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Federal Reserve Bank of Minneapolis
Staff Report
Fiscal Austerity during Debt Crises
Cristina Arellano
Yan Bai
Abstract

This paper constructs a dynamic model in which fiscal restrictions interact with government borrowing and default. The government faces fiscal constraints; it cannot adjust tax rates or impose lump-sum taxes on the private sector, but it can adjust public consumption and foreign debt. When foreign debt is sufficiently high, however, the government can choose to default to increase domestic public and private consumption by freeing up the resources used to pay the debt. Two types of defaults arise in this environment: fiscal defaults and aggregate defaults. Fiscal defaults occur because of the government's inability to raise tax revenues. Aggregate defaults occur even if the government could raise tax revenues; debt is simply too high to be sustainable. In a quantitative exercise calibrated to Greece, we find that our model can predict the recent default, but that increasing taxes would not have prevented it. In fact, increasing taxes would have made the recession deeper because of the distortionary effects of taxation.


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Cristina Arellano & Yan Bai, Fiscal Austerity during Debt Crises, Federal Reserve Bank of Minneapolis, Staff Report 525, 26 Jan 2016.
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Keywords: Sovereign default; Tax reforms; Debt crisis
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