Impact of fiscal policy on inequality

The redistributive consequences of economic adjustment following the near recession of 2011- 2013 in Albania have been lately at the center of policy discussions. Social discontent has been brewing even in economies with a positive track record of sustained growth and reductions in poverty and inequality.

In this context, there has been an increased policy interest in the macroeconomic determinants of income inequality and, in particular, the link between inequality and fiscal policy.

While the empirical literature on the microeconomic determinants of inequality is vast, especially in Albania, much less attention has been paid to the underlying macroeconomic setting.

It is this discussion which aim to bring in the light of this comment to give an opinion about the links between national fiscal policy and income inequality.

The statistical data confirms that the unemployment rate tends to be positively correlated with inequality. Nevertheless, the effects of inflation on inequality are likely to be non-linear. High inflation can lead to an increase in inequality as poorer segments of the population cannot protect themselves against the inflation tax.

However, it is possible that moderate inflation is associated with reductions in inequality as real debt burdens are eroded, as the evidence for developed economies suggests.

On the other hand, the recent analysis about different countries in Balkan and Europe indicates that extreme rates of anticipated and unanticipated inflation have significantly increased inequality.

Economic theory points to ambiguous effects of overall economic growth on inequality. For instance, if growth is driven by increased human capital accumulation, it is likely to lead to a reduction in the relative wage of skilled workers (as the relative supply of skilled labor increases) and therefore to a reduction in inequality.

On the other hand, when growth is driven by technological change that is skill-biased, it is likely that faster growth will lead to more inequality, as the wage premium for skilled workers increases.

The evidence on the impact of overall growth on inequality is also mixed. Cross-country studies tend to find evidence of both positive and negative correlations. In turn, inequality is also likely to have an important impact on macroeconomic variables, most notably on overall economic growth.

The recent empirical literature on the effects of the fiscal policy stance on inequality has focused mostly on OECD/Advanced economies and used data at the national level. Wolff and Zacharias (2007) show that net government spending reduces inequality at the national level in the US and this is mostly due to expenditures rather than taxes.

Agnello and Sousa (2012) look at the impact of fiscal consolidation on inequality in a panel of 18 industrialized countries and find that inequality increases during periods of fiscal consolidation. In addition, consolidation is particularly detrimental to inequality if led by expenditure cuts.

On the other hand, fiscal consolidations that are driven by revenue increases are associated with reductions in inequality.

Nevertheless, Ball and others (2013) find that both expenditure and taxed-based fiscal consolidations at the national level have typically raised inequality for a panel of OECD countries, even if the distributional effects of spending-based adjustments tends to be larger relative to tax-based adjustments.

These conclusions are largely confirmed for a broader panel of countries that also includes emerging markets in a study by Woo and others (2013). These authors find positive and statistically significant elasticities of spending-based consolidations on inequality (of around 1.5 to 2), but the coefficients for tax-based consolidations are not statistically significant.

The impact of fiscal policy on inequality in developing economies is typically shaped by lower levels of taxes and transfers relative to advanced economies, which is compounded by greater reliance on regressive taxes (such as consumption taxes) and low coverage and benefit levels of transfer programs. Furthermore, overall in-kind public expenditures (on health and education for example) have been found to be regressive in several developing countries, reflecting the lack of access by lower- income households to public services.

The extent of inequality reduction due to direct taxes and transfers is relatively small compared to what is observed for Western Europe. In this analysis, taxes and transfers lead to a 15 percentage points for Western European countries.

The revenue increases are not associated with increases in inequality. In addition, reductions in primary expenditures do not seem to have deleterious impacts on inequality measures. Some further disaggregation indicates that revenue increases due to revenue transfers to local authority are linked to decreases in inequality, whereas changes in investment expenditure are positively linked to inequality measures. Several robustness checks performed confirm that there is no evidence that fiscal adjustment at the sub-national level is positively linked to inequality.

Furthermore, fiscal adjustment might also could be achieved through efficiency gains both on the expenditure-side, but also in terms of revenue collection with no discernible impact in terms of increasing inequality. In addition, greater fiscal discipline could also have big role in improvement of the investment climate, which facilitates job creation and investment.

Future research could focus on drilling down on the mechanism linking the fiscal stance and inequality dynamics. This would be important to ascertain where the relationship is likely to be maintained over time as the country macroeconomic and social conditions evolve, thus informing policy making more precisely.

The results linking fiscal adjustment to an increase in inequality in advanced economies cannot be easily generalized to developing countries, given the Albanian experience.