Inequality, taxation, and sovereign default risk
What is this research about and why did you do it?
Income inequality affects fiscal policies related to taxation, borrowing, and default. This research is driven by the empirical observation that governments in more unequal economies are more likely to default and face higher debt spreads. This pattern is evident in both US state-level and international data. The paper aims to explain and quantify how inequality influences fiscal outcomes and debt sustainability. By examining the interplay between redistribution policies, worker behavior, and debt repayment, this study provides deeper insights into the fiscal challenges posed by rising inequality.
How did you answer this question?
I develop a sovereign default model that incorporates income inequality, endogenous taxation, and labor mobility to capture the interactions between taxation, debt, and inequality. In the model, workers are heterogeneous in income, supplying labor elastically and consuming after-tax income. They can also migrate by paying an idiosyncratic cost, making labor elastic along both intensive (labor supply) and extensive (migration) margins. The government chooses a nonlinear tax scheme, debt, and default policy. Progressive taxation redistributes income but reduces labor supply and induces high-income emigration, eroding the tax base and increasing default risk, creating a trade-off between redistribution and debt sustainability.
What did you find?
Governments face a trade-off between redistribution and debt default risk. A more progressive tax redistributes income and reduces inequality but discourages labor and increases sovereign default risk. In an economy where inequality is a key concern, the government opts for more redistribution and has higher spreads. Calibrated to US state-level data, inequality accounts for one-fifth of the average spread. During recessions, the interaction between income inequality and migration amplifies negative productivity shocks, limiting the government’s ability to adjust taxes and further increasing debt spreads.
Note: This table compares the average sovereign spread and debt-to-GDP ratio in equilibrium between the benchmark model and a model without income inequality.
After a one standard deviation negative productivity shock, the government spread goes up in all models (panel A)
What implications does this have for the study (research and teaching) of wealth concentration or economic inequality?
This research highlights the intricate connection between economic inequality and fiscal sustainability. For both research and teaching, it underscores how progressive taxation can simultaneously reduce inequality and increase sovereign default risk, especially in economies with high inequality. It emphasizes the importance of considering labour mobility and fiscal policies when studying economic inequality and wealth concentration.
What are the next steps in your agenda?
Motivated by the findings in this paper, future work will explore the financial and fiscal connections between sovereign debt crises and the labour market, aiming to better understand how these linkages impact government policy decisions and broader macroeconomic outcomes.
Citation and related resources
Deng, M., 2024. Inequality, taxation, and sovereign default risk. American Economic Journal: Macroeconomics, 16(2), pp.217-249.
