Anastasios Karantounias

(Fed Atlanta)

will give a presentation on

Greed versus Fear: Optimal Time-Consistent Taxation with Default

Abstract:

This paper studies the optimal time-consistent distortionary taxation when the repayment of government debt is not enforceable. The government taxes labor income or issues non-contingent debt in order to finance an exogenous stochastic stream of fiscal shocks. Debt can be repudiated subject to some default costs. Optimal policy is characterized by two opposing incentives: an incentive to postpone taxes by issuing more debt for the future (“Greed”), and an incentive to tax more currently in order to avoid punishing de- fault premia (“Fear”). A Generalized Euler Equation (GEE) captures these two effects and determines the optimal back-loading or front-loading of tax distortions. Even if de- fault risk is small, tax-smoothing is severely limited. The same mechanisms operate also in environments with long-term debt.