“Austerity” and Inequality: Is there a Link?

Prakash Loungani is an an advisor at the IMF's Research Department.

Inequality is at historic highs. The richest 10 percent took home half of U.S. income in 2012, according to estimates released this week by economists Emmanuel Saez and Thomas Piketty, a level of inequality not seen since the 1920s. In the "rich man's club"—in countries that belong to the Organization of Economic Cooperation and Development (OECD) recent estimates show that inequality increased more in the three years leading up to 2010 than in the preceding twelve.

What explains this rise in inequality? Reductions in government budget deficits are a factor. Such fiscal consolidations—commonly referred to as times of "austerity"—lead to significant increases in inequality, a decline in the share of income going to labor, and higher long-term unemployment, according to a recent IMF working paper.

Greater income inequality and a setback for labor's share

To establish these links, my co-authors and I looked at a large number of episodes of fiscal consolidations in OECD economies, a total of 173 episodes during 1978-2009. On average across these episodes, governments took policy actions—either spending cuts or tax hikes or a combination of the two—that reduced the budget deficit by about 1 percent of GDP.

We then studied the impacts of shrinking budget deficits on two measures of inequality. One is the Gini coefficient, which takes the value 0 if all income is equally shared within a country and the value 1 if one person has all the income. There are large variations in the Gini coefficient across OECD countries. In Iceland and in Nordic countries, the level of inequality is low—a Gini coefficient of about 0.25. Inequality is high in Chile (its Gini coefficient is twice that of Iceland’s), Mexico, Turkey, the United States, and Israel.

Another measure of inequality we studied was labor's share of income, that is, the share of total income that is accounted for by wages as opposed to profits and rents. This measure harks back to times when the roles of workers, capitalists, and landlords were fairly distinct. While these distinctions have eroded over time, the split between wages and other forms of income represents a common way for summarizing how income is divided between Main Street and Wall Street.

For both measures we found that the decline in budget deficits leads to increases in inequality (see Figures 1 and 2). The Gini coefficient increases by about 0.4 percent in the very short term a year after the fiscal consolidation and by about 3 ½ percent over the longer run. Fiscal consolidations also lead to long-lasting reductions in the slice of the income pie that goes to labor.

Figure 1 “Austerity” leads to inequality
(Impact of fiscal consolidation on the Gini measure of income inequality)

Figure 2 "Austerity" lowers labor's share of the income pie
(Impact of fiscal consolidation on wage income as a percent of GDP)

More long-term, but not short-term, unemployment

How about the impact on jobs? We also found that fiscal consolidations typically lead to increases in long-term unemployment, while they don't have significant effects on short-term unemployment (see Figure 3). Austerity thus adds to the pain of those who are likely to be already suffering the most—the long-term unemployed. This is a particular worry today given that the share of long-term unemployed rose in most OECD countries during the Great Recession. And even in countries where it didn't increase—such as Germany, France, Italy and Japan—the share had already been very high even before the recession. Recent work shows that job loss is associated with persistent earnings loss, poorer health, and declines in the academic performance and earnings potential of the children of displaced workers. These adverse impacts are exacerbated the longer a person is unemployed.

Figure 3 "Austerity" raises long-term unemployment rates
(Impact of fiscal consolidation on unemployment spells greater than 6 months)

Crafting fiscal policies with an eye on inequality

Our results don't imply that governments shouldn't undertake fiscal consolidation. After all, such actions aren't taken by governments on a whim. Rather they typically reflect a desire to lower government debt to safer levels, which in turn can help the economy by bringing down interest rates. Over time the lighter burden of interest payments on the debt can also allow the government to cut taxes.

What the results of our research do suggest is that these benefits from fiscal consolidation should be weighed against the distributional impacts they can have. In many cases, governments may have the flexibility to design the spending cuts or tax increases in a way that lessens the distributional impact. At a time when inequality is on the rise—and a potential source of hardship and social unrest—paying attention to the distributional impacts of fiscal policy may be more important than ever.

This post was first published on the Jobs Knowledge Platform.