Scandinavian Working Papers in Economics

Research Papers in Economics,
Stockholm University, Department of Economics

No 2017:8: Fiscal Consolidation Programs and Income Inequality

Pedro Brinca (), Miguel Ferreira (), Francesco Franco (), Hans Holter () and Laurence Malafry ()
Additional contact information
Pedro Brinca: Center for Economics and Finance, Postal: Universidade of Porto, Portugal
Miguel Ferreira: Nova School of Business and Economics, Postal: Universidade Nova de Lisboa, Campus de Campolide, 1099-032 Lisboa, Portugal
Francesco Franco: Nova School of Business and Economics, Postal: Universidade Nova de Lisboa, Campus de Campolide, 1099-032 Lisboa, Portugal
Hans Holter: Department of Economics, Postal: University of Oslo, Postboks 1095 , Blindern , 0317 OSLO, Norway
Laurence Malafry: Dept. of Economics, Stockholm University, Postal: Department of Economics, Stockholm University, S-106 91 Stockholm, Sweden

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 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 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.

Keywords: Fiscal Consolidation; Income Inequality; Fiscal Multipliers; Public Debt; Income Risk

JEL-codes: E21; E62; H31; H50

59 pages, November 27, 2017

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