The Fiscal Theory of Income Distribution in Action: South African Low-income vs. High-Income Earners Response to Fiscal Policy Shocks

This study seeks to test the fiscal theory of income distribution in action in South Africa using low- and high-income earners, covering the period 1979–2022, using the Bayesian Vector Autoregression (BVAR) model with hierarchical priors. The BVAR technique accommodates a wide range of shortcomings in the data, such as the cross-section, without running out of degrees of freedom, and handles dense parameterization by imposing structure on model coefficients and optimizing the degree of formativeness. This study examines the impact of fiscal policy on income distribution among low-income and high-income earners. It was found that unexpected increases in government expenditure decreased income inequality, while all forms of taxation contributed to it. However, income inequality responds positively to an unexpected 1% increase in government expenditure on high-income earners. Taxation plays a significant role in reducing income inequality with a negative response. This study also explores how income inequality responds to changes in government expenditure and total government revenue. The lagged response suggests that expectations and market dynamics play a crucial role in reducing income inequality regardless of income level. This study suggests that South Africa should adopt a balanced tax policy that combines regressive and progressive measures. This would ensure an equitable distribution of burdens across income levels, with revenue from progressive taxes used to fund social welfare programs, such as education, healthcare, and affordable housing. This approach could reduce the wealth gap, promote social mobility, and create a more just society, making it an effective solution for income inequality in the country.