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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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    File URL: http://www.repec.eae.fea.usp.br/documentos/Eduardo01WP.pdf
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    References listed on IDEAS

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    1. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "Varieties of Crises and Their Dates," Introductory Chapters,in: This Time Is Different: Eight Centuries of Financial Folly Princeton University Press.
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    5. Vreeland,James Raymond, 2003. "The IMF and Economic Development," Cambridge Books, Cambridge University Press, number 9780521016957.
    6. Fuentes, Miguel & Saravia, Diego, 2010. "Sovereign defaulters: Do international capital markets punish them?," Journal of Development Economics, Elsevier, vol. 91(2), pages 336-347, March.
    7. Bulow, Jeremy & Rogoff, Kenneth, 1989. "A Constant Recontracting Model of Sovereign Debt," Journal of Political Economy, University of Chicago Press, vol. 97(1), pages 155-178, February.
    8. Fernando Broner & Jaume Ventura, 2011. "Globalization and Risk Sharing," Review of Economic Studies, Oxford University Press, vol. 78(1), pages 49-82.
    9. Martinez, Jose Vicente & Sandleris, Guido, 2011. "Is it punishment? Sovereign defaults and the decline in trade," Journal of International Money and Finance, Elsevier, vol. 30(6), pages 909-930, October.
    10. Brutti, Filippo, 2008. "Legal enforcement, public supply of liquidity and sovereign risk," MPRA Paper 13949, University Library of Munich, Germany.
    11. Jonathan Eaton & Mark Gersovitz, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Oxford University Press, vol. 48(2), pages 289-309.
    12. Corsetti, Giancarlo & Guimaraes, Bernardo & Roubini, Nouriel, 2006. "International lending of last resort and moral hazard: A model of IMF's catalytic finance," Journal of Monetary Economics, Elsevier, vol. 53(3), pages 441-471, April.
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    More about this item

    Keywords

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

    JEL classification:

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

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