## _spn1017 — Annex 1: Fiscal Adjustment and Income Distribution in Advanced Economies

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### Human cost of recessions and unemployment
- Recessions leave scars on the labor market; the Great Recession of 2007–09 has left gaping wounds.
- Global unemployment and distribution:
  - Over 200 million people across the globe are estimated to be unemployed at present.
  - Among countries with unemployment data in the IMF’s World Economic Outlook (WEO) database, there has been an increase of over 20 million unemployed people since 2007.
  - The ILO estimates that globally the increase is over 30 million.
  - Three-fourths of the increase in the number of unemployed people occurred in the “advanced” economies and the remainder among emerging market economies.
  - The unemployment rate increased by 3 percentage points in advanced countries since 2007 and by 0.25 percentage points in emerging markets.
  - In low-income countries on the whole, unemployment fell during the Great Recession.
- Individual and family costs:
  - Earnings losses are substantial both short- and long-run; U.S. studies show earnings losses persist 15–20 years after a job loss in a recession, with the earnings loss amounting on average to 20%.
  - Schmieder et al. (2009): workers who lost stable jobs in 1982 in Germany suffered earnings losses of 10–15% that lasted at least 15 years.
  - Estimated average loss of life expectancy due to increased mortality from unemployment: from 1 to 1.5 years.
  - Children: parental job loss increases probability a child repeats a grade by nearly 15 percent (Stevens and Schaller, 2009); Oreopoulos et al. (2008) estimate children whose fathers were displaced have annual earnings about 9% lower.
- Youth and long-term unemployment:
  - Youth defined as age 15-24.
  - In OECD countries the ratio between the under-25 and over-25 year old unemployment rate is on average around 2.5 to 1.
  - Spain: largest rise in youth unemployment (almost 40 percent).
  - For eight countries with long time-series, the increase in the youth unemployment rate averaged 6 ½ percentage points during the Great Recession, compared with 4 percent in previous recessions.
  - Long-term unemployed defined as unemployed six months or more; share of long-term unemployed increased in most selected OECD countries between 2007 and 2009.
  - U.S. specifics:
    - Share of workers unemployed 27 weeks or more as share of all unemployed rose to about 45% during the Great Recession.
    - Nearly half of U.S. unemployed workers have been out of work for over six months and the average duration of unemployment is nine months.
  - Rehire probabilities (Q4 2009):
    - person unemployed for 26 weeks or more: less than 10 percent;
    - person unemployed for less than 4 weeks: over 30 percent.

### Labor-market policy instruments and effects
- Short-time work programs:
  - Typically subsidize firms for parts of the wage bill and sometimes subsidize on-the-job training.
  - When well-designed, can spread downturn burden, support aggregate demand, reduce future hiring costs, and preserve human capital.
  - Heavily used in Germany, Italy, and Japan during the Great Recession; effectiveness varied.
  - Costs/risks: fiscal strain, deadweight loss from free-riding, obstruction of necessary reallocation if downturn effects are permanent.
  - Recommendation: phase out short-time work as recovery takes hold; ensure program targets jobs viable in the long term.
  - Country notes: Germany’s outcomes partly driven by pre-crisis shortage of trained workforce and high costs of layoffs/rehiring; Italy’s pre-crisis use in certain sectors may have delayed structural layoffs; Spain’s short-time work ineffective where shock was permanent (housing/construction).
- Unemployment insurance (UI):
  - UI helps maintain consumption; propensity to consume out of UI benefits is close to one.
  - Common cost: potential disincentive to job search; longer/higher UI often correlated with longer unemployment spells.
  - Chetty (2008): increased unemployment duration with longer UI benefits holds mainly for households with very low wealth, implying liquidity alleviation rather than supply-side disincentives.
  - In severe recessions, negative UI effects on employment are likely small because scarce vacancies mean jobs not taken by one worker are filled by others.
  - Fiscal cost-effectiveness: Congressional Budget Office estimates increasing aid to the unemployed carries the highest cost effectiveness; Between 8 and 19 years of full-time equivalent employment are predicted to be created per million dollars of budgetary cost.
  - U.S. example: UI extension from 26 to 99 weeks.
  - Recommendation: beyond a certain unemployment duration (say six months), UI provision should be tied to part-time work or job training to maintain labor-force attachment; extensions make sense in the U.S. context but are not a universal recommendation.
- Job subsidies and hiring incentives:
  - Targeted subsidies (direct job/wage subsidies or payroll tax reductions) used to support long-term unemployed and youth and to spur hiring in hard-hit regions/sectors.
  - Benefits: can prevent mass layoffs and stimulate net employment growth if targeted and temporary.
  - Risks: deadweight loss and sustaining jobs that should be reallocated.
  - In deep recessions, inefficiencies are less severe than the costs of persistent unemployment.
  - Targeting reduces misallocation by focusing on groups least likely to be rehired.
  - Comparison with short-time work: short-time work preferable if massive job destruction can be avoided; if retention incentives are weak, direct job subsidies may be the only effective short-run policy.
- Dual employment systems:
  - Many OECD countries expanded temporary contracts not subject to strict protections of permanent contracts.
  - Spain had about 30 percent of employed persons under temporary contracts.
  - Spain: employment declined by 20 percent during the Great Recession, with the vast majority of job losses in the temporary workforce.
  - Two-tier systems can increase disparity, reduce on-the-job training for temporary workers, raise turnover in low-productivity jobs, and lower aggregate output and employment.

### Macroeconomic interactions, hysteresis, and wage policy
- Hysteresis and fiscal policy:
  - Fiscal policy benefits are larger in the presence of hysteresis (when the natural rate of unemployment has increased due to persistent cyclical weakness).
  - Stimulative policies that counteract increases in the natural rate can raise tax revenues by returning output to potential and may lower the debt-to-GDP ratio over the medium run under some illustrative calculations.
  - Risk of hysteresis is elevated in some countries, particularly the United States and Spain, given sharp increases in unemployment duration and persistent shocks (e.g., to housing).
  - Additional empirical work is needed to gauge importance of hysteresis for policy design.
- Monetary policy and inflation:
  - Monetary policy remains important; headline and core inflation are expected to be around 1¼ percent in 2011.
  - Headline inflation expected to remain around 1¼-1½ percent in 2010 and 2011.
  - Subdued inflation pressures allow monetary conditions to remain supportive in most advanced economies as fiscal support diminishes.
- Wage moderation:
  - Wage moderation can limit unemployment losses but may not always be desirable.
  - For relatively closed economies like the United States, wage moderation could add to deflationary pressures or lower aggregate demand.
  - For more open economies, wage moderation can boost competitiveness and external demand, useful in currency areas without nominal depreciation options.
  - Preferable that wage moderation arises through social partner negotiations rather than heavy-handed government intervention.
  - Example: New Zealand adjusted via declines in real wages and hours worked largely through negotiations between social partners.
  - Targeted cuts in certain sectors (e.g., very high public sector wages) may be appropriate.

### Fiscal consolidation, distributional effects, and composition
- Short-term macro and distributional effects:
  - Fiscal consolidation can increase income inequality in the short term; duration and magnitude depend on the growth response and composition of adjustment.
  - Adverse short-term effects attributable mainly to rising unemployment.
  - Fiscal consolidation reduces output and increases unemployment in the short run due to positive fiscal multipliers; these effects are reversed over the longer term (Blanchard and Perotti, 2002; Spilimbergo et al., 2009).
  - In episodes of large fiscal adjustment, consolidation has been associated with increases in unemployment during the early years; larger adjustments are associated with greater persistence in unemployment, especially if there is an increase in structural unemployment.
  - Over the longer term, effects of fiscal consolidation on unemployment are reversed (Clinton et al., 2010).
- Role of expenditure and revenue composition:
  - Large and durable fiscal adjustments have often been associated with significant expenditure cuts, including in public cash transfers.
  - In Europe, public cash transfers have been shown to lower income inequality (as measured by the Gini coefficient) by about 9 percentage points (OECD, 2008); reductions in these outlays may contribute to widening income inequality during adjustment episodes.
  - Substantial fiscal adjustment can be associated with relatively small changes in income inequality if expenditure reductions are accompanied by efforts to better target benefits (examples cited: Denmark, Germany, Sweden).
  - Revenue measures, particularly those related to income and wealth, are likely to reduce income disparities due to progressive tax systems in advanced economies; a caveat is efficiency limits if taxes are already high.
  - Reductions in marginal tax rates historically have offset some equalizing effects of revenue measures.
- Key fiscal figures cited:
  - Consolidation plans for 2011 imply an average change in the structural balance of 1¼ percentage points of GDP.

### Policy recommendations and timing
- Near-term macro stance:
  - Maintain support for aggregate demand; most advanced economies should not tighten fiscal policies before 2011, since earlier tightening could undermine recovery.
  - Adapt fiscal strategy to country-specific fiscal space.
  - Monetary policy should remain accommodative where inflation pressures are subdued.
- Labor-market policy sequencing:
  - Phase out subsidies to short-time work as recovery takes hold; ensure targeting on jobs viable in the long term.
  - Tie UI provision to active job search, training, or part-time social work after extended durations to maintain labor-force attachment.
  - Use targeted and temporary hiring subsidies to spur employment for groups most adversely affected, balancing short-run benefits against long-run reallocation needs.
- Distributional emphasis in consolidation:
  - Protect or better target social transfers to preserve their equalizing role.
  - Where possible, rely on progressive revenue measures to reduce income disparities, while mindful of efficiency limits when tax rates are already high.
  - Improve targeting of expenditures to reduce adverse distributional effects while achieving fiscal consolidation.
- Cross-border and demand rebalancing:
  - Macro policy coordination across advanced and emerging countries helps recovery; emerging markets with large external surpluses should adopt policies that nurture domestic demand to offset demand losses from fiscal consolidation in advanced economies.
  - Combined with structural reforms that alleviate supply constraints, demand rebalancing raises global GDP and supports job creation.

_Annex 1. Fiscal Adjustment and Income Distribution in Advanced Economies — IMF staff paper (excerpt)._

### Annex 1: Fiscal Adjustment and Income Distribution in Advanced Economies .......................... 22

### Annex 1: Fiscal Adjustment and Income Distribution in Advanced Economies

### I. Introduction and overview
- Recessions leave scars on the labor market; the Great Recession of 2007–09 has left gaping wounds.
- Over 200 million people across the globe are estimated to be unemployed at present.
- Among countries with unemployment data in the IMF’s World Economic Outlook (WEO) database, there has been an increase of over 20 million unemployed people since 2007.
- The ILO estimates that globally the increase is over 30 million.

### Distribution of unemployment increases by country group
- Three-fourths of the increase in the number of unemployed people occurred in the “advanced” economies (the term used in the WEO to denote high per capita income countries) and the remainder among emerging market economies.
- Unemployment changes, 2007-10:
  - Change in Number of Unemployed People (2007-10, in millions): Advanced, Emerging, LIC (chart indicates Advanced largest increase; exact chart values not provided in text).
  - Change in Unemployment Rate (2007-10): Advanced, Emerging, LIC (chart indicates Advanced increased more).
- The unemployment rate increased by 3 percentage points in advanced countries since 2007 and by 0.25 percentage points in emerging markets.
- In contrast, in low-income countries (LIC) on the whole, unemployment fell during the Great Recession.

### Data and source notes
- The classification of countries into groups is the one used in the IMF's World Economic Outlook.
- Source for calculations: Authors' calculations based on WEO database.

*Source: Annex 1: Fiscal Adjustment and Income Distribution in Advanced Economies (excerpt).*

### Section II of this paper assesses the human cost of the increase in unemployment by surveying what

### Section II of this paper assesses the human cost of the increase in unemployment by surveying what

### II. The Human Cost of Recessions — Overview
- Unemployment costs extend beyond temporary income loss to:
  - loss of lifetime earnings;
  - loss of human capital and worker discouragement;
  - adverse health outcomes, including reduced life expectancy;
  - reduced social cohesion;
  - negative effects on children’s education and earnings.
- Certain groups face particularly high costs: youth and the long-term unemployed.

### A. Cost to Individuals and Families
- Loss of earnings
  - Earnings losses are substantial both short- and long-run; most pronounced for job losers during a recession.
  - Studies for the United States show earnings losses persist 15–20 years after a job loss in a recession, with the earnings loss amounting on average to 20%.
  - Schmieder et al. (2009) find workers who lost stable jobs in 1982 in Germany suffered earnings losses of 10–15% that lasted at least 15 years.
  - Mechanisms for persistent earnings losses include:
    - decline in value of occupation- or industry-specific skills that become obsolete;
    - time-intensive process of finding an appropriate job, especially for mature workers;
    - “cyclical downgrading” when workers take worse jobs than they otherwise would have.
  - Earnings losses are most pronounced for unemployment spells experienced at youth, especially upon college graduation.
- Impact on health
  - Short-run: layoffs associated with higher risk of heart attacks and other stress-related illnesses.
  - Long-run: increased mortality rate of laid-off workers can persist up to 20 years after job loss.
  - Estimated average loss of life expectancy due to increased mortality from unemployment: from 1 to 1.5 years.
  - Evidence indicates that earnings losses associated with displacement are crucial for explaining increased mortality: displaced workers who do not suffer earnings losses are not found to have a higher mortality rate.
  - Proposed channel: reduced financial resources limit ability to invest in health care and healthy lifestyles; stress and depression also contribute.
- Impact on children
  - Parental job loss tends to reduce children’s schooling achievement in the short run.
  - Stevens and Schaller (2009): parental job loss increases probability that a child repeats a grade by nearly 15 percent.
  - Long-run: a father’s income loss reduces sons’ earnings prospects; Oreopoulos et al. (2008) estimate children whose fathers were displaced have annual earnings about 9% lower than similar children whose fathers did not experience an employment shock.
  - Evidence from Sweden (Palme and Sandgren, 2008) shows lower parental income during childhood significantly increases children’s mortality later in life, even after controlling for children’s lifetime income and education attainment.
- Summary point
  - Literature provides compelling evidence that parental job and income loss have persistent negative effects on children’s well-being, emphasizing importance of early investment in education and health of children.

### B. Loss of Social Cohesion
- Findings from surveys and cross-country data:
  - Giuliano and Spilimbergo (2009): individuals who experienced a recession in formative age 18–25 tend to believe less in personal effort, perceive stronger inequalities, and have less confidence in public institutions.
  - Altindag and Mocan (2010): personal joblessness experience translates into negative opinions about effectiveness of democracy and increases desire for a rogue leader; effect stronger for long-term unemployed and extends to individuals living in a country/period with high unemployment.
- Demographic concern:
  - Due to population aging, the youth cohort in Europe today forms the largest share of total population at least for the next 20 years, amplifying social cohesion risks from youth unemployment.

### C. Cost of Youth Unemployment
- Baseline and empirical observations:
  - Youth defined as age 15-24.
  - In OECD countries, the ratio between the under-25 and over-25 year old unemployment rate is on average around 2.5 to 1.
  - The largest rise in youth unemployment is observed for Spain (almost 40 percent).
  - For a set of eight countries with long time-series, the increase in the youth unemployment rate averaged 6 ½ percentage points during the Great Recession, compared with 4 percent in previous recessions.
  - Bell and Blanchflower (2010): increase in probability of unemployment for youth aged 15–24 has been much greater than the impact of living in a particular country, and greater than the effect of different education level and gender.
- Policy-relevant concern:
  - Adverse effects on lifetime earnings are most pronounced for unemployment spells experienced at youth, especially upon college graduation.
  - High and increasing youth unemployment poses risks to social cohesion.

### D. Cost of Long-Term Unemployment
- Duration and composition trends
  - Long-term unemployed defined as those unemployed six months or more.
  - Share of long-term unemployed increased in most selected OECD countries between 2007 and 2009; in Germany, France, Italy and Japan the share was high even before the crisis.
  - U.S. specific patterns:
    - Share of workers unemployed 27 weeks or more as share of all unemployed rose to about 45% during the Great Recession.
    - Average duration of unemployment has a secular upward trend; historically the average duration started to decline within the same year the recession ended, but starting in the 1990s duration has only declined as late as three years after the end of each recession and has not reverted to pre-recession levels.
  - Nearly half of U.S. unemployed workers have been out of work for over six months and the average duration of unemployment is nine months (U.S. data context).
- Consequences for re-employment and hysteresis
  - Probability of being rehired in the next month for Q4 2009:
    - person unemployed for 26 weeks or more: less than 10 percent;
    - person unemployed for less than 4 weeks: over 30 percent.
  - Longer unemployment spells increase risk of skill loss, detachment from labor force, and hysteresis in unemployment.
- Earnings impacts
  - Negative earnings impacts of job loss may be exacerbated with longer duration of unemployment.

### Summary links to policy (as discussed later in paper)
- Supporting recovery in real GDP—maintaining aggregate demand—is a direct way to help labor markets.
- Cross-country differences in unemployment response reflect:
  - extent of fall in aggregate demand (“Okun’s Law”);
  - coincidence of demand decline with stresses in financial and housing sectors;
  - extent of active labor market policies and expectations about shock persistence.

*Source: IMF staff paper, Section II content as provided in the supplied PDF excerpt.*

### Annex 1 provides evidence that fiscal consolidations in the past,

### _spn1017 - Annex 1 provides evidence that fiscal consolidations in the past,

### Fiscal consolidation, inequality, and social targeting
- Annex 1 documents that fiscal consolidations in the past, particularly expenditure-based ones, have widened inequality in advanced economies.
- Targeting of social benefits can guard against widening inequality.

### Macro policy coordination and demand rebalancing
- Coordination of policies across advanced and emerging countries helped during the recession and would help during the recovery.
- A G-20 Mutual Assessment Process policy scenario shows collaborative actions can produce outcomes that make everyone better off.
- Emerging markets with large external surpluses should adopt policies that nurture domestic demand to offset demand losses from fiscal consolidation in advanced economies.
- Combined with structural reforms that alleviate supply constraints (particularly in advanced G-20 economies), demand rebalancing raises global GDP and supports job creation.

### Hysteresis, labor market scarring, and fiscal-monetary interactions
- Fiscal policy benefits are larger in the presence of hysteresis (when the natural rate of unemployment has increased due to persistent cyclical weakness).
- Stimulative policies that counteract increases in the natural rate can raise tax revenues by returning output to potential and may lower the debt-to-GDP ratio over the medium run under some illustrative calculations.
- There is a risk of hysteresis in some countries, particularly the United States and Spain, given sharp increases in unemployment duration and persistent shocks (e.g., to housing).
- Additional empirical work is needed to determine how important hysteresis is and how it should influence policy.
- Monetary policy remains important: headline and core inflation are expected to be around 1¼ percent in 2011, and inflation pressures are subdued, allowing monetary conditions to remain supportive in most advanced economies as fiscal support diminishes.

### Wage moderation considerations
- Wage moderation can limit unemployment losses but may not always be desirable:
  - For relatively closed economies like the United States, wage moderation could add to deflationary pressures or lower aggregate demand.
  - For more open economies, wage moderation can boost competitiveness and external demand, useful for countries in a currency area without nominal depreciation options.
- Government influence on wage-setting varies by country; preferable for wage moderation to arise through social partner negotiations rather than heavy-handed government intervention.
- Example: New Zealand adjusted via declines in real wages and hours worked largely through negotiations between social partners.
- Targeted cuts in certain sectors (e.g., very high public sector wages in some countries) may be appropriate.

### Policies to ease the pain in labor markets
- Governments implemented measures to allow firms to retain workers while reducing hours and wages; automatic stabilizers like unemployment insurance (UI) were allowed to work.
- Many countries extended UI provision during the recession (example: United States extended from 26 to 99 weeks).
- Assessment of policies over the next couple of years is necessary.

Short-time work
- Short-time work programs typically subsidize firms for parts of the wage bill and sometimes subsidize on-the-job training.
- When well-designed, they can:
  - Spread the downturn’s burden across workers and employers.
  - Support aggregate demand by preventing wage deflation.
  - Reduce future hiring costs and preserve workers’ human capital.
- Heavily used in Germany, Italy, and Japan during the Great Recession; effectiveness varied across countries.
- Möller (2010) suggests Germany’s benign labor market outcomes were driven partly by the nature of the shock and pre-crisis conditions (shortage of trained workforce, high costs of layoffs/rehiring), with short-time work reinforcing labor-hoarding incentives.
- Costs and risks of continuing short-time work:
  - Fiscal strain and deadweight loss from firms free-riding on subsidies.
  - Potential obstruction of necessary reallocation if downturn effects are permanent.
- Policy recommendation: phase out short-time work as recovery takes hold; ensure program targets jobs viable in the long term.
- Country examples:
  - Germany: short-time work concentrated in sectors with temporary export shocks.
  - Italy: persistent pre-crisis use in mechanical, textiles, leather sectors suggests delay of structural layoffs in declining industries.
  - Spain: short-time work ineffective where shock was permanent (housing/construction).

Unemployment benefits (UI)
- UI benefits help maintain consumption and welfare post-layoff; propensity to consume out of UI benefits is close to one, providing demand stabilization.
- UI allows job search, improving potential job matches.
- Common cost: potential disincentive to job search; longer/higher UI often correlated with longer unemployment spells.
- Chetty (2008): in the US, increased unemployment duration with longer UI benefits holds mainly for households with very low wealth (credit-constrained), implying liquidity alleviation rather than supply-side disincentives.
- Studies for Germany (Schmieder et al., 2009) and Austria (Card et al., 2007) indicate moderate unemployment increases or liquidity-driven benefits from extended UI.
- In severe recessions, negative UI effects on employment are likely small because scarce vacancies mean jobs not taken by one worker are filled by others.
- Fiscal cost-effectiveness: Congressional Budget Office estimates increasing aid to the unemployed carries the highest cost effectiveness due to direct and immediate impact on consumption and aggregate demand; between 8 and 19 years of full-time equivalent employment are predicted to be created per million dollars of budgetary cost (see CBO, 2010).
- Recommendation: beyond a certain unemployment duration (say six months), UI provision should be tied to part-time work or job training to maintain labor-force attachment.
- Extension of UI makes sense in the US context but is not a universal recommendation for countries (e.g., European countries with already long entitlement periods).

### Policies to accelerate jobs recovery
Dual employment systems
- Many OECD countries expanded temporary contracts not subject to strict protections of permanent contracts, creating a dual employment system.
- Spain had about 30 percent of employed persons under temporary contracts (the highest level in the OECD).
- Dual systems can make employment more responsive to output changes; Spain saw employment decline by 20 percent during the Great Recession, with most losses among temporary workers.
- Concerns:
  - Greater disparity in wages and benefits between permanent and temporary workers.
  - Temporary workers have less access to on-the-job training, reducing human capital and future opportunities.
  - Theoretical and empirical evidence suggests a two-tier system can increase unemployment and be inefficient by creating high turnover in low-productivity jobs and lowering aggregate output and employment.
- References: Blanchard and Landier (2002); Jaumotte (2010).

Job subsidies
- Targeted subsidies (direct job/wage subsidies or payroll tax reductions) were used to support groups most vulnerable to joblessness: the long-term unemployed and youth (Austria, Finland, Portugal, Sweden, Switzerland) and to spur hiring in hard-hit regions or sectors (Korea, Mexico, services in Japan).
- Benefits and risks:
  - Can prevent mass layoffs and stimulate net employment growth if targeted and temporary.
  - Risks include deadweight loss (subsidizing jobs that would have been created anyway) and sustaining jobs that should be destroyed for efficient reallocation.
- In deep recessions, potential inefficiencies are less severe than costs of persistent unemployment.
- Targeting strategies reduce misallocation by focusing on groups least likely to be rehired.
- Comparison with short-time work:
  - If massive job destruction can be avoided, short-time work is preferable in the short run as it spreads costs and benefits.
  - If downturn expectations are entrenched and retention incentives weak, direct job subsidies may be the only effective short-run policy against mass layoffs.
- Country-specific note: recovery in the United States and Spain is tied to addressing housing and construction problems.

### Key statistics and facts preserved from source
- UI extension in the United States: from 26 to 99 weeks.
- Headline and core inflation expected to be around 1¼ percent in 2011.
- Headline inflation expected to remain around 1¼-1½ percent in 2010 and 2011.
- Consolidation plans for 2011 imply an average change in the structural balance of 1¼ percentage points of GDP.
- Spain: about 30 percent of employed persons were under temporary contracts.
- Spain: employment declined by 20 percent during the Great Recession, with the vast majority of job losses in the temporary workforce.
- Global unemployment: over 200 million people across the globe are unemployed.
- Share of increase in unemployed during the Great Recession: nearly three-fourths occurred in the “advanced” (i.e. high-income) economies.
- Recommendation threshold for tying UI to activity: beyond a certain level of unemployment duration (say six months).
- CBO estimate: Between 8 and 19 years of full-time equivalent employment are predicted to be created per million dollars of budgetary cost (see CBO, 2010).

### Policy recommendations and timing
- Maintain support for aggregate demand: most advanced economies should not tighten fiscal policies before 2011, since earlier tightening could undermine recovery.
- Adapt fiscal strategy to country-specific fiscal space.
- Monetary policy should remain accommodative where inflation pressures are subdued.
- Phase out subsidies to short-time work as recovery takes hold.
- Tie UI provision to active job search, training, or part-time social work after extended durations to maintain labor-force attachment.
- Use targeted and temporary hiring subsidies to spur employment for groups most adversely affected, balancing short-run benefits against long-run reallocation needs.

*Source: _spn1017 - Annex 1 provides evidence that fiscal consolidations in the past,*

### Annex 1. Fiscal Adjustment and Income Distribution in Advanced Economies

### Annex 1. Fiscal Adjustment and Income Distribution in Advanced Economies

### Short-term macroeconomic and distributional effects
- Fiscal consolidation can increase income inequality in the short term; the duration and magnitude depend on the growth response and the composition of fiscal adjustment.
- Adverse short-term effects are attributable mainly to rising unemployment.
- Fiscal adjustment reduces output and increases unemployment in the short run due to positive fiscal multipliers; these effects are reversed over the longer term (Blanchard and Perotti, 2002; Spilimbergo et al., 2009).
- Fiscal consolidation may lead to a decline in the share of wages within a few quarters by lowering demand and output, putting upward pressure on unemployment and downward pressure on wages (Rotemberg and Woodford, 1999).
- Inequality of labor income widens if:
  - low-wage workers are hit harder (Agenor, 2002); or
  - employers start hoarding skilled labor (Mukoyama and Sahin, 2006).
- The duration of these effects depends on how quickly and strongly private demand responds to fiscal shocks.
- In episodes of large fiscal adjustment:
  - consolidation has been associated with increases in unemployment during the early years;
  - larger adjustments are associated with greater persistence in unemployment, especially if there is an increase in structural unemployment (Mocan, 1999; Galbraith, 2009).
- Over the longer term, the effects of fiscal consolidation on unemployment are reversed (Clinton et al., 2010).

### Role of expenditure and revenue composition
- Large and durable fiscal adjustments have often been associated with significant expenditure cuts, including in public cash transfers (Alesina and Perotti, 1997; Alesina and Ardagna, 2009).
- In Europe, public cash transfers have been shown to lower income inequality (as measured by the Gini coefficient) by about 9 percentage points (OECD, 2008); reductions in these outlays may contribute to widening income inequality during adjustment episodes.
- However, substantial fiscal adjustment can be associated with relatively small changes in income inequality if expenditure reductions are accompanied by efforts to better target benefits (examples cited: Denmark, Germany, and Sweden).
- The small share of means-tested social spending in the EU (Figure 2) suggests ample scope for reducing spending without adverse effects on inequality.
- Revenue measures, particularly those related to income and wealth, are likely to reduce income disparities due to progressive tax systems in advanced economies (OECD, 2008).
- A caveat: if taxes are already high, efficiency considerations place a limit on how much adjustment should be achieved through tax adjustment.
- The equalizing effects of revenue-based adjustments have, to some extent, been offset by reductions in marginal tax rates; top marginal personal income tax rates in OECD countries have been reduced considerably over the past decades (Mankiw et al., 2009).

### Evidence and country-level observations
- In the United States, Japan, and Canada, social spending plays a less critical role in equalizing incomes (footnote).
- Denmark and Germany: household income distribution data suggest an increase in the progressivity of transfers during large fiscal adjustments (OECD, 2008) (footnote).
- Sweden: referenced targeting efforts during adjustment (IMF, 2001) (footnote).

### Key statistics and exact figures cited
- Transfers lower income inequality (Gini) by about 9 percentage points in Europe (OECD, 2008).
- Examples of country-specific patterns and targeting efforts: Denmark, Germany, Sweden (no numeric magnitudes provided beyond the 9 percentage points).
- Footnote numeric example: reduction in marginal tax rates noted historically (no specific percentage provided in the main text).

### Policy implications and recommendations
- Prioritize the composition of adjustment to limit short-term increases in income inequality:
  - Protect or better target social transfers to preserve their equalizing role.
  - Where possible, rely on progressive revenue measures to reduce income disparities, while being mindful of efficiency limits when tax rates are already high.
- Improve targeting of expenditures to reduce adverse distributional effects while achieving fiscal consolidation.
- Recognize that larger consolidations may require additional measures to prevent prolonged unemployment and structural unemployment increases.

- Contribution: The material in this annex was contributed by Javier Arze, Benedict Clements, David Coady, and Alvar Kangur of the Fiscal Affairs Department.

*Annex 1. Fiscal Adjustment and Income Distribution in Advanced Economies — IMF Staff*

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