The 2007-09 Great Recession has led to an unprecedented increase in public debt in many countries, triggering substantial fiscal adjustments. What are the distributional consequences of fiscal austerity measures? This is an important policy question. This paper analyzes the effects of fiscal policies on income inequality in a panel of advanced and emerging market economies over the last three decades, complemented by a case study of selected consolidation episodes. The paper shows that fiscal consolidations are likely to raise inequality through various channels including their effects on unemployment. Spending-based consolidations tend to worsen inequality more significantly, relative to tax-based consolidations. The composition of austerity measures also matters: progressive taxation and targeted social benefits and subsidies introduced in the context of a broader decline in spending can help offset some of the adverse distributional impact of consolidation. In addition, fiscal policy can favorably influence long-term trends in both inequality and growth by promoting education and training among low- and middle-income workers.

This paper examines the distributional effects of fiscal consolidation. Using episodes of fiscal consolidation for a sample of 17 OECD countries over the period 1978–2009, we find that fiscal consolidation has typically had significant distributional effects by raising inequality, decreasing wage income shares and increasing long-term unemployment. The evidence also suggests that spending-based adjustments have had, on average, larger distributional effects than tax-based adjustments.

Fiscal Consolidation: Taking Stock of Success Factors, Impact, and Design

We quantitatively investigate the macroeconomic and distributional impacts of fiscal consolidations in low-income countries (LICs) through value added tax (VAT), personal income tax (PIT), and corporate income tax (CIT). We extend the standard heterogeneous agents incomplete markets model by including multiple sectors and rural-urban distinction to capture salient features of LICs. We find that overall, VAT has the least efficiency costs but is highly regressive, while PIT impacts the economy in the opposite way with CIT staying in between. Cash transfers targeting rural households mitigate the negative distributional impacts of VAT most effectively, while public investment leads to little redistribution.

This paper is an excerpt from Inequality and Fiscal Policy. The sizeable increase in income inequality experienced in advanced economies and many parts of the world since the 1990s and the severe consequences of the global economic and financial crisis have brought issues on equity and distribution to the top of the policy agenda. The book delves into this discussion by analyzing fiscal policy and its link with inequality. Fiscal policy is the government’s most powerful tool for addressing inequality. It affects household consumption directly and indirectly. An important message of the book is that growth and equity are not necessarily at odds; with the appropriate mix of policy instruments and careful policy design, countries can in many cases achieve better distributional outcomes and improve economic efficiency. Country case studies demonstrate the diversity of challenges and the diverging ways to use fiscal policy for redistribution. The analysis presented in the book builds on work by IMF economists and leading academics.

This note will describe recent trends in income inequality in both advanced and developing economies and how tax and expenditure policies have impacted on these trends. It will discuss how tax and expenditure policies should be designed to bring about a more equitable distribution of income, as well as to protect the most vulnerable populations during periods of fiscal consolidation.