the tax/transfer collection level, the incidence of the tax burden, and the distribution of transfer benefits. Finally, Section 4 closes with some concluding thoughts.

# **2. Income inequality and fiscal redistribution in Latin America**

We begin by reviewing the facts regarding income inequality and the redistributive performance of the fiscal system in Latin America. Before proceeding, it will be useful to define some terms. We use the term _market income_ to refer to income before taxes and government transfers – thus its distribution is largely determined by market rewards to the private assets and efforts of individuals, and by the underlying distribution of those private assets. However, from a welfare perspective a more relevant measure is _disposable income_ – i.e., household income after government cash benefits (e.g. pensions, unemployment insurance, social assistance transfers) have been received and direct taxes have been paid. Note that disposable income, rather than market income, is the relevant measure of the purchasing power of the different households. Two additional definitions used below are _gross income_ (market income plus government cash benefits, or total household income before taxes) and _post-tax income,_ which deducts from gross income all taxes, direct and indirect. This latter measure is useful to get a more comprehensive view of the tax burden, particularly in countries that rely heavily on indirect taxation.

Comparing these various income concepts, we can assess the distributional impact of the tax and transfer system and its separate components. It is important to clarify the limitations of this type of analysis. First, taxes and transfers may themselves affect the distribution of market income, a fact whose proper consideration would require a fully specified behavioral model, which is beyond the scope of our analysis.<sup>11</sup> Second, we focus on annual income, thus neglecting intertemporal issues (such as redistribution over the life-cycle), which may lead to overstating inequality as well as the regressivity of indirect taxation (Fullerton and Rogers 1993). Third, we focus on cash transfers only, and thus we do not assess the redistributive effects of transfers in kind like public health, education, or housing.<sup>12</sup> And fourth, our discussion of the incidence of transfers on income inequality focuses on who benefits from spending on _average_ , rather than _at the margin,_ and thus we ignore possible systematic differences between average and marginal incidence – which could lead us to underestimate the redistributive impact of transfer increases.

With these caveats in mind, Figure 1 reports the value of the Gini coefficient of the distributions of disposable income (Panels A and B) and market income (Panels C and D) in Latin America (Panels A and C) and Europe (Panels B and D).<sup>13</sup> Inspection of

> 11 An example of that approach is Fullerton and Rogers (1993).

> 12 Transfers in kind can also have a direct redistributive effect, but its quantitative assessment poses a number of difficulties. For example, one needs to make assumptions regarding how accurately the cost of the public good acquired by these transfers reflects its value for the private individuals receiving it. To avoid these complications, here we have limited our attention to the incidence of cash transfers only.

> 13 The Latin American data underlying Figure 2.1 come from two main sources. Tax incidence information is derived from  Breceda et al. (2006) for Argentina (1997), Brazil (1999), Colombia (2003), Mexico (2002), Peru (2004), Bolivia (2004), Honduras (2004) and Nicaragua (2001).  Chile’s tax incidence was

4