How Does a Budget Rule Affect Sovereign Default Incentives and Welfare?
This paper analyzes the role of a fiscal rule, especially a budget rule, on the likelihood of debt repudiation and the welfare of households. Following the Eaton-Gersovitz sovereign default model, I enrich fiscal features in the model by adding a budget rule. The budget rule ensures that spending cannot increase unless tax revenue increases. If more revenue is generated by issuing debt, taxes do not increase much, reducing government spending. The implicit cost of the rule on government spending lowers the government’s incentive to borrow, reducing default risks. A budget rule can improve households’ welfare if it addresses inefficiencies from the misaligned incentives of the government when the government does not behave in the best interest of the households.