Fiscal Commitment and Sovereign Default Risk

87 Pages Posted: 7 May 2018 Last revised: 10 Dec 2021

See all articles by Siming Liu

Siming Liu

Shanghai University of Finance and Economics - School of Finance

Hewei Shen

University of Oklahoma - Department of Economics

Date Written: May 17, 2021

Abstract

This paper studies the interaction between fiscal commitment and sovereign default risk in a model with optimal taxation and government spending. A time-inconsistency problem arises in our framework as the government cannot credibly commit to its future tax policies. As a result, it chooses suboptimally low fiscal adjustments and defaults too frequently. Introducing a commitment device to future tax policies can mitigate this time-inconsistency problem and improve the government's borrowing opportunities. However, such a commitment device also entails a loss of tax contingency that might be costly. Our quantitative analysis shows that committing to an inflexible tax plan is counterproductive: the lack of contingency hurts the government's debt sustainability and reduces welfare. In contrast, committing to a flexible tax plan that is contingent on future economic conditions can improve debt sustainability by 53.3% and result in a significant welfare gain.

Keywords: Sovereign default, Sovereign debt, Fiscal adjustment, Time inconsistency

JEL Classification: E62, F34, F41, H21, H63

Suggested Citation

Liu, Siming and Shen, Hewei, Fiscal Commitment and Sovereign Default Risk (May 17, 2021). Review of Economic Dynamics, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3165726 or http://dx.doi.org/10.2139/ssrn.3165726

Siming Liu (Contact Author)

Shanghai University of Finance and Economics - School of Finance ( email )

Shanghai, 200433
China
021-69508190 (Phone)

Hewei Shen

University of Oklahoma - Department of Economics ( email )

729 Elm Avenue
Norman, OK 73019-2103
United States

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