Subarna K. Samanta, Ph., D., Economics, Finance and International Business, The College of New Jersey, 29 Brians Circle, Princeton Junction, NJ 08550
Optimal policy makers are interested in understanding the welfare implications of their policy prescriptions as it depends on the economic infrastructure. One component of such infrastructure is the income distribution of the economy, and the effect of the optimal policy may be quite different if the income distribution is highly skewed or more symmetric. The extent to which taxes can be levied and government revenue generated depends on the distribution of income. Likewise, the economic impact of government expenditure may also be influenced by the income distribution, because revenue collection and expenditure affect the social welfare, thus income distribution is enormously important for fiscal policy formulation. But these relationships have not been adequately explored. There exist some researchs which addresses the theoretical nature of the relationship, but empirical investigation is seriously lacking to assess the actual implications of income distribution on the power and effectiveness of fiscal policy.
Our attempt in this paper is to test; using time series data for a set of OECD economies, whether there is a predictable relationship between the degree of income equality and the implementation of fiscal policy through manipulation of the government expenditures. There is an extensive literature on the role and implications of the fiscal policy on the growth of the economic activities (i.e. Gross Domestic Product, GDP) in a country. Moreover, macroeconomists typically argue that fiscal policy is procyclical in developing countries whereas it is acyclical or countercyclical in developed or high income countries. Estimated fiscal policy multipliers typically vary between .52 to 1.29 depending on countries and estimation methods. There has not been as thorough an evaluation of the effect of the distribution of income on the impact of fiscal policy on an economy, as the relationship between the aggregate demand (as measured by aggregate expenditure) and the extent to which the income distribution is skewed has been a largely unobserved phenomenon in the context of both fiscal and monetary policy formulation. It is typically assumed (perhaps correctly following Keynes’ assertion) a greater equality in income distribution results in a larger aggregate expenditure than a skewed income distribution would. No thorough theoretical analysis has been done, until Peter Lambert and Wilhelm Pfahler (1997) analyzed the relation between market demand and income distribution and concluded that this relation is ambiguous as it depends on a variety of assumptions regarding preference functions and the initial values of the parameters describing the economy. Consequently, they were unable to determine conclusively the effect of income distribution on the effectiveness of the fiscal policy.
Thus, the main purpose of our study is to find out the empirical nature of the relationship between a country’s income distribution and government expenditures (fiscal policy) and secondly, which is more important, to identify the extent to which the income distribution could effect the power of the fiscal policy. The econometric methodologies employed are cross sectional as well as time series and seek to isolate the factors exhibiting the proper sign while testing for stability and stationarity using traditional econometric techniques.