Fiscal Commitment and Sovereign Default Risk

Siming Liu () and Hewei Shen

Review of Economic Dynamics, 2022, vol. 46, 98-123

Abstract: This paper studies the interaction between fiscal commitment and sovereign default risk in a model with optimal taxation and government spending. A time-inconsistency problem arises in our framework as the government cannot credibly commit to its future tax policies. As a result, it chooses suboptimally low fiscal adjustments and defaults too frequently. Introducing a commitment device to future tax policies can mitigate this time-inconsistency problem and improve the government's borrowing opportunities. However, such a commitment device also entails a loss of tax contingency that might be costly. Our quantitative analysis shows that committing to an inflexible tax plan is counterproductive: the lack of contingency hurts the government's debt sustainability and reduces welfare. In contrast, committing to a flexible tax plan that is contingent on future economic conditions can improve debt sustainability by 53.3% and result in a significant welfare gain. (Copyright: Elsevier)

Keywords: Sovereign default; Sovereign debt; Fiscal adjustment; Time inconsistency (search for similar items in EconPapers)
JEL-codes: E62 F34 F41 H21 H63 (search for similar items in EconPapers)
Date: 2022
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DOI: 10.1016/j.red.2021.08.005

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