Sovereign Default, Inequality, and Progressive Taxation

Economics

Speaker:Axelle Ferriere, European University Institute
Date: Wednesday 28 October 2015
Time: 13.30
Location: Streatham Court B

Further details

A sovereign's willingness to repay its foreign debt depends on the cost of raising taxes. The allocation of this tax burden across households is a key factor in this decision. To study the interaction between the incentive to default and the distributional cost of taxes, I extend the canonical Eaton-Gersovitz-Arellano model to include heterogeneous agents, progressive taxation, and elastic labor supply. When the progressivity of the tax schedule is exogenous, progressivity and the incentive to default are inversely related. Less progressive taxes, and hence higher after-tax inequality, encourage default since the cost of raising tax revenue from a larger mass of low-income households outweighs the cost of default in the form of lost insurance opportunities. When tax progressivity is endogenous and chosen optimally, the government internalizes the influence of progressivity on default risk and the cost of borrowing. As such, committing to a more progressive tax system emerges as an effective policy tool to reduce sovereign credit spreads in highly indebted countries.