Fiscal Policy, Institutional Quality, and Inequality
Description
The study examined the effect of fiscal policy on income inequality and whether institutional quality matters given heterogeneity in fiscal policy approach and income redistribution among different countries. We use the Gini coefficient from the Sweiss Standardised Income Inequality Database (SWIID). It measures disposable income (income after tax) among individuals. The scale ranges from 0 (perfect equality) to 100 (perfect inequality). We used tax revenue (% of GDP) minus government spending (% of GDP) as a measure of fiscal policy. We calculated it using data from the World Bank World Development Indicators. We use an average of the six composite governance indicators—voice of accountability, political stability and absence of violence or terrorism, government effectiveness, regulatory quality, rule of law, and control of corruption—from the World Bank World Governance Indicators to comprehensively measure the efficiency and effectiveness of a country's formal institutions. We use growth and trade as control variables due to their potential redistributive effects. The World Bank World Development Indicators measure economic growth through the annual GDP growth rate. Another control variable is trade. We measure trade using the World Bank World Development Indicators data, calculating total exports and imports as a percentage of GDP. We used 21 countries from 1996 to 2022. The study included countries with high institutional quality and others with low institutional quality. The results show that strong institutions generally bolster the reduction of income inequality through expansionary fiscal policy. The individual country effects show varied results across countries with weak and strong institutions. This shows that the relationship between fiscal policy, institutional quality, and income inequality is affected by differences in how fiscal policy is applied and whether institutional quality puts efficiency ahead of redistribution.