Abstract

AbstractWe document a strong empirical relationship between higher income inequality and stronger recessive impacts of fiscal consolidation episodes across time and space. To explain this finding, we develop a life‐cycle economy with uninsurable income risk. We calibrate our model to match key characteristics of several European economies, including inequality and fiscal structures, and study the effects of fiscal consolidation programs. In our model, higher income risk induces precautionary savings behavior, which decreases the proportion of credit‐constrained agents in the economy. These agents have less elastic labor supply responses to fiscal consolidations, which explain the correlation with inequality in the data.

Highlights

  • The 2008 financial crisis led several European economies to adopt counter-cyclical fiscal policy, often financed by debt

  • Is debt consolidation contractionary or expansionary? How large are the effects and do they depend on the state of the economy? How does the impact of consolidation through austerity differ from the impact of consolidation through taxation? This paper contributes to this literature, both empirically and theoretically, by presenting evidence for a dimension that helps explain the heterogeneous responses to fiscal consolidations observed across countries: income inequality and in particular the role of uninsurable income risk

  • We use three independent data sources and three different empirical approaches to document a positive relationship between income inequality and the recessive impacts of fiscal consolidation programs

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Summary

Introduction

The 2008 financial crisis led several European economies to adopt counter-cyclical fiscal policy, often financed by debt. We begin by documenting a strong positive empirical relationship between higher income inequality and stronger recessive impacts of fiscal consolidation programs across time and place We do this by using data and methods from three recent, state-of-the-art, empirical papers, which cover various countries and time periods and make use of different empirical approaches: i) Blanchard and Leigh (2013) ii) Alesina et al (2015a) iii) Ilzetzki et al (2013). We find that countries with higher income inequality experience significantly stronger declines in output following decreases in government consumption To explain these empirical findings, we develop an overlapping generations economy with heterogeneous agents, exogenous credit constraints and uninsurable idiosyncratic risk. This implies that countries with higher levels of household debt should have experienced less recessive impacts of fiscal consolidation programs We show that this relationship exists in the data, by again performing a similar exercise to Blanchard and Leigh (2013).

Related Literature
Empirical Analysis
Calibration
Income Inequality and Fiscal Consolidation
Explaining the Mechanism
Inequality
Robustness
Cross-country Analysis
Empirical Validation of the Mechanism
Wealth and Labor Supply Responses to Fiscal Consolidation Shocks
10 Conclusion
A Appendix
Tax Function
The assets of the dead are uniformly distributed among the living:
Aggregate law of motion
A.10.1 Aggregate Hours Worked and Income Inequality
A.10.2 Age as Proxy for Wealth
A.11 Additional Figures and Tables
Findings
Macro ratios
Full Text
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