The politics of redistribution and sovereign default

This paper studies how distributional and electoral concerns shape sovereign default incentives within a quantitative model of sovereign debt with heterogeneous agents and non-linear income taxation. The small open economy is characterized by a two-party system in which the left-wing party has a larger preference for redistribution than the right-wing party. Political turnover is the endogenous outcome of the electoral process. Fiscal policy faces a tradeoff: On the one hand, the government has incentives to fi- nance redistribution via external debt to avoid distortionary income taxation. On the other hand, the accumulation of external debt raises the cost of borrowing. Quanti- tative findings suggest that the left-wing party implements a more progressive income tax, is more prone to default, and has a lower electoral support than the right-wing party due to worse borrowing conditions and the distortionary effects of income taxa- tion. In equilibrium, electoral uncertainty raises sovereign default risk.