Fiscal policy reactions and impact over the labor income distribution

Abstract

This paper investigates the implications of fiscal policy for labor income inequality through two causal channels. First, I estimate how fiscal policy reacts to negative income shocks happening at different points on the labor income distribution, to examine whether fiscal policy responds differently when there are changes in income for low-income earners, versus median-income earners or high-income earners. Secondly, I estimate the impact that various fiscal policies have on labor market income at the low, median, and high ends. I consider eight different fiscal policy variables, including four types of government transfer variables shown to be countercyclical, government consumption and government investment, and personal versus corporate tax revenue. Embedding each fiscal policy variable into a Bayesian structural vector autoregression, I estimate both the reaction of each fiscal policy variable to shocks to labor income at three points of the labor income distribution, and the impact of shocks to each fiscal policy variable on labor income along the same three points of the distribution. Impulse response functions show most fiscal policies are more responsive to shocks to the low end of the income distribution. The impulse response functions also show that it is often the median and upper-end of the income distribution that benefit most from fiscal expansions, leading to greater income inequality. The results also reveal that the fiscal policies most effective for boosting income at low income levels also lead to the largest increases in income inequality. Finally, I find that the fiscal policies most effective for stimulating labor income are also the least responsive to labor income shocks.