APPENDIX 3 Fiscal Adjustment and Income Distribution in Advanced and Emerging Economies

Philip Gerson, and Manmohan Kumar
Published Date:
November 2010
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Fiscal consolidation can increase income inequality in the short term, but the duration and magnitude of this effect depends on the growth response and the composition of fiscal adjustment. Adverse short-term effects are attributable mainly to rising unemployment. However, adjustment-induced changes in government expenditure and revenue policies that redistribute income can also play a critical role. The impact of these transmission channels on inequality has varied across advanced and emerging economies, reflecting differences in the size of multipliers and the incidence of revenue and spending adjustments.

Advanced economies

Fiscal adjustment reduces output and increases unemployment in the short term because of positive fiscal multipliers, but these effects are reversed over the longer term (Blanchard and Perotti 2002; Spilimbergo, Symansky, and Schindler, 2009; IMF, 2010a). Consistent with the stylized facts on the business cycle, fiscal consolidation may lead to a decline in the share of wages within a few quarters by lowering demand and output, thus putting upward pressure on unemployment and downward pressure on wages (Rotemberg and Woodford, 1999). Inequality of labor income widens if low-wage workers are hit harder or employers start hoarding skilled labor. The duration of these effects depends on how quickly and strongly private demand responds to fiscal shocks. In episodes of large fiscal adjustment, consolidation has been associated with increases in unemployment during the early years. Larger adjustments are associated with greater persistence in unemployment (Figure A3.1), especially if during the downturn there is an increase in structural unemployment. Over the longer term, the effects of fiscal consolidation on unemployment are reversed.

Figure A3.1.Advanced Economies: Unemployment Rate during Large Fiscal Adjustments


Sources: IMF staff estimates.

Note: Large fiscal adjustments as defined in IMF (2010a).

Improved targeting of expenditures can help reduce the effects of fiscal adjustment on income distribution. Large and durable fiscal adjustments have often been associated with significant expenditure cuts, including in public cash transfers (Alesina and Perotti, 1995; Alesina and Ardagna, 2009). In Europe, these transfers have been shown to lower income inequality (as measured by the Gini coefficient) by about 9 percentage points (OECD, 2008b), so reductions in these outlays may contribute to widening income inequality during adjustment episodes.58 However, substantial fiscal adjustment can be associated with relatively small changes in income inequality if expenditure reductions are accompanied by efforts to better target these benefits—as in Denmark, Germany, and Sweden.59 The fact that a small share of social spending in the EU is means-tested suggests that there may be ample scope for reducing spending without adverse effects on inequality (Chapter 3, Figure 3.8). In contrast to expenditure cuts, revenue measures—particularly those related to income and wealth—are likely to reduce income disparities due to progressive tax systems in advanced economies (OECD, 2008b).60 However, if taxes are already high, efficiency considerations place a limit on how much adjustment should be achieved through tax adjustment.

Emerging economies

Compared to advanced countries, large fiscal adjustments in emerging economies have been of similar size but of much shorter duration. Despite smaller multipliers, fiscal shocks can still have a significant impact on the real economy and unemployment (Figure A3.2). At the same time, contrary to advanced economies, the size of consolidation does not seem to be associated with higher unemployment persistence, contributing to better income distribution outcomes in the post-adjustment period. In addition, fiscal consolidation is often essential to reduce high inflation, which has adverse effects on inequality, and can help to offset other macroeconomic imbalances leading to improved employment prospects.

Fiscal adjustment has typically had an inequality-reducing effect over the longer term (Figure A3.3). Expenditure reductions implemented during fiscal adjustment can potentially improve equity, given that a large share of government spending in emerging economies is not progressive (Alesina, 1998; Chu, Davoodi, and Gupta, 2004). One exception to this pattern has been emerging Europe, where large consolidations have been associated with increased inequality. To be sustainable, fiscal adjustment in emerging economies is also likely to require revenue measures (Bevan, 2010; Gupta and others, 2005). The impact of tax measures on inequality can be mitigated if these are accompanied by tax reforms that enhance the efficiency and equity of the tax system.

Figure A3.2.Developing and Emerging Economies: Unemployment Rate during Large Fiscal Adjustments


Source: WEO and staff estimates.

Note: Large fiscal adjustments as defined in IMF (2010a).

Figure A3.3.Emerging Markets: Large Fiscal Adjustments

Source: IMF staff estimates. Data on large fiscal adjustments are as reported in IMF (2010a); data on Gini coefficients are taken from the WIDER database.

Note: Positive values for a change in Gini coefficient denote an increase in income inequality.

In the United States, Japan, and Canada, by comparison, social spending plays a less critical role in equalizing incomes.

In Denmark and Germany, changes in household income distribution data (OECD, 2008b) suggest an increase in the progressivity of transfers during large fiscal adjustments. For a description of targeting efforts in Sweden, see IMF (2010a).

The equalizing effects of revenue-based adjustments in the advanced economies have been offset by reductions in marginal tax rates, to some extent. Top marginal personal income tax rates in OECD countries have been reduced considerably over the past decades (Mankiw, Weinzierl, and Yagan, 2009).

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