Inequality, Taxation, and Sovereign Default Risk

Abstract

This paper studies the impact of income inequality on sovereign spreads under elastic labor and endogenous taxation. We first document that high pre-tax income inequality is associated with high spreads both across countries and across U.S. states. We then develop a sovereign default model with endogenous progressive taxation and heterogeneous labor in productivity and migration cost. The government chooses the optimal combination of tax and debt, considering their interaction. Progressive taxes redistribute income but discourage labor supply and induce emigration, eroding the tax base and the government's ability to repay debt. Default risk increases sovereign spreads and borrowing costs. Thus, the government faces a trade-off between redistribution and spreads. In more unequal economies, the government opts for more redistribution and higher spreads. With the model parameterized to state-level data, we find that income inequality is an important determinant of spreads, generating more than 20% higher spreads compared with a model without income inequality. In a recession, more unequal economies suffer a larger increase in spreads.