# 3.2. The CEQ Approach

To conduct fiscal incidence analysis for Bhutan, we adopt the Commitment to Equity (CEQ) approach, which was developed by Lustig et al. (2018). This approach can be used to examine the incidence of individual tax and subsidy policies, estimate the poverty and inequality impact of each fiscal intervention, and assess whether taxes and transfers are progressive and pro-poor. The distributional impact of the fiscal system as a whole can also be evaluated.

In the standard CEQ approach, the income concepts are constructed as follows:

- _Market income plus pension:_ market income is the income before any fiscal intervention such as taxes and government transfers. It includes labor income (e.g., wages and salaries), income from capital (e.g., rents, interests, and dividends), income from private and public pensions,<sup>13</sup> and private transfers (e.g., remittances). Old-age pensions exist primarily in the public sector in Bhutan and are considered deferred income given their contributory nature.<sup>14</sup> We align our approach to the standard CEQ methodology whenever possible, while labor income is constructed following the approach described in the next section.

- _Disposable income_ is obtained by adding direct transfers and subtracting direct taxes and social security contributions from market income. Since there are few government-supported direct transfer programs in Bhutan and no information in the household survey to identify beneficiaries, we assume that there are no receipts from direct transfers for the baseline assessment. Direct taxes refer to personal income taxes. Social security contributions comprise of payments into a pension fund and mandatory life insurance.

- _Consumable income_ subtracts indirect taxes from disposable income and adds indirect subsidies. Indirect taxes include green taxes, custom duties, sales taxes, and excise taxes in Bhutan. Indirect subsidies are not modeled in this paper.<sup>15</sup>

- _Final income_ is constructed by adding in-kind transfers to consumable income. In Bhutan, these mainly comprise education and health benefits.

Figure 1 illustrates the relationship between these income concepts and fiscal interventions. Only market income is considered pre-fiscal income while disposable income, consumable income, and final income are considered post-fiscal incomes. The heart of a CEQ assessment is the allocation of taxes and transfers to each individual or household so that one can construct the income concepts (Lustig et al. 2018). In practice, when the amount of taxes paid or transfers received is available in the survey, that information is directly

> 13 Pension income is included in the market income for retirees.

> 14 Old-age contributory public pensions can be treated either as deferred income or as government transfers, depending on the design and functioning of the pension system.

> 15 Subsidies are mainly provided through state-owned enterprises (SOEs) in Bhutan. For electricity, the central government provides subsidies to Bhutan Power Corporation for the domestic power tariff. In FY21/22 budget, of total Nu 2,000 million subsidies, Nu 1,800 million was allocated for the domestic power tariff. For LPG, Bhutan receives subsidized and non-subsidized gas from the government of India. The subsidized LGP is distributed to rural households. There are agricultural subsidies provided to farmers through local governments and SOEs, in the form of seeds, fertilizers, pesticides, agricultural machinery. There are also rural timber subsidies for households to construct houses in rural Bhutan, provided by the Natural Resources Development Corporation, an SOE. While with additional information and some assumptions, the incidence of electricity could be estimated, the other two subsidies will be more difficult to identify in the household survey.

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