FISCAL CONSOLIDATION PROGRAMS AND INCOME INEQUALITY

• Date: 01 February 2021
• Author: Hans A. Holter,Pedro Brinca,Miguel H. Ferreira,Laurence Malafry,Francesco Franco
• DOI: http://doi.org/10.1111/iere.12482
• Published date: 01 February 2021

INTERNATIONALECONOMIC REVIEW

Vol. 62, No. 1, February 2021 DOI: 10.1111/iere.12482

FISCAL CONSOLIDATION PROGRAMS AND INCOME INEQUALITY∗

By Pedro Brinca, Miguel H. Ferreira, Francesco Franco, Hans A. Holter,

and Laurence Malafry1

Nova School of Business and Economics, Portugal; University of Cambridge, United Kingdom;

University of Oslo, Norway; Potsdam Institute for Climate Impact Research, Germany

We document a strong empirical relationship between higher income inequality and stronger recessive im-

pacts 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 Eu-

ropean economies, including inequality and f‌iscal structures, and study the effects of f‌iscal consolidation pro-

grams. In our model, higher income risk induces precautionary savings behavior, which decreases the propor-

tion of credit-constrained agents in the economy. Theseagents have less elastic labor supply responses to f‌iscal

consolidations, which explain the correlation with inequality in the data.

1. introduction

The 2008 f‌inancial crisis led several European economies to adopt counter-cyclical f‌iscal

policy, often f‌inanced by debt. Government def‌icits exceeded 10% in many countries, and this

created an urgency for f‌iscal consolidation policies as soon as times returned to normal. In

response, some governments designed plans to reduce their debt through austerity, tax in-

creases, or, more commonly, a combination of the two—see Blanchard and Leigh (2013) and

Alesina et al. (2015a). However, the process of f‌iscal consolidation across European countries

raised a number of important questions about the effects on the economy. For example, is

debt consolidation ultimately 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

∗Manuscript received April 2018; revised June 2020.

1We thank Anmol Bhandari, Michael Burda, Gauti Eggertsson, Veronica Guerrieri, Mathias Hoffman, Loukas

Karabarbounis, Patrick Kehoe, Robert Kirkby, Dirk Krueger, Per Krusell, Ellen McGrattan, William Peterman, Ri-

cardo Reis, Victor Rios-Rull, Marcelo Santos, Chima Simpson-Bell, Kjetil Storesletten, Harald Uhlig, and anony-

mous referees for helpful comments and suggestions. We also thank seminar participants at Birbeck College, Hum-

boldt University, IIES, New York University, Stanford University, Federal Reserve Bank of St. Louis, University of

Bergen, University of California-Irvine, University of Minnesota, University of Nevada-Reno, University of Oslo,

University of Pennsylvania, University of Victoria-Wellington, University of Zürich, and conference participants at

the 2017 Junior Symposium of the Royal Economic Society,ADEMU, the 6th edition of Lubramacro, the 11th Meet-

ings of the Portuguese Economic Journal, the 70th European Meetings of the Econometric Society, ASSET 2017,

and the Spring Mid-West Macro Meeting 2017. Pedro Brinca is grateful for f‌inancial support from the Portuguese

Science and Technology Foundation, grants number (UID/ECO/00124/2013, UID/ECO/00124/2019, and Social Sci-

ences DataLab, LISBOA-01-0145-FEDER-022209), POR Lisboa (LISBOA-01-0145-FEDER-007722, and LISBOA-

01-0145-FEDER-022209), POR Norte (LISBOA-01-0145-FEDER-022209), and CEECIND/02747/2018. Miguel H.

Ferreira is grateful for f‌inancial support from the Portuguese Science and Technology Foundation, grant number

SFRH/BD/116360/2016. Hans A. Holter is grateful for f‌inancial support from the Research Council of Norway,

grants number 219616, 267428; the Oslo Fiscal Studies Program, and the Portuguese Science and Technology Founda-

tion, grants number CEECIND/01695/2018, UID/ECO/00124/2019, UIDB/00124/2020, Social Sciences DataLab, PIN-

FRA/22209/2016, POR Lisboa and POR Norte (Social Sciences DataLab, PINFRA/22209/2016). This work was sup-

ported by the German Federal Ministry of Education and Research (BMBF) under the research projects SLICE

(FKZ: 01LA1829A) and CLIC (FKZ: 01LA1817C). Please address correspondence to: Hans A. Holter, University of

Oslo, Problemveien 7, 0315 Oslo, Norway. E-mail: hans_holter@hotmail.com.

405

© 2020 The Authors. International Economic Review published by Wiley Periodicals LLC on behalf of the Eco-

nomics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Re-

search Association

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, dis-

tribution and reproduction in any medium, provided the original work is properly cited.

406 brinca et al.

austerity differ from the impact of consolidation through taxation? This article 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.2

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 pa-

pers, which cover various countries and time periods and make use of different empirical ap-

proaches: (i) Blanchard and Leigh (2013), (ii) Alesina et al. (2015a), and (iii) Ilzetzki et al.

(2013).3

Next we study the effects of f‌iscal consolidation programs, f‌inanced through both austerity

and taxation, in a neoclassical macro-model with heterogeneous agents and incomplete insur-

ance markets. We show that such a model is well-suited to explain the relationship between

income inequality and the recessive effects of f‌iscal consolidation programs. The mechanism

we propose works through idiosyncratic income risk. In economies with lower income risk,

there are more credit-constrained households and households with low wealth levels, due to

less precautionary saving. Importantly, these credit-constrained households have less elastic

labor supply responses to increases in taxes and decreases in government expenditures.

Our empirical analysis begins with a replication of the recent studies by Blanchard and

Leigh (2013, 2014). These studies f‌ind that the International Monetary Fund (IMF) underes-

timated the impacts of f‌iscal consolidation across European countries, with stronger consol-

idation causing larger GDP forecast errors. In Blanchard and Leigh (2014), the authors f‌ind

no other signif‌icant explanatory factors, such as pre-crisis debt levels4or budget def‌icits, bank-

ing conditions, or a country’s external position, among others, can help explain the forecast er-

rors. In Subsection 3.1, we reproduce the exercise conducted by Blanchard and Leigh (2013),

now augmented with different metrics of income inequality. We f‌ind that during the 2010 and

2011 consolidation in Europe, the forecast errors are larger for countries with higher income

inequality, implying that inequality amplif‌ied the recessive impacts of f‌iscal consolidation. A

one standard deviation increase in income inequality, measured as Y10/Y905leads the IMF to

underestimate the f‌iscal multiplier in a country by 66%.

For a second independent analysis, we use the Alesina et al. (2015a) f‌iscal consolidation

episodes data set with data from 12 European countries over the period 2007–2013. Alesina

et al. (2015a) expand the exogenous f‌iscal consolidation episodes data set, known as IMF

shocks, from Devries et al. (2011) who use Romer and Romer (2010) narrative approach to

identify exogenous shifts in f‌iscal policy. Again we document the same strong amplifying ef-

fect of income inequality on the recessive impacts of f‌iscal consolidation. A one-standard de-

viation increase in inequality, measured asY25/Y75, increases the f‌iscal multiplier by 240%.

Our third empirical analysis (for brevity included in the Appendix) replicates the paper

by Ilzetzki et al. (2013). These authors use time series data from 44 countries (both rich and

poor) and a SVAR approach to study the impacts of different country characteristics on f‌is-

cal multipliers. 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. We

2In this article, we focus on two main drivers of income inequality: permanent and transitory income shocks. Re-

cently, there has been much attention paid to job polarization and job displacement by automation as a source of

increases in income inequality over time. However, given the cross-sectional nature of our study, we abstract from

such mechanism.

3Although the f‌irst two papers study f‌iscal consolidation programs in Europe, Ilzetzki et al. (2013) study govern-

ment spending multipliers using a greater number of countries. We include this study for robustness and complete-

ness.

4In Section 8.1, we show that, in line with our proposed mechanism, household debt matters if an interaction term

between debt and the planned f‌iscal consolidation is included in the regression.

5Ratio of top 10% income share over bottom 10% income share.

fiscal consolidation programs and income inequality 407

calibrate the model to match data from a number of European countries along dimensions

such as the distribution of income and wealth, taxes, social security, and debt level. Then we

study how these economies respond to gradually reducing government debt, either by cutting

government spending or by increasing labor income taxes.

Output falls when debt reduction is f‌inanced through either a decrease in government

spending or increased labor income taxes. In both cases, this is caused by a fall in labor sup-

ply. In the case of reduced government spending, the transmission mechanism works through

a future income effect. As government debt is paid down, the capital stock and thus the

marginal product of labor (wages) rise, and thus expected lifetime income increases. This will

lead agents to enjoy more leisure and decrease their labor supply today,6and output to fall in

the short run, despite the long-run effects of consolidation on output being positive. Credit-

constrained agents and agents with low wealth levels do, however, have a lower marginal

propensity to consume goods and leisure out of future income (for constrained agents, the

marginal propensity to consume out of future income is zero.)7Constrained agents have a

lower intertemporal elasticity of substitution and do not consider changes to their lifetime

budget, only changes to their budget in the current time period.8

In the case of consolidation through increased labor income taxes, there will be a negative

substitution effect on labor supply today, in addition to an income effect that could be positive

or negative depending on whether the future taxes or higher future wages dominate. Because

wages are rising in the future, unconstrained agents would prefer to work relatively less today.

For constrained agents, who do not consider their life-time budget but only their budget to-

day, the tax would cause a drop in available income in the short run (no future wage increases

to be considered), possibly leading to a labor supply increase. It turns out that all agents de-

crease their labor supply, but the response is weaker for constrained and low-wealth agents.

When higher income inequality ref‌lects higher uninsurable income risk, there exists a neg-

ative relationship between income inequality and the number of credit-constrained agents.

Greater risk leads to increased precautionary savings behavior, thereby decreasing the share

of agents with liquidity constraints and low wealth levels. Since unconstrained agents have a

higher intertemporal elasticity of substitution of labor and thus a more elastic labor supply re-

sponse to both tax-based and austerity-based consolidation, labor supply and output will re-

spond more strongly in economies with higher inequality.

Through simulations in a benchmark economy, initially calibrated to Germany, we show

that varying the level of idiosyncratic income risk strongly affects the fraction of credit-

constrained agents in the economy and the f‌iscal multiplier, both for consolidation through

taxation and austerity. If we instead change inequality by changing the variance of initial con-

ditions, prior to entering the labor market (permanent ability and the age prof‌ile of wages in

the model), there is very little effect on the fraction of credit-constrained agents or on the f‌is-

cal multiplier.

In a multicountry exercise, we calibrate our model to match a wide range of data and

country-specif‌ic policies from 13 European economies, and f‌ind that our simulations repro-

duce the anticipated cross-country correlation between income inequality and f‌iscal multipli-

ers. Moreover, we show that in our model, countries with higher idiosyncratic uninsurable la-

bor income risk have a smaller percentage of constrained agents and have larger multipliers,

conf‌irming our analysis and mechanism for the benchmark model calibrated to Germany.

One should note that our mechanism relies on the premise that differences in income

inequality across countries are, at least to some extent, explained by differences in the

amount of uninsurable risk that agents in different countries are exposed to. The stronger the

6A recent paper by Cesarini et al. (2017) provides empirical evidence on how positive wealth shocks lead to a fall

in labor supply.

7The fact that constrained agents also very slightly change their labor supply in our model simulations is due to

general equilibrium effects (price changes) today.

8Domeij and Floden (2006) provide empirical evidence of the intertemporal elasticity of substitution of labor being

decreasing in wealth, using U.S.micro-data.