TY - JOUR AU - Aizenman,Joshua AU - Gavin,Michael AU - Hausmann,Ricardo TI - Optimal Tax and Debt Policy with Endogenously Imperfect Creditworthiness JF - National Bureau of Economic Research Working Paper Series VL - No. 5558 PY - 1996 Y2 - May 1996 UR - http://www.nber.org/papers/w5558 L1 - http://www.nber.org/papers/w5558.pdf N1 - Author contact info: Joshua Aizenman Economics and SIR USC University Park Los Angeles, CA 90089-0043 Tel: 213-740-4066 E-Mail: aizenman@usc.edu Michael Gavin Columbia University Department of Economics 1018 International Affairs Bldg New York, NY 10027 Tel: 212/854-4190 Ricardo Hausman Harvard Kennedy School 79 JFK St. Cambridge MA 02138 Tel: 617-496-3740 E-Mail: ricardo_hausmann@harvard.edu AB - This paper shows that the patterns of optimal tax rates and borrowing in the presence of endogenous borrowing constraints differ considerably from the patterns observed with fully integrated capital markets. We study a developing country characterized by a costly tax collection. Its access to the international credit market is determined by the efficiency of the tax system and the relative bargaining power of creditors. Partial defaults induce a `burden shifting' from bad to good states of nature, reducing the cost of borrowing, implying that a switch from no default to a partial default regime is associated with a borrowing boom. The switch to a partial default regime is associated with financial fragility, where small adverse changes in fundamentals lead to a large accumulation of debt. The tax rate exhibits strong counter-cyclical patterns in economies operating at the credit ceiling, whereas the tax rate exhibits strong pro-cyclical patterns in economies operating on the upward sloping portion of the supply of credit, where the risk premium is positive, and very little cyclical patterns in economies operating on the elastic portion of the supply of credit. We identify a volatility- debt curve for a given realization of output. With low debt, higher volatility tends to reduce borrowing. When volatility reaches a threshold, we observe a switch from a no default to a partial default regime, where a further rise in volatility increases borrowing and reduces present taxes. ER -