How are the optimal tax and debt policies affected if the government can default on its debt? We address this question from a normative perspective in an economy with noncontingent government debt, domestic default, and labor taxes. On one hand, default prevents the government from incurring future tax distortions associated with servicing the debt. On the other hand, default risk gives rise to endogenous credit limits that hinder the government's ability to smooth taxes. We characterize the fiscal policy and show how the option to default alters the near–unit root component of taxes in the economy with risk-free borrowing.
Pouzo, Demian, and Ignacio Presno.
"Optimal Taxation with Endogenous Default under Incomplete Markets."
American Economic Journal: Macroeconomics,
Taxation and Subsidies: Efficiency; Optimal Taxation
Personal Income and Other Nonbusiness Taxes and Subsidies; includes inheritance and gift taxes
National Debt; Debt Management; Sovereign Debt