Imperfect Financial Markets and the Cyclicality of Social Spending

Abstract

I develop a novel link between frictions in international financial markets and fiscal procyclicality.Complementing existing evidence, A decomposition of government expenditure into social spending and public good spending reveals that the cyclical correlation of social spending exhibits the biggest differences across countries. I build a small open economy model with income inequality, endogenous fiscal policy and sovereign default risk to rationalize this spending procyclicality. Government spending, divided into a public good and social spending, is financed by taxation and external debt. External debt is subject to endogenous risk premia because the government cannot commit to repay its debt. The government conducts a procyclical tax and social spending policy when debt is in or close to the risky zone. Social spending then only redistributes income, failing to smooth private consumption over time. Far away from the crisis zone, fiscal policy is countercyclical, only public goods spending is always procyclical. Social spending is cut most when the government faces positive risk premia, because it is better a substitute of private income than public good spending. It also accounts for the largest part in fiscal adjustment: because taxes are distortionary and cannot be targeted well. Fiscal procyclicality becomes stronger with higher economic inequality as revenue raising through taxation becomes more costly.