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Optimal Taxation with Endogenous Default under Incomplete Markets

Listed author(s):
  • Demian Pouzo
  • Ignacio Presno
Registered author(s):

    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.

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    File URL: http://arxiv.org/pdf/1508.03924
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    Paper provided by arXiv.org in its series Papers with number 1508.03924.

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    Date of creation: Aug 2015
    Date of revision: May 2016
    Handle: RePEc:arx:papers:1508.03924
    Contact details of provider: Web page: http://arxiv.org/

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