Optimal Taxation with Endogenous Default under Incomplete Markets

How are the optimal tax and debt policies affected if the government has the option to 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 that would come along with the service of 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. When we allow the government to default and calibrate the model to Spain, fiscal policies are more volatile, borrowing costs are higher, indebtness and welfare are both lower than in two alternatives economies, one with only risk-free debt available and the other with government's commitment to the default strategy.