IMF Working Papers

This paper develops a theory of sovereign debt sustainability driven by the government’s motive for redistribution. It studies a heterogeneous-agent small open economy in which redistribution relies on distortionary labor taxation and the government lacks commitment in its fiscal policies. Access to international credit markets lowers the cost of redistribution, while default into financial autarky raises it, generating an endogenous cost of default. Quantitatively, the model accounts for the buildup of Italy’s external debt and the positive cross-country correlation between pre-tax income inequality and external debt. Optimal austerity is more gradual when distributional concerns are present.