Social polarization, industrialization, and fiscal instability: theory and evidence

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Abstract

This paper is motivated by an important puzzle that arises from the contrasting macroeconomic experience across developing regions in the recent decades. In sharp contrast to East Asia, the fiscal policies in much of Latin America and sub-Saharan Africa are characterized by large fiscal deficits and volatilities of fiscal outcomes. In order to address both large deficits and volatile fiscal outcomes, we develop a simple model of endogenous fiscal policy in which government spending is strategically determined by heterogeneous policymakers in a dynamic game. In an economy that is highly polarized due to unequal income distribution, a larger fiscal deficit results, and the intertemporal fiscal policy path becomes more volatile. It is because the polarization of preference leads a policymaker representing each sector to spend more for her favorite sector, collectively contributing to large deficits. This polarization effect implies that a shock to tax revenue is translated into a more than proportional change in spending. Econometric evidence provides support for these predictions. Countries that have suffered from the greatest fiscal instability are those with highly polarized economic societies as measured by indicators of income inequality.

Introduction

This paper is motivated by an important puzzle that arises from the contrasting macroeconomic experience across developing regions in recent decades. In sharp contrast to East Asia, much of Latin America and sub-Saharan Africa has often engaged in unsustainable fiscal policies, leading to huge fiscal deficits, external debt crises, or hyperinflation (see Table 1).1 For instance, Korea's largest public deficit in the 1980s was 4.3% of GDP in 1982 against Mexico's 15.4% of GDP in 1982 or Zambia's 28.5% of GDP in 1986. Despite the substantial progress made on fiscal reform since the late 1980s, many developing countries still suffer from chronically recurrent large deficits. Brazil's recent financial crisis is closely related to its high budget deficit, which is 8.4% of GDP as of January in 1999. (See Newsweek of Jan. 25, 1999.) Moreover, past fiscal policies in Latin America and sub-Saharan Africa are characterized by high volatility of fiscal outcomes such as fiscal balance and its components, compared to East Asia (see Table 1).2

Why have certain countries, notably in Latin America and sub-Saharan Africa, repeatedly adopted unsustainable fiscal policies in recent decades, while East Asian countries have maintained stable fiscal policies? We argue that social polarization and degree of polarization are key to understanding differences in fiscal outcomes across countries. The unsustainable fiscal paths can best be viewed as politico-economic equilibria that arise from social conflicts of interest over government spending, created by interaction between initial income distribution and industrialization. In an economy with a manufacturing sector and a traditional sector, the more unequal the initial income distribution, the larger the sectoral income gap during industrialization and the more likely the polarization of sector preferences for different types of government spending. In a highly polarized society, each policymaker has a greater incentive to insist on higher spending for her preferred sector.3 A large fiscal deficit results, and the fiscal spending path becomes more volatile.

Income inequality has long been mentioned as a major source of social polarization. Many economists have argued that class and sectoral divisions due to unequal income distribution provide an important answer to the question of why populist fiscal policies appear more often in Latin American countries than other regions (see Rodrik, 1996, Kauffman and Stallings, 1991, Sachs, 1989, Berg and Sachs, 1988). Yet there are very few theories that explain why unequal income distribution can lead to large deficits and volatile fiscal outcomes. On the other hand, a growing literature on the political economy of fiscal deficits emphasizes the importance of government fragmentation and political instability in understanding fiscal deficits.4 While this paper shares the same spirit in emphasizing the political economy aspects of fiscal policies, it is also related to the tragedy of the commons literature in that the endogenous fiscal policy is jointly determined by heterogeneous policymakers who share common government resources.5

This paper, however, explores the theoretical linkage between initial income distribution and social polarization along the industrialization process. It then highlights the role of polarization in the development of fiscal instability, deriving new directly testable implications. Moreover, we address both fiscal deficits and volatilities in a single framework, whereas the existing models of fiscal deficits do not deal with the volatility of fiscal outcomes.

In our model, industrialization is viewed as the adoption of modern manufacturing technology that combines skill and capital stock (Goldin and Katz, 1998). Industrialization provides an incentive to accumulate human capital and enjoy a higher wage. But not everyone can invest in human capital because education is costly. The agents who mainly benefit from the industrialization are those who are already rich enough to invest in human capital. Assuming the human capital externality with a threshold property, the transition dynamics can be dramatically different depending on the initial income distribution.6 If industrialization starts with a large fraction of the population participating, it will experience a narrowing of wage/income inequality as observed in East Asia, contrary to historical experience and contemporary evidence of the Kuznets curve in other regions.7 By contrast, when only a small fraction of the population is able to participate in industrialization, it leads to a permanent segmentation between the manufacturing and traditional sectors that yields a large sectoral wage gap.8

If a wide wage gap between the two sectors results, the polarization of preference—conflicts of interest over government spending—is sharper. The polarization of preference leads a policymaker representing each sector to spend more for her favorite sector, collectively contributing to bigger overall spending. Given that two policymakers share the government budget, whatever government resources a policymaker does not exploit may or may not be available depending on the other's behavior. When policymakers disagree on the desirable composition of government spending, each of them has a greater incentive to overexploit the common resources, exerting negative externality on the other, which prevents them from achieving the social optimum.

Interestingly, a more polarized society also suffers from greater fluctuations in its fiscal outcomes. The higher the polarization, the bigger the fiscal spending and the larger the current fiscal deficit (polarization effect). But this raises the debt level more quickly and reduces government resources, forcing policymakers to cut tomorrow's spending by more. This polarization effect implies that a shock to tax revenue is translated into a more than proportional change in spending. Moreover, the higher is the degree of polarization, the greater is the change in spending in response to a shock to the tax revenue.

We test these predictions on fiscal deficits and volatility by running panel regressions, based on a panel data set covering 90 countries over the period of 1970–1990. Here we utilize recently assembled quality data on public sector deficits (Easterly et al., 1994) and income inequality (Deininger and Squire, 1996). As our theory suggests, income inequality as a proxy of polarization is found to be statistically significant and robust in the regressions of fiscal deficit and volatility. Countries that have suffered from the greatest fiscal instability are those with highly polarized economic societies as measured by indicators of income inequality.9 To our best knowledge, this is the first econometric test that reports the significance of income inequality in explaining different fiscal outcomes across countries.10

Section 2 describes an economy under a post-industrialization regime and discusses the dynamics of income distribution in the process of industrialization. Section 3 derives an endogenous fiscal policy and establishes the main results, followed by country experiences that support our conclusions. Section 4 presents econometric evidence, and Section 5 concludes. Appendix A derives the social planner's optimal fiscal policy.

Section snippets

The economy

We consider a two-sector small open economy with a government (fiscal authority) and a continuum of atomistic individuals endowed with perfect foresight. The economy is populated by overlapping generations of individuals who live two periods: young and old. The agents are equally able, but they are endowed with different amounts of initial wealth. For simplicity, we assume that the economy's two sectors produce essentially the same product (i.e., perfect substitutes). The price is normalized to

The fiscal policy

The fiscal policy consists of two different types of government spending {gt, ft}t=1 and taxation T. While the two different types of policymakers play a non-cooperative dynamic game, each policymaker of a generation also cares about the fiscal spending levels of the next generation, which cares about the government spending of the following generation and so on. Altruism is limited in our model in the sense that each generation derives utility only from its own spending and that of its

Econometric evidence

The basic implication of the model is that countries with greater polarization are more likely to run larger fiscal deficits and exhibit more volatile fiscal outcomes. We test these implications of social polarization for fiscal outcomes by running panel regressions of fiscal balance and its volatility. Many of the empirical studies on budget deficits use data on the central government's fiscal balance. However, using only the central government deficit data can be problematic because a large

Concluding remarks

Given the strikingly different fiscal policy paths among regions, we have argued that the volatile and unsustainable fiscal paths often adopted in Latin American and sub-Saharan African countries can be attributed to social polarization that arises from unequitable distribution of benefits from industrialization, which is rooted in unequal initial income distribution. A highly polarized society may have more acute struggles over government spending, and this may lead each representative

Acknowledgements

I am grateful to Daron Acemoglu, Philip Lane, N. Greg Mankiw, Jeffrey Sachs; and in particular Alberto Alesina, Dani Rodrik, and Aaron Tornell; and an anonymous referee for their insightful discussions. I also thank seminar participants at Harvard University, SUNY at Buffalo, University of Hawaii at Manoa, DePaul University, University of Calgary and the 2002 North American Econometric Society Summer Meeting for their useful comments. This paper is based on a chapter of my PhD dissertation

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