Fiscal responses to income inequality surges. A panel estimation for Emerging Market and Developing Economies

We assess the fiscal policy responses of Emerging Markets and Developing Economies’ (EMDEs) governments to unexpected shocks that increase income inequality. We focus on the relationship between income inequality and public expenditure, progressive taxation, and public debt. We aim particularly at the strategic use of public debt to finance greater public expenditure targeted to lessen the negative effects of increases in income inequality. To this end, we exploit the fact that a government that wants to be re-elected will try to avoid social conflict and class struggle related to increases in income inequality. Thus, it is expected that increasing social inequalities induce more political pressures the closer the next executive election is. We estimate dynamic panel models for 49 EMDEs with annual data for the 1990-2015 period. We find that the marginal effect of inequality on the public debt increases with the share of the executive term completed, and it becomes statistically significant after completing 85 percent of the corresponding term. This finding is robust to different empirical specifications and is more pronounced in Latin American countries and for economies with higher external liabilities. For EMDEs, the interaction between the political cycle—proxied by the remaining time to complete the mandate—and income inequality is significant and positively related only to public debt. On the contrary, the interaction between inequality and the share of the executive term completed is not significant in the other three cases (government consumption, progressive taxation, and the primary balance), which suggests that the relationships between income inequality and these variables are not mediated by the political cycle. However, there is a statistically significant and negative (positive) linear effect of income inequality on government consumption (primary balance).