Fiscal Consolidation Programs and Income Inequality

Brinca, Pedro and Ferreira, Miguel H. and Franco, Francesco and Holter, Hans A. and Malafry, Laurence (2017): Fiscal Consolidation Programs and Income Inequality.

Abstract

Following the Great Recession, many European countries implemented fiscal consolidation policies aimed at reducing government debt. Using three independent data sources and three different empirical approaches, we document a strong positive relationship between higher income inequality and stronger recessive impacts of fiscal consolidation programs across time and place. To explain this finding, we develop a life-cycle, overlapping generations economy with uninsurable labor market risk. We calibrate our model to match key characteristics of a number of European economies, including the distribution of wages and wealth, social security, taxes and debt, and study the effects of fiscal consolidation programs. We find that higher income risk induces precautionary savings behavior, which decreases the proportion of credit-constrained agents in the economy. Credit-constrained agents have less elastic labor supply responses to fiscal consolidation achieved through either tax hikes or public spending cuts, and this explains the relationship between income inequality and the impact of fiscal consolidation programs. Our model produces a cross-country correlation between inequality and the fiscal consolidation multipliers, which is quite similar to that in the data.

• Item Type: MPRA Paper
• Language: English
• Keywords: Fiscal Consolidation, Income Inequality, Fiscal Multipliers, Public Debt, Income Risk
• Subjects: E - Macroeconomics and Monetary Economics > E2 - Consumption, Saving, Production, Investment, Labor Markets, and Informal Economy > E21 - Consumption ; Saving ; Wealth; E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E62 - Fiscal Policy; H - Public Economics > H3 - Fiscal Policies and Behavior of Economic Agents > H31 - Household; H - Public Economics > H5 - National Government Expenditures and Related Policies > H50 - General

References

[1] Alesina, A., Barbiero, O., Favero, C., Giavazzi, F., and Paradisi, M. (2015a). Austerity in 2009-13. Economic Policy, 30(83):383-437.

[2] Alesina, A., Barbiero, O., Favero, C., Giavazzi, F., and Paradisi, M. (2017). The effects of fiscal consolidations: Theory and evidence. Technical report, National Bureau of Economic Research.

[3] Alesina, A., Favero, C., and Giavazzi, F. (2015b). The output effect of fiscal consolidation plans. Journal of International Economics, 96:S19-S42.

[4] Anderson, E., Inoue, A., and Rossi, B. (2016). Heterogeneous consumers and fiscal policy shocks. Journal of Money, Credit and Banking, 48(8):1877-1888.

[5] Antunes, A. and Ercolani, V. (2017a). Credit crisis and the age structure. Working Paper.

[6] Antunes, A. and Ercolani, V. (2017b). Pubic debt expansions and the dynamics of the household borrowing constraint. Working Paper.

[7] Basso, H. and Rachedi, O. (2017). The young, the old and the government: Demographics and fiscal multipliers. Working paper.

[8] Benabou, R. (2002). Tax and education policy in a heterogeneous agent economy: What levels of redistribution maximize growth and efficiency? Econometrica, 70:481-517.

[9] Blanchard, O. and Perotti, R. (2002). An empirical characterization of the dynamic effects of changes in government spending and taxes on output. Quarterly Journal of Economics, 117(4):1329-1368.

[10] Blanchard, O. J. and Leigh, D. (2013). Growth forecast errors and fiscal multipliers. American Economic Review, 103(3):117-120.

[11] Blanchard, O. J. and Leigh, D. (2014). Learning about _scal multipliers from growth forecast errors. IMF Economic Review, 62(2):179-212.

[12] Brinca, P., Chari, V. V., Kehoe, P. J., and McGrattan, E. (2016a). Accounting for business cycles. Handbook of Macroeconomics, 2:1013-1063.

[13] Brinca, P., Holter, H. A., Krusell, P., and Malafry, L. (2016b). Fiscal multipliers in the 21st Century. Journal of Monetary Economics, 77:53-69.

[14] Carroll, C. D., Slacalek, J., and Tokuoka, K. (2014). the distribution of wealth and the MPC: Implications of new European data. American Economic Review, 104(5):107{111.

[15] Devries, P., Guajardo, J., Leigh, D., and Pescatori, A. (2011). A new action-based dataset of fiscal consolidation. IMF Working Paper No. 11/128.

[16] Dupaigne, M. and Fève, P. (2016). Persistent government spending and fiscal multipliers: The investment-channel. European Economic Review, 89:425-453.

[17] Ferriere, A. and Navarro, G. (2016). The heterogeneous effects of government spending: It's all about taxes. Working Paper.

[18] Guajardo, J., Leigh, D., and Pescatori, A. (2014). Expansionary austerity? International evidence. Journal of the European Economic Association, 12(4):949-968.

[19] Guner, N., Lopez-Daneri, M., and Ventura, G. (2016). Heterogeneity and government revenues: Higher taxes at the top? Journal of Monetary Economics, 80:69-85.

[20] Hagedorn, M., Manovskii, I., and Mitman, K. (2016). The fiscal multiplier. Working paper.

[21] Heathcote, J. (2005). Fiscal policy with heterogeneous agents and incomplete markets. The Review of Economic Studies, 72(1):161-188.

[22] Heathcote, J., Storesletten, S., and Violante, G. (2017). Optimal tax progressivity: An analytical framework. Quarterly Journal of Economics, 132:1693-1754.

[23] Holter, H., Krueger, D., and Stepanchuk, S. (2017). How do tax progressivity and household heterogeneity affect laffer curves? Working paper.

[24] Huggett, M., Ventura, G., and Yaron, A. (2011). Sources of lifetime inequality. American Economic Review, 101(7):2923-2954.

[25] Ilzetzki, E., Mendoza, E. G., and Vegh, C. A. (2013). How big (small?) are fiscal multipliers? Journal of Monetary Economics, 60(2):239{254.

[26] Kaplan, G. and Violante, G. L. (2014). A model of the consumption response to fiscal stimulus payments. Econometrica, 82(4):1199{11239.

[27] Kaplan, G., Violante, G. L., and Weidner, J. (2014). The wealthy hand-to-mouth. Technical report, National Bureau of Economic Research.

[28] Krueger, D., Mitman, K., and Perri, F. (2016). Macroeconomics and household heterogeneity. Handbook of Macroeconomics, 2:843-921.

[29] Krusell, P. and Smith, A. (1999). On the welfare effects of eliminating business cycles. Review of Economic Dynamics, 2(1):245-272.

[30] Pappa, E., Sajedi, R., and Vella, E. (2015). Fiscal consolidation with tax evasion and corruption. Journal of International Economics, 96:S56-S75.

[31] Peterman, W. and Sager, E. (2016). Optimal public debt with life cycles motives. Working Paper.

[32] Romer, C. D. and Romer, D. H. (2010). The macroeconomic effects of tax changes: estimates based on a new measure of fiscal shocks. American Economic Review, 100(3):763-801.

[33] Stierli, M., Shorrocks, A., Davies, J. B., Lluberas, R., and Koutsoukis, A. (2014). Global Wealth Report 2014. Zurich: Credit Suisse Research Institute (CSRI).

[34] Trabandt, M. and Uhlig, H. (2011). The Laffer curve revisited. Journal of Monetary Economics, 58(4):305-327.

[35] Yang, W., Fidrmuc, J., and Ghosh, S. (2015). Macroeconomic effects of fiscal adjustment: A tale of two approaches. Journal of International Money and Finance, 57:31-60.48