The economics of inequality

Fiscal policy, growth, and inequality

Dr. Matthias Schnetzer

December 16, 2022

Recap

  • What are wage-led and profit-led growth?
  • How do growth regimes differ for small open and large closed economies?
  • What are the opposed theories for the relationship between personal inequality and current account balances?

Keynesian legitimation for fiscal policy

  • Aggregate demand determines economic growth
  • Lack of aggregate demand and involuntary unemployment persists
  • Fiscal policy is essential to reduce economic volatility
  • Anti-cyclic fiscal policy (government spending and taxation)
  • No balanced budget required in the short term
  • Public investment features multiplier effect

The fiscal multiplier

\[ Y = C(\theta) + I(r) + G + NX \]

\[ C = \alpha_0 + \alpha_1 (1 - \theta) Y \]

\[ Y - \alpha_1(1-\theta)Y = \alpha_0 + I(r) + G + NX \]

\[ \frac{\partial Y}{\partial G} = \frac{1}{(1 - \alpha_1 + \alpha_1 \theta)} \]

\[ \alpha_1 \in (0, 1); \; \theta \in (0, 1); \; \frac{\partial Y}{\partial G} > 1 \]

Second-round effects

\[ \alpha_1 = 0.6; \; \theta = 0.3; \]

Total multiplier: \[ Y^* = 1/(1 - 0.6 + 0.6 \cdot 0.3) \simeq 1.7 \]

First round: \[ \alpha_1 (1-\theta)\Delta Y = 0.6 \cdot (1-0.3) \cdot 1 \simeq 0.4 \]

Second round: \[ 0.6 \cdot (1-0.3) \cdot 0.4 \simeq 0.2 \]

Keynes Cross

Discuss with your neighbour

What do you expect the effect of restrictive fiscal policy (taxes and spending) on income inequality to be?

What are the potential channels for these effects?

Effects of fiscal consolidation

Studies typically find that inequality increases in periods of fiscal consolidation (with similar data):

  • Ball et al. (2013): 17 OECD countries from 1978 to 2009
  • Agnello/Sousa (2014): 18 industrialized countries from 1978 to 2009
  • Woo et al. (2016): 17 OECD countries from 1980 to 2010
  • Heimberger (2020): 17 OECD countries from 1978 to 2013

Data on fiscal consolidation is provided by Devries et al. (2011): “A New Action-based Dataset of Fiscal Consolidation”. Narrative approach that focuses on policy actions (tax hikes and/or spending cuts) taken by governments with the intent of reducing the budget deficit.

Methodology: Impulse response functions (IRF) from local projections as proposed by Jordà (2005).

Consolidation episodes

Country Epidodes Country Epidodes
🇦🇺 1985–1988, 1994–1999 🇮🇹 1991–1998, 2004–2007, 2010–2013
🇦🇹 1980–1981, 1984, 1996–1997, 2001–2002, 2011–2013 🇯🇵 1979–1983, 1997–1998, 2003–2007
🇧🇪 1982–1985, 1987, 1990, 1992–1994, 1996–1997, 2010–2013 🇳🇱 1981–1988, 1991–1993, 2004–2005
🇨🇦 1984–1997 🇵🇹 1983, 2000, 2002, 2005–2007, 2010–2013
🇩🇰 1983–1986, 1995, 2011–2013 🇪🇸 1983–1984, 1989, 1992–1997, 2009–2013
🇫🇮 1992–1997 🇸🇪 1984, 1993–1998
🇫🇷 1979, 1987, 1991, 1995–1997, 2011–2013 🇬🇧 1979–1982, 1994–1999, 2010–2013
🇩🇪 1982–1984, 1991–1995, 1997, 1999–2000, 2003–2004, 2006–2007, 2011–2013 🇺🇸 1978, 1980–1981, 1985–1988, 1990–1998, 2011–2013
🇮🇪 1982–1988, 2009–2013

Austerity measures have dampened growth in Europe

Fiscal consolidation increases inequality

Fiscal consolidation: Spending versus taxes

Results seem to be stable across studies

Fiscal consolidation increases unemployment

Effects of contractionary monetary policy shocks

Study by Furceri et al. (2018):

  • (unanticipated) changes in short-term interest rates for a panel of 32 countries from 1990 to 2013
  • contractionary monetary policy shocks increase income inequality, expansionary monetary policy reduces inequality
  • effect is asymmetric: tightening of monetary policy raises inequality more than easing lowers it

Effect of monetary policy on output, unemployment and inflation

Effect of monetary policy shocks on inequality

Bibliography

PI 2159 Special Topics in Economic Policy | Winter term 2022/23

Agnello, Luca/Sousa, Ricardo M. (2014). How does fiscal consolidation impact on income inequality? Review of Income and Wealth, 60(4), 702–726. DOI: 10.1111/roiw.12004
Ball, Laurence/Furceri, Davide/Leigh, Daniel/Loungani, Prakash (2013). The distributional effects of fiscal consolidation (Working Paper No. WP/13/151). IMF.
Devries, Pete/Guajardo, Jaime/Leigh, Daniel/Pescatori, Andrea (2011). A new action-based dataset of fiscal consolidation (Working Paper No. WP/11/128). IMF.
Furceri, Davide/Loungani, Prakash/Zdzienicka, Aleksandra (2018). The effects of monetary policy shocks on inequality. Journal of International Money and Finance, 85, 168–186. DOI: 10.1016/j.jimonfin.2017.11.004
Heimberger, Philipp (2020). The dynamic effects of fiscal consolidation episodes on income inequality: Evidence for 17 OECD countries over 19782013. Empirica, 47(1), 53–81. DOI: 10.1007/s10663-018-9404-z
Jordà, Òscar (2005). Estimation and inference of impulse responses by local projections. American Economic Review, 95(1), 161–182. DOI: 10.1257/0002828053828518
Woo, Jaejoon/Bova, Elva/Kinda, Tidiane/Zhang, Y. Sophia (2016). Distributional consequences of fiscal adjustments: What do the data say? IMF Economic Review, 65(2), 273–307. DOI: 10.1057/s41308-016-0021-1