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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.

Suggested Citation

  • Carlos Eduardo Gonçalves & Bernardo Guimaraes, 2012. "Optimal fiscal adjustment and the commitment-to-forgive issue," Working Papers, Department of Economics 2012_01, University of São Paulo (FEA-USP).
  • Handle: RePEc:spa:wpaper:2012wpecon01
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    References listed on IDEAS

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    More about this item

    Keywords

    fiscal adjustment; sovereign debt; default; bargaining; haircut.;
    All these keywords.

    JEL classification:

    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems

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