Fiscal Austerity during Debt Crises

Cristina Arellano and Yan Bai

No 525, Staff Report from Federal Reserve Bank of Minneapolis

Abstract: This paper constructs a dynamic model in which fiscal restrictions interact with government borrowing and default. The government faces fiscal constraints; it cannot adjust tax rates or impose lump-sum taxes on the private sector, but it can adjust public consumption and foreign debt. When foreign debt is sufficiently high, however, the government can choose to default to increase domestic public and private consumption by freeing up the resources used to pay the debt. Two types of defaults arise in this environment: fiscal defaults and aggregate defaults. Fiscal defaults occur because of the government's inability to raise tax revenues. Aggregate defaults occur even if the government could raise tax revenues; debt is simply too high to be sustainable. In a quantitative exercise calibrated to Greece, we find that our model can predict the recent default, but that increasing taxes would not have prevented it. In fact, increasing taxes would have made the recession deeper because of the distortionary effects of taxation.

Keywords: Debt crisis; Tax reforms; Sovereign default (search for similar items in EconPapers)
JEL-codes: F30 (search for similar items in EconPapers)
Pages: 21 pages
Date: 2016-01-26
New Economics Papers: this item is included in nep-dge, nep-fdg and nep-pbe
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (14)

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Journal Article: Fiscal austerity during debt crises (2017)
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedmsr:525

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