Fiscal Policy's Link to Inequality

This 19-minute podcast was released Sept. 13, 2018.

Rising inequality in both income and wealth are at levels comparable to the 1920s, before the Great Depression. St. Louis Fed economist Miguel Faria-e-Castro talks about fiscal policy’s link to inequality in the United States.

Transcript:

Matuschka Lindo Briggs: Welcome to the Timely Topic series from the St. Louis Fed. I'm Matuschka Lindo Briggs, your host for this podcast. With me today is Miguel Faria-e-Castro, an economist in the research division at the Federal Reserve Bank of St. Louis. Miguel has a PhD from NYU in economics and specializes in issues related to fiscal policy and financial crisis. Thank you so much for joining us today.

Miguel Faria-e-Castro: Thank you it's great to be here.

Lindo Briggs: Can you tell us where you're from and how did you find your way to the St. Louis Fed?

Faria-e-Castro: I'm originally from Portugal. I lived there all my life. I went to college there, then decided I want to do a PhD in economics so I applied to grad school. I got into the NYU PhD in economics program. I went there, then when I was about to finish I applied to different jobs. The St. Louis Fed made me a good offer, so I came here.

Lindo Briggs: Well we're very glad to have you. So, can you tell me why economics?  And, why did you choose to specialize in fiscal policy?

Faria-e-Castro: I guess I've always been interested by government and what does the government do and how can we improve on what the government does. But I also like mathematics a lot. So I figured that economics was a good way to combine the two. And I guess my interest in government drew me to both fiscal policy and to monetary policy, which is what the central bank such as the Federal Reserve does.

Lindo Briggs: I think most of us know enough fiscal policy to be dangerous. So why don't we just start with the basics. I'd like to ask what is fiscal policy and how does it work?

Faria-e-Castro: So I guess you can call fiscal policy anything that involves government revenue collection i.e. taxes or governments spending, and fiscal policy typically has three main objectives. The first one sounds a bit broad but its to influence the economy somehow, say try to sustain aggregate demand during the recession. The second one is to provide public services such as courts, defense, highways, and the third one is typically to redistribute income. So, to take away income from the wealthiest part of population and to try to provide services to the less wealthy segments of the population.

Lindo Briggs: And I would think that the latter, a lot of people get really interested in that part?

Faria-e-Castro: Yes, exactly, and it turns out that even though I mentioned it as the third objective of fiscal policy, turns out that it in some dimensions its actually the most important one. If you look at the federal government budget, for example, for 2018, you'll notice that a big part of it is actually going to what we call mandatory or entitlement spending. Which is mostly government spending directed at social programs, Social Security, Section 8 housing, things like that.

Lindo Briggs: So when I asked about fiscal policy and the effect, who does it affect and does it affect everyone the same way?

Faria-e-Castro: So, fiscal policy affects everyone but in very different ways. The first distinction that I want to make is between revenue and spending side policies. So, as I said in the beginning fiscal policy involves the use of both government's revenue and government spending. Government revenue comes mainly through taxes.

Lindo Briggs: OK.

Faria-e-Castro: Most taxes that are collected by the federal government are income taxes and these income taxes are typically what we call progressive schedule in the sense that the tax rates go up with your income. So, the higher your income, the higher is going to be the tax rate that you pay on that extra dollar. So, in that sense everyone pays taxes, so these affect everyone. But people with higher incomes are going to be paying higher income taxes. Other important taxes from which the government raises a significant amount of revenue are estate taxes and corporate income taxes. Even though these ones do not depend directly on your income, they tend to be progressive in a more subtle way, in the sense that it's typically wealthier people that own corporations that will be paying corporate income tax. And it's also wealthier people that have larger estates, so these taxes tend to fall more on wealthier than on less wealthy people.

On the other hand, as I said before, a big chunk of government spending-- like about 75 percent of total government spending -- is allocated to mandatory or entitlement spending, and most of this is going to be in what we call means-tested programs. So these are social programs that are given on the basis of a means test, so basically the government tries to ascertain based on your income mostly whether you have the means to survive without receiving help from these programs. And these are going to be things like unemployment insurance, housing, government housing, food stamps, etc.  So not only the revenue side of fiscal policy affects people with higher and lower incomes differently, but also the spending side is going to affect you differently depending on your income.

Lindo Briggs: So as you and I… or just the people in general, do we have a say or any power in the political world over fiscal policy?

Faria-e-Castro: All fiscal policy in the United States is set by Congress. So to the extent that you choose your representatives in Congress and then they said how is the government going to raise revenue and how is the government going to spend that revenue, you do have a say, at least an indirect say, on how fiscal policy is set. Another thing that I want to highlight is, most of what I've been saying applies to fiscal policy at the level of the federal government; fiscal policy is also conducted by state and local governments. So relatively simple things like voting on the referendum to maybe raise local sales taxes to finance police pensions or the construction of a new school-- all of that is fiscal policy and that's a type of fiscal policy where you probably have a more direct say.

Lindo Briggs: Right, which is nice to know that it's closer to home. Because when you think of fiscal policy you do push it away and think DC, but it is at home it's affecting all of us and we can make a difference.

Faria-e-Castro: Exactly yes, yes so every time you go out and vote you'll be having a say in fiscal policy, because most of what government does is fiscal policy.

Lindo Briggs: What are some of the policies in place currently that are tackling inequality in the United States?

Faria-e-Castro: So I've mentioned some of those already. So on the revenue side we have the fact that the main source of revenue for the government is the income tax that's a progressive tax in the sense that richer people pay more, pay higher on average, higher tax rates than poor people. On the other hand, most government spending programs, most mandatory entitlements… entitlement spending. As I said is allocated to means-tested programs, which means that lower-income people receive a relatively larger share of government spending, than people with higher incomes.

Lindo Briggs: Can I ask you real quick, I just wanted to stop you because sometimes when I think of tackling inequality are we talking wealth or income?

Faria-e-Castro: That's a great question. So, the way that fiscal policy depends on inequality relates mostly to income inequality.

Lindo Briggs: Ok.

Faria-e-Castro: Because as I've said for example the income tax depends on your income. So whatever tax rate you're going to pay doesn't depend on your wealth, depends on your income. While these means-tested programs are typically mostly a function of your income, they can also be a function of some programs have some provisions to… to make sure that even wealthier people with lower incomes do not receive money from the government, but it's mostly income. So an extreme example is that I can be a very wealthy person and I happen to be laid off and that means that I might be able to qualify for things like unemployment insurance, even though I'm individually wealthy. And also since my income, my wage income, is going to be low because I'm unemployed, I might be paying lower taxes because of that. Most fiscal policy both on the revenue and the spending side tries to mitigate inequality at the income level mostly.

Lindo Briggs: How do we compare to other countries when it comes to inequality?

Faria-e-Castro: So generally less -developed countries tend to have much higher levels of both wealth and income inequality than more- developed countries. So if you just compare the U.S. to a random country in the world, we'll probably be doing better than them. However, within developed countries, the U.S. doesn't do that great. Both wealth and income inequality levels in the United States tend to be worse, tend to be higher than in peer countries, and by peer countries I think about OECD countries, so think countries in Europe, Japan, Australia etc. It has become common to focus on the share of wealth of the top X percent of the population or the share of income of those top X percent. If you think about the share of wealth of the top 1 percent in the US, that's going to be over 40 percent of total wealth. While in peer countries, in OECD countries, it’s typically between 10 and 20 percent. And even if you think about income… income inequalities, we do slightly better in terms of income inequality but we are still worse than most peer countries. In the top 1 percent in the US receive around 22 percent of total income while these numbers going to be around 10 percent in other OECD countries.

Lindo Briggs: Why do you think we fare so poorly?

Faria-e-Castro: That's a very difficult question, I would say that the first reason that typically comes to people's minds has to do with the… with the social safety net in the U.S. So in a lot of European countries, we have what we call welfare states. Which tend to focus much more on the redistribution of income than the government does in the US. So in many European countries, tax income taxation tends to be much more progressive. So basically tax rates rise much faster as your income rises.

Lindo Briggs: So when we look at inequality, are there trends in general?

Faria-e-Castro: Yes, there are. So across countries inequality has been decreasing. That's a very strong fact since the Industrial Revolution. So, global inequality used to be very low before the Industrial Revolution because everyone all over the world was more or less poor. Then equality across countries increased substantially in the late starting in the late 18th century as some countries, especially in northern Europe, started experiencing the Industrial Revolution. So incomes in those countries grew a lot. More recently, especially with… with the growth and economic development of very large countries such as China or India, inequality across countries has been decreasing. It's also interesting to look within countries, for example, within the U.S. There are some interesting trends in inequality, so inequality used to be very high in the 20s and the 30s and then fell after World War II, and it probably hit the bottom standard measure of inequality hit their lowest levels in the early 80s. And then inequality, both income and wealth, has been rising since then. And right now we are at levels that are comparable to those of the 1920s, 1930s, especially 1920s before the Great Depression.

Lindo Briggs: What has caused that? Are there particular policies that brought this about?

Faria-e-Castro: That's a difficult question that many economists spend a lot of time trying to figure out. I would say that the closest thing that we have to consensus is that it's not really related to fiscal policy per se, because if anything fiscal policies have become slightly more progressive since… since that period. In the sense that they've been redistributing more and more and more income, I think that the closest thing that we have to consensus points to other factors, namely what people call a structural change. So just the fact that the structure of the economy itself is changing and is rewarding more and more highly skilled, highly educated people and less so people with lower skills or people with less education. Things like the rise of robots and the destruction of middle-class jobs, all of those are somehow manifestations of that underlying structural change that has contributed to rising levels of inequality. I would say that in terms of policies that might have contributed to that, that the waves of deregulation in the 80s, and the fact that now more than ever we see rising market concentration many industries in the U.S. and the rise of global conglomerates that can move their profits abroad for example, and that are controlled by a… by a smaller and smaller number of people. All those things have been contributing to… to the rising inequality.

Lindo Briggs: OK, Miguel, do you have any working papers or anything that you're doing right now that you'd like to share with us?

Faria-e-Castro: Yes, so as I mentioned before, I have some work done on discretionary fiscal policy spending in the Great Recession in 2008 and in particular I'm interested in separating all the government. All the money that the government was spending with what we call government consumption, say building highways in Oklahoma and transfers to… to households. Say all those programs that I mentioned that tried to support homeowners. I'm trying to separate that chunk of money, from all the money that the government was spending or could have potentially spent with bailing out banks and offering credit guarantees to financial institutions. It turns out it's interesting because a lot of that money that the government allocated to the financial sector was actually not spent, because those were… those were what we call contingent liabilities. In the sense that think about, if you're familiar with deposit insurance is something very similar, is that money's put to the side. And the government says OK, if these bank fails we're going to be… we're going to pay off to the people who lend to these banks.

Lindo Briggs: OK, almost a safety?

Faria-e-Castro: Exactly, exactly, it's a financial safety net. And turns out that a lot of the banks of the government did that to… think Citigroup, Bank of America, they did not fail. So the government did not actually have to spend that money. But just the fact that the government put that money out there, that has had an impact on how things unfolded during the crisis. So I'm currently working on… on credit guarantees and I have some… some upcoming work on that.

Lindo Briggs: You specialize in fiscal policy in times of financial crisis, correct?

Faria-e-Castro: Yes

Lindo Briggs: So it’s been a decade since the crisis, how has fiscal policy and inequality changed in the last 10 years, or even say the last 20 years?

Faria-e-Castro: So the financial crisis of the Great Recession of 2008 were a very interesting period to study fiscal policy because most of the fiscal policy that we've been talking about things like income tax, income taxes, means-tested, welfare programs, those things are what the economists typically call automatic stabilizers. In the sense that they are rules that are in place and whether the government raises more revenue or spends more with them it's going to depend on the business cycle. It's going to depend on how many people are unemployed, how many people are in need of food stamps, etc.

Lindo Briggs: So that's always fluctuating?

Faria-e-Castro: Exactly. Now during the crisis of 2008, the government at some point realized, well things are going really bad. So Congress realized we cannot just sit back and do nothing. So there was a lot of what we call discretionary fiscal policy intervention. So basically the government, Congress, stepped in and said let's spend a lot of money to try to jumpstart the economy again. Federal debt increased considerably, because the government was spending so much money at the time. But where the government was spending money, that's a very interesting question. Because the government was doing a lot of very different things with that money that was spending. It was building highways all over the U.S., it was expending a lot of social transfer programs, to mostly very well targeted to for example homeowners in need. And the government also did other very interesting things such as bailing out banks or bailing out car manufacturers. These were very politically hot topics at the time. And economists spend a lot of time and effort trying to understand how socially valuable these interventions were.

Lindo Briggs: So that's really your focus, and I guess my other question would be if your focus is on the recession, what are you working on when we're not in the middle of a recession?

Faria-e-Castro: Even if we're not in a recession, it's good to be prepared for the next one. And I think especially right now we've been in the second largest expansion since World War II, so we don't know when the next recession is coming. We don't know when, the how large is going to be the next recession, we don't know if another financial crisis might be coming. So it's always good to step back, look at the past, look at what we've done, look at what we could have done better, and be prepared for what might be coming.

Lindo Briggs: So basically, with your specialty you're not only looking at the past 10 and 20 years, but you're also looking at what could happen in the future?

Faria-e-Castro: I think trying to inform future policies is the, is the main thing that motivates me to look at the past. And that's a lot of what economists do is looking at past events and using models to study counterfactuals. So, something happened in the past and the government did something. What could have happened if the government had done something completely different? Or what could have happened if the government had done nothing? These are not easy questions, because they require… they require a lot of data, they require a lot of mathematical modeling, and these are… these are the questions that I try to answer.

Lindo Briggs: Right, and I'm sure for many, they're the questions that a lot of people ask. When they're sitting and talking over… you know a dinner table, you know, what if? The big what if?

Faria-e-Castro: Yes, I think that a very interesting question is, and the question that I've studied is what would have happened if Congress had decided to just stand back and see, and watch the world burning in 2008. We don't have a clear idea of what would have happened if Congress had not spent all that money. If you want to criticize something, or if you want to say that some course of action is better than another, you really need to know what would have happened if either course of action had been chosen, right?

Lindo Briggs: Have you done any type of research that you could share, to think of what would have been the outcome if they would have sat back and done nothing?

Faria-e-Castro: I find that the fall in aggregate consumption would have been twice as large, which if you think about the fact that aggregate consumption tends to be one of the least volatile components of GDP. It means that aggregate GDP in the United States could have fallen by much… much more than what it fell, if Congress had not spent a single cent with discretionary fiscal policy measures.

Lindo Briggs: So can we revisit the three objectives of fiscal policy?

Faria-e-Castro: Yes, so the first fiscal policy consists of anything that involves the government collecting revenues or spending money in order to first influence the economy. Say for example try to boost aggregate demand during a recession. Second, providing public services, things like building roads, or keeping a standing army to protect the United States, or financing courts, and to make sure that the rule of law is upheld. And finally redistributing income among the population, so taking income from the wealthier and the people with higher incomes towards people with lower incomes.

Lindo Briggs: OK, great! Thank you so much for joining us today and sharing fiscal policy and inequality with us. And for more of Miguel's research on fiscal policy you can go to research.stlouisfed.org/econ/faria-e-castro. And to listen to more of our podcasts go to stlouisfed.org/timely-topics. Thank you for joining us.

Faria-e-Castro: Thank you.