Sovereign Debt vs Redistributive Taxes: Financing Recoveries in Unequal and Uncommitted Economies

In this paper, we study optimal design of taxes and debt in the medium term in presence of domestic inequality and lack of commitment. We study an OLG economy in which individuals work and save for retirement when young. Government of the small open economy provides transfers to both the young and the old while it can decide to finance its spending via taxation of labor income as well as borrowing from the rest of the world. We show that in such environment, government has two different motives to renege on its past promises: 1. `Domestic default' to reduce domestic wealth inequality, 2. `Sovereign default' to reduce transfers to foreign lenders. We show that episodes of high income inequality create strong incentive for sovereign default. We show that this interaction between the domestic and sovereign default motive leads to oscillatory dynamics in the model. That is, it is optimal for such economies to periodically raise taxes above and below its long-run levels during an episode of economic recovery. Moreover, the level of after tax income inequality is time-varying: When the government is repaying foreign debt it is optimal to allow for more inequality.