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Greed versus Fear: Optimal Time-Consistent Taxation with Default

Author

Listed:
  • Anastasios G. Karantounias

    (University of Surrey)

  • Vytautas Valaitis

    (University of Surrey)

Abstract

This paper studies optimal time-consistent distortionary taxation with default. The government taxes labor income or issues non-contingent debt to finance an exogenous stochastic stream of fiscal shocks. Debt can be repudiated subject to default costs. Optimal policy is characterized by two opposing incentives that capture the double lack of commitment to old tax policies and to repaying debt, respectively: an incentive to postpone taxes by issuing more debt for the future (“Greed†), and an incentive to tax more currently to avoid punishing default premia (“Fear†). A Generalized Euler Equation captures these forces and determines the optimal back-loading or front-loading of tax distortions. Even with small default risk, tax-smoothing and debt issuance are substantially limited when short-term debt is available. The same mechanisms operate in environments with long-term debt, but debt serves more as a fiscal absorber.

Suggested Citation

  • Anastasios G. Karantounias & Vytautas Valaitis, 2026. "Greed versus Fear: Optimal Time-Consistent Taxation with Default," School of Economics Discussion Papers 0626, School of Economics, University of Surrey.
    • Handle: RePEc:sur:surrec:0626
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    File URL: https://repec.som.surrey.ac.uk/2026/DP06-26.pdf
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    More about this item

    JEL classification:

    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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