Fiscal Commitment and Sovereign Default Risk

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.