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 labour 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 behaviour, which decreases the proportion of credit-constrained agents in the economy. Credit-constrained agents have less elastic labour 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.

The Impact of Labor Income Tax Progressivity on the Fiscal Multipliers in the Context of the Fiscal Consolidation

“…The standard life -cycle model with heterogenous agents as it is employed in Brinca et al, (2017) and similar to the one developed in Brinca et al (2016) is calibrated for the U.S. economy. The model follows the model 1 of the introduction.…”

“…The model follows the model 1 of the introduction. Moreover, in order to study the relationship between labor income tax progressivity and the impact of fiscal consolidation programs on output it is considered a fiscal experiment that consists of a 50 year of reduction in government debt, , financed through a decrease in government spending, G, by 0.2% of benchmark GDP or financed through an increase in labor income tax by 0.1% for all agents, as in Brinca et al (2017). After 50 periods, regardless the instrument used, it goes back to initial levels.…”

“…The benchmark model delineated in Brinca (2020) is calibrated to match moments of U.S. economy ten times considering ten different levels of labor income tax progressivity θ 1 , that are set constructing a uniform distribution between the lowest and one of the highest θ 1 in the data found in Brinca et al (2017). The lowest θ 1 corresponds to the levels of progressivity of Slovakia of 0.105 and the highest θ 1 considered corresponds to the levels of progressivity of the Netherlands of 0.254.…”

“…Openness to trade and public debt as determinants of the size of the fiscal multiplier are also documented in the case of fiscal consolidation by Cugnasca and Rother (2015) who state high degree of openness result in lower multipliers because aggregate demand is diluted through foreign demand and that lower government debt may imply larger multipliers. Brinca et al (2017) focus on the impact of income inequality on the multipliers and observed that the higher income inequality, the higher are the recessive impacts of fiscal adjustments.…”

“…Such question is motivated by the theoretical relationship study in Brinca et al (2017). The authors state the inability of constrained agents to smooth consumption facing an increase of future income as a result of lower debt -to -GDP ratio.…”