Optimal Taxation with Endogenous Default Under Incomplete Markets

In a dynamic economy, we characterize the fiscal policy of the government when it levies distortionary taxes and issues defaultable bonds to finance its stochastic expenditure. Households anticipate the possibility of default, generating endogenous debt limits that hinder the government's ability to smooth spending shocks using debt. Default is followed by temporary financial autarky. The government can only exit this state by repaying a fraction of the defaulted debt. Since this payment may not occur immediately, in the meantime, households trade the defaulted debt in secondary markets; this device allows us to price the government debt before and during the default. Our model matches various qualitative features observed in the data for emerging economies