with Miguel H. Ferreira, Francesco Franco, Hans Holter and Laurence Malafry.
Abstract: Following the Great Recession, many European countries implemented fiscal consolidation policies, aimed at reducing government debt. Using three independent data sources and three different empirical approaches, we document a strong positive relationship between higher income inequality and stronger recessive impacts of fiscal consolidation programs across time and place. To explain this finding, we develop a life-cycle, overlapping generations economy with uninsurable labor market risk. We calibrate our model to match key characteristics of a number of European economies, including the distribution of wages and wealth, social security, taxes and debt and study the effects of fiscal consolidation programs. We find that higher income risk induces precautionary savings behavior and decreases the proportion of credit-constrained agents in the economy. Credit constrained agents have less elastic labor supply responses to increases in taxes or decreases in government expenditures. This explains the relation between income inequality and impact of fiscal consolidation programs. Our model produces a cross-country pattern between inequality and the fiscal multipliers, resulting from consolidation, which is quite similar to that in the data.
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