Austerity and inequality: The size and composition of fiscal adjustment matter

Elva Bova, Tidiane Kinda, Jaejoon Woo

Understanding the distributional consequences of fiscal adjustment measures is important for equity, but also to ensure the sustainability of the measures. This column shows that fiscal adjustments increase inequality, including through unemployment. Spending-based adjustments worsen inequality more significantly than tax-based adjustments. Progressive taxation and targeted social benefits and subsidies introduced in the context of a broader decline in spending can help offset some of the distributional impact of fiscal adjustments.

The Great Recession of 2007-09 has led to an unprecedented increase in public debt, raising concerns about fiscal sustainability. Against this backdrop, many governments have been making substantial fiscal adjustments through a combination of spending cuts and tax hikes to reduce their debt-to-GDP ratios. Large and protracted fiscal consolidation is likely to impose a social toll, raising the additional challenge of how to devise an adjustment plan that does not exacerbate the increase in income inequality often accompanying economic downturns. Besides equity issues, preventing a significant worsening of income distribution during the adjustment period would be critical to the sustainability of deficit reduction efforts, as an adjustment that is perceived as being fundamentally unfair will be difficult to maintain. Moreover, high income inequality can harm long-term growth (e.g. Berg et al. 2011, Woo 2011).1

In a recent article, we analyse the distributional consequences of fiscal adjustments through the following sets of specific questions (Woo et al. 2017). First, does fiscal austerity worsen income inequality? If so, how and by how much? Does the size and composition of fiscal adjustment matter? Second, what are the effects on income distribution of specific fiscal policies, such as tax structure, direct and indirect taxes, social benefits spending, and wage bills? Building on a large literature on the determinants of cross-country variations in income inequality (De Gregorio and Lee 2002, Barro 2008), our study examines the effects of fiscal adjustments on income inequality in a panel of advanced and emerging market economies over the last three decades. A case study of selected adjustment episodes complements the analysis.

The empirical analysis relies on the Standardized World Income Inequality Database (SWIID), which standardises the World Income Inequality Database (WIID) of the United Nations University and provides comparable Gini coefficients for market and disposable income for more than 150 countries starting from 1960. For robustness checks, we use alternative data on Gini coefficients and alternative measures of income inequality (e.g. ratios of top to bottom quintiles/deciles, and labour income share) compiled from original sources, including the WIID, Luxembourg Income Study, World Bank’s PovcalNet, and Eurostat. Regarding fiscal adjustment data, we use two alternative datasets, the action-based fiscal consolidation data for 17 OECD countries for the period of 1978-2009 from Devries et al. (2011), which attempts to capture policymakers’ intentions to reduce deficit rather than responses to prospective economic conditions, and episodes of fiscal adjustments using changes in the cyclically-adjusted primary balances, following the methodologies by Alesina and Ardagna (1998) and Giavazzi and Pagano (1996).

Results

Our results suggest that fiscal adjustments tend to increase income inequality, including through their effects on unemployment. On average, an adjustment of 1% of GDP is associated with an increase in the disposable income Gini coefficient of around 0.4-0.7% over the first two years, and inequality tends to start rising about one year after the fiscal adjustment (Figure 1). The results are robust under alternative estimation methods. Given the inelasticity of the Gini, this coefficient unveils a sizeable impact of fiscal adjustments, particularly if compounded over multiple years. Spending-based adjustments tend to significantly worsen inequality, relative to tax-based adjustments, as do large-sized adjustments (those greater than 1.5% of GDP). This seems to reflect the fact that large-sized adjustments tend to be longer in duration and mostly expenditure-based, which is confirmed in the case study.

Figure 1 Dynamic effects of fiscal adjustment on income inequality and unemployment

Unemployment also tends to increase inequality, and hence, to the extent that fiscal adjustment raises unemployment (Figure 2), it constitutes an important channel through which adjustment affects inequality. Loosely speaking, about 15-20% of the increase in inequality due to fiscal adjustment seems to be occurring via the increase in unemployment.

Figure 2 Dynamic effects of fiscal adjustment on unemployment

Sources: Authors’ estimates.

The composition of fiscal adjustment also matters. Progressive taxation and targeted social benefits and subsidies introduced in the context of a broader reduction in spending can help offset some of the adverse distributional impact of fiscal adjustments. For example, discretionary spending cuts could be combined with an enhancement of social safety nets, supported by means testing and efficient monitoring. In particular, the progressivity of taxation (as measured by the ratio of direct to indirect taxes), social benefits (including health care, social security pensions, and unemployment compensation), and subsidies tend to be associated with lower inequality for disposable income in the regressions, even after controlling for other determinants of inequality. These results support the view that in advanced economies, reforms since the 1980s have been a factor behind rising income inequality, as they lessen the generosity of social benefits and the progressivity of income tax systems. Moreover, fiscal policy can favourably influence long-term trends in both inequality and growth by promoting education and training among low- and middle-income workers. Consistent with the literature, higher educational attainment and skill-biased technological progress (as measured by information technology capital share in the total capital stock) are also found to be associated with lower and greater inequality, respectively.

Case study of fiscal adjustment episodes

Similar patterns also emerge from a case study of selected fiscal adjustment episodes, where the impact on income distribution of each episode seems to vary with the specific composition of austerity measures, a country’s position in the business cycle, and labour market conditions. Spending-based adjustments tend to be associated with more noticeable increases in income inequality (Figure 3). Looking at simple averages from the 14 selected fiscal adjustment episodes, the Gini coefficient increased by about 0.3 after spending-based consolidations, while it declines by 0.1 in the case of tax-based episodes. This seems to be largely because lower-income earners are typically more affected by spending cuts as a larger portion of their disposable income comes from public spending, and they are more vulnerable to losing their jobs. In contrast, tax-based consolidations tend to have mixed net effects on inequality – direct taxes tend to be progressive, whereas indirect taxes are regressive. Looking at the episodes, spending-based consolidations tend to be larger in size and longer in duration, which could be another reason for their more pronounced effects on inequality compared to tax-based consolidations. That said, the net effect of a fiscal consolidation on inequality depends crucially on the specific composition of austerity measures. Cuts in social benefits tend to worsen inequality more than other spending reductions, for example, public wage cuts.

Figure 3 Changes in income inequality, spending-based versus tax-based adjustment episodes

Sources: Authors’ estimates; IMF/Fiscal Affairs Department Database; Eurostat; Standardized World Income Inequality Database (SWIID); and national sources.

The recent fiscal adjustment experience in Ireland shares many of these features, although it is difficult to disentangle the distributional impact of fiscal adjustment itself from that of the financial crisis and ensuing recession. Inequality initially fell as upper income groups suffered major income losses while taxes increased and redistributive social transfers expanded. However, the impact of the deepening crisis and recession quickly spilled over to broader income groups via rising unemployment. Against this backdrop, the government had to embark on a large fiscal adjustment in 2010 due to adverse market reactions to the soaring sovereign debt. The adjustment package was sizable and mainly expenditure-based. Public sector wage cuts mainly affected the middle-upper class, which might have mitigated the rising inequality, whereas social benefit cuts (family allowances, old-age benefits) heavily weighed on the lower income group, contributing to higher inequality. Despite some offsetting tax measures that were progressive in nature, the largely spending-based adjustment in 2010 amid deepening crisis and recession appears to start worsening inequality.

Conclusion

The above findings have important policy implications for countries with high debt levels, which are expected to pursue fiscal adjustments in the future. Our results argue for a better targeting of both spending and revenue adjustment measures to limit their negative social effects and improve their sustainability. As fiscal adjustments that are viewed as being unfair are unlikely to be sustainable, it is critical that the costs associated with fiscal adjustments are shared equitably going forward.

Authors’ note: The views expressed in this column represent those of the authors and not necessarily those of the institutions to which they are affiliated.

References

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Alesina, A, and S Ardagna (1998), “Tales of Fiscal Adjustments”, Economic Policy 13(27): 487–545.

Barro, R (2008), “Inequality and Growth Revisited”, Asian Development Bank Working Paper Series on Regional Economic Integration, no. 11.

Berg, A, J D Ostry, and J Zettelmeyer (2011), “What makes growth sustained?”, European Bank for Reconstruction and Development Working Paper, 33.

De Gregorio, J, and J Lee (2002), “Education and Income Inequality: New Evidence From Cross-Country Data”, Review of Income and Wealth 48(3): 395-416

Devries, P, J Guajardo, D Leigh, and A Pescatori (2011), “A New Action-based Dataset of Fiscal Consolidation,” IMF Working Paper, 128.

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Perrotti, R (2011), “‘The "Austerity Myth’: Gain Without Pain?”, in A Alesina and F Giavazzi (eds), Fiscal Policy after the Financial Crisis, Chicago: University of Chicago Press.

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Woo, J (2011), “Growth, Income Distribution and Fiscal Policy Volatility”, Journal of Development Economics 96(2): 289-313.

Woo, J, E Bova, T Kinda, and Y Zhang (2017), “Distributional Consequences of Fiscal Adjustments: What Do the Data Say?”, IMF Economic Review 65(2): 273-307.

Endnotes

[1] The article focuses on the distributional effects of fiscal adjustments. However, it is important to recognise the potential trade-off between equity and efficiency when designing redistributive policies. Redistributive tax and benefit systems can introduce economic inefficiencies with implications for long-term productivity and growth, as redistributive policies can influence the incentives for people to work, save and invest.