Who let the Gini out? Searching for sources of inequality

Davide Furceri, Prakash Loungani

Income inequality has been growing in many economies over the past two decades, and it is currently historically high. This column adds two new contributors to the popular explanations of increased inequality. Fiscal consolidations, especially those following the recent crisis, can increase inequality, mostly by affecting the long-term unemployment. A second source that leads to a persistent increase in inequality is capital account liberalisation. Therefore, the effects of these policies on inequality should be taken into account when deciding upon policy designs.

Last month’s World Economic Forum at Davos will be remembered as the one where the rich realised that incomes were unequal. One suspects the rich had always been dimly aware of this fact, but even they seem to have been astounded by the degree of inequality.

Income inequality is at historic highs.

The richest 10% took home half of the US income in 2012 – a division of spoils not seen in that country since the 1920s.

In OECD countries, inequality increased more in the three years up to 2010 than in the preceding 12 years.

The recent increases come on top of growing inequality for over two decades in many advanced economies (Levy and Temin 2007, D’Alessio et al. 2013).

What explains this rise?

One common explanation is that technological change in recent decades has conferred an advantage to those adept at working with computers and information technology. Moreover, global supply chains have moved low-skilled tasks out of advanced economies. Thus, the demand for highly skilled workers in advanced economies has increased, raising their incomes relative to those less skilled.

Our recent research uncovers two other contributors to increased inequality.

The opening up of capital markets to foreign entry and competition, referred to as capital account liberalisation.

The policy actions taken by governments to lower their budget deficits.

Such actions are referred to as fiscal consolidation in economists’ jargon and, by their critics, as ‘austerity’ policies.

Whom does it hurt?

The Great Recession of 2007-09 has led to a significant increase in public debt in advanced economies due to the decline in tax revenues, the costs of financial bailouts of banks and companies, and the fiscal stimulus provided by many countries at the onset of the crisis. Public debt increased, on average, from 70% of GDP in 2007, to about 100% of GDP in 2011 – its highest level in 50 years. Against this backdrop, many governments have embarked on fiscal consolidation in recent years.

Such consolidations – combinations of spending cuts and taxes hikes to reduce the budget deficit—are a common feature of government actions. So, history offers a good guide to studying the impacts of these policies on inequality. Over the past 30 years, there have been 173 episodes of fiscal consolidation in our sample of 17 advanced economies. On average across these episodes, the policy actions reduced the budget deficit by about 1% of GDP.

There is clear evidence that the decline in budget deficits was followed by increases in inequality. The Gini coefficient, the most commonly-used measure of inequality, increased by 0.3 percentage points two years following the fiscal consolidation, and by nearly 1 percentage point after eight years (Chart 1).

Figure 1. Fiscal consolidations are followed by increases in inequality (impact on the Gini coefficient in the years following a fiscal consolidation)

Note: The chart shows point estimates and one-standard-error bands. See Ball, Furceri, Leigh, and Loungani (2013) for details. Fiscal consolidation episodes are taken from Guajardo, Leigh and Pescatori (forthcoming, JEEA).

These effects are quantitatively significant. The Gini coefficient is measured here on a scale from zero to 100; the average value of the coefficient in our sample is 25. Hence, an average-sized fiscal consolidation of 1% of GDP raises the Gini by about 4%.

One explanation for these results could be that while fiscal consolidations coincide with inequality, it is actually a third factor that is responsible for movements in both. For example, a recession, or a slowdown, could raise inequality and at the same time lead to an increase in the debt-to-GDP ratio, thus increasing the odds of a fiscal consolidation. However, the impact of fiscal consolidation on output holds even after controlling for the impacts of recessions and slowdowns. Other tests of the robustness of these results is reported in two recent papers (Ball, Furceri, Leigh, and Loungani, 2013, Woo, Bova, Kinda, and Zhang, 2013).

There can be many channels through which fiscal consolidation raises inequality. For instance, cuts in social benefits and in public sector wages and employment, often associated with fiscal consolidation, may disproportionately affect lower-income groups. Another channel could be through the impact of fiscal consolidations on long-term unemployment, since long spells of unemployment are likely to be associated with significant earnings losses. Some evidence in favour of this comes from our finding that fiscal consolidations lead to an increase in long-term unemployment. The long-term unemployment rate is about 0.5 percentage points higher four years after an episode of consolidation; in contrast, the impact on short-term unemployment is very small (Chart 2).

Figure 2. Fiscal consolidations are followed by an increase in long-term unemployment

Note: The chart shows point estimates and one-standard-error bands. See Ball, Furceri, Leigh, and Loungani (2013) for details. Fiscal consolidation episodes are taken from Guajardo, Leigh and Pescatori (forthcoming, JEEA).

Open to inequity?

The past three decades have been associated with a steady decline in the number of restrictions that countries impose on cross-border financial transactions, as reported in the IMF's Annual Report on Exchange Arrangements and Exchange Restrictions. An index of capital account openness constructed from these reports shows a steady increase; that is, restrictions on cross-border transactions have been steadily lifted.

To uncover whether there is a link between this increased openness and inequality, we study episodes when there were large changes in the index of capital account openness, which are more likely to represent deliberate policy actions by governments to liberalise their financial sectors. Using this criterion, there were 58 episodes of large-scale capital account reforms in our sample of 17 advanced economies.

What happens to inequality in the aftermath of these episodes? The evidence is that, on average, capital account liberalisation is followed by a significant and persistent increase in inequality. The Gini coefficient increases by about 1.5% a year after the liberalisation, and by 2% after five years (see Chart 3).

Figure 3. Capital account liberalisations are followed by increases in inequality (impact on Gini coefficient in years following capital account liberalisation)

Note: The chart shows point estimates and one-standard-error bands. See Furceri, Jaumotte, and Loungani (2013) for details.

The robustness of this result is documented extensively in our research (Furceri, Jaumotte and Loungani 2013). In particular, the impact of capital account liberalisation on inequality holds even after the inclusion of myriad of other determinants of inequality such as output, openness to trade, changes in the size of government, changes in industrial structure, demographic changes, and regulations in product, labour and credit markets.

There are many channels through which opening up the capital account can lead to higher inequality. For example, an opening up allows financially constrained companies to borrow capital from abroad. If capital is more complementary to skilled workers, liberalisation increases the relative demand for such workers, leading to higher inequality in incomes. Indeed, there is evidence that the impact of liberalisation on wage inequality is greater in industries that are more dependent on external finance, and where the complementarity between capital and skilled labour is higher (Larrain 2013).

Policy lessons

These results do not imply that countries should not undertake capital account liberalisation or fiscal consolidation. After all, such policy actions are not taken on a whim, but reflect an assessment that they will benefit the economy. Capital account liberalisation allows domestic companies to access pools of foreign capital, and often—through foreign direct investment in particular—access to the technology that comes with it. It also allows domestic savers to invest in assets outside their home country. If properly managed, this expansion of opportunities can be beneficial. Likewise, fiscal consolidation is generally undertaken with the aim to reduce government debt to safer levels. Lower debt levels in turn can help the economy by bringing down interest rates; and over time the lighter burden of interest payments on the debt can also allow the government to cut taxes.

However, at a time when rising inequality is a source of concern to many governments, weighing these benefits against the distributional effects is also important. Awareness of these effects might lead some governments to choose to design the policy actions in a way that redresses the distributional impacts. For instance, greater resort to progressive taxes and the protection of social benefits for vulnerable groups can help counter some of the effect of fiscal consolidations on inequality. By promoting education and training for low- and middle-income workers, governments can also counter some of the forces behind the long-term rise in inequality.

References

Ball, Laurence, Davide Furceri, Daniel Leigh and Prakash Loungani (2013), “The Distributional Effects of Fiscal Consolidation,” IMF Working Paper 13/151 (Washington: International Monetary Fund).

D'Alessio, Giovanni, Romina Gambacorta, Giuseppe Ilardi (2013), “Are Germans poorer than other Europeans? The principal Eurozone differences in wealth and income”, VoxEU.org, 24 May.

Furceri, Davide, Florence Jaumotte and Prakash Loungani (2013), “The Distributional Effects of Capital Account Liberalization,” forthcoming IMF Working Paper (Washington: International Monetary Fund).

Larrain, Mauricio (2013), “Capital Account Liberalization and Wage Inequality,” Columbia Business School Working Paper (June).

Levy, Frank and Peter Temin (2007), “Inequality and institutions in 20th century America”, VoxEU.org, 15 June.

Woo, Bova, Kinda and Zhang (2013), “Distributional Effects of Fiscal Consolidation and the Role of Fiscal Policy: What Do the Data Say?” IMF Working Paper 13/195 (Washington: International Monetary Fund, September).