Public Debt Consolidation and its Distributional Effects

Abstract

We build a dynamic general equilibrium model with heterogeneous households, namely Rich and Poor, and capitalskill complementarity structure in the production function, to study aggregate and distributional implications of fiscal consolidation policies when the government uses a rich set of spending and tax instruments. Fiscal policy is conducted through constrained optimized fiscal rules. Our results show that, in the long run, fiscal consolidation enhances both aggregate efficiency and equity; however, it may hurt Rich households depending on which fiscal instrument takes advantage of the fiscal space created. Along the transition, wage inequality significantly increases due to the capital skill complementarity structure of the production function. Specifically, this happens because debt consolidation crowds in capital and this favours Rich (skilled) households. On the other hand, the reduction in interest rates and government bonds lead to a decrease in Rich households income coming from capital and government bonds which eventually decrease income inequality. Finally, a rather novel finding is that the combination of asset and skill heterogeneity amplifies the increase in wage inequality in the early phase of fiscal consolidation.

When does public debt hurt inequality in Africa?

“…Specifically, model 1 shows that a unit increase in the general government debt is associated with about 0.13% point increase in income inequality in SSA in the short run. This is not surprising in Africa because the results of the study corroborate the findings of some empirical studies such as Tung (2020), Sakkas and Varthalitis (2019), Arslan (2019), Azzimonti et al. (2014), and Salti (2015) who all found a positive and significant relationship between debt and inequality.…”

“…Specifically, model 1 shows that a unit increase in the general government debt is associated with about 0.13% point increase in income inequality in SSA in the short run. This is not surprising in Africa because the results of the study corroborate the findings of some empirical studies such as Tung (2020), Sakkas and Varthalitis (2019), Arslan (2019), Azzimonti et al (2014), andSalti (2015) who all found a positive and significant relationship between debt and inequality. Also, the finding confirms the dynamic politico-economic theory Tax burden has a coefficient of 0.0045 and is statistically significant at 5%, suggesting that each percentage increase in tax burden increases inequality by about 0.45% point.…”

“…According to Salti (2015), Arslan (2019), Obiero and Topuz (2021), domestic debt contributes to the growing inequality in many economies. Sakkas and Varthalitis (2019), and Tung (2020) find that public debt worsens inequality in the Eurozone and the Asia–Pacific region, respectively. The effect of corruption on economic outcomes is also well established (Fakir, 2017a; Ariely and Uslaner, 2017; Adams and Klobodu, 2016; Andres and Ramlogan-Dobson, 2011; Gupta, 1998).…”

Do public and internal debt cause income inequality? Evidence from Kenya

“…These studies are summarized in Table 1. Sakkas and Varthalitis (2019) and Tung (2020) ascertain that public debt harms inequality for countries in the Euro Area and Asia-pacific region respectively. These studies taken together suggest that governments may use public debt as a means of reducing inequality.…”

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

“…Significantly lower domestic financing costs stemming from fiscal consolidation are associated with stronger growth dividends (Gupta et al, 2005). Income distribution may also improve or recover in the long run as stronger growth following a successful consolidation can improve the wage share or reverse its decline and reduce interest rates, which reduces capital income for richer households (IMF, 2014c;and Sakkas and Varthalitis, 2019).…”