Inequality and Fiscal Policy
Chapter

Chapter 9. Fiscal Consolidation and Income Inequality

Author(s):
Benedict Clements, Ruud Mooij, Sanjeev Gupta, and Michael Keen
Published Date:
September 2015
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Author(s)
Stefania Fabrizio and Valentina Flamini 

Introduction

Fiscal adjustment, by its very nature, affects income inequality. It does so through the direct effect of tax increases and government spending cuts on disposable income as well as the macroeconomic effects of the adjustment on market income and employment. Given the significant adjustments undertaken by many economies after the initial response to the global financial crisis—against the background of increased inequality—the interest of policymakers worldwide in this theme has intensified. With many economies still needing more fiscal adjustment to meet their medium-term fiscal targets (IMF 2014a), the issue has taken center stage in the policy debate of many countries.

This chapter, which draws upon work in IMF 2014b, provides an overview of recent evidence on fiscal adjustment and income inequality in both advanced and developing economies. It makes several contributions to the literature. First, it provides evidence of how the social environment and support for redistribution have changed in recent years. Second, it shows that, when it comes to the redistributive effect of fiscal adjustment, the composition and design of the fiscal consolidation measures matter. In fact, both revenue- and expenditure-based adjustments can be designed to mitigate the adverse effect of the consolidation on inequality. Finally, the chapter provides policy advice about specific measures that policymakers in advanced and developing countries could consider to mitigate the impact of fiscal adjustment on inequality.

The rest of this chapter is structured as follows. To set the background for the current debate, the next section presents evidence on the recent evolution of the social environment and public support for income redistribution worldwide, including in countries undertaking fiscal adjustment. The subsequent section reviews how fiscal consolidation affects inequality in advanced economies and examines the recent experiences of a number of European countries. The chapter then turns to the distributional incidence of fiscal consolidation in developing countries and why in general it differs from the experience in advanced economies. The final section concludes by setting out options for equitable fiscal consolidation.

Fiscal Consolidation and the Social Context

The legacy of the global crisis has been challenging for many countries that have begun to adjust public finances in a fragile macroeconomic environment. These countries have made important fiscal efforts in the past few years, but uncertainties are still widespread. Specifics, of course, vary across countries. In advanced economies, fiscal adjustment following the financial crisis has stabilized the average debt-to-GDP ratio. Nevertheless, this ratio is expected to remain at historic highs (and exceed 100 percent by 2020), and countries will have to continue to reduce it to safer levels. In developing countries, debt ratios and deficits remain generally moderate, although, on average, above precrisis levels, and fiscal risks are on the rise.

The task of fiscal consolidation has been made more difficult by the intensification of social tensions. Between 2008 and 2013, domestic conflict increased worldwide (in 90 out of 139 countries for which data are available), including in countries that underwent fiscal consolidation (Figure 9.1).1 This account is in line with the findings of Vegh and Vuletin (2014), who go a step further and show that the recent fiscal adjustment in the euro area countries has aggravated social outcomes, specifically unemployment and domestic conflict.

Figure 9.1Domestic Conflict in Advanced and Developing Economies

(Logarithm)

Source: IMF staff calculations based on Banks and Wilson (2014).

Note: Data for 2012 or 2011 are used when data for 2013 are not available. Data labels in the figure use International Organization for Standardization (ISO) country codes.

With intensified social tensions, public support for income redistribution has also increased. International public surveys such as the World Value Survey, regional barometers, and international social surveys monitor public support for redistribution in both advanced and developing countries by asking citizens whether they favor more or less redistribution. Evidence from these surveys indicates that since 2008 support for redistributive policy has grown in 34 out of 41 advanced and developing economies, including in countries that underwent fiscal consolidation (Figure 9.2).

Figure 9.2Public Support for Redistribution in Advanced and Developing Economies

(Index)

Source: Integrated World Values Survey, 1981–2014 (http://www.worldvaluessurvey.org/WVSDocumentationWV6.jsp).

Note: The survey variable ranges between 1 (income should be made more equal) and 10 (we need larger income differences as incentives for individual effort). The data points in the figure are country averages of responses less than or equal to 5, which indicate support for different degrees of redistribution. Data labels in the figure use International Organization for Standardization (ISO) country codes.

This intensification of social tensions and the greater support for redistribution have stirred a lively debate about the potential impact of fiscal policy on inequality. This debate has become relevant given that sizable and prolonged fiscal consolidation requires public support to be politically sustainable (Cournède and others 2013; IMF 2014b). At the present juncture, a key priority for policymakers is to understand the distributional impact of tax and spending adjustment policies and to design them in a way that does not increase inequality. Indeed, a broad consensus that the burden of adjustment is being shared fairly is essential for generating the public support required for successful and sustainable fiscal consolidation.

Fiscal Consolidation and Income Inequality in Advanced Economies

Fiscal policy affects inequality through its impact on the distribution of both market and disposable income. Fiscal consolidation typically leads to a short-term reduction in output and employment, which often leads to a decline in wages.2 This decline tends to increase market-income inequality, given the relatively high share of wages in the incomes of lower-income groups (Jenkins and others 2011). Increasing unemployment also tends to widen wage inequality, since wages for unskilled workers fall relative to wages for skilled workers as employers hoard skilled labor (Mukoyama and Sahin 2006). For example, considering 42 episodes of fiscal consolidation from 1945 to 2012 in advanced countries, evidence suggests that as unemployment went up, on average, from 7½ to almost 10 percent, the Gini index also increased, by more than 1 percent, on average (Figure 9.3). The duration and magnitude of these effects depend on the size of automatic stabilizers, as well as on the growth response and its impact on employment. If multipliers are particularly high during downturns (Jordà and Taylor 2013), fiscal contraction can have a strong effect on employment. These effects may be long-lasting if a prolonged period of slow growth has adverse effects on the supply side of the economy (Aghion, Hemous, and Kharroubi 2009).3 However, labor market regulations that increase labor supply can help accelerate the decline in unemployment as economic growth resumes and avoid persistently high unemployment (Bastagli, Coady, and Gupta 2012).

Figure 9.3Unemployment Rates and Gini Coefficients during Periods of Fiscal Consolidation

(Percent)

Sources: Solt (2014); Eurostat; and IMF, World Economic Outlook.

Note: Fiscal adjustment episodes are defined as in Escolano and others 2014 based on changes in cyclically adjusted primary balances in countries with positive primary gaps. The sample covers 91 episodes across 49 advanced and developing economies between 1945 and 2012.

In addition to its magnitude, the composition and pace of fiscal consolidation influence its impact on inequality. Beyond its effects on market incomes, fiscal adjustment affects the level and composition of taxes and spending items and thus disposable incomes. Income inequality tends to increase the more fiscal adjustment relies on raising regressive taxes and on cutbacks in progressive spending. Econometric studies find that fiscal consolidations based on spending cuts worsen inequality by more than revenue-based ones (Box 9.1). Frontloaded adjustments can have especially strong effects on social welfare if they are implemented when unemployment is already high (Blanchard and Leigh 2013).

Evidence from recent fiscal consolidation episodes, however, suggests that a progressive mix of adjustment measures can significantly help offset the adverse effects of adjustment on inequality, though the consolidation may still lead to reduced incomes in the short term, reflecting its impact on output and employment. Comparing changes in the Gini index for market and disposable income during 27 recent consolidation episodes in advanced economies and emerging Europe suggests that, in more than half of these economies, market-income inequality increased during these periods. However, in almost all these cases, fiscal policy mitigated the increase in market-income inequality, leading to either a decrease in disposable-income inequality or an offsetting of the worsening of market inequality (Figure 9.4). It should be noted, however, that the reported Gini indices do not single out policy developments that occurred during this period that were not aimed at fiscal consolidation. The next section focuses on the redistributive effect of fiscal consolidation measures only in selected European economies.

Figure 9.4Changes in Market- and Disposable-Income Gini Coefficients, 2007–13

Source: EUROMOD statistics on Distribution and Decomposition of Disposable Income, accessed at http://www.iser.essex.ac.uk/euromod/statistics/ using EUROMOD version No. G2.0.

Note: An increase in the Gini coefficient indicates an increase in inequality. The Gini coefficient for market income is estimated based on disposable-income micro data by adding back (in the case of taxes) or deducting (in the case of benefits) each income component, using the EUROMOD microsimulation model. Estimates for market-income Gini in 2007 and 2013 are based on European Union Statistics on Income and Living Conditions 2008 (income reference period: 2007) and European Union Statistics on Income and Living Conditions 2010 (income reference period: 2009), respectively. For the latter, market-income updates from the income reference period to later years are based on a combination of updating factors. For more information on the exact updating factors used for each country, please refer to the Country Reports (https://www.iser.essex.ac.uk/euromod/resources-for-euromod-users/country-reports). Changes between years and tax-benefit components are not necessarily statistically significant. Data labels in the figure use International Organization for Standardization (ISO) country codes.

Box 9.1Fiscal Consolidation and Inequality: A Brief Review of the Empirical Literature Based on Econometric Analysis

There is a broad consensus in the regression-based research that adjustments based on spending cuts have larger effects on income inequality than those based on tax hikes. A number of econometric studies assess how fiscal consolidation affects income inequality both through its impact on market-income inequality (through rising unemployment and wage inequality) and disposable incomes (through changes in taxes and spending). Woo and others (2013) find that spending cuts are significantly associated with an increase in inequality, whereas tax increases have a negative but statistically insignificant effect. Ball and others (2013) show that both spending- and tax-based fiscal consolidation have typically led to a significant and persistent increase in inequality, decline in wage income and in the wage share of income, and increases in long-term unemployment, although spending-based consolidations tend to worsen inequality more than tax-based ones. Agnello and Sousa (2012) find that income inequality significantly rises during periods of fiscal consolidation. However, although spending-driven austerity plans are detrimental to income distribution, tax increases may have an equalizing effect. Finally, Mulas-Granados (2005) finds that expenditure-based adjustments have a greater effect on inequality than do revenue-based ones, but are less detrimental to short-term growth, unemployment, and inflation.

Recent Experience in Selected European Countries

The magnitude, composition, and design of recent fiscal consolidation packages implemented in nine European countries since the global financial crisis varied substantially. The timing also varied across countries, with Estonia, Lithuania, Latvia, Portugal, and the United Kingdom starting to consolidate in 2009; Greece, Spain, and Romania in 2010; and Italy in 2011. The impact of fiscal adjustments on overall disposable income between 2008 and 2012 ranged from 2 percent to more than 15 percent, contributing to reductions in living standards of the population (Figure 9.5; Box 9.2).4 Public sector pay reductions were significant in Greece, Latvia, Portugal, Romania, and Spain. Public pension cuts or a freeze in benefits were prevalent in Romania, Portugal, and to a lesser extent, Spain. Changes in pension indexation were adopted in Estonia. Reductions in means-tested benefits were large in Portugal and the United Kingdom, while reductions in untargeted benefits were sizable in Lithuania and Latvia. Direct tax hikes played a major role in Greece (with an important base-broadening component) and Spain,5 and increases in worker social insurance contributions played a role in Latvia and Estonia. Increases in value-added tax (VAT) rates were adopted in all nine countries.

Figure 9.5Aggregate Effect and Composition of Simulated Fiscal Consolidation Measures, 2008–12

(Percent of total household disposable income)

Source: Avram and others (2013).

Note: The aggregate impact of the value-added tax is calculated as the unweighted average of the percentage impact across household disposable income quantiles and is likely to overestimate the aggregate impact. SIC = social insurance contribution; VAT = value-added tax.

The direct distributional outcome reflects the composition and design of the consolidation package. Microsimulation studies indicate that these fiscal adjustments relied in most cases on measures that had a direct progressive impact on disposable income (Callan and others 2012; Avram and others 2013; Koutsampelas and Polycarpu 2013). These studies focus exclusively on the direct impact of spending- and tax-consolidation measures on household disposable income and consumption, and do not capture the interactions between policies and market-income dynamics, which can play a crucial role, especially in times of major changes, in market incomes.6 Furthermore, although the specific consolidation measures considered account for the bulk of the fiscal consolidation in most countries, cuts in spending on public services and employment, or other spending not directly affecting household income, are not captured.

The analysis of the distributional impact of the fiscal adjustment packages suggests that both revenue and spending measures can be designed in ways that reduce their burden on lower-income groups. Simulations show that five countries (Greece, Latvia, Portugal, Romania, and Spain) implemented progressive measures between 2008 and 2012, with households in the richest quantiles bearing most of the adjustment cost (Figure 9.6).7 In other countries, the impact of the adjustment tended to be less redistributive and smaller in size (Italy and the United Kingdom). In contrast, for two economies (Lithuania and Estonia), those in the poorest deciles suffered relatively larger reductions of their incomes. In Greece, there was also a larger drop in incomes of the poorest 10 percent of the population, but the overall effect was progressive given that the second through fourth deciles experienced smaller decreases in their incomes while the eighth through tenth income deciles experienced larger drops. The simulated effects of the fiscal consolidation measures on the Gini for disposable income are shown in Figure 9.7; they suggest that fiscal measures have a direct positive effect on disposable income inequality in seven out of nine countries. In particular, the analysis suggests the following:

Figure 9.6Change in Household Disposable Income Due to Simulated Fiscal Consolidation Measures, 2008–12

(Percentage of household disposable income)

Source: Avram and others (2013).

Note: Bars refer to the impact of changes in cash payments, direct taxes, social insurance contributions, and value-added tax as a percentage of each income quantile’s total household disposable income. Income quantiles are derived based on equivalized household disposable income in 2012 in the absence of fiscal consolidation measures. Other rankings could give different distributional effects.

Figure 9.7Simulated Impact of Fiscal Consolidation Measures on Gini Index, 2012

(Simulated disposable Gini coefficient indices and their difference)

Source: Based on information from Avram and others (2013).

Note: The effect of fiscal consolidation measures equals the difference between Gini coefficients before and after the fiscal consolidation measures (bars). Unlike the Gini coefficients in Figure 9.4, the coefficients reported here reflect the simulated effects of only the consolidation measures adopted during 2008–12 that directly affect disposable income and were not reversed before mid-2012. Estimates of Gini for disposable income before and after fiscal consolidation measures are conditional on the same distribution of market income. FC = fiscal consolidation.

Box 9.2Distributional Impact of Fiscal Adjustment Measures in Nine European Countries, 2008–12

Recent microsimulation studies simulate the direct impact on disposable income of specific consolidation measures adopted during the period 2008–12 (see Annex 9.1 for a discussion of the methodology).

The results suggest the following:

  • The overall progressivity of the consolidation package in Greece has been driven by progressive public sector pay cuts, pension cuts, and direct taxation. Public sector wages were capped, special allowances for civil servants reduced, and the 13th and 14th months of pay abolished for high-earning workers. The poorest 10 percent of the population was hit relatively harder by the introduction of self-employed and liberal professions social insurance contribution requirements.

  • The progressive incidence in Spain was also due to public sector pay cuts and changes in income taxation, although the poorest 10 percent of households were relatively harder hit by the 5 percentage point cumulative value-added tax increases imposed in 2010 and 2012. The public sector pay cut averaged 5 percent but increased with wages up to 9.7 percent, and was followed by a freeze and the elimination of the 14th month of pay.

  • Moderately progressive public sector wage and pension cuts also drove the overall mildly progressive effect of consolidation in Italy, although the scale of the average household income loss was very limited as the result of narrow targeting of the implemented measures, which by design only affected a small part of the population. Public sector wages above €90,000 and €150,000 per year were cut by 5 and 10 percent, respectively.

  • In Portugal, the overall progressive incidence was due to progressive cuts in public wages and pensions, which offset the regressive cuts in means-tested social transfers that negatively affected households in the bottom decile. Public sector pay cuts increased with wages to a maximum of 10 percent in 2011, and were followed by a suspension of the 13th and 14th months of pay in 2012. Benefit reductions included a decrease of the amount and tightening of the eligibility conditions for family benefits. The suspension of the 13th and 14th months of pay was reversed in 2013 (after the period under consideration in the analysis).

  • The moderately regressive path observed in Lithuania was the result of the regressivity of VAT increases, which more than offset the progressivity of public sector pay cuts (involving basic wage rates, coefficients, and bonuses).

  • In Romania, the overall progressivity was driven mostly by public sector pay cuts and real pension reductions for middle-class and rich pensioners. Large losses from real pension cuts occurred because high inflation eroded the real value of pensions that had been frozen as part of the consolidation plan. The part of the population receiving the minimum pension was not affected by the latter measure because the minimum pension was not indexed to inflation even before the pension reform. These large reductions in public pension benefits, coupled with no policy changes in income tax and social contributions, resulted in a net increase in the income of the richest households, because taxable pensions and benefits shrank.

  • Progressive reductions in public sector pay, which decreased the average wage by about 9.5 percent, and nonpension benefits more than offset regressive cuts in public pensions and drove the overall progressivity in Latvia.

  • The overall regressive effect observed in Estonia was driven by a change in the indexation of public pensions as pensioners are prevalently in low-income groups, although means-tested social assistance was made more generous and lessened the impact on the incomes of the poorest.

  • In the United Kingdom, the overall incidence was progressive, due to higher taxes, especially on the richest 1 percent of the population. Losses to households in the bottom half of the income distribution were due to cuts in benefits to families with children, including some sharper means testing.

Figure 9.2.1Change in Household Disposable Income by Type of Measure and Income Group, 2008–12

(Percentage)

Source: Avram and others (2013).

Note: Income quantiles are derived based on equivalized household disposable income in 2012 in the absence of fiscal consolidation measures. Other rankings could give different distributional effects. SIC = social insurance contribution; VAT = value-added tax. Missing panels indicate that a particular country did not implement consolidation-related changes of the relevant type.

  • Public sector wage reductions were progressive, given that public sector employees usually earn more than do inactive people such as the unemployed and pensioners, and hence are positioned higher up in the income distribution, and because the cuts were generally structured to have a greater impact on higher-income workers.

  • Cuts in untargeted benefits were largely progressive, whereas reductions in means-tested benefits were regressive.

  • Proportional reductions in pensions across all beneficiaries proved to be strongly regressive because pensioners in the lower-middle-income groups lost a greater share of their total income. In economies where pension freezes or cuts (or both) were targeted to high pensions, the overall effect was progressive.

  • Increases in income tax and social contributions proved to be mostly progressive. However, the design of some of the changes in the income tax, such as decreases in the tax-free threshold, reduced the progressivity of income taxation.

  • Increases in VAT rates were regressive, with the relative degree of regressivity depending on the relationship between the VAT structure and consumption patterns of different income groups.

Changes in property taxes were implemented in Greece, Italy, Latvia, Lithuania, Portugal, Romania, and Spain, but they could not be modeled for most countries because of data limitations. However, their design suggests that they were conceived to be, in general, progressive, with reduced rates and exemptions applied to vulnerable populations. Property taxes are generally found to be a relatively growth-friendly and equitable source of revenue (Chapter 11).

Fiscal Consolidation and Income Inequality in Developing Economies

Although less evidence is available on the distributional incidence of fiscal policy in developing economies, the low levels of both taxes and spending suggest that the incidence is limited for these countries (Chapter 4). Furthermore, a larger share of revenues derives from indirect taxes, which tend to be less progressive than direct taxation. In addition, social spending is, in general, much lower than in advanced economies, which substantially reduces the redistributive effects of fiscal policy. The coverage of social benefits, that is, the percentage of poor households that receive benefits, is generally very low. Also, social spending in developing economies is often not well targeted and in some cases actually increases inequality. With the exception of emerging Europe, in developing economies the poorest 40 percent of the population receives less than 20 percent of the benefits of social protection spending. Many developing countries use energy subsidies as a form of social assistance, which disproportionately benefits upper-income groups. In-kind social spending in developing economies is also not well targeted and exacerbates inequality because the poor often lack access to key public services.

Since government spending in developing economies is often regressive, spending cuts undertaken as part of fiscal adjustment could actually enhance equality. Inequality and unemployment may even decline in the longer term if fiscal adjustment helps bring down inflation—which is damaging to the poor—or corrects macroeconomic imbalances that are hindering growth (Easterly and Fisher 2001; Agenor 2002; Albanesi 2007).

In this respect, fiscal consolidations can have adverse effects on inequality in the short term, but their long-term effects are often positive. Evidence from 27 past episodes of large fiscal adjustment in 19 economies shows that fiscal consolidation is associated with increased unemployment in the near term (Figure 9.8).8 By the end of these adjustment episodes, however, unemployment had declined to close to its preadjustment levels, and income inequality also declined.9 In general, the results also hold at the regional level.

Figure 9.8Unemployment Rates and Gini Coefficients during Large Fiscal Adjustments in Developing Economies

Sources: Solt (2014); IMF, World Economic Outlook; Tsibouris and others (2006); and IMF staff calculations.

Note: Data for both unemployment and Gini coefficients are available for 27 episodes in 16 countries. The entire sample for Gini coefficients includes 68 episodes in 41 countries.

However, the impact of fiscal consolidation could be longer lasting if the country experiences an economic recession during the adjustment period. In 12 out 27 episodes of fiscal consolidation, countries experienced an economic recession, defined as a contraction of GDP in at least one year during the adjustment period. As shown in Figure 9.9, the experiences of the two country groups were quite different during the consolidation periods. Countries that had an economic recession during fiscal adjustment episodes experienced, on average, a larger increase in unemployment during the consolidation period than did the other countries. Furthermore, although unemployment declined after the adjustment, it remained at significantly higher levels than before the adjustment for the countries that had a recession, suggesting that fiscal consolidation may not fully correct the macroeconomic imbalances that hindered growth if such imbalances are structural in nature. It is also remarkable that, after the adjustment period, inequality was lower compared with the preadjustment period for both country groups.

Figure 9.9Unemployment Rates and Gini Coefficients during Large Fiscal Adjustments in Developing Economies that Experienced Economic Contraction and Expansion during the Consolidation Period

Sources: Solt (2014); IMF, World Economic Outlook; Tsibouris and others (2006); and IMF staff calculations.

Note: “Economic contraction” countries are those that had at least a year of GDP contraction during a period of fiscal consolidation. The two groups include 12 episodes of economic contraction in 9 countries (panel 1) and 15 episodes of economic expansion in 14 countries (panel 2).

Conclusion

Both expenditure- and revenue-based fiscal adjustments can be designed to mitigate their adverse effects on inequality. Although the appropriate pace of fiscal adjustment depends on the state of the economy, the state of public finances, and the extent of market pressures, the analysis in this chapter suggests that the progressivity of consolidation efforts, as well as their macroeconomic impact, depends on the specific composition and design of the measures. Governments should consider protecting the most progressive and efficient redistributive spending during fiscal adjustment to minimize the effects of the adjustment on inequality. They should improve the targeting of spending and broaden the scope of spending cuts to decrease untargeted subsidies, military spending, and public sector wages, which will reduce the need for cuts in social transfers. For example, energy subsidies, which exacerbate inequality (see Chapter 14) and hold back growth, should be avoided and replaced with better targeted instruments (Clements and others 2013).

In advanced economies, greater reliance on progressive revenue measures can also prevent the need for large cuts in social transfers, though room to increase revenue may be limited if taxes are already high (Baldacci, Gupta, and Mulas-Granados 2012). Progressive tax measures should also be considered, such as reductions in regressive tax expenditures and greater taxation of wealth and property. Spending measures should be designed to reduce labor market distortions. For example, linking child benefits to labor market participation can strengthen incentives for women to enter the labor market and decrease welfare dependency (Elborgh-Woytek and others 2013). Pension reforms should safeguard the distributive role of pensions by making benefit cuts progressive to protect low-income pensioners (IMF 2014b). Finally, expanding active labor markets programs, such as job-search support, targeted wage subsidies, and training programs, can help accelerate the decline in unemployment as economic growth resumes.

In developing economies, social insurance and social assistance programs often cover only a small share of the population (see Chapter 4). To prevent short-term increases in inequality, social safety nets should be strengthened to protect vulnerable households during fiscal adjustments. Replacing widespread universal subsidies with targeted social spending (see Chapter 14) can also help prevent a surge in inequality during the adjustment. Fiscal consolidations may nevertheless need to include revenue measures to be sustainable (Gupta and others 2005; Bevan 2010). Increasing the efficiency and equity of the tax system through greater reliance on progressive taxation can also help mitigate the impact of tax measures on inequality.

Annex 9.1. EUROMOD Simulations: A Brief Description of the Methodology

This annex provides a brief description of the methodology and main assumptions used by the EUROMOD model for simulating the redistributive effects of fiscal consolidation policies (see Avram and others 2013).

The analysis focuses on the fiscal consolidation measures implemented after the 2008 economic downturn and up to mid-201210 that were explicitly introduced for austerity reasons to cut the public deficit or stem its growth.11 It looks at first-round effects of changes in cash payments and direct personal taxes and contributions that have a direct impact on income distribution—including reductions in cash benefits and public pensions, increases in direct taxes and contributions paid by households, and public sector pay cuts12—plus indirect tax increases. The analysis does not consider increases in employer-paid contributions, cutbacks in public services, reductions in public expenditure or increase in taxes that cannot be allocated to households, and cuts in public sector employment. This also leaves aside the potentially larger effects on income inequality from labor market developments and financial, macroeconomic, and political disarray.

For the simulations, household survey data collected before the global crisis are considered, with market incomes adjusted by source, in line with actual changes in average levels between the period when the data were collected and 2012. The counterfactual scenario, which would be the absence of fiscal consolidation measures, assumes the continuation of precrisis tax and benefit policies, indexed according to standard practices and official assumptions or law.13

The analysis makes use of EUROMOD, the European Union tax-benefit microsimulation model, developed by the University of Essex Institute for Social and Economic Research. This is a static model, that is, the simulations of taxes and benefits do not capture the potential behavioral reactions of individuals, and sociodemographic characteristics are assumed to be fixed over time. The model calculates the static effects of the tax-benefit system on household incomes in a comparable manner across countries. This allows an assessment to be made of the effects of consolidated tax-benefit policies and how tax-benefit policy reforms may affect income distribution. Simulations are based on individual microdata from Eurostat, national versions of the European Union Statistics on Income and Living Conditions (EU-SILC), and the Family Resources Survey for the United Kingdom.

Market incomes and information on other personal and household characteristics (for example, age and marital status) come from the microdata, and cash benefit entitlements, direct personal tax and social insurance contribution liabilities, and indirect tax payments are estimated on the basis of the tax-benefit system in place and information available in the underlying data sets. Disposable incomes are derived by applying the estimated cash benefit entitlements and direct personal tax and social insurance contribution liabilities to market incomes. Posttax incomes are obtained by deducting the proportion of disposable income paid in indirect taxes. Income quintiles are derived based on equivalized household disposable income in 2012 in the absence of fiscal consolidation measures.14 The distributional effect of tax and benefit changes is calculated by comparing final incomes after policy changes with incomes under a no-policy-change scenario.15

References

As a measure of domestic social tensions, this chapter uses the variable “weighted conflict measures” from the Cross-National Time-Series database (Banks and Wilson 2014), which captures various dimensions of domestic conflict, including assassinations, strikes, guerrilla warfare, government crises, purges, riots, revolutions, and antigovernment demonstrations.

If fiscal consolidation is postponed and macroeconomic imbalances are not addressed, a reduction in growth and employment may still occur.

This effect can operate through the labor market as the number of long-term unemployed rises and individuals lose human capital.

Only measures adopted for fiscal consolidation purposes are considered.

Changes in property taxes were only simulated for Italy and Greece. However, property taxes are present in the other countries and are taken into account for the calculation of household disposable income.

This is a crucial assumption because taxes and benefits affect market income and are, in turn, affected by it.

Box 9.2 discusses specifics of the measures and simulation results in the nine economies. Results for Ireland and Cyprus are also available but only capture the aggregate effect of fiscal measures on inequality, and do not include the effect of VAT increases. The results for Ireland indicate that the aggregate effect of tax and social benefit measures, as well as reductions in the public wage bill, was to decrease the incomes of the bottom 10 percent by about 5 percent, and of the top 10 percent by about 13 percent, during 2009–12 (Callan and others 2012). Results for Cyprus indicate that tax and payroll contribution increases implemented in 2012 reduced the incomes of households in the bottom 20 percent by less than 0.1 percent and those of the top 20 percent by about 2 percent (Koutsampelas and Polycarpou 2013).

The sample includes Algeria, Belize, Brazil, Bulgaria, Chile, El Salvador, Hungary, Jamaica, Jordan, Kazakhstan, Mexico, Moldova, Panama, Russia, South Africa, Suriname, Trinidad and Tobago, Turkey, and Venezuela.

Successful fiscal adjustments are also beneficial in the longer term because they reduce public debt ratios and create the fiscal space for countercyclical policy responses to external shocks. This can help dampen the effects of these shocks on unemployment.

The starting point of the changes varies across countries because countries began consolidating in different years.

The removal of temporary fiscal stimulus measures is not considered as part of the fiscal consolidation packages if those reforms were originally presented as temporary. Since the aim is to quantify the effect of fiscal consolidation on 2012 incomes, measures that were reversed before mid-2012 are also not considered.

Public sector pay cuts are measured net of any reduction in income tax and social contributions.

Such indexation is not the same across countries.

It is essential to note that other rankings could give different distributional effects.

See Sutherland and Figari 2013, Sutherland 2007, and Lietz and Mantovani 2007 for further technical and methodological information.

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