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# **I.   INTRODUCTION**

The redistributive consequences of economic adjustment following the great recession of 2007/09 have been at the center of policy discussions in both advanced and emerging economies. Social discontent has been brewing even in economies with a positive track record of sustained growth and reductions in poverty and inequality. In this context, there has been an increased policy interest in the macroeconomic determinants of income inequality and, in particular, the link between inequality and fiscal policy. While the empirical literature on the microeconomic determinants of inequality is vast, especially in Latin America, much less attention has been paid to the underlying macroeconomic setting. This paper attempts to bridge this gap by combining fiscal data with household survey information at the state level for Brazil over the period 1995-2011 to assess the links between sub-national fiscal policy and income inequality.

The rich data available for Brazil provides a unique opportunity for assessing this issue. Brazil is organized politically and administratively as a federal system consisting of 26 states and one federal district. The states are characterized by heterogeneous levels of inequality and fiscal outcomes, but share common institutions and federal regulations. The period under analysis is marked by important changes in fiscal institutions as states had to increase their primary balances in order to comply with debt renegotiation programs agreed with the federal government in the late 1990’s. Even those states that did not have significant debt levels were bound by new fiscal rules. This fiscally-constrained environment reshaped revenue and expenditure policies at the sub-national level after 2000.

Against this backdrop, income inequality decreased significantly over the last two decades. The Gini coefficient declined from 57.7 in 1995 to 52.2 percent in 2011, although it remains among the highest in the world. Microeconomic studies have linked inequality reduction in Brazil to changes in labor income, including changes in both the supply and demand for skilled workers, and to the emergence of effective social transfer programs at the federal level (Azevedo and others, 2013, Pecora and Menezes, 2013, Barros and others, 2010, Lopez-Calva and Rocha, 2012, and, Foguel and Azevedo, 2007).

Our paper sheds further light into this issue by exploiting the role of macroeconomic factors, namely the fiscal policy at the sub-national level. The results indicate that a tighter fiscal stance in Brazilian states, measured by changes in their cyclically adjusted primary balance, is not linked to a deterioration in inequality. This conclusion differs from the results of several papers that analyze the impact of fiscal consolidations on inequality at the national level for OECD countries, which typically conclude that fiscal consolidations are associated with increases in inequality. In addition, we find that a tighter fiscal stance at the sub-national level is often positively associated with a measure of “shared prosperity”. Our findings caution against extrapolating policy implications of the literature focusing on advanced economies to other settings.

The paper is structured as follows. Section II provides a literature review on the relationship between income inequality and macroeconomic factors with a focus on fiscal policy. Section III presents stylized evidence on fiscal dynamics and income inequality for Brazilian states.