Hanging off a Cliff: Fiscal Consolidations and Default Risk

In countries with imperfect tax enforcement, tax compliance is volatile and markedly responds to fiscal policy. To explore the consequences of this fact, we build a model of sovereign debt with limited commitment and distortionary taxes, in which fiscal consolidations generate long-run distortions which affect default risk. The interaction of imperfect tax enforcement and limited commitment allows to reproduce the following empirical regularities. First, the sensitivity of debt price to fiscal policy differs across environments. Some highly indebted economies are hanging off a cliff, and cannot lower the cost of servicing debt with fiscal consolidations. Second, distortions give rise to pro-cyclical fiscal traps, and periods of high tax rates, low output, high tax evasion and high default risk may be long-lasting. Third, the model replicates dynamics of fiscal policies in high- and low-tax enforcement environments, and rationalizes the rise of pro-cyclical fiscal policies.