Egypt’s economic paradox: Income equality v wealth inequality

By Osama Diab

Despite having one of the world's highest levels of income equality, Egypt's wealth gap is growing to become one of the widest. What is behind this paradox?

Wednesday 8 June 2016

From the global Occupy movement to Egyptian revolutionaries' calls for “bread, freedom and social justice,” inequality has been a rallying point for social movements and a talking point for political players across the ideological spectrum.

In Egypt, where luxury hotels and upscale neighborhoods abut sprawling informal settlements, inequality is out in the open, bringing with it the constant potential for social unrest. Yet despite this glaring inequity, the disparity in Egyptians incomes is statistically low and the gap has narrowed since the turn of the millennium, as measured by the Gini coefficient. The answer to this puzzle — how can a country in which people have relatively equal incomes have such a marked difference in wealth? — lies mostly in government policy, or lack thereof.

Even in a completely tax-free setting, wealth gaps will grow at a larger rate than income gaps because rich people have an easier time saving and accumulating wealth, and because return on capital (the wealthy people's income) is larger than growth in Gross National Income (the total incomes of everyone in a certain economy). But tax records show that Egypt's extremely regressive taxation system exaggerates this trend.

Egypt performs quite well in measures of income equality. According to estimates by economists Facundo Alvaredo and Thomas Piketty, the top 10% of earners in Egypt account for roughly 30-35% of total income. This is less than the roughly 36% of income earned by the top decile of earners in Western Europe, 48% in the United States or 53.6% in South Africa.

The Gini coefficient — a method for calculating income distribution on a scale where 0 represents absolute equality and 100 absolute inequality — largely confirms this. In 2000, Egypt scored 32.76 on the Gini Index. In 2005, the figure improved to 32.14.  By 2008, Egypt improved to 30.77 on the index. By this measure, Egypt is again one of the most income-equal countries in the world. According to the World Bank, in 2000, the US Gini index was 41.1, Spain was 35.8 and Germany was 30.6.

The Gini coefficient is based on household surveys, a dataset with many shortcomings — among them the facts that well-off groups tend to underestimate their wealth, and survey takers usually lack access to people at the very top of the wealth and income pyramids. However, Piketty and Alvaredo made an effort to correct this distortion, and their results still confirmed Egypt's relative income equality.

Regardless of the reliability of such data, the fact remains that wealth gaps are always wider than income gaps everywhere, and therefore are better as an indicator of social and economic inequality.

In the right environment and in the absence of just tax policy, even small differences in income can quickly spiral into massive disparities in wealth — and Egypt appears to be such an environment.

Imagine two people whose monthly incomes are LE1,000 (Person A) and LE2,000 (Person B), both starting with no accumulated wealth. They both need LE800 per month to meet minimum basic living expenses. On average, Person A spends LE900 a month and saves LE100. Person B, who has a larger income, spends LE1,200 and saves LE800. After four months, Person B would have a wealth of LE3,200 and Person A only LE400. Person B's income is still only twice that of Person A's, but her wealth is now eight times as much.

The gap would widen further if Person B now invests her money as capital and get a 20% return on it, whereas Person A could only hope for a slight raise from her employer. The idea that return on capital (a source of income that is virtually restricted to the wealthy) is larger than GDP growth (the growth in everyone's income) was popularised by Piketty's famous r>g formula, and means that the gap between top and low income groups will keep widening unless there is an active policy intervention.

If we look at wealth inequality, we find out that in 2000, the richest 10% of Egyptians held 61% of total wealth, despite earning just 28.3% of income. In 2007, their share of wealth shot up to 65.3%, although their share of income dropped in 2008 to 25.57%. The top decile's share of wealth in 2014 rose even more to 73.3%, according to Credit Suisse's Global Wealth Report. This means Egypt has one of the biggest wealth gaps in the world, despite its relative income equality.

Since the turn of the millennium, according to available household survey data, we have simultaneously seen a sharp rise in wealth inequality and a narrowing income equality gap.

Taxing explanations

Although the data is imperfect and incomplete, given both the lack of transparency in tax records and the high degree of informality in Egypt's economy, there are indications that from 2001 to 2014, the Egyptian government's policies and failures led to the shifting of tax burdens toward those with lower incomes.

In addition to serving as a means for the government to raise funds, taxation is a social tool that can be used to ease or intensify economic inequality. The difference depends a great deal on whether taxes are progressive — higher tax rates for people who earn or own more — or regressive, disproportionately burdening poorer and lower-earning citizens. Progressive taxation is one of the primary means of reducing inequality, and regressive taxation quite naturally does the opposite.

There are two ways to flatten tax rates. The first and the most obvious is reducing the number of tax brackets and bringing the rates of different brackets closer together, meaning that people with a large disparity in income are taxed at similar rates. The second method is increasing the reliance on taxes that are flat (or even regressive), such as consumption taxes.

As it happens, Egypt's taxes have been getting flatter and flatter, and even regressive in many instances. Until 2005, some types of taxes, such as the payroll tax, had 32 brackets, with upper brackets being charged as much as 65% for personal income tax, 40% for corporate income tax and 32% for payroll tax. In 2005, a major tax “reform” took place, capping all taxes at 20%. The new tax code had only one bracket for corporate income tax, and four brackets for personal income tax.

After the 2011 revolution, there were modest attempts to increase the tax rate for upper brackets and add new tax brackets to introduce a new form of mild progressive taxation. These reform efforts faced fierce resistance from wealthy and powerful interest groups. The income tax rate for the highest earners briefly went up to 30% in the aftermath of the revolution, but was revised down to 22.5% in August 2015.

On top of that, even mild attempts at introducing progressive taxes have rarely been enforced. Wealthy people and big companies always have better access to tax incentives and breaks. In reality, Egypt is faced with a situation of heavy regressive taxation — that is, the more money one makes, the less taxes one will pay as a percentage of income.

To get a sense of the impact of regressive taxation on wealth, consider again the two people from our earlier example: Person A, who earns LE1,000, and Person B, who earns LE2,000. Imagine taxation of 7.5 percent for A and 5 percent for B. If they keep the same spending patterns, A will pay LE75 per month in taxes, and therefore save just LE25, while B will pay LE100 and save LE700. After four months of this regressive tax, A would have saved LE100 and B LE2,800, making the wealth disparity even bigger — 28 times bigger, in fact, compared to eight times in the tax-free scenario. Even if we reduce the income disparity a little, the wealth gap will still increase exponentially, albeit at a slower rate. This could explain why Egypt's wealth gaps have widened while income gaps have narrowed since the turn of the millennium.

Figures from 2009 tax reports demonstrate that Egypt has an extreme form of regressive taxation. The figures show that small sole proprietorships with operations of less than LE2 million made an average profit of LE5,892 a year, and paid 28% of that as taxes. At the other end of the spectrum, giant sole proprietorships with business operations over LE1 billion had average taxable profit of LE22.6 million and paid an average of 3.5% of their profits in taxes.

The situation is less extreme for joint stock companies, but follows the same pattern. Small joint stock companies (with volume of business under LE2 million) made on average LE124,122 annually of taxable profits, and paid an effective tax rate of 9.8%. Firms with a business volume of over LE1 billion made LE471 million on average, but only paid 5.7% of their profits in taxes (see table 4).

Flattening tax rates isn't done just by smoothing out tax brackets. It can also come from increasing reliance on taxes that are flat by definition, such as sales tax or Value Added Tax (VAT).

Consumption taxes might also be key to understanding how taxation can cause a widening wealth gap even as income gaps are shrinking. With a smaller pot of money to work with, people with lower incomes are more likely to spend a greater percentage of their earnings every month, while people with higher incomes have enough funds to put a chunk of their earnings into savings and investment. Although consumption taxes are flat when measured by what people spend (everyone pays 10 percent of their expenditures), when measured as a percent of earnings, they become clearly regressive. The poorer a person is, the more consumption taxes she will pay as a percentage of her income.

Let us again return to the earlier scenario of Person A, who makes LE1,000 and spends LE900, and Person B, who makes LE2,000 and spends LE1,200. If they were Egyptian, they would be subject to a 10% sales tax on most goods. For Person A, this would be LE90 a month, or 9% of her income. For Person B, it would be LE120 a month — a larger amount, but only 6% of her income. If we count this as a percentage of their saved income, the results will be even more striking. If we factor in wealth from inheritance, or from other sources like transfers of public land to private ownership, the difference becomes even more extreme.

In the last two decades, consumption taxes, most importantly sales tax, have become increasingly important to Egypt's budget. In fiscal year 1995/96, sales tax constituted a modest 27.1% of total tax revenues. In fiscal year 2000/01, that rate went up to 31.6%. This year, officials estimate sales tax will make up 43.6% of tax revenues.

This increased reliance on consumption taxes reflects the state's continuous failure or unwillingness to impose income or wealth taxes on high-income groups. There have been a few modest attempts since the revolution, but implementation has failed. A 10% tax on income from stock trading was suspended within months of being introduced, a suspension that was renewed last month. The newly introduced property tax is facing great difficulties in implementation and great resistance.

By contrast, the government seems determined to go ahead with its plans to replace the sales tax with VAT, which is expected to further increase the government's income from taxes on sales of goods and services to half of tax revenues, compared to a quarter two decades ago. If official policies continue to head in this direction, Egypt's wealth gap is likely to keep widening.

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This article first appeared on MadaMasr on 23 May 2016.