Welfare-improving Government Behaviour and Inequality-Inspection using a Heterogeneous-agents Model

Governments’ behavior is expected to be non-neutral in terms of impacts on both welfare and inequality. In spite of their multivariate form, a tentative assessment of such inequality impacts can be provided by using a general equilibrium heterogeneous-agents model where distribution is determined endogenously.Using a general equilibrium heterogeneous-agents model calibrated according to the empirical reality of EU countries, and capable of exploring the relationship between fiscal policy variables and the endogenous cross-section distribution of income, wealth, consumption and leisure, this paper develops a welfare and inequality analysis on several equilibriums resulting from different combinations of debt levels together with alternative composition of government budget variables.We conclude that optimal combination of debt and social transfer levels are smaller than the values observed in the EU countries during the last decades and, in the case of debt, optimal values are below the limits established by the Stability Growth Pact and they are larger, the larger the size of government. Also, the larger government size is, the worse is welfare inequality. As for government budget composition, we find that (i) substituting unproductive spending by transfers is welfare enhancing and improves inequality but only up to a lower bound of unproductive spending, rather inelastic; (ii) substituting unproductive by productive spending is always welfare enhancing and has no impact on any inequality measure; and (iii), shifting transfers for productive expenditure is always welfare enhancing for a sufficiently high output elasticity of public investment; since productive expenditure has no direct effects on inequality, transfer reduction impacts negatively on inequality welfare.