Inequality, imperfect competition, and fiscal policy

This paper analyses a simple model of an economy with imperfect competition in the goods markets and heterogeneous individuals due to different skill endowments. We then examine how the combination of income inequality, and imperfect competition, affect taxing and spending policies. Results indicate that firms’ market power and income inequality positively affect the size of fiscal multipliers, meaning that spending and taxing multipliers are bigger the more unequal an economy is. We also use the balanced budget multiplier to examine how income inequality and imperfect competition affect the net increase in output and expenditure caused by fiscal policies. The model shows that in highly unequal societies the maximum net increase in output and expenditure comes when increased government spending is funded by taxing the minority of high-income workers, as the adverse effects on the economy will be smaller compared to a tax imposed on the majority. However, this result changes as the economy becomes more equal and for high enough percentages of the population belonging in the high-income group the maximum net increase in output and expenditure comes when the government increases government spending and taxes low-income people instead. Finally, we examine the welfare effects of government policies. We see that while taxes reduce taxpayers’ welfare, if the net increase in output and expenditure is big enough, fiscal policy can be Pareto improving, as both income groups benefit from it; or at least the income group not paying taxes benefits while the income group paying taxes is not worse off. Income inequality is once again crucial in our analysis as it affects the size of welfare losses the taxpaying segments of the population have and whether government policies can be Pareto improving.