Income distribution and effectiveness of government expenditure multiplier

Economic literature has not come to a consensus about the effect of government expenditure on the GDP and employment of an economy. The recent American Recovery and Reinvestment Act was motivated by a relatively high estimate of the multiplier of 1.6, but other studies argue that the multiplier is substantially smaller and potentially close to zero, (in particular, if the determination of output is dominated by supply-side factors,). The wide range of views on the multiplier also results from a lack of clear understanding in the theoretical literature of macroeconomics as the government spending multiplier is not assumed to be a deep structural parameter. Different models, therefore, differ in their implications about the multiplier depending on what is assumed about economic infrastructure. The  recent worldwide economic crisis has brought renewed attention to the question of the usefulness of government spending as a way of stimulating aggregate economic activity and employment during a period of prolonged recession. Consequently, interest about the effectiveness of government expenditure has greatly increased.

 However, another important issue in this context is the role of income distribution. The nature and the distributions of the disposable income is one of the important ingredients of the economic infrastructure of any country. The effect on social welfare of the policy prescriptions may be quite different if the income distribution is highly skewed or is more egalitarian. The extent of taxes levied and/or government revenue generated, transfer payments are made, depends on the distribution of income. The issue of income distribution is an important topic in public economic literature and its various implications have been examined in a  greater detail there.   But the fact that the economic impact of government expenditure (i.e. fiscal policy implication) is likely to be influenced by the income distribution; has not been as adequately investigated in economics literature.  Some research works address the theoretical nature of this impact, but there is much less empirical work to assess the actual implications. In this paper, we intend to fill up this gap by investigating how the effectiveness of stabilizing policies can be affected by the nature of the income distribution of the economy. For this purpose, we use time series data for a set of several OECD countries spanning over several years  

 to identify whether there is a predictable relationship between the degree of income equality and the effectiveness of the government expenditures on the economy. Thus, our study focuses on two specific relationships:

 

• the nature of the relationship between a country’s income distribution and government expenditures (fiscal policy), and
• The extent to which the income distribution could influence the effectiveness of fiscal policy (measured in terms of real GDP and employment). 

Traditional econometric  methodologies based on cross sectional as well as time series analyses are used to draw statistical inferences, based on a) traditional Vector Autoregressive Analysis (based on Sim’s suggestion) of fiscal policy shocks , and b) traditional Simultaneous Equation Panel Estimation Methodology.