Optimal fiscal adjustment and the commitment-to-forgive issue

Carlos Goncalves and Bernardo Guimaraes

No 2012_01, Working Papers, Department of Economics from University of São Paulo (FEA-USP)

Abstract: This paper studies the incentives for fiscal adjustment for a debtor government under the risk of defaulting on its external debt. An externality arises from the bargaining process that follows default: higher tax revenues levied by the debtor lead to higher repayment to the creditor, and thus to a smaller haircut. In consequence, the optimal tax rate set by the debtor is lower than the socially optimal. If parties can negotiate contingent contracts ex-ante, the socially optimal fiscal stance can be implemented as long as creditors can commit to forgive a larger part of the debt in bad states. The model yields a different interpretation of IMF adjustment programmes and can account for some recent developments in the Eurozone debt crises.

Keywords: fiscal adjustment; sovereign debt; default; bargaining; haircut. (search for similar items in EconPapers)
JEL-codes: F34 (search for similar items in EconPapers)
Date: 2012-03-29
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