A/HRC/31/60 III. Addressing central questions: how do inequality and debt crises interact?28 A. Inequality as a source of sovereign debt increase and crisis 22. Inequality may affect sovereign debt both directly and indirectly. In short, the direct impact proceeds from the “corrosive” influence of inequality on the tax base, as well as from its enhancing effect on demand for redistribution through debt default. As for the indirect impact, it is mainly private debt that acts as an interface between inequality and sovereign debt. Increasing inequality may lead to private overborrowing and overlending. The resulting excessive private leverage can accumulate over many years, destabilize the financial system29 and even become so volatile for the economy that the debt can trigger a banking crisis, leading to both output losses and massive bailout costs for Governments. In addition, both the direct and the indirect channel may simultaneously prompt a currency crisis if external debt is involved. 1. Inequality as a direct cause of sovereign debt increase and financial crises 23. Inequality may exert a considerable direct influence on the structure and the level of government revenues and spending. Increased levels of inequality also mean that the income tax base of the State concerned is rather small, at least if income taxation is not progressive. This diminishes sovereign revenues and consequently makes the State more dependent on borrowing. Thus inequality contributes in many cases to sovereign debt, which may eventually result in sovereign default and financial crises. There is a growing body of evidence for this mechanism. 24. Empirical studies point to a clear nexus between inequality, income tax base and sovereign debt. One study, using data from 50 countries in 2007, 2009 and 2011, found a negative correlation between income inequality and the tax base and a positive correlation with sovereign debt.30 An analysis of a panel of 17 countries of the Organization for Economic Cooperation and Development (OECD) covering the period 1974-2005 found a positive correlation between the top 1 per cent income share, a widely used indicator of income inequality, and fiscal deficit.31 The erosion of the income tax base following an increase in inequality is also likely to affect the structure of tax revenue. The alternative to experiencing a fiscal deficit would be to increase other types of taxes, such as import or export duties and indirect or corporate taxes. This would, however, lead to higher revenue volatility, consequently increasing the risk of sovereign debt crisis. 25. Increased inequality is also found to contribute to the degeneration of sovereign debt into sovereign debt crises. A number of studies show that high inequality increases the 28 29 30 31 8 For a detailed overview of the interrelationships between inequality and financial crises, see R. Bazillier and J. Hericourt in “The circular relationship between inequality, leverage and financial crisis”, Laboratoire d’Économie d’Orléans, (University of Orleans, 2015). The Independent Expert wishes to thank the authors of that article for having prepared a background research paper for the present report. See M. Kumhof, R. Rancière and P. Winant, “Inequality, leverage and crises”, American Economic Review, vol. 105, No. 3 (2015), pp. 1217-1245. See J. Aizenman and Y. Jinjarak, “Income Inequality, Tax Base and Sovereign Spreads”, FinanzArchiv: Public Finance Analysis, vol. 68, No. 4 (2012), pp. 431-444. See S. Milasi, “Top income shares and budget deficits”, Centre for Economic and International Studies, Research Paper Series, vol. 10, issue 11, No. 249 (August 2013).