Inequality, Taxation, and Sovereign Default Risk
Discussion Papers from Department of Economics, Simon Fraser University
Income inequality and worker migration significantly affect sovereign default risk. Governments often impose progressive taxes to reduce inequality, which redistribute income but discourage labor supply and induce emigration. Reduced labor supply and a smaller high-income workforce erode the current and future tax base, reducing the governmentâ€™s ability to repay debt. I develop a sovereign default model with endogenous non-linear taxation and heterogeneous labor to quantify this effect. In the model, the government chooses the optimal combination of taxation and debt, considering its impact on workersâ€™ labor and migration decisions. With the estimated model, I find that income inequality and its interactions with migration explain one-third of the average U.S. state government spread.
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