Examining the hidden link: How public debt impacts income inequality in OECD member states

The theory of redistribution, which argues that individuals from higher-income groups are the primary holders of public debt, serves as the theoretical foundation for our research. The impact of redistribution based on the realization of receipts from interest on the public debt, cannot be entirely offset by the insufficient progressiveness of the tax system. Given that it significantly affects how income is distributed, the paper also considers the financial structure aspect, which is measured by the ratio of bank-based to market-based financing. The purpose of this paper is twofold. First, examine whether public debt increases inequality in income distribution, and second, test if the relative increase in market financing compared to bank financing increases inequality in income distribution. Thus, the paper investigates whether, in countries where public debt ownership is not distributed equally, public debt has a non-negligible effect on income transfer between different socioeconomic groups. The empirical part of this work was conducted using a dynamic panel model on a sample of 27 OECD member countries, for the period from 2004 to 2021. Precisely, we employ the Vector Error Correction Model (VECM). Research findings indicate that an increase in state borrowing results in a long-term redistribution of income from lower-income groups to higher-income groups. Conversely, an increase in the financial system’s emphasis on bank financing results in a short-term decrease in income inequality. So, while high levels of public debt are certainly a cause for concern, it is crucial to also consider the distribution of this debt within the economic policy-making process, and when evaluating its potential impact on economic inequality.