metadata: authors: 0: author: Cuevas,Pablo Facundo
1: author: Lucchetti,Leonardo Ramiro
2: author: Nebiler,Metin
count: Türkiye
docna: 0: docna: What Are the Poverty and Inequality Impacts
            of Fiscal Policy in Turkey ?
docty: Policy Research Working Paper
subtopic: Inequality,Health Care Services Industry,Educational Sciences,Public Finance Decentralization and
            Poverty Reduction,Macro-Fiscal Policy,Economic Adjustment and Lending,Public Sector Economics,Disability,Access of Poor to Social Services,Economic Assistance,Services & Transfers to Poor
teratopic: Macroeconomics and Economic Growth,Industry,Social Protections and Labor,Public Sector Development,Education,Poverty Reduction
abstracts: cdata!: Fiscal policy is central to not only
            macroeconomic stability and growth, but also to poverty and
            inequality reduction. This paper provides the most
            comprehensive assessment of the distributional incidence of
            Turkey’s fiscal policy to date. It analyzes the combined and
            individual incidence of direct and indirect taxes,
            transfers, and social spending and benchmarks Turkey’s
            achievements against peer countries. The results show that
            fiscal policy significantly reduces income inequality in
            Turkey, driven by social spending on education and health,
            and complemented by direct taxes and transfer schemes that
            countervail the inequality-increasing impact of indirect
            taxes. At the bottom of the income distribution, targeted
            transfers are insufficient to compensate for the effect of
            taxes, resulting in net increases in poverty. In the context
            of upper-middle-income countries, Turkey’s performance is
            below the median. This is driven by the relatively larger
            negative impacts of indirect taxes and the more limited
            positive impacts of direct transfers and taxes. From a
            policy perspective, the paper contributes to identifying
            entry points for improving the equity impact of the fiscal
            package. Among these, targeting the minimum subsistence
            allowance (AGI) program toward the poor could be an
            efficient way forward. More broadly, the study represents a
            platform to simulate the distributional implications of a
            variety of fiscal changes to inform stakeholders and the
            policy debate.
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repnme: repnme: What Are the Poverty and Inequality Impacts
            of Fiscal Policy in Turkey ?
display_title: What Are the Poverty and Inequality
            Impacts of Fiscal Policy in Turkey
listing_relative_url: /research/2020/06/32168497/poverty-inequality-impacts-fiscal-policy-turkey
topicv3: Poverty m1326687 695,Education m1327048 470,Fiscal Policy m1327144 445,Cash Transfers m1327437 1608,Health m1504661 3480
publishtoextweb_dt: 2020-06-24T00:00:00Z
historic_topic: Macroeconomics and Economic Growth,Industry,Social Protections and Labor,Public Sector Development,Education,Poverty Reduction
origu: EFI-ECA-POV-Poverty and Equity (EECPV)
no_of_pages: 57
author_keys: 0: author_key: 956000
1: author_key: 763344
2: author_key: 1478749
model_extractions: Policy Research Working Paper 9300 What Are the Poverty and Inequality Impacts of Fiscal Policy in Turkey?

_P. Facundo Cuevas Leonardo Lucchetti Metin Nebiler_ Poverty and Equity Global Practice June 2020
Policy Research Working Paper 9300

# **Abstract**

Fiscal policy is central to not only macroeconomic stability and growth, but also to poverty and inequality reduction. This paper provides the most comprehensive assessment of the distributional incidence of Turkey’s fiscal policy to date. It analyzes the combined and individual incidence of direct and indirect taxes, transfers, and social spending and benchmarks Turkey’s achievements against peer countries. The results show that fiscal policy significantly reduces income inequality in Turkey, driven by social spending on education and health, and complemented by direct taxes and transfer schemes that countervail the inequality-increasing impact of indirect taxes. At the bottom of the income distribution, targeted transfers are insufficient to compensate for the effect of taxes, resulting in net increases in poverty. In the context of upper-middle-income countries, Turkey’s performance is below the median. This is driven by the relatively larger negative impacts of indirect taxes and the more limited positive impacts of direct transfers and taxes. From a policy perspective, the paper contributes to identifying entry points for improving the equity impact of the fiscal package. Among these, targeting the minimum subsistence allowance (AGI) program toward the poor could be an efficient way forward. More broadly, the study represents a platform to simulate the distributional implications of a variety of fiscal changes to inform stakeholders and the policy debate.

This paper is a product of the Poverty and Equity Global Practice. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://www.worldbank.org/prwp. The authors may be contacted at fcuevas@worldbank.org, llucchetti@worldbank.org, mnebiler@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# What Are the Poverty and Inequality Impacts of Fiscal Policy in Turkey?

P. Facundo Cuevas Leonardo Lucchetti Metin Nebiler<sup>♣</sup> World Bank World Bank World Bank _Keywords_ : fiscal policy, incidence, social spending, transfers, taxes, poverty, inequality, Turkey _JEL classification: H22, I38, D31_

> ♣ Authors’ contact information: <u>fcuevas@worldbank.org; llucchetti@worldbank.org; mnebiler@worldbank.org.</u> Special thanks go to Stephen Younger, Nora Lustig, Gabriela Inchauste, Matt Wai, Luis-Felipe Lopez-Calva, Habib Rab and Auguste Tano Kouame for their generous suggestions and guidance throughout the study. We also gratefully acknowledge feedback from Turkey’s Revenue Administration, Ministry of Treasury and Finance, and Central Bank on earlier drafts of the paper, and from seminar and workshop participants at Turkey’s Ministry of Treasury and Finance, the Strategy and Budget Office of the Presidency, Middle East Technical University, Oziegyn University, and the World Bank. All remaining errors are our own.
# **1. Introduction**

Fiscal policy can play an important role in fostering inclusive growth and advancing poverty and inequality reduction in a country. However, a comprehensive analysis of the distributional impact of fiscal policy in Turkey is missing. A core objective of this paper is to fill in that knowledge gap.

Turkey has made significant progress in reducing poverty in the new century. The poverty headcount ratio is less than a third of what it was in 2003. The proportion of the population living with a budget below the poverty line for upper-middle-income countries decreased from 36.5 to 9.9 percent between 2003 and 2016.<sup>1</sup> Robust economic growth, through more employment and higher labor incomes, has been the main driver of poverty reduction (World Bank 2016). After the severe financial crisis of 2001, real domestic product grew annually at about 5.7 percent between 2002 and 2016.

Despite these valuable achievements, significant challenges remain. The poverty downward trend has stagnated in recent years and almost 8 million individuals still live in absolute poverty. In addition, Turkey has one of the highest relative poverty rates among OECD countries, with 17 percent of the population living below the relative poverty line.<sup>2</sup> Moreover, even though income inequality fell significantly in the 2000s, the trend was reversed after the global financial crisis. Income inequality, measured by the Gini coefficient, increased from 0.39 to 0.42 between 2009 and 2016. Fiscal policy could be instrumental to strengthen the link between growth and inclusion in order to achieve further social gains going forward.

This paper assesses the effectiveness of Turkey’s fiscal policy in reducing poverty and inequality, examines its comparative performance, and identifies the constraints faced by the fiscal package in promoting equity. In essence, the paper aims to answer the following four questions: (a) what is the overall impact of fiscal policy on inequality and poverty in Turkey? (b) how do individual taxes and transfers affect distributional outcomes? (c) how does Turkey compare with

> 1 Poverty is measured using the World Bank’s absolute poverty line for upper-middle-income-countries (UMIC), set at $5.50 per-person per-day in 2011 Purchasing Power Parity (PPP) (World Bank 2017). The data are publicly available in the Poverty and Equity Data Portal (World Bank 2018). Unlike other countries, Turkey’s Institute of Statistics (TUIK) does not publish a national poverty line using cost of food and non-food basic needs. It stopped doing so in 2009.

> 2 Measured as the share of people whose income falls below the OECD relative poverty line; taken as half the median household income of the total population (OECD 2018).

2
peer countries in terms of the distributional impact of its fiscal policy? and (d) how can the analysis be used to inform policy reform?

The approach of the paper is largely based on the Commitment to Equity (CEQ) methodology (Lustig 2018). As such, the paper builds a comprehensive incidence analysis by sequentially quantifying the poverty and inequality impact of direct and indirect taxes, noncontributory direct transfers, contributory pensions, and social spending on health and education.<sup>3</sup> To do so, we use the 2016 Household Budget Survey (HBS), and the 2016 Survey of Income and Living Conditions (SILC) collected by Turkey’s Institute of Statistics (TUIK), together with administrative information on transfers and taxes from Turkey’s Ministry of Treasury and Finance (MoTF). The data allow for relatively good coverage of fiscal interventions for this class of studies. The analysis covers about 46 percent of total revenues—including 74 percent of social contributions and 45 percent of tax revenue—and about 50 percent of government spending— including 87 percent of social spending.

The main findings of the paper are that: (a) fiscal policy significantly decreases inequality in Turkey, and (b) among low-income households the magnitude of targeted transfers does not fully mitigate the effect of taxes, resulting in net poverty increases. In driving these changes, social spending on education and health have the largest impact on inequality, complemented by direct taxes and direct transfers that counter the inequality-increasing impact of indirect taxes. Turkey’s relative performance, however, is below median compared to peer countries. In particular, Turkey’s indirect taxation is comparatively more inequality-and-poverty-increasing, while direct transfers and taxes are less inequality-and-poverty-decreasing than in the median upper-middleincome economy. From a forward-looking stand, the diagnostic identifies some potential entry points for policy change. The large-scale Minimum Subsistence Allowance program ( _AGI_ in Turkish) presents an opportunity if its design were more targeted to the poor and vulnerable, while keeping a neutral fiscal position. Overall, the paper offers a platform to simulate the distributional implications of a variety of policy changes and inform the policy debate among stakeholders. Finally, the analysis provides a building block for future policy research to dig deeper into the reasons that could explain Turkey’s performance relative to peers.

> 3 EUROMOD is another initiative that aims to comprehensively analyze taxes and transfers. However, since it is based on household income, it does not consider household spending and therefore does not estimate the impact of indirect taxes like VAT.

3
The paper makes three contributions to the literature. First, the paper analyzes the cumulative impact of the fiscal system as a whole on poverty and inequality in Turkey; in contrast to existing studies which have focused on specific fiscal interventions of Turkey’s system. In fact, the empirical literature on the distributional impact of fiscal interventions in Turkey is relatively scarce. On the tax side, Albayrak (2010) finds that indirect taxes increase income inequality using data from 2003. Albayrak (2011) compares the distributional impacts of tax policies implemented before and after the 2008 financial crisis, and finds that the decrease in Value Added Tax (VAT) and Special Consumption Tax (SCT) rates introduced after the crisis made indirect taxes more regressive. Cross-country studies show that the social security system in Turkey is the least redistributive among all OECD countries since the coverage of the population is lower (OECD, 2008). In addition, while the share of VAT is uniform across income groups in Turkey, excise taxes are regressive (OECD/Korea Institute of Public Finance, 2014).

On the spending side, although public spending on education, health and employment constitutes an important and increasing share of the national budget in Turkey, the articles assessing the redistributive effects of social spending are very few. Koç and Sarisoy (2010) show that social spending decreased poverty in Turkey between 2002 and 2008. Caner and Okten (2012) find that publicly financed higher education in Turkey is progressive since students from rich families select themselves into private universities while students from poor families enroll in public universities. OECD cross-country studies find that the distributional impact of overall cash transfers is very limited in Turkey, and that while the contributory pension system is progressive, its performance is below the OECD average (Causa and Hermansen 2019, Joumard et al, 2012).

The second contribution of the paper, building on the fact that the CEQ methodology has been applied in over 50 countries, is to benchmark Turkey’s performance with peer upper-middleincome economies, such as Argentina, Brazil, Chile, Croatia, Mexico, Poland, and the Russian Federation, and with the developed context of the United States.<sup>4</sup> Third and finally, the paper introduces some innovations to the methodology by incorporating tax avoidance in consumption taxes in a distributionally-sensitive form, and by constructing Fiscal Incidence Curves (FICs) to visualize the incidence of each fiscal intervention along the income distribution.<sup>5</sup>

> 4 A regularly updated list of countries can be found in www.commitmentoequity.org.

> 5 These curves are the analogous of the growth incidence curves that Ravallion and Chen (2003) introduced to assess the incidence of economic growth along the income distribution.

4
The next section summarizes the tax and transfer system in Turkey, while Section 3 covers the methodology. The data set used and the empirical approach implemented in Turkey are described in Section 4. Sections 5 and 6 present the main results, and Section 7 concludes. Annexes A and B include a more detailed empirical approach and results table, respectively.

# **2. Turkey’s Fiscal System**

# **_2.1. Tax System in Turkey_**

Turkey is not a federal country, thus most revenue collection takes place at the central level of government. In total, central government revenue (including social security contributions) amounts to 28.3 percent of gross domestic product (GDP), while local government revenue reaches 4.2 percent of GDP. The main source of revenue of the central government comes from indirect taxes (10.3 percent of GDP), followed by social security contributions (7.1 percent of GDP), and direct taxes (5.8 percent of GDP). The revenue structure of the central government is shown in more detail in Table 1.

# _Direct Taxes_

Direct taxes amount to about a fifth of total revenues, with personal income tax raising almost twothirds of proceeds among direct taxes. Turkey’s personal income tax (PIT) is levied on individual income from several sources. PIT consists of two main components; withholding tax (WHT) where the tax is paid at the source before the individual receives the gross amount of specific earnings, and PIT based on declaration (PITBD) where the individual is obliged to declare the annual earnings to the state.

The major share of the WHT is given by the payroll tax, which is paid by the employer to the state on behalf of the employee. The PIT on employee’s income adopts a progressive tax bracket scheme. The main features of this scheme are that: a) it does not include a zero-tax bracket, b) the lowest tax rate is 15 percent, and c) the highest marginal tax rate is 35 percent.<sup>6</sup> Taxes on interest income from bank accounts, private pension, rent and agricultural activity are also withheld, and the tax is paid directly to the government by the responsible entities. For

> 6 A detailed description of all direct taxes is included in the Annex.

5
those income sources, the WHT rates vary for each type of income but remain constant regardless of the amount of the earnings.

**Table 1. Central Government Budget Revenue, 2016**

|**Source**|Million<br>Turkish Lira<br>(TL)|Percent<br>of GDP|Share of<br>Government<br>Revenue|
|---|---|---|---|
|**Total Revenues (I+II+III)**|**738,585**|**28.3**|**100.0**|
|**I. Taxes**|**459,002**|**17.6**|**62.1**|
|**I.1) Taxes on Income, Profits and Capital Gains**|**139,574**|**5.4**|**18.9**|
|a) Corporate Tax|42,970|1.6|5.8|
|b) Personal Income Tax|96,605|3.7|13.1|
|Withholding Tax|89,752|3.4|12.2|
|Based on Declaration|4,522|0.2|0.6|
|Other|2,331|0.1|0.3|
|**I.2) Taxes on Property**|**10,606**|**0.4**|**1.4**|
|**I.3) Taxes on Goods and Services**|**268,165**|**10.3**|**36.3**|
|a) Domestic VAT + VAT on Imports|130,822|5.0|17.7|
|b) Special Consumption Tax|120,402|4.6|16.3|
|c) Gambling Tax|900|0.0|0.1|
|d) Special Communication Tax|4,976|0.2|0.7|
|e) Others|11,065|0.4|1.5|
|**I.4) Other Taxes**|**40,657**|**1.6**|**5.5**|
|**II. Social Security Contributions**|**184,446**|**7.1**|**25.0**|
|II.1) Retirement|122,963|4.7|16.6|
|II.2) Health|61,481|2.4|8.4|
|**III. Other Revenue* **|**95,138**|**3.6**|**12.9**|

Source: Ministry of Treasury and Finance.

*Other revenues include taxes on international trade and transactions, stamp duties, fees, government property income, grants and aids and special revenues, interest, shares and fines, capital revenues, collection from loans, revenue from special budget institutions and revenues from regularity and supervisory institutions.

Individuals are obliged by law to declare their income from different sources every year, and pay taxes accordingly. Any income that is taxed with WHT will be deducted from the total amount of taxes that should be paid. PITBD has a relatively complicated schedular structure whereby every individual is expected to calculate their taxes from different incomes and 6
combination of certain incomes. The following categories are distinctively considered for the purposes of calculating the taxable income of individuals in Turkey: 1) Business profits, 2) Agricultural profits, 3) Salaries and wages, 4) Income from independent personal services, 5) Income from immovable property and rights (rental income), 6) Income from capital investment, and 7) Other incomes and earnings.

Property taxes are paid according to the type of the property. The residence property tax is paid according to the value of the residence in the administrative records, rather than the actual market value of the property. The rate is 0.1 percent in rural areas and 0.2 percent in urban areas. The motor vehicle property tax is paid according to the characteristics of the vehicle (i.e., age, cylinder, power).

# _Social Security Contributions_

Social security contributions comprise a quarter of total revenues. In Turkey, employers and employees are obliged by law to pay social insurance contributions for health services, unemployment benefit, and retirement pensions. Contributions are paid directly from the salaries of formally employed workers. Overall, total contributions represent 32.5 percent of the gross salary. While formal employees are obliged to pay their contributions, self-employed or employees working in the informal sector can pay voluntary contributions. The informality rate in Turkey amounts to 32.7 percent of workers.<sup>7</sup>

# _Indirect Taxes_

Indirect taxes are the main tax collection channel in Turkey, raising 36 percent of total revenue. Among them, VAT on domestic and imported goods is the largest revenue source, amounting to almost half of indirect tax revenue. The VAT rate in Turkey is 18 percent, but some items have reduced tax rates. For instance, food and beverages are subject to 8 percent VAT, while bread purchases pay only 1 percent.

The second largest indirect tax is the special consumption tax (SCT). Certain products that are considered to be harmful to the health of the population, create pollution or are considered

> 7  Measured as the share of persons working without social security in their main job (TUIK Labor Force Statistics, December 2016).

7
luxury items are taxed under the SCT. Those include alcoholic beverages, tobacco products, energy products, motor vehicles and luxury items.

Finally, certain taxes are collected according to household consumption of specific services. Households pay 1-5 percent of their electricity use and 3 percent of their water consumption as taxes to the state. Those taxes aim to generate funds for some specific state activities. For instance, environment and cleaning tax is collected as a share of the water consumption and aims to provide cleaning services for each municipality. Finally, taxes are also collected from gambling and from communication expenditure.

# **_2.2. Social Spending in Turkey_**

Overall government budget expenditures in Turkey amounted to 30.9 percent of GDP in 2016. Social spending, the largest allocation, made up around 58 percent of total expenditures and almost 18 percent of GDP. Within social expenditures, contributory benefits and spending on education and health absorb the majority of resources, with almost 8 percent of GDP allocated to each of them. Non-contributory transfers are contained to 1.2 percent GDP. Table 2 presents Turkey’s public spending details across categories.

# _Non-contributory Transfers_

There are 40 social assistance programs or schemes in Turkey, focusing on supporting access to 5 critical needs: basic income, housing, food, education, and health. Income-support transfers to direct beneficiaries are the most common modality to support vulnerable populations. These include in-kind household transfers of food and coal; conditional cash transfers (CCT) to promote children’s access to education and health; and cash transfers to widow women, elderly, disabled, and home-based caretakers of elderly and disabled.

Another important feature of Turkey’s social assistance system is that it is highly targeted based on socio-economic vulnerability. Compared to other countries, Turkey stands out in this regard. The proportion of social assistance spending on targeted programs is significantly higher than the average high- or middle-income country. While targeted programs make up about 60 percent of the budget in upper-middle settings, they make up about 96 percent in Turkey (Cuevas _et al_ 2019).

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**Table 2. Central Government Expenditure, 2016**

|**Source**|Million<br>Turkish Lira<br>(TL)|Percent of<br>GDP|Share of<br>Government<br>Expenditure|
|---|---|---|---|
|**Central Government Expenditure (A+B)**|**805,205**|**30.9**|**100**|
|**A) Social Spending (I+II+III+IV+V)**|**465,434**|**17.8**|**57.8**|
|**I. Non-contributory Benefits**|**32,007**|**1.2**|**4.0**|
|Old-Age Benefit|1,580|0.1|0.2|
|Family Benefit|3,253|0.1|0.4|
|Disability Benefit|3,182|0.1|0.4|
|Home Care Benefit|5,039|0.2|0.6|
|Scholarship Benefit|2,357|0.1|0.3|
|Near Cash Benefit|5,387|0.2|0.7|
|Health Premium Fee Waiver|7,003|0.3|0.9|
|Widow Transfer for Women|810|0.0|0.1|
|Birth Support|512|0.0|0.1|
|Others|2,884|0.1|0.4|
|**II. Contributory Benefit**|**205,691**|**7.9**|**25.5**|
|Disability Transfers|3,128|0.1|0.4|
|Unemployment Transfers|3,713|0.1|0.5|
|Retirement Pension|160,372|6.1|19.9|
|Widow and Orphan Pension|38,478|1.5|4.8|
|**III. Agricultural Support**|**3,244**|**0.1**|**0.4**|
|**IV. Minimum Subsistence Allowance (AGI)**|**23,864**|**0.9**|**3.0**|
|**V. In-kind Transfers**|**200,628**|**7.7**|**24.9**|
|Education|106,616|4.1|13.2|
|Health|94,012|3.6|11.7|
|**B) Other Spending* **|**339,771 **|**13.0**|**42.2 **|

Source: Ministry of Treasury and Finance.

*Other Spending includes: General public services, defense, public order and safety, economic affairs, environmental protection, housing and community amenity, recreation, culture and religious services, and social security and aid.

_Contributory Benefits_ 9
The system of pensions (retirement, widow, orphan, and disability), health insurance, work injury, non-pension disability benefits, and unemployment benefits constitute Turkey’s traditional model of social security. They are all linked to employment in the formal sector and are financed by employer and employee contributions. The widow and orphan pensions correspond to survivors’ benefits when relatives receive the retirement pension of the deceased person.

Retirement pensions amount to 6.2 percent of GDP and a fifth of total spending, and this increases to a quarter when adding in widow and orphan pensions. Contributory disability and unemployment benefits constitute a very small share of the overall contributory pension system, under 1 percent of total spending.

Finally, an important program within Turkey’s system is the Minimum Subsistence Allowance (AGI), with a budget almost as high as the social assistance transfers. The AGI program is the exclusion of tax for formal employees who are over 16 years of age, with the size of the benefit depending on marital status and the number of children, but not on level of income. AGI functions as a tax allowance by subtracting the amount of the entitled transfer from the payroll tax paid by the employee. The AGI is paid to the employee by the employer on behalf of the state and deducted from the employer's income tax. We treat AGI as a transfer instead of a tax allowance in the analysis.

# **3. Methodology**

To study the distributional impact of fiscal policy in Turkey, we use the CEQ methodology (Lustig 2018). The CEQ is a comprehensive incidence analysis that uses data from household surveys and national accounts to assess the impact of taxes and public transfers on household poverty and inequality. The approach has been applied in over 70 countries, which allows to benchmark Turkey’s performance with relevant peer countries.<sup>8</sup> The method is based on an accounting approach; it adds and subtracts taxes and transfers to household per capita income to measure income _before_ and _after_ each fiscal intervention. The per capita household income after transfers and taxes _Yh_ for household _h_ is given by

> 8 CEQ analysis has been completed in a total of 55 countries. In addition, 19 countries have a CEQ study ongoing. Source: www.commitmentoequity.org accessed January 30, 2020.

10
<!-- Start of picture text --> Market Income<br>Wages and salaries, income from capital,<br>private transfers; before government<br>T f taxes, social security contributions and<br>ransfers transfers. Taxes<br>+ - Personal income taxes and<br>Direct transfers employee contributions to<br>social security<br>Disposable Income<br>+ -<br>Indirect subsidies Indirect taxes<br>Consumable Income<br>In-kind transfers (free or + -<br>subsidized government<br>: : : Co-payments, user fees<br>services in education and<br>health)<br><!-- End of picture text -->
There is no consensus in the literature on how to treat contributory pensions and the corresponding contributions. Two treatments are usually given: [i] consider contributory pensions as individual deferred income (and the corresponding contributions as savings), or [ii] consider contributory benefits as transfers (and the corresponding contributions as taxes). Both treatments have their merits and reality, in the context of Turkey, is somewhere in between. The pension benefit level that each retiree receives has a positive relationship with the contributions made while working, but there are also government subsidies depending on the case. Therefore, following the CEQ approach, we present results under two scenarios. In the base scenario, we treat pensions as deferred income and the corresponding contributions as savings. In this scenario, contributory pensions are considered part of _Market Income_ . In a second scenario, contributory pensions are considered transfers and the corresponding contributions as taxes. Under this scenario, pensions are added (and contributions substracted) to _Market Income_ to generate _Disposable Income_ .

Relative to standard incidence analysis, the CEQ methodology’s main strength is to provide a framework to analyze not only the individual impact of different taxes and transfers, but also their overall combined impact on poverty and inequality. As such, the CEQ is a tool that enables the generation of evidence on both the ‘small picture’ (the impact of a specific fiscal intervention), and the ‘big picture’ of overall taxes and spending for policy research. Moreover, once the overall system has been estimated, it offers a platform to simulate policy changes, assess their distributional implications, and contribute an equity lens to policy discussions about fiscal reform.

At the same time, the CEQ shares certain limitations with standard incidence analysis. Among these caveats are: (a) it is a partial equilibrium analysis: it does not model behavioral responses, lifecycle and spillover effects; (b) it does not consider externalities, for instance longterm increases in national productivity that arises from higher investment in education; (c) the approach assumes that indirect taxes and contributions are borne entirely by the income earner, and indirect taxes are borne entirely by the consumer; (d) the methodology cannot analyze all taxes and spending, and interventions such as corporate profit taxes, corporate subsidies, infrastructure investment (e.g., water projects) are left out; and (e) the approach does not consider the quality of public services provided.

All in all, the CEQ is a first-order approximation to the impact of taxes and social spending on poverty and inequality, but the most comprehensive methodology to do so up-to-date.

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# **4. Data and Empirical Approach**

# _Data_

We use multiple sources of data to assess the distributional impact of fiscal policy in Turkey. The main source of information is the 2016 Household Budget Survey (HBS) collected by the Turkish Statistical Institute (TUIK). The HBS is a nationally representative household survey that collects detailed information on consumption (302 expenditure items in total), labor income, social assistance, pensions, remittances, financial income, assets, housing characteristics, accessibility to labor and financial market, health services, education opportunities, and individual characteristics such as education, health, and labor market status and experience. The survey has been collected on an annual basis since 2002. We use the 2016 round, which was the latest available HBS round at the start of the study. That year, the survey interviewed 12,092 households, encompassing 42,605 individuals.<sup>9</sup> In addition, we use the Survey of Income and Living Conditions (SILC), collected by TUIK to monitor living standards following a methodology consistent with the European Union (EU) SILC initiative. The survey aims to provide comparable data on income distribution, living conditions, access to services, material deprivations, and relative poverty. Although it does not collect data on consumption, one of the main advantages of SILC is that its sampling design allows to conduct analysis representative at subnational NUTS2 level (26 regions). We use the 2016 round, which includes 22,441 households, to allocate in-kind benefits in education across households while taking into account regional differences in spending and personnel. Annex A includes a detailed explanation of the approach.

Third, we use IPSOS Consumption Expenditure Panel, a nationally representative survey that collects detailed information on household purchases (food and beverages, cleaning products, personal care, and other products), their channel of purchase, and socio-economic status of the household. We use this data set to account for informality in consumption, by identifying the share of purchases that are made without invoice and avoid paying VAT. This allows to consider VAT evasion in a distributionally-sensitive form and represents an innovative element of the paper relative to the standard CEQ approach.

> 9 Since 2014, HBS as well as other surveys conducted by TUIK cannot produce urban/rural disaggregations, due to changes introduced in administrative divisions throughout the country.

13
These micro-data sets are complemented by administrative data on transfers and taxes from the Ministry of Treasury and Finance (MoTF), as well as the Turkish tax code and laws to understand the design features of each specific fiscal intervention.

# _Empirical Approach_

There are largely three steps involved in the empirical approach of a CEQ. First, assess the coverage of the study. Second, measure taxes and transfers in the survey. Third, construct poverty and inequality measures for distributional analysis. While these are all important steps on its own, the second step is, by far, the most complex and labor-intensive component of the exercise.

_Step 1_ : The first step in the approach is to examine the HBS questionnaire, assess what information is being collected about the interaction of the household with the economy and its different markets, evaluate how questions are asked, and inventory which fiscal interventions can be plausibly studied. This determines the coverage of the study.

As a result, it was assessed that the following taxes and transfers can be analyzed using the HBS questionnaire, and subsequently captured in the study:

- _Direct taxes:_ Payroll Income Tax, Personal Income Tax, (including Agricultural Income Tax, Rent Income Tax from Workplace, Interest Income Tax, Private Pension Income Tax(Individual Retirement System Income Tax)), Motor Vehicle Tax, and Residence Property Tax.

- _Indirect taxes_ : VAT and Special Consumption Taxes.

- _Direct transfers:_ Total Direct Transfers, Old Age Transfer, Family Transfers, Disability Benefit, Home Care Benefit, Health Premium Fee Waiver, Disability Contributory Benefit, Scholarship Transfers, Unemployment Transfers, Near Cash Transfers, Sickness Transfer, Agricultural Support Transfer, and AGI.

- _In-kind transfers_ : health and education services.

_Step 2:_ The second step in the approach is to measure taxes and transfers for households in the HBS. Using laws, codes, program rules, plausible assumptions, and household survey responses we calculate how much each household is paying in taxes, and how much is receiving in transfers. For some interventions, the task is more straightforward, such as when the survey has a specific question to ask if a household is a beneficiary of a certain transfer program. Other interventions 14
are more intricate to treat and need further elaboration and assumptions. All details of the country’s taxes and transfers system, and how they are identified and assigned to households using the data sources described above, are presented in the methodological Annex A.

One methodological contribution we make to the approach is to treat VAT non-compliance in a distributionally-sensitive manner. Incidence studies typically treat VAT as if all households pay the statutory rates in their purchases, or as if they contribute an effective VAT rate calculated from national accounts. In the former case, households are assumed to fully comply with VAT in all their purchases. In the latter, the full compliance assumption is lifted, but all households are assumed to pay the same rate, regardless of their socio-economic background. The majority of CEQ studies fit the latter case, treating VAT evasion as uniformly distributed.

In developing countries, however, where the informal economy is more prevalent, VAT compliance is a function of consumer behavior and purchase channel, and this varies across the household income distribution. Lower income households tend to make a larger share of their purchases in informal outlets without invoice. Using this observation, we depart from previous studies and lift the assumption of uniformly distributed non-compliance.

To do that, we use data from the IPSOS consumption survey to estimate the share of purchases made in places that normally do not invoice (like open bazaars) by each socio-economic segment of the population. We then apply these shares of no-VAT purchases to adjust the calculation of VAT in the purchases declared by each socio-economic segment in the HBS. As expected, the share of purchases in places like open bazaars is higher among lower-income households than higher-income households. This small tweak in the methodology matters from a distributional viewpoint.<sup>10</sup> After calculating taxes and transfers for all households, we aggregate them and compare the aggregates to the public administrative records. Table 3 below present the results of the comparison. We find that HBS does a relatively good job in capturing the magnitudes of fiscal interventions. Overall, HBS captures 46 percent of total government revenue (as presented in Table 1), including 74 percent of social contributions and 50 percent of direct and indirect tax revenue; and about 50 percent of government spending (as shown in Table 2), including 87 percent of social spending.

**Table 3. Fiscal Interventions in the HBS: Amounts and Comparison with Administrative Records**

> 10 The approach is described in more detail in Annex A.

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**a. Government Revenue**

||Amount in HBS,<br>million TL|Ratio HBS /<br>Administrative data, %|
|---|---|---|
|**Total Revenue (I+II+III)**|**342,692**|**46.4**|
|**I. Tax**|**207,057**|**45.1**|
|**1.Taxes on Income, Profits and Capital Gains**|**69,272**|**49.6**|
|a) Corporate Tax|0|0.0|
|b) Personal Income Tax|69,272|71.7|
|Withholding Tax|65,627|85.2|
|Based on Declaration|3,644|100.0|
|Other|0|0.0|
|**2. Taxes on Property**|**5,259**|**49.6**|
|**3. Taxes on Goods and Services**|**132,526**|**49.4**|
|a) Domestic VAT + VAT on Imports|76,149|58.2|
|b) Special Consumption Tax|52,767|43.8|
|c) Gambling Tax|64|7.2|
|d) Special Communication Tax|3,545|71.2|
|e) Others|0|0.0|
|**4. Other Taxes**|0|0.0|
|**II. Social Contributions**|**135,635**|**73.5**|
|**III. Other Revenue**|0|0.0|

# **b. Government Spending**

||Amount in HBS,<br>million TL|Ratio HBS /<br>Administrative data, %|
|---|---|---|
|**A) Social Spending (I+II+III+IV+V)**|**396,319**|**86.9**|
|**I. Non-contributory Benefits**|**15,507**|**48.4**|
|Old Age Benefit|1,475|93.4|
|Family Benefit|1,133|34.8|
|Disability Benefit|1,518|47.7|
|Home Care Benefit|3,035|60.2|
|Scholarship Benefit|717|30.4|
|Near Cash Benefit|1,288|23.9|
|Health Premium fee waiver|4,957|70.8|
|Widow Transfer for Women|819|101.1|
|Birth Support|565|110.2|
|Others|0|0.0|
|**II. Contributory Benefit**|**160,552**|**78.1**|
|Disability Transfer|1,540|49.2|
|Unemployment Transfers|1,891|50.9|
|Sickness Transfers|882||
|Retirement Pension|126,551|78.9|
|Widow and Orphan pension|29,688|77.2|
|**III. Agricultural Support**|**2,999**|**92.5**|
|**IV. Minimum Subsistence Allowance (AGI)**|**16,632**|**69.7**|
|**V. In-kind transfers**|**200,628**|**100.0**|
|Education|106,616|100.0|
|Health|94,012|100.0|
|**B) Other Spending**|0|0.0|

Source: authors’ calculations.

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_Step 3:_ Poverty and inequality outcomes are measured as follows. The poverty headcount ratio is measured as the proportion of individuals with a household per capita income below the poverty line. We use the upper-middle-income-country (UMIC) poverty line, which is calculated globally by the World Bank and takes the value of $5.50 per-person per-day in 2011 Purchasing Power Parity (PPP).<sup>11</sup> The headcount ratio is complemented by the poverty gap index, which measures how far below individuals are from the poverty line, as a proportion of the line. Finally, inequality is measured using the Gini coefficient, with 0 representing perfect equality, and 1 representing perfect inequality. Since the Gini is more sensitive to changes in the middle of the distribution, we use the 90/10 ratio as complementary measure. This ratio compares the income of the 90<sup>th</sup> percentile to the income of the 10<sup>th</sup> percentile.

Finally, taking advantage of the global scale of the CEQ initiative, the findings are benchmarked to international comparators. To choose comparators relevant to Turkey, we used the following criteria: a) the country is (at least) upper-middle-income, and b) a CEQ study has been produced in the last 5 years. As a result, we benchmark Turkey’s performance in comparison to the following eight countries: Argentina, Brazil, Chile, Mexico, Croatia, Poland, Russia, and the United States.

# **5. Overall Impact of Taxes and Spending on Poverty and Inequality**

# **_5.1 Impact on Income Inequality_**

The overall system of taxes and spending in Turkey leads to a significant reduction in income inequality. Figure 2 shows the overall impacts on the Gini coefficient and the 90/10 ratio following the income concepts described in Figure 1. The country achieves a reduction in Gini of about 0.07, down from 0.44, in the base scenario when old-age contributory pensions are treated as deferred income. The reduction is around 0.11 when those pensions are considered as transfers. Before any fiscal intervention, Market Income Gini is 0.48 (0.44 if pensions are added). The Disposable Income Gini drops to 0.42 once direct taxes and direct transfers are considered. Indirect taxes have a slight unequalizing effect, making the Gini coefficient of Consumable Income increase to 0.44. Of all the fiscal tools, in-kind benefits in education and health have the largest impact on inequality; the Gini coefficient of Final Income drops to 0.38.

> 11 Turkey’s National Institute of Statistics (TUIK) does not calculate a national poverty line based on local cost of food and non-food basic needs. It stopped doing so in 2009.

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The 90/10 ratio displays a similar trend. Before fiscal interventions, high-income households (90<sup>th</sup> percentile of the distribution) have an income that is 8.1 times higher than lowincome households (10<sup>th</sup> percentile) when pensions are treated as deferred income (and almost when pensions are treated as transfers). The 90/10 ratio drops to 5 after all fiscal interventions.

**Figure 2. Inequality before and after fiscal policy in Turkey, 2016**

**a. Gini Coefficient**

<!-- Start of picture text --> Old-age pensions as transfers Old-age pensions as deferred income<br>0.50<br>0.48 0.485<br>0.46<br>0.444<br>0.437<br>0.44<br>0.42<br>0.419<br>0.40<br>0.378<br>0.38<br>0.36<br>0.34<br>Market Income (M.I.) Disposable Income Consumable Income Final Income<br><!-- End of picture text -->

# **b. 90/10 ratio**

<!-- Start of picture text --> Old-age pensions as transfers Old-age pensions as deferred income<br>14<br>12<br>9.9<br>10<br>8 7.6<br>8.1<br>6 6.8<br>5.0<br>4<br>2<br>0<br>Market Income (M.I.) Disposable Income Consumable Income Final Income<br><!-- End of picture text --> 18
Source: Own estimates based on Turkey 2016 HBS. Note: The figure shows the Gini coefficient for each income concept described in Figure 1. M.I. refers to before and after fiscal interventions, Disposable income refers to after direct taxes and transfers, Consumable Income refers to after indirect taxes and Final Income refers to after in-kind (education and health) transfers.

Figure 3 presents the overall impact of fiscal policy on inequality in peer countries to benchmark Turkey’s performance. For comparability, in all cases the baseline scenario considers market income plus pensions as starting point, treating old-age pensions as deferred income. Qualitatively speaking, income inequality falls in all countries after taxes and transfers, which implies that there is fiscal redistribution in all these economies. The differences are in the magnitudes. The highest absolute decrease in the Gini is observed in Argentina, at 0.18 Gini points, and the smallest drop is found in Russia, at 0.06. Among peer countries, Turkey shows a below median performance, close to Mexico and just ahead of Chile and Russia. The differential performance with comparator countries is driven by the inequality-increasing impacts of indirect taxes, first, and the relatively moderate inequality-decreasing impacts of direct transfers and taxes, second.

**Figure 3. Gini coefficient before and after fiscal policy in Turkey and peer countries**

<!-- Start of picture text --> Market Income plus Pensions (M.I. P.) Disposable Income<br>Consumable Income Final Income<br>0.6<br>0.5<br>0.4<br>0.3<br>0.2<br>0.1<br>0.0<br>Argentina Brazil Chile (2013) Mexico Croatia Poland Russia USA Turkey<br>(2012) (2009) (2014) (2014) (2014) (2014) (2016) (2016)<br><!-- End of picture text --> Source: Argentina (Rossignolo 2017); Brazil (Higgins and Pereira 2017); Chile (Martinez-Aguilar et al. 2016); Croatia (Inchauste and Rubil 2015); Mexico (Scott et al. 2018); Poland (Goraus and Inchauste 2016); Russia (Popova et al. 2018); US (Higgins et al. 2016). Turkey: Own estimates based on Turkey 2016 HBS. Note: The figure shows the Gini coefficient for each income concept described in Figure 1.

# **_5.2 Impact on Poverty_**

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The overall impact of taxes and transfers on poverty is positive. In the base scenario, when pensions are considered as deferred income, the bulk of taxes and direct transfers increase poverty from 11.1 to 16.4 percent. When pensions are treated as transfers, the impact is significantly muted, from 16 to 16.4 percent. Figure 4 shows the impact on the poverty rate (panel a) and the poverty gap (panel b) following the income concepts described in Figure 1.<sup>12</sup>

**Figure 4. Poverty rate and Poverty gap before and after fiscal policy in Turkey, 2016**

# a. Poverty rate

<!-- Start of picture text --> Old-age pensions as transfers Old-age pensions as deferred income<br>19<br>17 16.4<br>16.0<br>15<br>13<br>11.1<br>11<br>10.3<br>9<br>7<br>5<br>Market Income (M.I.) Disposable Income Consumable Income<br>b. Poverty gap<br><!-- End of picture text --> 12 Since conceptually it is not sound to include the value of the government’s social spending on health and education in the household income aggregate for poverty measurement, we do not present the poverty rates for Final Income.

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<!-- Start of picture text --> 7<br>Old-age pensions as transfers Old-age pensions as deferred income<br>6<br>5.8<br>5.3<br>5<br>4<br>3.5<br>3<br>2.7<br>2<br>1<br>0<br>Market Income (M.I.) Disposable Income Consumable Income<br>Poverty gap (%)<br><!-- End of picture text --> Source: Own estimates based on Turkey 2016 HBS. Note: The figure shows the poverty rate and the poverty gap for income concepts described in Figure 1.

The combined impact of direct taxes and direct transfers reduces the incidence of poverty. The poverty headcount ratio decreases from 11.1 to 10.3 percent, when pensions are treated as deferred income. Similarly, the poverty gap is strongly reduced by the combined action of direct taxes and transfers.

Indirect taxes, however, lead to substantial increases in poverty. While all individuals are affected by indirect taxes along the income distribution, the less well-off suffer a relatively higher impact (as shown in the inequality results of Figure 3). As such, poverty rises by more than 5 percentage points from Disposable to Consumable income. The poverty gap increases by almost 50 percent, from 2.7 to 5.3 percent.

In comparative terms, the overall impact of taxes and transfers on poverty in Turkey and peer countries is mixed (Figure 5). Poverty decreases in 4 countries, increases in 4 others, and stays constant in one of them. A common pattern across countries is that indirect taxes are poverty increasing, since low-income households allocate all their income to consumption. Turkey’s relative performance is below-median, driven by the relatively stronger poverty-increasing impact of indirect taxes, and the comparatively smaller poverty-decreasing impact of transfers and direct taxes. While the poverty rate for Consumable income is higher than for Disposable income in all upper-middle-income countries with available data, the magnitude of the increase in Turkey is among the highest of the lot.

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For a better understanding of the changes in inequality and poverty presented so far, the final result we present in this section looks at the incidence of fiscal interventions across deciles of the distribution, as a share of market income plus pensions. Results are shown in Figure 6. The strong progressive profile of the education and health transfers, with benefits relatively more concentrated in the bottom deciles, explain the sharp reduction obtained in the Gini of Final income. In addition, these in-kind transfers lift the impact of fiscal policy in the bottom of the distribution. If we consider only in-cash transfers, we observe that they are not sufficient to offset the burden of taxes across all deciles of the distribution. But once in-kind transfers kick in, they have a boosting effect on the final position of low-income households, making them net receivers of fiscal resources. From decile 4 and above, households are net payers to the fiscal authority.

**Figure 5. Poverty rate before and after fiscal policy in Turkey and peer countries**

<!-- Start of picture text --> Market Income (M.I.) Disposable Income Consumable Income<br>35<br>30<br>25<br>20<br>15<br>10<br>5<br>0<br>Argentina Brazil Chile (2013) Mexico Croatia Poland Russia USA (2016) Turkey<br>(2012) (2009) (2014) (2014) (2014) (2014) (2016)<br><!-- End of picture text --> Source: Argentina (Rossignolo 2017); Brazil (Higgins and Pereira 2017); Chile (Martinez-Aguilar et al. 2016); Croatia (Inchauste and Rubil 2015); Mexico (Scott et al. 2018); Poland (Goraus and Inchauste 2016); Russia (Popova et al. 2018). Turkey: Own estimates based on Turkey 2016 HBS. Note: Argentina, Brazil, Chile, Mexico, and Russia are based on a $4/day poverty line in 2005 PPP. Croatia and Poland are based on $5/day poverty line in 2005 PPP. Turkey is based on 5.5/day poverty line in 2011 PPP. The figure shows the poverty rate for each income concept described in Figure 1.

**Figure 6. Distribution of taxes and transfers across income deciles in Turkey, 2016**

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<!-- Start of picture text --> 150 Health<br>Education<br>All direct transfers<br>Non-pension contributions<br>100 All indirect taxes<br>All direct taxes<br>Net cash position (excluding health and education spending)<br>Total<br>50<br>0<br>-50<br>Poorest 2 3 4 5 6 7 8 9 Richest<br><!-- End of picture text --> Source: Own estimates based on Turkey 2016 HBS. Note: The figure shows each fiscal intervention as a share of Market income plus pensions, by decile of Market income plus pensions. The figure also shows the net cash position of each household as the difference between the cash transfers received and the taxes paid (excluding inkind transfers in health and education).

# **6. Individual Contributions of Taxes and Spending to Poverty and Inequality Reduction**

The section unpacks the aggregate results presented in the previous section, and analyzes the separate contribution of each fiscal intervention to poverty and inequality. Interventions are analyzed in terms of their progressivity and marginal contribution to poverty and inequality.

To measure progressivity we follow the standard practice and use the Kakwani index (Kakwani 1977). A tax (benefit) is progressive whenever its burden (entitlement) rises (decreases) with income. In the case of transfers, the index is defined as the difference between the Gini coefficient of Market income plus pensions (when pensions are treated as deferred income) and the concentration coefficient of the transfers. While for each tax the Kakwani index is calculated as the difference between the concentration coefficient of the tax and the Gini coefficient of Market income plus pensions. A Kakwani index for taxes will be positive (negative) if a tax is globally progressive (regressive), while a Kakwani index for transfers is positive if a transfer is progressive in relative terms.

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To analyze if a tax or transfer is equalizing, we use the marginal contribution of taxes and transfers to income inequality measured by the Gini coefficient.<sup>13</sup> The marginal contribution measures the marginal reduction in inequality due to a tax or a transfer, and is the difference between the Gini coefficient without the particular fiscal intervention and the Gini coefficient of all income components together.<sup>14</sup> The intervention is equalizing whenever the marginal contribution is positive. By comparing the marginal contribution and the Kakwani index we can determine whether a fiscal intervention is equalizing (unequalizing) despite being regressive (progressive).

# **_6.1 Direct Taxes and Transfers and Their Effects on Inequality_**

The Fiscal Incidence Curve of Disposable Income shows how direct taxes and transfers impact different deciles of the income distribution (Figure 7). The first decile is a net receiver, the direct transfers they receive are higher than the direct taxes they pay. All other deciles are net payers. For the poorest decile, these taxes and transfers represent an income increase of 18 percent, while for the richest decile these bring about an income decrease of 25 percent.

**Figure 7. Fiscal Incidence Curve of Direct Taxes and Transfers**

<!-- Start of picture text --> 20<br>15<br>10<br>5<br>0<br>-5<br>-10<br>-15<br>-20<br>-25<br>-30<br>Poorest 2 3 4 5 6 7 8 9 Richest<br>Deciles of Market Income plus Pensions<br>share in per capita income (%)<br><!-- End of picture text --> 13 If there was a single fiscal intervention in the system, then the Kakwani index would be sufficient to determine whether that intervention is unambiguously equalizing. However, this is no longer the case when there is more than one intervention. As Lambert (2001) shows, a tax or transfer can reduce (increase) inequality despite being regressive (progressive).

14 Since there is path dependency, the sum of the marginal contributions of each intervention is not equal to the total change in inequality (Enami, Lustig, and Aranda 2017).

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Source: Own estimates based on Turkey 2016 HBS. Note: changes calculated from Market income plus pensions to Disposable income.

Panel (a) of Figure 8 shows the Kakwani coefficient and the marginal contribution to inequality of all direct taxes in Turkey in 2016. In general, direct taxes are progressive; the Kakwani coefficient for most of the direct taxes is positive. They are also broadly inequalityreducing as shown by a positive marginal contribution to the Gini coefficient. However, there is substantial heterogeneity across tax categories. For instance, payroll income tax is progressive and the most inequality-reducing, while agricultural income tax is regressive and does not contribute to reduce inequality.

Relative to its peers, the equalizing effect of direct taxes in Turkey is similar to Chile, Poland and Mexico, but lower than Russia, Croatia and the United States (panel (b) of Figure 8). Most countries’ direct taxation is more progressive than Turkey’s. It is also the case that, with the exception of Mexico and Croatia, all peer countries collect more direct taxes than Turkey, as a share of GDP.<sup>15</sup>

**Figure 8. Progressivity and redistributive impact of direct taxes**

# **a. Direct taxes in Turkey, 2016**

<!-- Start of picture text --> 0.5 Kakwani Coefficient Marginal Contribution 0.020<br>0.015<br>0.3 0.010<br>0.005<br>0.0 0.000<br>-0.005<br>-0.3 -0.010<br>EQUALITY<br>KAKWANI INDEX<br>(CHANGE IN GINI POINTS)<br>MARGINAL CONTRIBUTION TO<br>REGRESSIVE <-------------> PROGRESSIVE (property) Payrol Inc. Tax All direct taxes contributions<br>Agricultural Inc. Tax Private Pension Inc. Tax Residence Prop. Tax Bank Profit Inc. Tax Rent Tax Inc. from Store Personal Inc. Tax Motor Vehicles Tax All Contributions (SSI) All direct taxes and<br><!-- End of picture text -->

**b. Direct taxes in selected countries (excluding contributions)**

> 15 Revenue from direct taxes in percent of GDP: Turkey 5.8, Chile 6.6 Poland 6.3 Mexico 5.1 Brazil 9.5 Russia 9.1 Croatia 5.4 Argentina 8.4. Source: CEQ Data Center on Fiscal Redistribution.

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Source: Argentina (Rossignolo 2017); Brazil (Higgins and Pereira 2017); Chile (Martinez-Aguilar et al. 2016); Croatia (Inchauste and Rubil 2015); Mexico (Scott 2013); Poland (Goraus and Inchauste 2016); Russia (Popova et al. 2018); US (Higgins et al. 2018). Turkey: Own estimates based on Turkey 2016 HBS. Note: Marginal contribution to equality is the difference between the Gini coefficient without the particular fiscal intervention and the Gini coefficient of all income components together. There is no marginal contribution calculated for Argentina. USA results are preliminary.

**Figure 9. Progressivity and redistributive effect of transfers in Turkey, 2016**

**a. Direct transfers in Turkey, 2016**

<!-- Start of picture text --> AGI<br>Agricultural... Disability... Unemployment... Widow transfer...<br>Scholarship Transfers Birth support for... Sickness Transfers Near Cash Transfers Disability Benefit Family Transfers Old Age Transfers Home Care Benefit All direct transfers... All direct transfers...<br><!-- End of picture text -->

- **b. Direct transfers in selected countries (excluding contributory)**

26
Source: Argentina (Rossignolo 2017); Brazil (Higgins and Pereira 2017); Chile (Martinez-Aguilar et al. 2016); Croatia (Inchauste and Rubil 2015); Mexico (Scott 2013); Poland (Goraus and Inchauste 2016); Russia (Popova et al. 2018); US (Higgins et al. 2018). Turkey: Own estimates based on Turkey 2016 HBS. Note: Marginal contribution to equality is the difference between the Gini coefficient without the particular fiscal intervention and the Gini coefficient of all income components together. There is no marginal contribution calculated for Argentina and Brazil. USA results are preliminary.

With regards to transfers, all exhibit a progressive pattern; Kakwani coefficients are all positive (Figure 9). These transfers are also inequality-reducing as most of the marginal contributions are also positive, but there is marked heterogeneity across them. Social assistance transfers are strongly progressive, given their poverty-targeted design, though taken individually their marginal impacts look relatively small, given their limited benefit levels. Despite having low progressivity, the AGI program has the largest distributional impact among all programs, since it channels a relatively large budget.

From a policy perspective, the AGI offers an interesting entry point to consider. It has a budget that is almost two-thirds of the budget of all social assistance transfers, and has a design with good space for improvement in terms progressivity. Reforming AGI towards a design more targeted to low-income households could be a policy option to explore to improve the equalizing impact of the fiscal system in Turkey. For example, an alternative design could consider introducing a ceiling around the minimum wage for eligibility to receive AGI. This would generate savings from the current AGI budget, that could then be allocated to: i) increase the amount that 27
AGI gives to low wage earners, and/or ii) increase benefit levels in targeted social transfers to provide more adequate support to existing beneficiaries.

In comparison to its peers, Turkey is below the median. Overall, the progressivity and inequality reducing nature of social transfers is relatively lower than in comparator countries (panel (b) of Figure 9). Turkey’s transfers show a better equalizing performance than Chile’s and Mexico’s, but are less equalizing than in the rest of the countries. However, Turkey allocates a smaller budget to social transfers than most of its peers, as a share of GDP.<sup>16</sup>

# **_6.2 Indirect Taxes and Their Effect on Inequality_**

The Fiscal Incidence Curve of Consumable Income shows how indirect taxes affect incomes across different deciles of the distribution (Figure 10). The negative incidence of these taxes is higher for lower income households. For the poorest decile, these taxes represent an income decrease of 22 percent, while for the richest decile these bring about an income decrease of 11 percent.

**Figure 10. Fiscal Incidence Curve of Indirect Taxes**

<!-- Start of picture text --> 0<br>-5<br>-10<br>-15<br>-20<br>-25<br>Poorest 2 3 4 5 6 7 8 9 Richest<br>Deciles of Market Income plus Pensions<br>share in per capita income (%)<br><!-- End of picture text --> Source: Own estimates based on Turkey 2016 HBS. Note: changes calculated from Market income plus pensions to Disposable income.

16 Spending in social transfers (non-contributory) in percent of GDP: Turkey 1.2 Chile 1.6 Mexico 1.0 Russia 5.3 Brazil 5.4 Argentina 5.8. Source: CEQ Data Center on Fiscal Redistribution.

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All indirect taxes combined lead to an increase in inequality, as presented in Figure 2. Panel (a) of Figure 11 presents the Kakwani coefficient and the marginal contribution to inequality of each indirect tax taken separately. We find that most indirect taxes are regressive, as shown by a negative Kakwani coefficient. Moreover, nearly all indirect taxes contribute to higher inequality, that is their marginal contribution to the Gini coefficient is negative. There is, however, substantial heterogeneity between taxes. Taxes on alcohol and tobacco, and food and beverages are the most regressive, and, in particular, the SCT on alcohol and tobacco has the largest unequalizing effect. The VAT on motor vehicles is slightly progressive but unequalizing.

The unequalizing effect of indirect taxes on income distribution in Turkey is significantly higher than in nearly all peer countries (panel (b) of Figure 11), even though Turkey’s indirect tax burden is not particularly high. Turkey ranks in the median in terms of revenues collected through indirect taxation, as a share of GDP.<sup>17</sup> Turkey’s indirect taxes are not among the most regressive either. On the one hand there are countries with a more regressive but less burdensome (less revenue) combination of indirect taxes than Turkey, like Russia, and on the other hand there are countries with a less regressive but more burdensome mix, like Brazil. In both cases, however, indirect taxes are less unequalizing than in Turkey.

# **Figure 11. Progressivity and redistributive impact of indirect taxes**

# **a. Indirect taxes in Turkey, 2016**

> 17 Revenue from indirect taxes, in percent of GDP: Turkey 10.3 Croatia 17.0 Poland 10.8 Russia 7.7 Brazil 14.5 Chile 9.8 Mexico 4.4 Argentina 15.3. Source: CEQ Data Center on Fiscal Redistribution.

29
<!-- Start of picture text --> 0.30 0.025<br>Kakwani Coefficient Marginal Contribution<br>0.20<br>0.015<br>0.10<br>0.005<br>0.00<br>-0.005<br>-0.10<br>-0.015<br>-0.20<br>-0.30 -0.025<br>b. Indirect taxes in selected countries<br>0.05 Kakwani Index Marginal Contribution 0.015<br>0.00<br>0.005<br>-0.05<br>-0.005<br>-0.10<br>-0.015<br>-0.15<br>-0.025<br>-0.20<br>-0.25 -0.035<br>KAKWANI INDEX<br>(CHANGE IN GINI POINTS)<br>REGRESSIVE <-------------> PROGRESSIVE MARGINAL CONTRIBUTION TO EQUITY<br>All indirect taxes VAT on durables VAT on clothing VAT on individual... Petroluem excise on... SCT on durables VAT on education<br>SCT on alcohol and tobacco VAT on energy products VAT on motor vehicles VAT on alcohol and tobacco SCT on energy products SCT on motor vehicles Other Indirect Taxes VAT on food and beverages VAT on communication... SCT on communication... SCT on sports and hobbies VAT on medical products VAT on sports and hobbies VAT on entertainment and...<br>KAKWANI INDEX<br>TO EQUITY<br>(CHANGE IN GINI POINTS)<br>REGRESSIVE <-----> PROGRESSIVE MARGINAL CONTRIBUTION<br>Croatia (2014) Poland (2014) USA (2016) Russia (2014) Brazil (2009) Chile (2013) Mexico (2010) Argentina (2012) Turkey (2016)<br><!-- End of picture text --> Source: Argentina (Rossignolo 2017); Brazil (Higgins and Pereira 2017); Chile (Martinez-Aguilar et al. 2016); Croatia (Inchauste and Rubil 2015); Mexico (Scott 2013); Poland (Goraus and Inchauste 2016); Russia (Popova et al. 2018); US (Higgins et al. 2018). Turkey: Own estimates based on Turkey 2016 HBS. Note: Marginal contribution to equality is the difference between the Gini coefficient without the particular fiscal intervention and the Gini coefficient of all income components together. There is no marginal contribution calculated for Argentina. USA results are preliminary.

# **_6.3 Taxes and Transfers and Their Effects on Poverty_**

Panels (a) and (b) of Figure 12 show the increase in poverty due to each direct and indirect tax, respectively. These results vary widely depending on the taxes considered. On the direct tax side, the payroll income tax has the highest poverty-increasing effect, raising the share of poor by about 30
one percentage point. Private pensions income tax, interest income tax, rent tax income from workplace, and personal income tax leave poverty unchanged since they mainly affect those who are better-off, distant from the poverty line.

Indirect taxes lead to higher overall increases in poverty than direct taxes. Among them, the SCT on alcohol and tobacco, which was found to be the most unequalizing indirect tax (panel b of Figure 11), increases poverty by about two percentage points. Others, like VAT on education does not affect poverty because it is a tax paid by those that enroll their children in private education, which have incomes far enough from the poverty line.

With regards to direct transfers, they reduce the poverty headcount ratio by 3 percentage points when old-age contributory pensions are treated as deferred income. Their impact rises to about ten percentage points when old-age contributory pensions are treated as transfers (Figure 13). In any case, the program with the strongest impact on poverty is the AGI, reducing the headcount by 0.6 percentage points. The individual impact of each of the social transfers is relatively small—even though they are targeted to low-income households, they all have budgets that are far lower than AGI’s. As mentioned before, if AGI adopted a more targeted approach, the distributional impacts of fiscal policy could be improved.

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# **Figure 12. Marginal contribution of taxes to poverty**

# **a. Direct taxes in Turkey, 2016**

> Private Pension Income Tax 0.0

> Bank Profit Income Tax 0.0

> Rent Tax Income from Store 0.0

> Personal Income Tax 0.0

> Motor Vehicles Tax 0.1

> Residence Property Tax 0.1

> Agricultural Income Tax 0.1

> Cont (SSI) unemployment worker 0.2

> Cont (SSI) retirement pension short employer 0.2

> Cont (SSI) unemployment employer 0.2

> Cont (SSI) health worker 0.6

> Cont (SSI) health employer 0.7

> Cont (SSI) retirement pension worker 0.7

> Cont (SSI) retirement pension employer 0.8

> Payrol Income Tax 0.9

> All contributions 1.3

> All direct taxes 1.7

> All direct taxes and contributions 2.2 0.0 0.5 1.0 1.5 2.0 2.5 Increase in poverty rate, percentage points

# **b. Indirect taxes in Turkey, 2016**

> VAT on education 0.0

> SCT on sports and hobbies 0.0

> VAT on medical products 0.0

> SCT on durables 0.1

> SCT on communication products 0.1

> VAT on sports and hobbies 0.1

> Petroluem excise on transportation 0.1

> VAT on entertainment and vacation 0.1

> VAT on clothing 0.2

> VAT on communication products 0.3

> VAT on food and beverages 0.3

> SCT on motor vehicles 0.4

> VAT on durables 0.4

> Other Indirect Taxes 0.4

> VAT on individual expenditures 0.4

> VAT on alcohol and tobacco 0.5

> VAT on motor vehicles 0.6

> SCT on energy products 0.7

> VAT on energy products 0.7

> SCT on alcohol and tobacco 2.1

> All indirect taxes 6.2 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 Increase in poverty rate, percentage points

Source: Own estimates based on Turkey 2016 HBS. Note: Marginal contribution to poverty is the difference between the poverty rate without the particular fiscal intervention and the poverty rate of all income components together.

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**Figure 13. Marginal contribution of direct transfers to poverty reduction, 2016**

<!-- Start of picture text -->
-0.01 Birth support for newborn<br>-0.07 Home Care Benefit<br>-0.07 Scholarship Transfers<br>-0.10 Sickness Transfers<br>-0.12 Unemployment Transfers<br>-0.13 Disability Contributory Benefit<br>-0.14 Agricultural Support Transfers<br>-0.17 Family Transfers<br>-0.23 Disability Benefit<br>-0.26 Near Cash Transfers<br>-0.38 Widow transfer social assistance<br>-0.42 Old Age Transfers<br>-0.62 MSAAGI<br>-2.95 All direct transfers excl contributory pension<br>-6.49 All contributory pensions<br>-9.83 All direct transfers incl contributory pensions<br>-12.0 -10.0 -8.0 -6.0 -4.0 -2.0 0.0<br>Change in poverty rate, percentage points<br><!-- End of picture text -->

Source: Own estimates based on Turkey 2016 HBS. Note: Marginal contribution to poverty is the difference between the poverty rate without the particular fiscal intervention and the poverty rate of all income components together.

# **7. Conclusions**

This paper contributes the most comprehensive analysis of the poverty and inequality impacts of fiscal policy in Turkey to date, by considering both the combined and individual incidence of direct and indirect taxes and social spending. While fiscal interventions can be pivotal instruments in the policy toolkit to foster inclusive growth, an integrated analysis of the distributional implications of fiscal policy was missing.

The paper finds that Turkey’s overall tax and social spending policy significantly reduces income inequality in the population. The observed inequality-reducing impact is driven primarily by the strong equalizing effect of social spending on education and health. Direct taxes and transfer schemes are also equalizing and help mitigate the inequality-increasing impact of indirect taxes. In contrast, with regards to poverty, the system of direct transfers and direct taxes cannot counterweight the poverty-increasing impact of indirect taxes, and therefore net increases are observed in poverty indicators.

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In comparative terms, relative to other upper-middle-income countries where similar studies have been conducted, Turkey shows a below median performance in the distributive impact of taxes and transfers. The differential performance with comparator countries is explained by, first, Turkey’s larger inequality-increasing effect of indirect taxes, and, second, Turkey’s relatively moderate inequality-decreasing impacts of direct transfers and taxes. Turkey’s indirect taxation, however, is not particularly burdensome relative to its peers, as share of GDP; but most peer countries collect more direct taxes and spend more on social transfers than Turkey, relative to their GDPs.

In addition to providing a comprehensive diagnostic of the distributional impacts of the existing system of taxes and transfers, the paper offers a platform to simulate the potential impacts of changes to the existing system. A forward-looking use of the platform to contribute to policy discussions would be to think beyond the current architecture of taxes and transfers and consider changes in their design to identify marginal improvements in the distributional incidence of fiscal policy. Simulations would be limited by lack of behavioral change considerations and the partial equilibrium approach, but they would be useful to obtain first-order estimates of the distributional impacts of these changes.

One such entry point could be to consider changes to the Minimum Subsistence Allowance (AGI) program, either by making it more progressive, or by reallocating some of its resources to the poverty-targeted social transfers. Given AGI’s relatively large budget, these changes bear promising potential to bring about marginal improvements in the poverty and inequality impacts of fiscal policy.

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