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Fiscal Commitment and Sovereign Default Risk

Author

Listed:
  • Siming Liu

    (Shanghai University of Finance and Economics)

  • Hewei Shen

    (University of Oklahoma)

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)

Suggested Citation

  • Siming Liu & Hewei Shen, 2022. "Fiscal Commitment and Sovereign Default Risk," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 46, pages 98-123, October.
    • Handle: RePEc:red:issued:18-490
    DOI: 10.1016/j.red.2021.08.005
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    More about this item

    Keywords

    Sovereign default; Sovereign debt; Fiscal adjustment; Time inconsistency;
    All these keywords.

    JEL classification:

    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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