Inequality and public debt: A positive analysis

• Author: Ryo Arawatari,Tetsuo Ono
• Published date: 01 November 2017
• Date: 01 November 2017
• DOI: http://doi.org/10.1111/roie.12299

ORIGINAL ARTICLE

Inequality and public debt: A positive analysis

Ryo Arawatari

1

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Tetsuo Ono

2

1

Nagoya University, Japan

2

Osaka University, Japan

Correspondence

Ryo Arawatari, Graduate School of

Economics, Nagoya University,

Furo-cho, Chikusa-ku, Nagoya,

Aichi 464-8601, Japan.

E-mail: arawatari@soec.nagoya-u.ac.jp

Funding information

JSPS KAKENHI, Grant/Award Number:

17K03620; JSPS KAKENHI,

Grant/Award Number: 15K03509

Abstract

This study extends the multi-country, politico-economic

model of fiscal policy to incorporate wage inequality within

each country. In this extended framework, we present con-

flict over fiscal policy within and across generations and

show that a low-inequality country realizes tight fiscal policy

with low public debt accumulation, whereas a high-

inequality country experiences loose fiscal policy with high

public debt. This model prediction is consistent with empiri-

cal evidence from OECD countries for the years 1980 to

2010.

1

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INTRODUCTION

Conventional economic theory suggests that higher income inequality is associated with a higher level

of income redistribution (see, e.g., Romer, 1975; Roberts, 1977; Meltzer & Richard, 1981). Given gov-

ernment budget constraints, higher inequality should increase pressure on politicians to shift the fiscal

burden from the present generation to future generations. This pressure incentivizes politicians to

finance a part of government expenditure by issuing public debt, which may result in a higher debt-to-

gross domestic product (GDP) ratio in the long run.

The purpose of this study is to develop a simple model that examines the aforementioned argument

from a theoretical point of view. For this purpose, we use Song, Storesletten, and Zilibotti’s (2012)

multi-country politico-economic model of public debt. They present a two-period overlapping-genera-

tions’model with many small open countries that differ in their public goods’preferences. Each coun-

try decides its public goods’provision financed by taxes and public debt through probabilistic voting,

reflecting the conflicting preferences of two successive generations. In this model, they show that pub-

lic goods’preferences shape cross-country differences in fiscal policy.

This study modifies their framework by assuming away differences in preferences among countries

and instead introduces wage inequality within each country. In this alternative framework, we present

conflict over fiscal policy within and across generations and show that when agents’elasticity of inter-

temporal substitution (EIS) is less than one, a low-inequality country realizes tight fiscal policy with

low public debt accumulation, whereas a high-inequality country experiences loose fiscal policy with

high public debt. The reverse occurs when EIS is greater than one: a higher inequality level is associ-

ated with a lower level of public debt.

Rev Int Econ. 2017;25:1155 –1173. wileyonlinelibrary.com/journal/roie V

C2017 JohnWiley & Sons Ltd

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1155

Received: 28 September 2016

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Revised: 18 May 2017

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Accepted: 22 May 2017

DOI: 10.1111/roie.12299

To evaluate the empirical plausibility of the two conflicting model predictions, we first review the

empirical estimates of EIS and find that an EIS below one is an empirically valid assumption

(Havr

anek, 2015; Havr

anek, Horvath, Irsova, & Rusnak, 2015). We then look at the evidence of

inequality and public debt from the Organisation for Economic Co-operation and Development

(OECD) countries for the years 1980 to 2010, and find a positive and highly significant correlation

between inequality and public debt. Therefore, we could conclude that the prediction of a positive asso-

ciation is an empirically valid perspective of inequality and public debt.

The present study contributes to the literature on the political economy of public debt. While many

studies consider how politics determines the size of public debt, most abstract away the role of inequal-

ity among voters. Previous studies instead focus on the roles of common pool problems (Tabellini,

1986; Velasco, 1999), political instability (Persson & Svensson, 1989; Aghion & Bolton, 1990;

Alesina & Tabellini, 1990; Tabellini & Alesina, 1990; Natvik, 2013), altruistic and selfish agents (De

Walque & Gevers, 2001), tax smoothing (Battaglini & Coate, 2008), and intergenerational conflict

(Song et al., 2012).

Studies by Cukierman and Meltzer (1989) and Azzimonti, De Francisco, and Quadrini (2014)

are exceptions. Cukierman and Meltzer (1989) develop an overlapping-generations model with

income inequality, and suggest a positive relationship between inequality and public debt. How-

ever, their analysis is confined to a closed economy, ignoring cross-country differences in

inequality and fiscal policy. The present study addresses this unresolved issue, and shows that the

level of inter-country inequality, rather than the level of intra-country inequality, is an important

factor in shaping fiscal policy.

The present study is also related to Azzimonti et al. (2014), who develop a multi-country model

with income risk. They show that higher risk in a home country results in more public debt issues in

home and foreign countries, and argue that public debt responds positively to income inequality, pro-

vided that rising income inequality is associated with an increase in individual income risk. Our study

differs from that of Azzimonti et al. (2014) in that we focus directly on income inequality, particularly

wage inequality, and show that when EIS is below one, rising inequality in a home country may result

in an increase in its public debt and a decrease in public debt in foreign countries. These results based

on a different mechanism from that in Azzimonti et al. (2014), could be viewed as a component of an

alternative testable hypothesis for the relationship between inequality and public debt from a political

economy perspective.

The remainder of this paper is organized as follows. Section 2 presents our model. Section 3 pro-

vides a characterization of political equilibrium. Section 4 conducts numerical analysis to investigate

the effects of wage inequality on debt distribution. Section 5 provides concluding remarks. Proofs are

given in the Appendix A.

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MODEL

We base our model on that developed by Song et al. (2012) and consider a discrete-time economy

where time is denoted by t50,1,2, .... We assume that the world economy consists of a unit

mass of small open countries. Each country is populated with overlapping generations of agents

who live for two periods: they work in the first and retire in the second. Each generation has a

unit mass.

Within each generation, agents belong to either of two income classes based on their first-period

wages: the poor or the rich. Let wp

jand wr

jdenote the exogenous wages of the poor and the rich,

respectively, in country j, and let p2ð0;1Þdenote the fraction of the poor within a generation. The

average income level, assumed to be identical across countries, is denoted by 

w5

wjpwp

j1ð12pÞwr

j.

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ARAWATARI AND ONO