SUSTAINABLE PLANS AND MUTUAL DEFAULT

This paper presents a simple general equilibrium model of optimal taxation in which both private agents and the government can default on their debt. As a benchmark we consider Ramsey equilibria in which the government can precommit to its policies at the beginning of time, but in which private agents can default. We then consider sustainable equilibria in which both government and private agent decision rules are required to be sequentially rational. We adapt Abreu's (1988) optimal trigger strategies to completely characterize the entire set of sustainable equilibria. In particular, we show that when there is sufficiently little discounting and government consumption fluctuates enough, the Ramsey allocations and policies (in which the government never defaults) can be supported by a sustainable equilibrium. By way of an example we show that the larger the variance of government consumption the easier it is to support good outcomes. We also show for moderate discount factors that in the best sustainable equilibrium, tax rates are more volatile and debt is smaller than in the Ramsey equilibrium.