1. FISCAL CONSOLIDATION
& INEQUALITY
Prakash Loungani
Advisor, Research Department, IMF
Co-Chair, IMF “Jobs and Growth” Working Group
September 2013
VIEWS EXPRESSED SHOULD NOT BE ATTRIBUTED TO THE IMF OR TO MY CO-AUTHORS.
Background presentation for talks at UNICEF (September 9) and World Bank (September 12).
I thank Hites Ahir, Ezgi Ozturk and Jair Rodriguez for excellent research assistance.

2. Outline
1. Evolution of fiscal policy over the Great Recession
– Coordinated fiscal stimulus at onset of crisis
– Then, turn to consolidation
2. IMF advice on fiscal policy
– Support for initial fiscal stimulus
– On consolidation: credible medium-term plans rather than
strong front-loading
– Fiscal policy and output: WEO chapter (Will it Hurt?)
– Fiscal multipliers: Blanchard-Leigh
– Fiscal policy and global recoveries: Kose, Loungani, Terrones
3. Fiscal consolidation and inequality

3. Fiscal Policy during the Great Recession
• Coordinated global fiscal stimulus at the onset of the crisis
• Over 2007-09, a significant increase in public debt, in large part
because of the collapse in tax revenues
• Against this backdrop, many governments started to undertake or
plan policies to reduce government debt and deficits, through a
combination of spending and tax-based consolidation measures
EvolutionofFiscalPolicy

4. Revenue losses were the bulk
of projected increase in public debt
EvolutionofFiscalPolicy

5. 0
50
100
150
200
250
Japan
Greece
Iceland
Italy
Belgium
UnitedStates
Portugal
France
Canada
Ireland
UnitedKingdom
Israel
Germany
Austria
Spain
Netherlands
Norway
Denmark
Finland
Sweden
Korea
NewZealand
Australia
Estimate of "fiscal space": Red, yellow and green cells indicate probability less than 50 percent, between 50 and 85 percent, and
above 85 percent, respectively.
Public Debt, 2010 (% of GDP)
EvolutionofFiscalPolicy

6. IMF Supported Initial Fiscal Stimulus
“The optimal fiscal package should be
timely, large, lasting, diversified, contingent, collective, and sustainable:
timely, because the need for action is immediate;
large, because the current and expected decrease in private demand is exceptionally large;
Lasting, because the downturn will last for some time;
diversified because of the unusual degree of uncertainty associated with any single measure;
contingent, because the need to reduce the perceived probability of another “Great Depression”
requires a commitment to do more, if needed;
collective, since each country that has fiscal space should contribute; and
sustainable, so as not to lead to a debt explosion and adverse reactions of financial markets. “
Fiscal Policy for the Crisis, Dec. 29, 2008
Antonio Spilimbergo, Steve Symansky, Olivier Blanchard,
and Carlo Cottarelli
IMFAdviceonFiscalPolicy

7. IMF Advice on Fiscal Consolidation
• It is important to have realistic expectations about the
consequences of fiscal consolidation
• Consolidations are contractionary (WEO Chapter, “Will it
Hurt?”)
• Previous global recoveries relied on expansionary fiscal
policies (Kose, Loungani, Terrones, 2013)
IMFAdviceonFiscalPolicy

8. IMF Advice on Fiscal Consolidation
• Fiscal consolidation should be gradual, with credible medium-term
plans
• Effects of fiscal consolidation on growth should be offset by other
measures to the extent possible
- Continued ease in monetary policies
- Financial sector repair & reform
• Fiscal measures that are approved now but only kick in to reduce deficits in
the future—when the recovery is more robust—would be particularly
helpful. Examples include linking statutory retirement ages to life expectancy
and improving the efficiency of entitlement program
• Fiscal consolidation plans should spell out how policies would respond to
shocks, such as slower growth than envisaged in the plan
IMFAdviceonFiscalPolicy

9. Fiscal Policy and Global Recoveries:
Why is this recovery slow?
• Many theories
– recovery from financial crises are typically slower
– deleveraging provides headwinds to the recovery
– policy uncertainty
• Stance of policies
IMFAdviceonFiscalPolicy

10. A Recovery on Track?
World Real GDP per capita
Notes: Dashed lines denote WEO forecasts. Indexed to 100 in the year before global recession.
Zero is the time of the global recession year. Each line show the PPP-weighted average of the
countries in the sample.
Figure 1. Real GDP Per Capita
(index, PPP weighted)
80
90
100
110
120
130
-4 -3 -2 -1 0 1 2 3 4
World
Global Recession Year
Average of previous recoveries
Recovery from the Great Recession
IMFAdviceonFiscalPolicy

11. The Divergence in Recovery
between Advanced Countries and Emerging Markets
Figure 2. Real GDP per Capita: Advanced Countries and Emerging Markets
Notes: Dashed lines denote WEO forecasts. Indexed to 100 in the year before global recession. Zero is the
time of the global recession year. Each line show the PPP-weighted average of the countries in the
respective group.
(index, PPP weighted)
80
90
100
110
120
130
-4 -3 -2 -1 0 1 2 3 4
Advanced Countries
Global Recession Year
Average of previous recoveries
80
90
100
110
120
130
-4 -3 -2 -1 0 1 2 3 4
Emerging Markets
Recovery from the Great Recession
IMFAdviceonFiscalPolicy

12. Divergence in Government Spending
between this Global Recovery and Past Global Recoveries
Notes: Dashed lines denote WEO forecasts. Indexed to 100 in the year before global recession. Zero is the
time of the global recession year. Each line show the PPP-weighted average of the countries in the
respective group.
Figure 3. Real Primary Expenditure
(index, PPP weighted)
60
90
120
150
-4 -3 -2 -1 0 1 2 3 4
Advanced Countries
Average of previous recoveries
60
90
120
150
-4 -3 -2 -1 0 1 2 3 4
Emerging Markets
Recovery from the Great Recession
IMFAdviceonFiscalPolicy

13. Divergence in Government Spending
between this Global Recovery and Past Global Recoveries:
US and Euro Area
IMFAdviceonFiscalPolicy

14. How IMF was viewed on fiscal issues during our 2013
Spring Meetings
How the IMF became the
friend who wants us to work
less and drink more
-- Washington Post
April 16, 2013
“It is to the credit of the
economists at the Fund that
their recommendations to
policymakers have adapted to
this strange world we’re living
in rather than sticking with
their more
normal, doctrinaire advocacy
of monetary and fiscal
restraint.”
IMF Renews Push Against Austerity
-- Wall Street Journal
April 17, 2013
“ … the International Monetary
Fund called on countries that
can afford it -- including the U.S.
and Britain -- to slow the pace
of their austerity measures.”
IMFAdviceonFiscalPolicy

15. IMF Statement on Fiscal Policy in Spain
“I strongly support the Spanish government's
objectives of restoring a sound fiscal position
while securing a recovery and creating jobs.
Today's announcement to pursue a more
gradual consolidation path is a welcome step
toward meeting these goals, building on major
reforms and structural fiscal improvements
last year.”
– Christine Lagarde, April 26, 2013
IMFAdviceonFiscalPolicy

16. The distributional effects of fiscal
consolidation
(joint work with Larry Ball and Daniel Leigh)

17. Why should we care about inequality?
Potential economic and social costs
 Lower duration of growth spells (Berg & Ostry, 2011)
 Latent social conflicts (Campante and Chor, 2012)
 Greater use of leverage induces financial crises (Fitoussi and
Saraceno, 2010; Kumhof and Ranciere, 2010)
 Lower intergenerational mobility and increased health
problems (Wilkinson and Pickett, 2010)
Fiscalconsolidationandinequality

18. Data
• Gini for disposable income (Standardized World Income
Inequality Database -- SWIID; Solt 2009 & 2011)
• Shares of wage and profit in GDP (OECD Analytical Database);
• Short (lasting less than six months) and long-term (lasting more
than six months) unemployment rates taken from the OECD
Analytical Database.
Fiscalconsolidationandinequality

19. Data
•Fiscal consolidation episodes are taken from Devries et al.
(2011) database.
•The database contains information on 173 episodes of fiscal
consolidation for 17 OECD economies
(Australia, Austria, Belgium, Canada, Denmark, Finland, France,
Germany, Ireland, Italy, Japan, Netherlands, Portugal, Spain, Swe
den, the United Kingdom, and the United States) during 1978-
2009.
•Measures of fiscal consolidation based on a narrative approach
and focuses on policy actions.
Fiscalconsolidationandinequality

20. Cumulative changes in Gini before and after fiscal
consolidation episodes
Fiscalconsolidationandinequality

21. Cumulative changes in the wage share before and after
fiscal consolidation episodes
Fiscalconsolidationandinequality

22. Regression framework
Impulse Response Functions by Local Projections (Jorda, 2005)
G = measure of inequality
D =dummy variable that takes the value equal to 1 for the starting date
of a consolidation episode in country i at time t and 0 otherwise
=distributional impact of fiscal consolidation episodes for each future
period k
IRF obtained by estimating the equation for each k and plotting the beta
coefficients
𝐺𝑖,𝑡+𝑘 − 𝐺𝑖,𝑡 = 𝛼𝑖
𝑘
+ 𝑇𝑖𝑚𝑒𝑡
𝑘
+ 𝛾𝑗
𝑘
𝑙
𝑗=1
∆𝐺𝑖,𝑡−𝑗 + 𝛽𝑘 𝐷𝑖,𝑡 + 𝜀𝑖,𝑡
𝑘
𝛽𝑘
Fiscalconsolidationandinequality

23. The effect of fiscal consolidation on inequality (Gini)
Note: dotted lines equal one standard error bands.
0
0.2
0.4
0.6
0.8
1
1.2
1.4
0 1 2 3 4 5 6 7 8
estimate lower limit upper limit
Fiscalconsolidationandinequality

24. The effect of fiscal consolidation on inequality (Gini)Fiscalconsolidationandinequality

25. The effect of fiscal consolidation on inequality (Gini)Fiscalconsolidationandinequality

26. The effect of fiscal consolidation on inequality (Gini)Fiscalconsolidationandinequality
MEDIUM-TERM EFFECT OF CONSOLIDATIONS ON GINI
SWIID OECD SWIID for
observations in the
OECD database
Milanovic’s
All the Ginis
database
𝐺𝑖𝑛𝑖𝑖,𝑡+5 − 𝐺𝑖𝑛𝑖𝑖,𝑡 0.456
(2.04)**
1.294
(3.43)***
0.836
(3.20)***
2.223
(2.02)**
N 473 55 55 147
R2
0.13 0.27 0.17 0.12
Note. T-statics based on clustered robust standard errors in parenthesis.
**, **** denote significance at 5% and 1%, respectively

27. The effect of fiscal consolidation on inequality (Gini)-
spending vs. tax-based adjustments
Fiscalconsolidationandinequality

28. The effect of fiscal consolidation on wage income
(% of GDP)
Note: dotted lines one standard error bands.
-1.5
-1
-0.5
0
0 1 2 3 4
estimate lower limit upper limit
Fiscalconsolidationandinequality

29. The effect of fiscal consolidation on wage vs. profits
and rents (percentage change)
Fiscalconsolidationandinequality

30. The effect of fiscal consolidation on wage income
spending vs. tax-based (percentage change)
Fiscalconsolidationandinequality

31. The effect of fiscal consolidation on
short vs. long-term unemployment
Fiscalconsolidationandinequality

32. Key Results
• Fiscal consolidation episodes have typically had significant
distributional effects:
• increase inequality by 0.1 percentage point (about 0.4 percent) in the very
short term, and by 0.9 percentage point (about 3.4 percent) over the
medium term;
•significant and long-lasting fall in the wage income share of about 0.8
percentage point of GDP;
• raise long-term unemployment by about 0.5 percent over the medium
term.
Fiscalconsolidationandinequality

33. Fiscal consolidation occurring via spending restraints
Fiscalconsolidationandinequality

34. Conclusions
“While growth is essential for the future global economy, it
must be a different kind of growth, inclusive and not simply the
fallout of unfettered globalization. The policy implications of
such a reorientation are profound … It requires a fiscal policy
that focuses not only on efficiency, but also on
equity, particularly on fairness in sharing the burden of
adjustment, and on protecting the weak and vulnerable.”
Christine Lagarde (China Daily, Dec. 27, 2012)
Fiscalconsolidationandinequality