By Francesco Pappadà and Yanos Zylberberg
The effect of fiscal policy on default risk is mitigated by the response of tax compliance. To explore the consequences of this stylized fact, we build a model of sovereign debt with limited commitment and imperfect tax enforcement. Fiscal policy persistently affects the size of the informal economy, which impacts future fiscal revenues and default risk. The interaction of imperfect tax enforcement and limited commitment strongly constrains the dynamics of optimal fiscal policy and leads to costly uctuations in consumption.
This sounds obvious, but needs reinforcing. If a state has weak enforcement of taxation, it is more at risk of default because the tax base shrinks right when it is most needed. Fund tax agencies well, it is worth it!