Fiscal Consolidation Programs and Income Inequality

Pedro Brinca, Miguel H. Ferreira, Francesco Franco, Hans A. Holter and Laurence Malafry

Abstract:

Following the Great Recession, many European countries implemented fi scal 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 nding, 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 fi scal consolidation achieved through either tax hikes or public spending
cuts, and this explains the relationship between income inequality and the impact of fi scal consolidation programs. Our model produces a cross-country correlation between inequality and the fi scal consolidation multipliers, which is quite similar to that in the data.

 

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Published Jan. 29, 2018 9:30 AM - Last modified Jan. 29, 2018 1:14 PM