Imperfect financial markets and the cyclicality of social spending

Froemel, Maren and Paczos, Wojtek ORCID: https://orcid.org/0000-0002-8129-0235 2024. Imperfect financial markets and the cyclicality of social spending. European Economic Review 167 , 104786. 10.1016/j.euroecorev.2024.104786

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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.

Item Type:	Article
Date Type:	Publication
Status:	Published
Schools:	Business (Including Economics)
Publisher:	Elsevier
ISSN:	0014-2921
Date of First Compliant Deposit:	19 September 2024
Date of Acceptance:	5 June 2024
Last Modified:	24 Sep 2024 15:00
URI:	https://orca.cardiff.ac.uk/id/eprint/172270

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