Optimal Taxation with Endogenous Default under Incomplete Markets

Demian Pouzo and Ignacio Presno

American Economic Journal: Macroeconomics, 2022, vol. 14, issue 3, 1-41

Abstract: How are the optimal tax and debt policies affected if the government can default on its debt? We address this question from a normative perspective in an economy with noncontingent government debt, domestic default, and labor taxes. On one hand, default prevents the government from incurring future tax distortions associated with servicing the debt. On the other hand, default risk gives rise to endogenous credit limits that hinder the government's ability to smooth taxes. We characterize the fiscal policy and show how the option to default alters the near–unit root component of taxes in the economy with risk-free borrowing.

JEL-codes: D52 E62 H21 H24 H63 (search for similar items in EconPapers)
Date: 2022
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Citations: View citations in EconPapers (3)

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DOI: 10.1257/mac.20160101

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