Fiscal Commitment and Sovereign Default Risk
2018-003 CAEPR Working Paper Series
55 Pages Posted: 7 May 2018 Last revised: 7 Aug 2018
Date Written: August 4, 2018
This paper studies the eﬀects of ﬁscal policy commitment in countries that suffer sovereign default risk. Since a government does not incorporate the eﬀect of their taxation decisions on past bond prices, a time-inconsistency problem arises, resulting in too many defaults and too few ﬁscal adjustments. We show that a ﬁscal commitment device can mitigate the government’s default incentives and improve their borrowing opportunities. Moreover, instead of committing to a single tax rate, introducing a commitment device that depends on economic conditions can further reduce default risk while preserving the contingency of a pro-cyclical ﬁscal policy.
Keywords: Sovereign default risk; Pro-cyclical ﬁscal policy; Time-inconsistency; Fiscal commitment; Fiscal austerity
JEL Classification: E62, F34, F41
Suggested Citation: Suggested Citation