In most developed countries and major developing countries, there has been a recent increase in income and wealth inequality. A small, affluent pocket of the population obtains their income from salary and assets, whilst the larger, less affluent population receives only labour earnings. Because of these different sources of income, it is likely that economic shocks and resulting fiscal policies affect these groups in different ways. Policy experiments are a tool used by economists to explore the impact of different fiscal policies, such as taxation and public spending. For example, they might seek to understand policy responses to economic expansions and contractions, and their outcomes on inequality. Read More
In a recent paper, Professor Meng Li and Professor Chengrui Xiao explore the effect of fiscal policies on the welfare of two different economic groups with two different sources of income: entrepreneurs and workers. Specifically, they study responses of fiscal policy instruments to booms and recessions, and their impacts on the economic welfare of workers and entrepreneurs.
In general, workers’ economic welfare is promoted through procyclical capital income tax, where capital tax rates decrease during economic booms and increase during recessions. Entrepreneurs’ welfare, on the other hand, is maximised by implementing a mirrored version of this taxation structure.
This creates a quandary for government: when they know that each policy will benefit one group over another, which should they choose? This quandary creates conflicts between entrepreneurs and workers.
Professor Li and Professor Xiao created a mathematical model, which incorporates various agents, such as workers, entrepreneurs, firms, and government. They used this to elucidate the impacts of fiscal policy on the welfare of various social groups. In this research, welfare is defined using the consumption index, which essentially represents the quantity or value of goods and services consumed by individuals or households.
Their results show that changes to labour income tax solely influence the welfare of workers, while capital income tax affects both capital holders and workers, with a more prominent impact on the former. This indirectly influences the wages and consumption of workers.
Typically, governments respond to recessions by cutting taxes and raising government spending. However, the team’s research suggests that this benefits entrepreneurs, while negatively impacting workers over their lifetime. The socially optimal option would, of course, be a trade-off that balances the welfare of entrepreneurs and workers, by stimulating the economy while protecting those whose wealth is dependent on labour income.
Given this, Professors Li and Xiao propose a solution. When economic contraction hits, governments should cut income taxes and subsidise workers simultaneously. While tax cuts promote the economic recovery of entrepreneurs, subsidies can compensate for the harm this causes workers. In this way, it is possible to achieve both economic efficiency and equity.
