Fiscal Policy and Income Inequality in Pakistan: An ARDL Approach

Abstract

This study is an attempt to capture the impact of fiscal policy on income inequality in Pakistan. It employed Autoregressive Distributed Lag (ARDL) model on annual time series data from 1980 to 2012. The stationarity of data is checked by Augmented Dickey Fuller unit root test. Short-run dynamics are tested by error correction model. Model reliability is tested with the help of the diagnostic tests. Chow test is applied to detect structural breaks and Gregory-Hansen technique is employed as a remedial measure of the structural breaks. Results indicate that development expenditures and financial development has diminishing effect on income inequality. On the other hand fiscal deficit and urbanization are affecting the income inequality positively. The current expenditures and indirect tax has no influence on Gini-coefficient. The study recommends that fiscal deficit should be diminished by reducing current expenditures. The development expenditures require an increase to decrease income inequality. For the financing revenue from indirect taxes may be increased, it will not hurt the income inequality. The financial development as a tool for decreasing inequality is also proposed. 1. Introduction Debate on income inequality is not new in the economic literature. Earlier Marxists focused on the theory of social classes and blamed capitalistic system for having unequal societies. They argued that propertied class suppress labor class and generate inequality. Classical economists were mainly concerned with the income distribution between factors of production. Now the economists are conscious about income distribution at household and personal level. With the passage of time there emerged a number of determinants of income inequality in an economy. For instance, role of urbanization in income inequality was introduced by Kuznets (1955). He took the urbanization and industrialization as two complimentary processes. The urbanization lead to industrialization and it increases inequality at the initial stage of