Fiscal Policy and inequality in economies with large, unproductive, agricultural sectors

Poor countries devote the largest fraction of their labor force to agriculture, which is also their least productive sector. This turns out to be key for understanding cross-country disparities in per capita incomes. A large and active literature aims at finding the causes behind these facts. Most models employed highlight that a minimum (subsistence) level of agricultural production is required before the economy can produce anything else. Hence, “too many†resources may be devoted to an unproductive sector. We evaluate the interactions between fiscal policy (in particular infrastructure investment), income inequality, and economic performance in such type of frameworks. We uncover and study the following policy tradeoff: infrastructure investment expansions may have the largest impact on GDP when targeted to the highest productivity sector, but they may also increase income inequality, and even depress the income of the poorest. The reason is that such expansions require increased production of non agricultural goods. General equilibrium forces may lower the price and ultimately the income of agriculture to accommodate the required shift of resources. Labor reallocation frictions prevent equalization of wages across sectors. Further, wage and relative price movements may be large, due to the highly inelastic demand for agriculture when output is close to subsistence levels.