Optimal Fiscal Policy when Agents Fear Government Default

We consider a model in which a benevolent government has to choose optimally distortionary taxes on labor income and uncontingent debt, in order to finance an exogenous stream of public expenditure. We compare the optimal fiscal plan in two frameworks. In the first one households are fully confident about government solvency. In the second, households believe that there is a positive default probability which is positively related to the level of debt. While in the first framework a temporary bad shock translates into a permanent increase in the debt level, in the second one the increase in government debt is only temporary. The result provides a theoretical rationale for the policy recommendations made by policy analysts for copying with the high debt inherited from the recent crisis. More generally, we aim to derive the optimal strategy for a policymaker which does not consider default as a viable policy option but has to design its fiscal policy by taking into account both private agents’ default expectations and macroeconomic dynamics. Email: [email protected] Email: [email protected] Email: [email protected] We are heavily indebted to Sandro Momigliano for his excellent supervision and encouragement. We would like to thank the seminar participants at the UPF University. Any remaining errors are our own. The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Bank of Italy.