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Optimal fiscal adjustment and the commitment-to-forgive issue

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  • Carlos Eduardo Gonçalves

    ()

  • Bernardo Guimaraes

    ()

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.

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File URL: http://www.fea.usp.br/feaecon/RePEc/documentos/Eduardo01WP.pdf
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Bibliographic Info

Paper provided by University of São Paulo (FEA-USP) in its series Working Papers, Department of Economics with number 2012_01.

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Date of creation: 29 Mar 2012
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Handle: RePEc:spa:wpaper:2012wpecon01

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Related research

Keywords: fiscal adjustment; sovereign debt; default; bargaining; haircut.;

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References

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  1. Bulow, Jeremy & Rogoff, Kenneth S., 1989. "A Constant Recontracting Model of Sovereign Debt," Scholarly Articles 12491028, Harvard University Department of Economics.
  2. Fernando A Broner & Jaume Ventura, 2006. "Globalization and Risk Sharing," Working Papers 307, Barcelona Graduate School of Economics.
  3. Giancarlo Corsetti & Bernardo Guimaraes & Nouriel Roubini, 2003. "International Lending of Last Resort and Moral Hazard: A Model of IMF's Catalytic Finance," NBER Working Papers 10125, National Bureau of Economic Research, Inc.
  4. Andrew K. Rose, 2002. "One Reason Countries Pay Their Debts: Renegotiation and International Trade," Working Papers 042002, Hong Kong Institute for Monetary Research.
  5. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "This Time Is Different: Eight Centuries of Financial Folly," Economics Books, Princeton University Press, edition 1, volume 1, number 8973.
  6. Brutti, Filippo, 2008. "Legal enforcement, public supply of liquidity and sovereign risk," MPRA Paper 13949, University Library of Munich, Germany.
  7. Miguel Fuentes & Diego Saravia, 2009. "Sovereing Defaulters: Do International Capital Markets Punish Them?," Working Papers Central Bank of Chile 515, Central Bank of Chile.
  8. Jose Vicente Martinez and Guido Sandleris, 2008. "Is it Punishment? Sovereign Defaults and the Decline in Trade," Business School Working Papers 2008-01, Universidad Torcuato Di Tella.
  9. Ugo Panizza & Federico Sturzenegger & Jeromin Zettelmeyer, 2009. "The Economics and Law of Sovereign Debt and Default," Journal of Economic Literature, American Economic Association, vol. 47(3), pages 651-98, September.
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