Optimal Taxation with Endogenous Default under Incomplete Markets

How are the optimal tax and debt policies affected if government can default on its debt? We address this question from a normative perspective in an economy with noncontingent debt, domestic default, labor taxes. On one hand, prevents incurring future distortions associated servicing debt. other risk gives rise to endogenous credit limits that hinder government's ability smooth characterize fiscal policy show how option alters near–unit root component of taxes risk-free borrowing. (JEL D52, E62, H21, H24, H63)