Optimal fiscal adjustment and the commitment-to-forgive issue

This paper studies the incentives for fiscal adjustment for a debtor government under the risk of defaulting on its external debt. An externality arises from the bargaining process that follows default: higher tax revenues levied by the debtor lead to higher repayment to the creditor, and thus to a smaller haircut. In consequence, the optimal tax rate set by the debtor is lower than the socially optimal. If parties can negotiate contingent contracts ex-ante, the socially optimal fiscal stance can be implemented as long as creditors can commit to forgive a larger part of the debt in bad states. The model yields a different interpretation of IMF adjustment programmes and can account for some recent developments in the Eurozone debt crises.