This paper presents a simple general equilibrium model of optimal taxation similar to that of Lucas and Stokey (1983), except that we let the government default on its debt. As a benchmark, we consider Ramsey equilibria in which the government can precommit its policies at the beginning of time. We then consider sustainable equilibria in which both government and private agent decision rules are required to be sequentially rational. We concentrate on trigger mechanisms which specify reversion to the finite horizon equilibrium after deviations by the government. The main result is that no Ramsey equilibrium with positive debt can be supported by such trigger mechanisms.
Published in: _Journal of Economic Theory_ (Vol 61, No. 2, December 1993, pp. 230-261) https://doi.org/10.1006/jeth.1993.1068.
Published in: _The legacy of Robert Lucas, Jr._ (Vol. 3, 1999, pp. 325-356)