Optimal Time-Consistent Taxation with Default

44 Pages Posted: 3 Jan 2018

See all articles by Anastasios G. Karantounias

Anastasios G. Karantounias

Federal Reserve Banks - Federal Reserve Bank of Atlanta

Date Written: 2017-11-01


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.

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

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

Suggested Citation

Karantounias, Anastasios G., Optimal Time-Consistent Taxation with Default (2017-11-01). FRB Atlanta Working Paper No. 2017-12. Available at SSRN: https://ssrn.com/abstract=3092153

Anastasios G. Karantounias (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Atlanta ( email )

1000 Peachtree Street N.E.
Atlanta, GA 30309-4470
United States

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