Optimal Taxation with Endogenous Default under Incomplete Markets

TL;DR

This paper analyzes how governments optimize fiscal policy when they can default on debt, considering the effects of endogenous credit limits, default risk, and renegotiation, leading to more volatile fiscal policies and specific default dynamics.

Contribution

It introduces a model of optimal taxation with endogenous default and incomplete markets, highlighting the impact on fiscal policy volatility and debt dynamics, aligned with empirical observations.

Findings

Default prevents future tax distortions, influencing fiscal policy volatility.

Endogenous credit limits restrict debt smoothing, increasing fiscal volatility.

Default and renegotiation policies match observed government behaviors.

Abstract

In a dynamic economy, we characterize the fiscal policy of the government when it levies distortionary taxes and issues defaultable bonds to finance its stochastic expenditure. Default may occur in equilibrium as it prevents the government from incurring in future tax distortions that would come along with the service of the debt. Households anticipate the possibility of default generating endogenous credit limits. These limits hinder the government's ability to smooth taxes using debt, implying more volatile and less serially correlated fiscal policies, higher borrowing costs and lower levels of indebtedness. In order to exit temporary financial autarky following a default event, the government has to repay a random fraction of the defaulted debt. We show that the optimal fiscal and renegotiation policies have implications aligned with the data.