Fiscal space, redistribution and the macroeconomic transmission of fiscal uncertainty shocks

This paper examines how fiscal policy uncertainty shapes macroeconomic stabilization, public debt dynamics, and inequality in an economy with household heterogeneity and sovereign debt constraints. I develop a Two-Agent New Keynesian (TANK) framework featuring hand-to-mouth (H2M) households, Ricardian asset-holders, distortionary taxation, countercyclical targeted transfers, and fiscal uncertainty shocks, disciplined by a structural VAR on four decades of U.S. data. Unlike first-order fiscal demand shocks, fiscal uncertainty triggers a conditional comovement—a joint slump in output, consumption, investment, and employment— matching empirical patterns. The framework delivers novel distributional insights: while sharp declines in equity prices, corporate dividends, and Tobin’s Q compress top-tier financial income and temporarily narrow gross income inequality, liquidity constraints severely amplify the consumption drop at the bottom, driving a sharp expansion in consumption inequality. Countercyclical targeted transfers provide effective public insurance by sustaining high-MPC disposable income and generating positive demand spillovers. Quantitatively, over an eight-quarter horizon (h = 8), a 1 percentage point reduction in income inequality requires a cumulative debt expansion of 0.336 percentage points of GDP, with 74.5% of the transfer outlay directly absorbed into real economic activity and targeted consumption. Crucially, targeted fiscal support absorbs 34.94% of the total cumulative GDP slump observed in the unmitigated counterfactual economy, preserves the tax base, albeit at the cost of a temporary public debt expansion. Finally, this paper shows that initial fiscal space is a critical determinant of policy effectiveness, underscoring a structural trade-off between redistributive stabilization and fiscal sustainability.