REDISTRIBUTION AND NON-CONSUMPTION SMOOTHING IN AN OPEN-ECONOMY

This paper presents a model where income distribution and redistributi ve fiscal policy interact to affect the budget deficit and the pattern of net borrowing of a country. According to the standard representati ve agent paradigm, a small open economy should smooth consumption by b orrowing from (lending to) the rest of the world when its income incre ases (declines) over time. The simple model of this paper delivers exa ctly the same predictions in the absence of income dispersion. When in come distribution is not degenerate, however, the same model gives ris e to a surprising wealth of results. In particular, poor economies wit h high inequality may exhibit completely counter-intuitive patterns of fiscal policy and external borrowing. The country's production path; declines over time, because the more mobile agents leave the country t o escape taxation; yet, the country might end up having a budget defic it and borrowing from abroad, thereby reinforcing rather than smoothin g the asymmetry in consumption between the two periods. An important f eature of this outcome is that it is backed by both the poor and the r ich, who gain from the fiscal system at the expense of the middle clas s.