This paper examines how the dynamics of informality affects optimal fiscal policy and default risk. We build a model of sovereign debt with limited commitment and informality to assess the consequences of dynamic distortions induced by fiscal policy. In the model, social policy has a persistent impact on taxable activity, which affects future fiscal revenues and thus default risk. The interaction of tax distortions and limited commitment strongly constrains the dynamics of optimal fiscal policy and leads to (i) more frequent default episodes and (ii) costly fluctuations in consumption. Original language English Journal Journal of Political Economy Macroeconomics Early online date 14 Jan 2026 DOIs https://doi.org/10.1086/739336 Publication status Published - 1 Mar 2026 Bibliographical note © 2025 The University of Chicago.
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Pappadà et al. (2025) studied this question.
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