The Dynamics of Informality and Fiscal Policy under Sovereign Risk

Francesco Pappadà and Yanos Zylberberg

No 20604, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: This paper examines how the dynamics of informality affects optimal fiscal policy and default risk. We build a model of sovereign debt with limited commitment and informality to assess the consequences of dynamic distortions induced by fiscal policy. In the model, fiscal policy has a persistent impact on taxable activity, which affects future fiscal revenues and thus default risk. The interaction of tax distortions and limited commitment strongly constrains the dynamics of optimal fiscal policy and leads to (i) more frequent default episodes and (ii) costly fluctuations in consumption.

JEL-codes: E26 E62 F34 F41 H20 (search for similar items in EconPapers)
Date: 2025-08
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