Inequality and Fiscal Policy Effectiveness

Abstract

This paper examines the role of income inequality in determining fiscal policy effectiveness by using panel data of 42 advanced and developing countries during Q1 2000-Q3 2007. Our panel VAR analysis shows that the effect of fiscal policy on output is smaller in economies with high income inequality: the 1-year fiscal multiplier for a country with relatively equal income distribution is estimated to be significant at 0.52 or greater significantly, while that for a country with relatively unequal income distribution is insignificant from zero. The responses of consumption to an expansionary fiscal policy shock show that consumption is more crowded-out for relatively more unequal economies, thus affirming that the low-income households in the economies with high inequality tend to have strong incentives to save additional income from fiscal policy for precautionary reasons.