Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/300371 
Year of Publication: 
2024
Series/Report no.: 
Cardiff Economics Working Papers No. E2024/3
Publisher: 
Cardiff University, Cardiff Business School, Cardiff
Abstract: 
This paper explores the link between default risk and fiscal procyclicality. We show that countries with higher sovereign risk have a more procyclical fiscal expenditure policy, which is driven mostly by transfers. We build a small open economy model with income inequality, social transfers, and default risk to rationalize this fact. Without default risk transfers are countercyclical, inequality is procyclical, and external debt is used to smooth distortionary taxation. With default risk, transfers account for most of fiscal adjustment because taxation becomes costly for the government. Transfers become procyclical and inequality worsens during times when risk premia are high. We confirm the predictions of the model in the data: in recessions in economies with default risk, transfers take the bigger burden relative to government consumption, whereas the opposite is true in economies with low default risk.
Subjects: 
fiscal policy
default risk
income inequality
redistribution
emerging markets
JEL: 
E62
F34
F41
Document Type: 
Working Paper

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