Essays on Fiscal Policies in Open Economies

Abstract

This dissertation consists of three chapters. A unifying theme across all chapters is the interaction between government's motive for redistribution and its commitment to repay debt. The first chapter studies optimal taxation in an open economy in which the government has a redistributive motive and faces self-enforcing debt constraints that arise from its limited commitment. Redistributive policies are proportional taxes on labor and domestic saving. Optimal labor taxes decrease over time and eventually converge to a non-zero limit, and the optimal capital tax is positive in the limit. The efficient contract features front-loading distortion and back-loading efficiency, allowing the government to borrow more in the future. The model's numerical exercise shows that a stronger redistributive motive requires greater tax distortions at the beginning of time as well as a higher external debt level in the long run. The second chapter, in turn, proposes a theory of external debt sustainability based on the government’s motive for redistribution. Given the endogenous debt constraints, the value of financial autarky determines the sustainable level of debt. Financial autarky is endogenously costly because redistribution requires high labor taxes, which distort labor supply and reduce the economy's efficiency. Having access to external financing allows the government to have more redistribution, measured as the differences in individual utilities than in financial autarky at the same level of efficiency cost. Quantitatively, the theory can account for the external debt’s recent buildup in Italy and is consistent with the positive correlation between pre-tax income inequality and external debt across countries and time periods. In response to a negative productivity shock, the optimal austerity policies are increasing external borrowing and redistribution while reducing redistribution to repay debt in the future. The magnitude of these responses varies with the underlying wage inequality. The third chapter examines how income inequality affects the sovereign default risk. I study fiscal policies in a sovereign default model with heterogeneous agents and distortionary taxation. I quantify the model in the case of Spain and find that inequality worsens the debt crisis by increasing the government's incentive to default.