3 Section IV presents the econometric methodology for linking inequality and fiscal performance at the state-level along with the results. Section V discusses the robustness of the results obtained and section VI concludes.

# **II.   BACKGROUND ON THE LITERATURE**

# **Macroeconomic Factors and Inequality Dynamics**

The literature on the impact of macroeconomic conditions on inequality typically focuses on two main channels: unemployment and inflation (Marrero and Rodriguez, 2012, Jantti and Jenkins, 2010, and Bittencourt, 2009). The empirical evidence confirms that the unemployment rate tends to be positively correlated with inequality. Nevertheless, the effects of inflation on inequality are likely to be non-linear. High inflation can lead to an increase in inequality as poorer segments of the population cannot protect themselves against the “inflation tax”. However, it is possible that moderate inflation is associated with reductions in inequality as real debt burdens are eroded, as the evidence for developed economies suggests (Marrero and Rodriguez, 2012). On the other hand, Bittencourt (2009) provides a recent analysis for Brazil during the period 1983-1994, which indicates that extreme rates of anticipated and unanticipated inflation have significantly increased inequality.

Economic theory points to ambiguous effects of overall economic growth on inequality (Garcia-Penalosa, 2010). For instance, if growth is driven by increased human capital accumulation, it is likely to lead to a reduction in the relative wage of skilled workers (as the relative supply of skilled labor increases) and therefore to a reduction in inequality. On the other hand, when growth is driven by technological change that is skill-biased, it is likely that faster growth will lead to more inequality, as the wage premium for skilled workers increases. The empirical evidence on the impact of overall growth on inequality is also mixed. Cross-country studies tend to find evidence of both positive and negative correlations (Duflo and Banerjee, 2003).

In turn, inequality is also likely to have an important impact on macroeconomic variables, most notably on overall economic growth. Aghion, Caroli, and Garcia-Penalosa (1999) provide a survey of the topic from the perspective of new growth theories. Political economy and institutional implications of highly polarized societies and their consequences for macroeconomic policies and outcomes have also been highlighted by several authors (Acemoglu and others, 2003).

# **Fiscal Policy and Inequality**

The recent empirical literature on the effects of the fiscal policy stance on inequality has focused mostly on OECD/Advanced economies and used data at the national level. Wolff and Zacharias (2007) show that net government spending reduces inequality at the national level in the US and this is mostly due to expenditures rather than taxes. Agnello and Sousa (2012) look at the impact of fiscal consolidation on inequality in a panel of 18 industrialized countries and find that inequality increases during periods of fiscal consolidation. In addition, consolidation is particularly detrimental to inequality if led by expenditure cuts. On the other