A Poverty-Focused
Evaluation of Commodity
Tax Options
B. Essama-Nssah
World Bank Poverty Reduction
Group
April 2007
Introduction

Context

Poverty Reduction:
A fundamental objective of development (MDGs)
 Need to design policies and assess effectiveness
in terms of this objective.
Importance of Commodity Taxation
 Difficult for developing countries to collect direct
taxes on individuals and firms, hence reliance on
indirect taxes on goods and services.




One key reason: Sizable informal sector
Developing countries derive about 40% of tax revenue
from indirect taxes and about 25% from income tax
(Keen and Simone 2004)
2

Purpose


Demonstrate identification of socially desirable options
for commodity taxation in the context of a poverty
reduction strategy.
General Approach

Embed the concept of price elasticity of poverty within
the logic of social impact evaluation

Social Impact Evaluation: assessment of variations in
individual and social welfare attributable to a shock or
policy. This entails:



Identification of individual outcomes.
Aggregation of these outcomes into a social outcome on the
basis of value judgments underlying members of the additively
separable class of poverty measures (e.g. FGT, Watts).
Ranking based on the distributional characteristic of each
commodity.
3

Specification


Focal policy problem
 Reform of an indirect tax system to maintain or increase
yield, reduce distortions and minimize burden on the
poor.
 Presentation focuses on the latter.
Maintained hypothesis


Observed poverty in a given society depends on individual
endowments and behavior , and the socio-political
arrangements that govern social interaction.
Consequential evaluation

Identification of desirable changes from status quo
based on the computation of consequences of the policy
reform and use of explicit value judgments to assess
such consequences.
4

Focus of the presentation:

Evaluation Framework
 Individual Outcomes





Welfare Impact
Poverty Implications
Aggregation

Additively Separable Poverty Measures

Price Elasticity of Real Income

Price Elasticity of Poverty
Ranking Social Outcomes

Benchmark

Decision Rule
Empirical Illustration
 A Poverty Profile for South Africa
 Distributional Characteristic of Household Spending
5
Evaluation Framework

Individual Outcomes

Welfare Impact
 Need to link policy instruments to determinants of
individual living standard.


Commodity taxes affect the prices at which such
commodities are sold.
Represent individual welfare by indirect utility: maximum
attainable level of utility attainable given an exogenous
budget, x, and prevailing prices, p.
v( x, p)  max [u(q); p  q  x]

q
This envelope function summarizes optimal behavior by
consumer.
6

Welfare Impact ,


continued
Marginal change in the price of commodity k
induces adjustment in optimal behavior.
Invoke envelope theorem in the form of Roy’s
identity to compute welfare impact as (Deaton and
Muellbauer 1980).


d*(x,p) = – qk(x,p)dpk , where *(x,p) stands for
indirect utility normalized by the marginal utility of
income.
Measure of welfare loss (in monetary terms) induced by a
marginal increase in the price of commodity k.
7

Poverty Implications

Measure of individual poverty (Kakwani 1990)


Let (x|z) be that measure (x is same as above and z is
poverty line)
Assume: (1) indicator is zero when x greater or equal
poverty line; (2) a decreasing convex function of x,
given z. Hence first-order derivative with respect to x
is negative.
 ( x | z ) 
 ( x | z )
 0.
x
8

Poverty Implications, continued

Linking changes in individual welfare and poverty




Observed demand function is a consequence of
optimal behavior (Envelope theorem)
Duality between expenditure function and indirect
utility implies x is the minimum expenditure
required to attain *(x,p).
Loss in real income associated with tax increase on
k is: dx=– qk(x,p)dpk
Poverty impact
 ( x | z )
  ( x | z )q k
p k
9

Aggregation

Additively Separable Poverty Measures
z
    ( x | z ) f ( x)dx
0


Aggregate impact of price change
z

   q k ( x | z ) f ( x)dx
0
p k
Price elasticity of real income
pk qk
x pk
 
 wk (x)
pk x
x

Price elasticity of poverty
1 z
 k ( )    xwk ( x) ( x | z ) f ( x)dx
 0
10

Ranking Social Outcomes

Benchmark



An increase (reduction) in price of commodity k (possibly
induced by a tax reform) is pro-poor if it leads to an absolute
increase (reduction) in poverty smaller (greater) than it would
in a benchmark case.
Chosen benchmark: situation of equal relative impact i.e. a one
percent change in price of k would have the same relative
impact on real income x.
If everybody assigned same proportion of real income, wok, to
the purchase of k.
w0 k


mx
0
xwk ( x) f ( x)dx

mx
0
xf ( x)dx
11

Benchmark, continued

Benchmark price elasticity of poverty
w0k
 0k ( )  



z
 x ( x | z) f ( x)dx
0
A one percent increase in the price of commodity
k would increase poverty by k under the
observed budget shares, and by 0k in the
hypothetical case.
Whether the change is pro-poor depends on which
term dominates.
12

Decision Rule


Based on a comparison of the poverty impact given the
observed distribution of budget shares and the
hypothetical impact
Choice between ratio or additive comparison



Focus on ratio comparison
Normalize budget shares
 k ( x) 
Ratio measure of pro-poorness is a weighted average of
normalized budget shares among the poor (i.e. along the
distribution of real income up to the poverty line)
k

( ) 
z
0
x k ( x) ( x | z ) f ( x)dx

z
0

wk ( x)
w0 k
x ( x | z ) f ( x)dx
Price increase would hurt the poor less than the non-poor if
this indicator less than one.
13

Decision Rule, continued


Indicators associated with some members of
the additively separable class of poverty
measures.
Headcount
wk ( z )
 k (H ) 
 k ( z)
w0 k

Watts
1
 k (W ) 
H

FGT
 k (  ) 

z
0
z

0
k
( x) f ( x)dx
 1
x x 
1    k ( x) f ( x)dx
z z 

z
0
x x 
1  
z z 
 1
f ( x)dx
14
Empirical Results

A Poverty Profile for South Africa

Data

2000 Income and Expenditure Survey (IES)



[Statistics South Africa]
Sample size: 26, 214 households (Nationally
representative)
Poverty line: About US $1.00 per day, or Rand
2,533 per person per year.
15

Poverty Profile, continued

Poverty Estimates

Incidence: about 37 percent. 5 provinces out of 9 have rates
higher than national average.
A Poverty Profile for South Africa (2000)
Western Cape
Eastern Cape
Northern Cape
Free State
Kwazulu Natal
Northwest
Gauteng
Mpumalanga
Northern Province-Limpopo
South Africa
Headcount
11.00
57.02
35.49
44.52
46.85
38.60
17.20
35.98
55.92
37.29
Poverty Gap
3.22
24.95
14.00
19.00
19.76
16.51
5.86
12.84
23.17
15.22
Squared Poverty Gap
1.44
14.03
7.34
10.54
10.86
9.31
2.84
6.30
12.53
8.23
Watts
4.12
39.10
21.12
29.75
30.29
24.96
8.51
18.85
35.75
23.24
Source: Author’s cal calculations (results in percentage)
16

Poverty Profile,

continued
TIP Representation

TIP stands for “three i’s of poverty”, namely: incidence,
intensity and inequality among the poor.



Construction: (1) rank individuals from poorest to richest; (2)
form the cumulative sum of poverty gaps divided by population
size; (3) plot cumulative sum of poverty gaps as a function
cumulative population share (Jenkins and Lambert 1997).
Interpretation
 Length of non-horizontal section reveals poverty incidence.
 Intensity is represented by height of the curve
 Concavity of non-horizontal section translates degree of
inequality among the poor.
Usefulness: An alternative way to test for unanimous poverty
comparisons across time, across regions and across countries
based on a wide class of poverty meaures.
17
A Normalized TIP Curve for South Africa (2000)
16
Cumulative Poverty G aps
14
12
10
8
6
4
2
0
0
10
20
30
40
50
60
70
80
90
100
Cumulative Percentage of Population
18

Distributional Characteristic of Household Spending

Recall Decision Rule
 Commodities for which the ratio measure of propoorness is greater than ones are those with higher
budget shares for low-income households.



Hence deserve special consideration, ceteris paribus, in policy
design and evaluation.
Data from the 2000 Income and Expenditure Survey
reveal:
 Food
 Tobacco
 Clothing
 Personal Care
 Fuel
Health and education expenditures are distributed in
favor of the non-poor. Given their importance for
human development, they too merit special treatment in
the context of a poverty reduction strategy.
19
Distributional Characteristic of Expenditure Components in South Africa
(2000)
Headcount Poverty Gap Squared Poverty Gap Watts
Food
Health
Education
Non Alcoholic Beverages
Alcoholic Beverages
Tobacco
Clothing
Personal Care
Housing
Furniture
House Operation
Fuel
Transport
Communication
Reading
Entertainment
Miscellaneous
2.90
0.10
0.27
0.00
0.00
NA
3.33
1.81
0.53
1.98
0.48
5.02
0.13
0.07
0.00
0.00
0.09
2.29
0.22
0.75
1.01
0.90
1.13
1.40
1.61
1.07
0.62
0.84
4.59
0.31
0.32
0.18
0.21
0.22
2.35
0.21
0.80
0.87
0.77
1.06
1.33
1.59
1.10
0.49
0.87
4.78
0.28
0.28
0.18
0.20
0.19
2.32
0.21
0.81
0.90
0.82
1.11
1.35
1.60
1.08
0.53
0.87
4.78
0.30
0.29
0.19
0.21
0.20
Source: Author’s calculations
20
Conclusion




Poverty reduction has become a benchmark measure of
performance for development interventions.
Many developing countries rely heavily on indirect taxes on
goods and non-factor services to finance such interventions.
A rigorous application of the logic of social evaluation
confirms the basic intuition that, ceteris paribus, progressive
public policy should protect commodities with higher budget
shares for low-income households.
Application to data for South Africa identified food,
tobacco, clothing, housing, and fuel.
 Health effects of tobacco should be taken into consideration
 Even though expenditure on health and education is
distributed in favor of the non-poor their importance for
human capital development means that public policies should
aim at making these services affordable by the poor.
21
References






Bibi Sami and Duclos Jean-Yves. 2007. Poverty-Decreasing Indirect Tax
Reforms: Evidence from Tunisia. International Tax and Public Finance, Vol.
14, No.2:165-190.
Essama-Nssah, B. (2007). A Poverty-Focus Evaluation of Commodity Tax
Options. Forthcoming, Journal of International Development.
Essama-Nssah, B. and Lambert P.J. (2006). Measuring the Pro-Poorness of
Income Growth within an Elasticity Framework. World Bank Policy Working
Paper No. 4035 (October). Washington D.C. The World Bank.
Jenkins, S. and Lambert, Peter J. 1997. Three ‘I’s of Poverty Curves, with
Analysis of UK Poverty Trends. Oxford Economic Papers, 49: 317-327.
Son, Hyun H. 2006. Assessing the “Pro-Poorness” of Government Fiscal
Policy in Thailand. Public Finance Review, Vol. 34, No.4: 427-449.
____________ and Kakwani, Nanak. 2006. Measuring the Impact of Price
Changes on Poverty. Working Paper No. 33, International Poverty Centre,
Brazil.
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End.
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