Growth, Income Inequality, and Fiscal Policy: What Are the Relevant Trade-Offs?

By Garcia-Penalosa, Cecilia; Turnovsky, Stephen J. | Journal of Money, Credit & Banking, March-April 2007 | Go to article overview

Growth, Income Inequality, and Fiscal Policy: What Are the Relevant Trade-Offs?


Garcia-Penalosa, Cecilia, Turnovsky, Stephen J., Journal of Money, Credit & Banking


THE LAST DECADE has seen a revival of interest in the relationship between income inequality and growth. This research has employed a range of theoretical frameworks and yielded conflicting empirical results. While earlier evidence suggested a negative trade-off between growth and inequality, more recent studies have tended to support a positive relationship; see, e.g., Barro (2000), Forbes (2000), and Lundberg and Squire (2003). Virtually all of this debate has ignored the role of distortionary taxes. But once their presence is acknowledged, it becomes evident that policy makers may face two potential trade-offs, in that growth-enhancing policies may have conflicting effects on the pre- and post-tax distributions of income. Of these two measures, it would seem that the latter is in fact the more relevant as a guide to policy. Indeed, one can go even further. Since presumably, one is ultimately interested in the effect of fiscal policy on economic welfare, a further potential trade-off--one between growth and welfare inequality itself--naturally arises.

In this paper we analyze the effects of fiscal policy on these various growth-inequality trade-offs. To do so we develop an endogenous growth model with elastic labor supply and agents who differ in their initial endowments of physical capital. In this framework the equilibrium growth rate and the distribution of income are jointly determined. The key mechanism generating the endogenous distribution of income is the positive equilibrium relationship we derive between agents' relative wealth (capital) and their relative leisure. This relationship has a very simple intuition. Wealthier agents have a lower marginal utility of wealth. They, therefore, choose to work less and to enjoy more leisure, and given their relative capital endowments, this generates an equilibrium income distribution.

This role played by endogenous labor supply is analogous to its role in other models of capital accumulation and growth, where it provides the crucial mechanism whereby demand shocks, such as government consumption expenditure, stimulate capital accumulation. The key factor is the wealth effect and the impact this has on the labor--leisure choice. This mechanism is also central to empirical models of labor supply based on inter-temporal optimization: see, e.g., MaCurdy (1981).

There is substantial empirical evidence documenting this negative relationship between wealth and labor supply. Holtz-Eakin, Joulfaian, and Rosen (1993) find evidence to support the view that large inheritances decrease labor force participation. Cheng and French (2000) and Coronado and Perozek (2003) use data from the stock market boom of the 1990s to study the effects of wealth on labor supply and retirement, finding a substantial negative effect on participation. Algan et al. (2003) use French data to analyze the effect of wealth on labor market transitions, and find a significant wealth effect on the extensive margin of labor supply.

Assigning such a central role to the adjustment in labor supply relates our analysis to another body of literature. The widening gap between working hours in the United States and Europe has recently sparked a debate about the causes and effects of differences in labor supply; see Prescott (2004) and Alesina, Glasser, and Sacerdote (2005). This literature has largely focused on whether taxes have driven these differences, and on the impact of labor supply on growth. However, little attention has been paid to the distributional implications of an endogenous labor supply. Our analysis can, therefore, be viewed as extending this discussion to focus on this important, but neglected, aspect. The central role of the labor-leisure trade-off in our model, whereby policies that lead to a higher labor supply also tend to increase inequality is consistent with the positive correlation between average hours worked in a country and the Gini coefficient of income reported by Alesina, Glasser, and Sacerdote (2005) for OECD economies. …

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