Income inequality and the depth of economic downturns

Summary

Focus

Income inequality worldwide has been on an uptrend since the 1980s. We investigate whether greater income concentration at the top can affect cyclical economic outcomes. We do so by empirically analysing how changes in post-tax income inequality shape the dynamics of real per capita consumption across countries.

Contribution

Several recent papers have emphasised that inequality can significantly affect the dynamics of consumption and output over the course of a business cycle. In these models, inequality affects aggregate consumption because of the negative correlation between consumers' marginal propensities to consume and their income. We investigate the extent of this mechanism, using a panel of 91 advanced and emerging market economies between 1981 and 2019 and distinguishing between expansionary and contractionary phases of the business cycle.

Findings

Distinguishing between "normal" and downturn phases of the cycle is crucial. We find that income inequality has no effect on aggregate consumption during normal times. However, greater income concentration at the top is strongly associated with deeper contractions in real per capita consumption in the aftermath of economic downturns. This finding holds for normal downturns, as well as for "financial downturns", that is, downturns accompanied by widespread financial distress. Our findings are consistent with lower propensities to consume among wealthier households and indicate that when aggregate demand falls, the distribution of income across consumers matters for subsequent economic outcomes.

Abstract

Using an international panel data set, we analyze the implications of rising income inequality for aggregate consumption. We document that greater concentration of (after-tax) income in the top decile is associated with a significantly larger and more persistent contraction in consumption in the aftermath of economic downturns. These findings are consistent with lower propensities to consume among wealthier households and imply that disparities in income flows at turning points of the business cycle can significantly influence macroeconomic outcomes.

JEL-classification: D31, E20, E32
Keywords: consumption, income inequality, recessions, financial crises, cross-country evidence