Efficiency Before Equity: Navigating the Equity-Efficiency Trade-Off in Developing Countries
The equity-efficiency trade-off captures the tension between policies that increase output and those that reduce inequality. Equity-oriented policies—such as expanding transfer payments or improving the provision of public services—often rely on increased taxation of wealthier individuals and corporations. This can discourage consumption and investment, thereby reducing output. Efficiency-oriented policies, on the other hand, often increase output at the expense of equity.
Demand-side fiscal policy—the use of government spending and taxes to influence overall economic activity—is almost always governed by this trade-off. In theory, governments can shift along the trade-off according to their unique economic objectives, favouring one side over the other. In practice, a government’s ability to shift depends upon the country’s level of development. In particular, developing countries face two key structural challenges: narrow tax bases and high vulnerability to capital flight, where firms and individuals move assets abroad in response to higher taxes. These factors severely limit the efficacy of equity-oriented policies. Consequently, developing countries ought to prioritise efficiency-oriented policies until public finances and the domestic economy are robust enough to withstand redistributive policies.
Theory
Crucially, a country’s current approach does not reveal its optimal point upon the equity-efficiency trade-off, as existing policy is likely determined by a range of non-economic factors, such as political will or perceived diminishing marginal returns (for example, an already prosperous country may value a small increase in equity over a larger increase in efficiency). This means that a country’s current position does not necessarily reflect an efficient allocation of resources or a maximisation of welfare.
A country’s best balance between equity and efficiency is therefore defined by its unique characteristics. Policymakers should design fiscal policies aimed at equity and efficiency based on factors influencing their likelihood of success, while also minimising any negative impact on the other goal. This differs from such policies being guided by the country’s current performances in both equity and efficiency, or by non-economic or cyclical factors. While these underlying characteristics impact both equity and efficiency measures, their effects are felt more greatly when governments pursue redistribution, where any underlying fiscal constraints are more easily exposed. As a result, the structural factors that determine a country’s optimal position upon the trade-off are best understood within the context of equity-oriented policies.
Two central structural factors influence the effectiveness of equity-oriented policies: how easily the government can raise tax revenue, and how strongly taxpayers respond to higher rates. The first factor is dictated by the size of the country’s tax base – a wider tax base allows governments to fund expanded redistributive policies. The second factor depends on the behavioural responses of corporations and high-income individuals. If these agents respond to increased rates by relocating assets or scaling back operations, the loss in efficiency (and output) is amplified. Consequently, fiscal capacity and capital mobility are central to understanding how effectively equity-oriented policies can be implemented in any country.
Structural Constraint #1 – Fiscal Capacity
Assessing these structural factors within developing countries reveals the inapplicability of an equity-oriented approach. First, developing countries often have narrow tax bases and large informal sectors, limiting the ability of governments to fund spending. In addition, efforts to raise funds through borrowing are unlikely to fare better, as many developing countries suffer from low credit ratings and are vulnerable to debt spirals.
The difference in the sizes of tax bases between developed and developing countries is stark, even in relative terms; countries within the OECD – an international body of prosperous nations – collect 33.9% of GDP in tax revenues on average, compared to 18.9% in Middle-Income Countries (MICs) and 13.5% in Low-Income Countries (LICs). Moreover, IMF research finds that higher GDP per capita boosts tax capacity, while tax effort – tax revenues as a fraction of tax capacity – is 0.65 in LICs, compared to 0.76 in HICs. These findings demonstrate that low tax revenues in developing countries are caused both by low capacity and by poor administration and collection techniques.
Indonesia provides a clear illustration of how a narrow tax base can limit the implementation of equity-oriented policies. Its tax-GDP ratio is just 11.6% (below the MIC average), while its low debt-GDP ratio of 41% indicates a greater reliance on tax revenues to fund spending (as opposed to borrowing). As a result, total expenditure on social protection is just 3.7% of GDP, well below the 12% MIC average. Additionally, just 54% of the population is covered by at least one social protection benefit, the lowest of all MICs and High-Income Countries (HICs) in Asia excluding Malaysia.
Structural Constraint #2 – Capital Mobility
Developing countries are highly vulnerable to capital flight, which further reduces efficiency and output when equity-oriented policies are implemented. This is because firms and wealthy individuals are incentivised to relocate capital when tax rates rise in developing countries, as the underlying reasons to remain are already limited – factors such as a small domestic market, shallow labour pool and poor infrastructure all dissuade capital retention. This can be understood in terms of elasticity – capital is far more tax-elastic in LICs, leading to greater capital flight when rates rise. By contrast, capital is tax-inelastic in HICs, as the wider economic benefits offered by such countries outweigh small rises in tax rates, discouraging capital flight.
Cross-country evidence supports this point. A study assessing global fiscal policy across several decades found that rising corporate tax receipts as a share of total tax revenue reduced GDP per capita amongst LICs, but raised it in HICs. Specifically, a 1% increase in corporate tax revenue as a share of total tax revenue led to a 0.7% fall in GDP per capita in LICs, but a 0.5% increase in HICs. Moreover, this study only considers one direction of capital movement, failing to account for the impact of increases in corporate tax rates on foreign direct investment (FDI). Thus, the actual negative impact of corporate tax increases on output in LICs is likely more pronounced than the study suggests.
This pattern is also evident in specific cases. For example, increases in corporate taxation were ‘a very significant determinant of capital flight from Bangladesh’ in the final decades of the 20th century, as the share of corporate taxes in total revenue increased from 4% in 1973 to 13% in 1999, outpacing the rate of increase of total tax revenues, which rose from 18% of GDP in 1973 to 24% in 1999. The rate of capital flight generally accelerated as corporate tax rates rose, implying that disproportionate increases in corporation tax receipts contributed significantly to capital outflows in the period.
This is reinforced by a study of regional output growth in Indonesia from 2006-2015, which found that increases in tax effort reduced output, supporting the idea that increased taxation dampens growth by encouraging capital flight and discouraging FDI. The study also found that the marginal impact of current spending – government spending on goods and services – on output was negative when tax effort was high. For this to occur, output must be responding to incentives rather than the fiscal balance, since the net fiscal impact on output is zero (as the given change in spending is funded by tax receipts). This highlights the role of capital flight: even when the fiscal balance has no impact on output, high tax effort can cause capital outflows and deter FDI, reducing output.
Counterarguments
It is undoubtedly the case that certain equity-based policies can improve efficiency, particularly in the long run. For example, investment in education and healthcare can improve labour productivity and human capital, boosting potential economic growth. While these outcomes are desirable, the implementation of the policies themselves remains problematic, as their funding still encourages capital flight. Moreover, because developing countries have narrow tax bases, their fiscal packages tend to be small. This means that any long-term increases in efficiency delivered by certain equity-based policies will likely be offset by short-term falls in output caused by capital flight. As previously outlined, Indonesia is a clear example of this – its low tax-GDP ratio has limited the size of the government’s social protection packages, restricting the long-term efficiency boost that such packages could deliver.
Some may also argue that the narrow tax bases of developing countries limit the effectiveness of fiscal policy on both sides of the trade-off, not just for equity-oriented policies. While this is true, efficiency-oriented policies generally widen the tax base over time. Investments in areas such as infrastructure or research and development fuel supply-side growth, increasing the number and scale of tax payers, and in turn, boosting government revenue. This is particularly relevant for developing countries, where the scope for productive capacity expansion is larger. In this sense, while a narrow tax base limits all types of fiscal policy, efficiency-oriented policies seek to gradually alleviate this constraint.
Moreover, raising equity almost always necessitates the use of fiscal policy. By contrast, it is often more feasible to increase efficiency without relying on fiscal tools, notably through deregulation or labour market reform. Thus, it is easier for developing countries to circumvent their limited fiscal capacities to achieve efficiency rather than equity.
Final Thoughts
Ultimately, the equity-efficiency trade-off is not a matter of political will, nor of economic objectives, but one of structural feasibility. By definition, developing countries face narrow tax bases and highly elastic capital, both of which limit the application and effectiveness of redistributive policies. This conclusion does not imply a long-term normative preference for either side of the trade-off; rather, it underscores the importance of sequencing. Achieving fiscal stability and a resilient domestic economy are necessary conditions for redistribution to succeed. Until these prerequisites are realised, developing countries ought to pursue efficiency-oriented policies, as they are more effective than redistribution under such constraints, and help establish the very conditions under which equity-oriented policies can succeed. Thus, equity is only truly attainable once the foundations required to uphold it have been developed.