Transfer Progressivity and Development

With micro panel data from 32 countries including the poorest and the richest in the world we document (i) a negative relationship between the ability to insure consumption against income shocks and economic development and (ii) a negative relationship between the level of transfer progressivity and the stage of economic development. Importantly, our computation of transfer progressivity includes both public and private net transfers across households—e.g. food transfers. Using an overlapping generations model in which agents differ in permanent productivity, face income shocks and accumulate physical and human capital through learning-by-doing (a labor choice), we find that cross-country differences in transfer progressivity go a long way in explaining the larger ability to insure consumption in poor countries than in rich countries. Then, we use our model to assess the role of transfer progressivity in explaining income per capita differences across countries. We find that decreasing progressivity of poor countries to the levels of rich countries increases income per capita of poor countries by 62%. The opposite experiment, using the progressivity of poor countries on rich countries, reduces income per capita of rich countries by 30%. Since a decrease in transfer progressivity increases the incentives to work and accumulate (physical and human capital) while, at the same time, it reduces social insurance and redistribution, a reduction in progressivity is not necessarily welfare improving. For this reason, we also compute the optimal of transfer progressivity for rich and poor countries separately. We find that optimal progressivity is actually similar (for different reasons) across stages of development which implies that the status quo transfer progressivity for poor (rich) countries is too high (low). Reducing the progressivity of poor countries to optimal levels increases the GDP per capita of the poor by 46% and increases their welfare by 14% in consumption equivalent terms.