One of the most important goals of government policy is to address inequalities in the distribution of income and to try to improve the welfare of the poor. An important part of the theory and practice of public finance is dedicated to conceptualizing and measuring how the revenue and expenditure sides of government budgets affect the distribution of income among households. This is known as tax and expenditure incidence, or in short, fiscal incidence. This body of research allows us to understand how government policies change the distribution of income, how equitable these changes may be, and, in particular, how government policies actually help the poor.
Establishing the incidence of taxes is important because who actually bears the burden of taxes is generally quite different from those legally liable to make payment to the tax authorities. Establishing the incidence of government expenditures is important because not all expenditures benefit households of different income levels to the same extent. Even those government expenditures intended to benefit low income households may not do so because poor targeting or difficulties exist for the poor to have access to the public services. In short, the impact of government budgets on the distribution of income and the status of the poor is not immediate and general impressions regarding what the impact may be can be quite mistaken.
Incidence analysis is not only important but also, if done correctly, complex and difficult. Incidence analysis contains a blend of positive and normative issues. Asking the question of who benefits from and who pays for government services is eminently a positive question. However, judging the adequacy, desirability or rightness of these results is a normative question. Normative values are likely to differ, sometimes quite significantly across individuals, so we should not expect to always find consensus on the desirable degree of redistribution. Nevertheless, it would be a mistake to shy away from distributional and equity issues because they cannot be scientific. The distributional impact of government policy is in the core of what policy makers and ordinary citizens expect economists to do.
Ultimately, tax and benefit incidence analysis is an effective tool to review whether government tax policies and expenditure programs have the desired impact on income distribution and on the poor. Major tax reforms and large government expenditure programs are routinely undertaken in many countries with specific redistributional objectives, including lifting tax burdens borne by lower income groups and directly helping the poor. For example, understanding the incidence of expenditures on education and health vis-a-vis the poor is important because improved health and education status have been shown to be the most effective means of escaping poverty. Tax policy and public expenditures, especially the latter, are potentially powerful tools to combat poverty. Thus, an important question is whether government tax and expenditure policies have the intended effects. This is what benefit incidence analysis does.
Working Paper Number 01-10.