Social polarization, industrialization, and fiscal instability: theory and evidence

Abstract

This paper is motivated by an important puzzle that arises from the contrasting macroeconomic experience across developing regions in the recent decades. In sharp contrast to East Asia, the fiscal policies in much of Latin America and sub-Saharan Africa are characterized by large fiscal deficits and volatilities of fiscal outcomes. In order to address both large deficits and volatile fiscal outcomes, we develop a simple model of endogenous fiscal policy in which government spending is strategically determined by heterogeneous policymakers in a dynamic game. In an economy that is highly polarized due to unequal income distribution, a larger fiscal deficit results, and the intertemporal fiscal policy path becomes more volatile. It is because the polarization of preference leads a policymaker representing each sector to spend more for her favorite sector, collectively contributing to large deficits. This polarization effect implies that a shock to tax revenue is translated into a more than proportional change in spending. Econometric evidence provides support for these predictions. Countries that have suffered from the greatest fiscal instability are those with highly polarized economic societies as measured by indicators of income inequality.