Resumen de Economic growth and income inequality: a study of the relevant trade-offs of fiscal policy
The main aim of this thesis was to evaluate both theoretically and empirically the relevant trade-offs of fiscal policy. The research has looked at these trade-offs from different angles. In order to do so, the analysis uses different methodological approaches. Beyond analyzing aggregate measures of fiscal policy; the research has performed the analysis for a variety of disaggregated fiscal measures, both in terms of expenditures and revenues.
The substance of the thesis was divided into two major parts. The first part, chapters two and three, performed a critical analysis of the theoretical and empirical literature, while the second part, chapters four to six, presented empirical research.
Chapter 2 reviewed the arguments developed in the theoretical public models about the relevant trade-offs between efficiency and equity considering different instruments of fiscal policy. In a first instance, it has been shown how an efficient tax system places the burden of goods taxation on necessities. If implemented, such a system would be very damaging to low-income consumers. When equity is introduced, this outcome is modified to reduce the extent to which goods consumed primarily by those with low incomes are affected by the tax system.
Then, the analysis has studied the issues surrounding the design of income tax structure. Based on a simplified version of the original Mirrlees model, it was possible to observe that the optimal income tax system cannot be fully (marginal rate) progressive. However, it has also been argued that income taxation is well suited for the task of redistributing income. In a more general and applied framework, the policy-maker can discern a form of assignment of tax instruments to targets: direct taxation could be assigned to the equity objective; while indirect taxation could be assigned to the goal of raising revenues in an efficient manner. More specifically, by leaving taxes on goods that are substitutes for work and subsidizing those that are complements, it is possible to encourage people to work more and thus reduce the work-discouraging effect of income tax. This way, direct taxation is used as an important distributive instrument.
The theoretical review of public policy endogenous growth models in chapter 2 also provided a range of mechanisms by which government expenditures and taxes can affect the economic growth rate and income inequality. In this context, it was possible to observe that under certain circumstances the classic trade-off between efficiency and equity to implement specific tools of fiscal policy could be avoided. In particular, in the short term, increased public investment could stimulate growth and, in turn, reduce income inequality.
Considering the potential effects of fiscal policy on economic growth as well as on inequality, chapter 3 surveyed the contributions that analyze the relationship between inequality and economic growth, with a particular focus on the importance, in terms of size and composition, of different fiscal policies in explaining the relationship between both macro-aggregates. This review made it possible to document the revived interest in fiscal policy as an effective instrument for promoting economic growth and as a tool to correct undesirable outcomes of the process of skill-biased economic growth in terms of inequality. Moreover, it was possible to observe that more recent endogenous growth theories focus on the role of income and wealth inequality in the process of economic growth. In this latter case, only when inequality is harmful for growth, due to several economic and also political-economy channels, redistribution to the less well endowed, by reducing inequality, can therefore be growth-enhancing.
The diversity of theoretical predictions explaining the relationship between economic growth, inequality and fiscal policy places great emphasis on empirical research to determine the importance of their relationship. However, most empirical studies have been focused on the effects of fiscal policy on economic activity without considering the distributive effects and not offering, in turn, an analysis of the impact of different fiscal policy instruments. Furthermore, the joint response of economic growth and income inequality to fiscal policies has been largely overlooked in this empirical literature.
In this context, the last three chapters of the thesis constructed a well-specified empirical framework within which the link between economic growth, income inequality and disaggregate measures of fiscal policy were systematically analyzed.
Chapter 4 details the construction of the database. This chapter detailed the data sources and exposed the selection criteria and limitations of the data. The analyses of the empirical data also enabled observation of some important behaviours of the key variables.
Firstly, a study of economic growth trends shows a differentiated pattern across countries over the period from 1972 to 2006. In particular, in the case of upper-middle countries, the growth rate exhibits more frequent and pronounced fluctuations than in high income countries. However, even across high income countries it was possible to observe some differences. In this sense, economic recessions, especially in the nineties, were harsher in countries where the welfare state is more developed (Sweden) than in countries where distributive fiscal policies are less important (United States). Secondly, the cross-country empirical data showed an important rise in gross income inequities in most of the high and upper-middle economies. Moreover, this process intensified from the nineties until recent years, and seems to be more pronounced in high income countries.
Finally, this descriptive analysis showed important differences in the magnitude and composition of fiscal policy between countries. In turn, these differences may help to explain different performances in terms of growth and net income inequality across countries. The analysis of government expenditures showed important dissimilarities across countries in relation with the size of public current expenditure, investment and the magnitude of distributive expenditures. It was also documented that countries with more current and distributive government expenditures have more equity in terms of net income measures but also have lower average growth rates over the period analyzed. Moreover, it was not possible to observe a significant trade-off between efficiency and equity in the case of public investment or non distributive expenditures. In addition, the analysis of government revenues documented that direct taxes are the most important source of revenue for governments in rich countries; while poorer countries rely on indirect taxes for an important part of their tax burden. Moreover, it was possible to observe a clear negative relationship between direct tax measures and net income inequality across both samples of countries analyzed. However, it was also possible to observe a clear negative relationship between the economic growth rate and the direct tax measure. In case of indirect taxes it was not possible to observe a significant trade-off between efficiency and equity.
The next two chapters used a set of econometric panel data analysis tools to study the significance and magnitude of various fiscal policy tools for economic growth and income inequality measures for an extended set of high and upper-middle income countries.
Chapter 5 considered an unbalanced panel of 43 upper-middle and high income countries over the 1972-2006 period to observe the influence of different fiscal instruments simultaneously to economic growth and inequality, always taking into account their financial counterpart (in the form of direct or indirect taxes). The empirical results suggest that cuts in direct taxes increase GDP, whereas increases in public current expenditures diminish it. Beyond that, the results also show that different fiscal policies have significant distributive effects: an increase in public expenditure (current or in public investment) produces significant reductions in income inequality, as does increasing direct taxes. From a policy perspective, these results have clear implications. According to the estimates, increasing the size of the public sector (through current expenditures and direct taxes) improves the distribution of income at the expense of economic growth. The effects of indirect taxes on both output and inequality are found to be statistically insignificant. Moreover, the novelty of these results is that they indicate that under certain circumstances the classic trade-off between efficiency and equity when implementing specific public policies could be avoided. In particular, increasing public investment reduces inequality without harming output, no matter whether it is financed through direct or indirect taxes.
The empirical analysis in chapter 6 sought to discern whether gross income inequality determines the evolution of net income inequality and economic growth through fiscal policy. The empirical analysis developed in this chapter has estimated two different systems of structural equations with error components through which gross income inequality determines different fiscal policy outcomes which subsequently affect the evolution of economic growth and net income inequality. The empirical results obtained suggest that gross income inequality is a significant determinant of fiscal policy outcomes in the sample of 21 OECD high income countries analyzed. In general, it was possible to observe that the more egalitarian countries are, the greater the size of its public sector (in terms of expenditures and taxes over their GDP). Moreover, the richer economies of the sample use distributive expenditures and direct taxes more intensively; and poorer economies perform more strongly non distributive expenditures and uses indirect taxes as a source of revenues.
Additionally, the results show that distributive expenditures and direct taxes produce significant reductions in GDP growth and net income inequality. In short, this result reflects the standard efficiency-equity trade-off of fiscal policy: the smaller the size of the government, the larger the size of the pie but the less equally distributed. Moreover, the results show also that the only fiscal policy that may break the trade-off between efficiency and equity are non distributive expenditures, since a cut in this kind of government expenditures reduces inequality and slightly increase economic growth. Finally, the results are very inconclusive concerning the indirect taxes. The indirect taxes equations have a very low explanatory power so their results must be taken with very caution.
In summary, considering the global empirical results obtained in chapter 6 it is possible to argue that more egalitarian high income countries tend to present higher governments' size despite of the lesser short-run growth prospects.
