Optimal Fiscal Policy in Debt Constrained Economies∗

We study optimal fiscal policy in a small open economy (SOE) with sovereign default risk. The SOE’s government uses linear taxation to fund exogenous expenditures and uses public debt to inter-temporally allocate tax distortions. We characterize a class of environments in which the tax on labor goes to zero in the long run, while the tax on capital income may be non-zero, reversing the standard prediction of the Ramsey tax literature. The zero labor tax is an optimal long run outcome if the private agents are impatient relative to the international interest rate. We also extend the results to economies where the borrowing constrained is imposed on the citizens directly, rather than on their governments. We show that a similar result holds in a closed economy with imperfect inter-generational altruism. ∗Email: [email protected] and [email protected]. We thank V.V. Chari and Iván Werning for fruitful comments and suggestions. This research was supported by a grant from IGC. Manuel Amador acknowledges NSF support.