Income inequality and fiscal policy over the political cycle

Abstract

We examine the strategic use of public debt to finance compensatory and progressive fiscal policies oriented to lessen the negative effects of income inequality hikes. We exploit the fact that a government seeking reelection will try to avoid the associated social unrest. Thus, higher inequality is expected to exert more political pressure on the government as the next executive election approaches. We estimate dynamic panel models for 79 Advanced Economies and Emerging Markets and Developing Economies (EMDEs) with annual data for the 1990–2015 period. Our findings reveal that the marginal effect of inequality on public debt is increasing in the share of the executive term completed, and it becomes statistically significant after completing 60% of the term. We find that all countries react to increases in inequality by issuing public debt. However, in some countries, this reaction is strongly conditioned by the political cycle—proxied by the share of the executive term completed. This is particularly the case in EMDEs, countries with lower institutional constraints on the executive, and those without any fiscal rule. In addition, a higher degree of financial account openness allows governments to compensate for rising inequality earlier in their mandate.