21 July 2021 Fiscal Policy

Can Fiscal Policy Save Us From Rising Inequality?

Summary

A new IMF working paper examines the macroeconomic consequences of past pandemics.
The recovery from Covid-19 may be slower and more drawn out than previously thought.
But significant long-term fiscal support can mitigate much of the downside risk – important for addressing rising inequality.

Introduction

Many central banks entered the Covid-19 pandemic with their lowest ever policy rate going into a recession. And so, for arguably one of the first times in history, governments were left with a mandate to stimulate growth. Yet compared with monetary policy, researchers poorly understand the growth implications of fiscal policy.

The IMF leads this field. Their new working paper examines the medium-term consequences of pandemics and how governments might alleviate adverse effects. Specifically, the authors estimate the impact of five recent pandemics on four key macroeconomic variables: output, unemployment, inequality and poverty. Then, they determine how fiscal policy, particularly social expenditure and healthcare, can mitigate negative macroeconomic outcomes. They find:

GDP growth is about 2.2% lower three years after a pandemic, with unemployment and poverty 1ppt higher, and economies 1.7% more unequal.
Governments that offered lower fiscal support during the pandemic, relative to the full sample, experienced on average a 3.4% output decline after three years – a 50% greater contraction.
Similar results apply for the unemployment rate, poverty and inequality, with greater health expenditure significantly reducing the impacts on inequality.

Past Pandemics

The Covid-19 pandemic prompted many policies, few unique. Mask wearing, quarantining, unemployment support and adaptive schooling are all present in texts written on past pandemics stretching as far back as the 1300s. That pandemics share specific characteristics allows researchers to find common outcomes for a possible Covid-19 recovery trajectory.

The paper’s authors investigate the medium-term macroeconomic implications of five recent pandemics: SARS (2003), H1N1 (2009), MERS (2012), Ebola (2014) and Zika (2016). Covering 55 countries between 1990 and 2019, they look at unemployment, inequality, poverty and GDP data from WEO, SWIID and WDI. In all, they examine the impact of 108 pandemic episodes over a one- to five-year horizon.

The results corroborate recent findings from Covid-19. At the onset of a pandemic, output falls, while unemployment, inequality and poverty all increase. After three years, output declines by 2.2% and does not recover within the five-year estimation period (Chart 1). Unemployment, inequality and poverty also fail to recover to pre-pandemic levels, with inequality continuing to increase beyond the five-year window.

Informality can partially explain the almost linear rise in inequality after a pandemic. Especially in developing economies, low-skilled workers, informal workers, and youth experience the most pronounced effects. On this front, the authors find countries with more informal or shadow economies suffer greater levels of unemployment and poverty five years after the pandemic. By income percentiles, the share of income for the bottom 20% of the population falls, but increases for the top 10% (Chart 2).

Covid-19 and Inequality

The distributional consequences of past pandemics have re-emerged during Covid-19. Early research has already found rising global inequality. For the UK, the population in the lowest quintiles of income and ethnic minority groups experienced the largest job losses at the start of the pandemic. In the US, less educated women with young children were most adversely hit, and Spain is seeing rising income inequality owing to job losses for low-income households.

The Benefits of Fiscal Policy

While the medium-term outcomes of pandemics are concerning, the authors find clear evidence that fiscal policy can mitigate the risks. Using the fiscal impulse – a common indicator for gauging the fiscal stance of governments – they estimate the dynamics of the four macroeconomic variables for ‘high’ and ‘low’ fiscal support countries. ‘High’ and ‘low’ represent countries above or below/equal the median fiscal impulse across the sample in the pandemic year.

For low fiscal support countries, output declines by 3.4% after three years. Meanwhile, output declines by 1.5% for high-spending governments, and the pandemic’s negative effects are almost entirely mitigated after five years. The same large differences hold for the unemployment rate, poverty and inequality. For unemployment, the rate turns out to be lower than pre-pandemic levels after five years (Chart 3).

Social Expenditure and Health

During Covid-19, researchers estimate increased social protection reduced the rise of extreme global poverty by about 10mn people. And so, social benefits such as child-related transfers and public spending on services for families are effective tools for reducing the dislocation pandemics create. Specifically, the authors find that low social expenditure countries (measured relative to their decadal average) are significantly more likely to have higher unemployment, poverty and inequality.

Likewise, better healthcare can offer higher productivity and quicker and more equitable recoveries following a pandemic. A country with above-average health expenditure will benefit from a 0.4pp boost in output after three years. The unemployment is also 0.8% after four years, compared with 1.7% for low health expenditure countries. Finally, inequality is twice as high in low expenditure countries after five years.

Bottom Line

Evidence from past pandemics suggests countries will feel the macroeconomic impacts for some time yet. While output and unemployment will eventually return to pre-pandemic levels, inequality may take far longer to normalise. This means most of the pre-Covid gains will remain undone for many years. Greater inequality suppresses long-term growth, reduces inflation and creates political instability. And so, with governments likely to continue spending, expect greater emphasis on pro-growth and pro-redistribution policies, such as spending on infrastructure, health and education.