Power-Law Distribution in the Debt-to-Fiscal Revenue Ratio: Empirical Evidence and a Theoretical Model

This paper provides evidence that the external debt-to-fiscal revenue ratio in the emerging countries has a power-law distribution. Such a distribution reflects the fact that debt distress or debt crises are extreme events that have been found to happen fairly often. We formally test the hypothesis of a power-law, going further than the usual visual inspection of the distribution of the variable of interest on a doubly logarithmic scale. We further show that such a distribution can be derived from a theoretical model in which the debt dynamics is explained by tax evasion and corruption. Using the framework of an optimal stochastic growth model, we model the debt-to-fiscal revenue ratio as a diffusion process for which the stochastic steady state distribution is derived using the properties of Itô diffusion processes.