Greed versus Fear: Optimal Time-Consistent Taxation with Default

Anastasios Karantounias and Vytautas Valaitis
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Vytautas Valaitis: University of Surrey

No 626, School of Economics Discussion Papers from School of Economics, University of Surrey

Abstract: This paper studies optimal time-consistent distortionary taxation with default. The government taxes labor income or issues non-contingent debt to finance an exogenous stochastic stream of fiscal shocks. Debt can be repudiated subject to default costs. Optimal policy is characterized by two opposing incentives that capture the double lack of commitment to old tax policies and to repaying debt, respectively: an incentive to postpone taxes by issuing more debt for the future (“Greed†), and an incentive to tax more currently to avoid punishing default premia (“Fear†). A Generalized Euler Equation captures these forces and determines the optimal back-loading or front-loading of tax distortions. Even with small default risk, tax-smoothing and debt issuance are substantially limited when short-term debt is available. The same mechanisms operate in environments with long-term debt, but debt serves more as a fiscal absorber.

JEL-codes: D52 E43 E62 H21 H63 (search for similar items in EconPapers)
Pages: 78 pages
Date: 2026-10
New Economics Papers: this item is included in nep-dge
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Persistent link: https://EconPapers.repec.org/RePEc:sur:surrec:0626

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