Fiscal Commitment and Sovereign Default Risk

2018-003 CAEPR Working Paper Series

55 Pages Posted: 7 May 2018 Last revised: 7 Aug 2018

See all articles by Siming Liu

Siming Liu

Indiana University Bloomington

Hewei Shen

University of Oklahoma - Department of Economics

Date Written: August 4, 2018

Abstract

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

Liu, Siming and Shen, Hewei, Fiscal Commitment and Sovereign Default Risk (August 4, 2018). 2018-003 CAEPR Working Paper Series. Available at SSRN: https://ssrn.com/abstract=3165726 or http://dx.doi.org/10.2139/ssrn.3165726

Siming Liu (Contact Author)

Indiana University Bloomington ( email )

Bloomington, IL
United States
(812) 855-1021 (Phone)
(812) 855-3736 (Fax)

Hewei Shen

University of Oklahoma - Department of Economics ( email )

729 Elm Avenue
Norman, OK 73019-2103
United States

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