Joint determinants of fiscal policy, income inequality and economic growth

This paper analyses the relationship between income inequality and economic growth through fiscal policy. To this end, we present and estimate two systems of structural equations with error components through which gross income inequality determines different fiscal policy outcomes, which subsequently affects the evolution of economic growth and net income inequality.The empirical results, obtained using an unbalanced panel data of 21 high-income OCDE countries during the period 1972-2006, suggest that gross income inequality is a significant determinant of fiscal policy outcomes. Additionally, the results show that distributive expenditures and direct taxes may produce significant reductions in GDP growth and net income inequality reflecting the standard efficiency-equity trade-off associated to certain fiscal policy measures. Finally, the results also indicate that the most adequate fiscal policy strategy in a context of fiscal consolidation is to cut non distributive expenditure, since this could increase GDP growth while reducing income inequality.

► We model a system equations of growth, inequality and fiscal policy. ► We empirically examine the growth and distributive effects of fiscal policies. ► Gross income inequality determines fiscal policy outcomes ► Increasing distributive expenditure and direct taxes reduces GDP and inequality.