Economy

How to get it right: government balances, growth and income inequality

 

Austerity programmes to restore order to public finances can add to the woes of already struggling economies, leading to more job losses and social hardship. But there are ways for governments to put their fiscal houses in order, while supporting growth and reducing income inequality at the same time.

The crisis affecting OECD economies is now in its sixth year, yet sizeable efforts are still needed to put government finances back on a sustainable base, while underpinning growth. At the same time, pressure is mounting to tackle the deepening social problems with policies to reduce exclusion and inequality. It is a difficult balancing act, which few countries can ignore. Indeed, the two largest OECD economies, the US and Japan, are among those countries requiring the most fiscal consolidation of all, to the order of 10% of GDP. Consolidation requirements are also large in troubled countries of the euro area and the UK.

What impact will such prolonged and significant policy efforts have? Fiscal consolidation strategies, however important, have been questioned for adding to the woes of already struggling economies, and leading to even higher unemployment and more social hardship. We can gauge this by looking at the so-called fiscal multipliers–the decline in economic growth for every 1 percentage-point reduction in the government’s fiscal deficit. Though there is some debate about the size of these multipliers, which vary widely across countries and at different times, it is clear that their size was underestimated. They are higher than usual, largely because low or zero interest rates are making it harder for monetary policy to offset the adverse impact of austere fiscal policies.

Moreover, when many countries that interact together tighten policy at the same time, the negative impact is exacerbated as the chill wind of austerity in one country is felt among trading partners. Yet governments have little choice but to forge on with consolidation, given very high levels of public debt and the need to restore financial market confidence. Indeed, high and growing debt ultimately depresses growth and increases fragility.

A major policy concern is how this austerity will affect income inequality. A trend increase in income disparities was already a concern in many OECD countries prior to the financial crisis, but inequality has likely widened since. The Gini coefficient for disposable income, which measures income distribution whereby a value 0 means all households receive the same income, and 1 means just one household receives all income, has risen from an average of around 0.25 in the mid-1980s to around 0.3. Moreover, the financial crisis has drawn attention to excessive and distorting incentive pay in the financial sector, which many people believe to be a key culprit in the crisis.

There is real risk that fiscal consolidation will worsen this inequality, sparking more social anger that can threaten even the most carefully designed and legitimate consolidation programmes, or even destabilise public institutions, including the EU. There is also some discussion as to whether widening inequality can in turn undermine growth. For instance, the concentration of income and wealth among the few can spur reckless financial decision-making to the detriment of growth. Also, there is a danger that declining incomes or a rise in poverty will affect productivity.

The situation is grave. According to current consolidation plans, most governments aim to improve the budget primarily via restraining spending. Social security transfers are planned to decline in cyclically adjusted terms in about half of all OECD countries, while adjusted household income taxes will increase in most of these countries. The net redistributive effect of all measures combined is likely to be negative. This has to be avoided.

 

 

Fortunately, despite all the tightening to date, there is still scope for countries to adjust their fiscal consolidation efforts and redesign them in such a way so as to achieve more fiscal sustainability, more growth and more equity. To do this, governments must act on both sides of the fiscal equation, while also introducing structural reforms.

On the expenditure side, cutting benefits and other cash transfers often significantly increases inequality. However, cuts can be designed to have less impact on lower earners, and be supplemented by structural measures in a way that minimises, or even eliminates, any adverse effects on wealth distribution.

For instance, cuts in unemployment-related benefits tend to hit poorer people most, particularly when weak economic activity prevents an offsetting rise in employment. Such cuts might not be desirable during deep and protracted downturns such as the present one. Moreover, there is still considerable scope among OECD countries to improve benefit-tax systems, including disability benefits, to encourage higher employment and greater equity. Such measures should be reinforced by structural reforms, for example, to support unemployment policies that keep the unemployed in touch with the labour market, and by making it easier to set up and run businesses, so generating revenue and creating jobs.

Raising the effective retirement age would be another good place to take action. Many people still retire young, compared with today’s robust life expectancy, and this often means a drop in income. Later retirement has the potential to raise earnings and so reduce income inequality, as well as giving economic activity a boost. True, acting on this will not produce immediate budgetary savings, but addressing it should at least reassure financial markets that the long-term fiscal outlook is in safe hands.

Education and healthcare reforms should also rank highly on the policy agenda, since these areas are both big-ticket spending items and vital for social well-being and progress. Most countries have substantial margins to improve the efficiency of health and education provision, allowing for large savings without compromising equity or service quality, and possibly improving both. However, such gains might take several years to fully materialise and could lower employment growth in the near term.

The revenue side of fiscal policies merits particular attention, since cutting certain tax expenditures can increase both equity and economic growth. Many tax expenditures have been introduced without serious welfare considerations, although there are exceptions like income tax credits and payroll tax rebates for low-wage workers. The value of many other tax reliefs– including tax breaks for health and childcare, education, owner-occupied housing, and various saving schemes–often increases for earners in higher tax brackets. This is costly and hardly helps improve equity, and should be addressed.

Meanwhile, tax hikes that can bolster equality and have relatively little impact on long-term growth, such as on real estate, should be considered. However, serious consideration must first be given to the state of the housing market, which has been struggling in many countries. Moreover, to be effective, additional measures, such as carrying out proper (and possibly costly) valuation of property, might be needed. Meanwhile, hikes in capital income taxes would be positive for equity and would not necessarily distort growth, while shifting tax burdens away from labour and towards green consumption taxes, for instance, would also bring benefits.

Though fiscal consolidation must continue for a while, progress especially in Europe has been substantial, as many countries have been taking the right steps. If more similar reforms had been made in the past couple of years, the benefits might already be starting to lift the economy. Hopefully, we have seen the bottom of the crisis, but there is still time for policymakers across the OECD area to carry out reforms and give more weight to the tax expenditure side of the fiscal equation, for the sake of both restoring sustainable growth and improving equality.

 

References and recommended sources

OECD (2013), Economic Policy Reforms: Going for Growth, OECD Publishing

OECD (2012), OECD Economic Outlook, Vol. 2012/2, OECD Publishing

Rawdanowicz, L., E. Wurzel and A. Christensen (2013), "The Equity Implications of Fiscal Consolidation", OECD Economics Department Working Papers, No. 1013, OECD Publishing

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©OECD

 

By Pier Carlo Padoan, Chief Economist and Deputy Secretary-General of the OECD  

 

©OECD Yearbook 2013

 

 

 

 

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