Fiscal Consolidation Programs and Income Inequality.- Pedro Brinca, Miguel H. Ferreira, Francesco Franco, Hans A. Holter, Laurence Malafry

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  • Last update: 28 November 2017
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  • Version: November 15, 2017
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  • Author: Pedro Brinca, Miguel H. Ferreira, Francesco Franco, Hans A. Holter, Laurence Malafry

Abstract

Following the Great Recession, many European countries implemented fi scal con-
solidation policies aimed at reducing government debt. Using three independent data
sources and three different empirical approaches, we document a strong positive re-
lationship 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, in-
cluding 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 re-
sponses to fiscal consolidation achieved through either tax hikes or public spending
cuts, and this explains the relationship between income inequality and the impact of
fi scal 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