Optimal Time-Consistent Taxation with Default

Anastasios G. Karantounias

Working Paper 2017-12
November 2017

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We study optimal time-consistent distortionary taxation when the repayment of government debt is not enforceable. The government taxes labor income or issues noncontingent debt in order to finance an exogenous stream of stochastic government expenditures. The government can repudiate its debt subject to some default costs, thereby introducing some state-contingency to debt. We are motivated by the fact that domestic sovereign default is an empirically relevant phenomenon, as Reinhart and Rogoff (2011) demonstrated. Optimal policy is characterized by two opposing incentives: an incentive to postpone taxes by issuing more debt for the future and an incentive to tax more currently in order to avoid punishing default premia. A generalized Euler equation (GEE) captures these two effects and determines the optimal back-loading or front-loading of tax distortions.

JEL classification: D52, E43, E62, H21, H63

Key words: labor tax, sovereign default, Markov-perfect equilibrium, time-consistency, generalized Euler equation, long-term debt

The author thanks Manuel Amador, Marco Basseto, Alessandro Dovis, Karen Kopecky, Federico Mandelman, Fernando Martin, and Mark Wright for comments, Pablo D'Erasmo for his discussion, conference participants at the 2015 SED Meetings in Warsaw, the 2015 PET Meetings in Luxembourg and the 2015 Econometric Society World Congress in Montreal, and seminar participants at the Federal Reserve Bank of Chicago. The views expressed here are the author's and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the author's responsibility.
Please address questions regarding content to Anastasios Karantounias, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street NE, Atlanta, GA 30309, 404-498-8825, anastasios.karantounias@atl.frb.org.
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