihma Ekonomike_ ) which are pro-poor and equalizing, but not large enough to fully offset the burden placed on the less well-off.

**The rest of the paper is organized as follows** . Section II describes the fiscal system in Albania, providing the context for this paper. Sections III and IV describe the methodology, as well as the application to Albania, respectively. Results are presented in sections V and VI, including the impact of the fiscal system on poverty and inequality, with a subsequent zooming into the role of taxes and transfers. Section VII showcases some additional uses of the tool for policy making, by simulating changes in the personal income tax, and Section VIII concludes.

# **II. Overview of the Fiscal System in Albania**

**The structure of the fiscal revenue in Albania relies heavily on indirect taxes, as well as direct taxes and social contributions.** Table 1 shows that the Value-Added Tax (VAT) represents nearly 33 percent of the government total revenue and 9.1 percent of GDP. When compared to the other taxes collected from tax offices and customs, VAT accounts for about half of the revenue. In addition, the excise tax revenues represent 11 of total revenue and about 3.1 percent of GDP. Direct taxes and contributions, namely the Personal Income Tax (2.2 percent of GDP), and Social Insurance and Health Insurance (4.8 percent of GDP), also provide an important source of revenue to the government, representing 25 percent of overall government revenue.

> 3 We will see later that in-kind transfers, namely public spending in health and education, have an important and positive redistributive effect in Albania.

> 4 In Croatia, the analysis captures 83 percent of tax revenue and 65 percent of government spending (Inchauste and Rubil, 2017). In Poland, it captures 62 percent of tax revenue and 51 percent of government spending. In Montenegro, 79 and 42 percent is captured, respectively.

5