Large public expenditure shocks in a Ramsey taxation model with default

This paper analyses a three-period Ramsey’s model with heterogeneous agents and a bond offered by a central planner. We show that Ramsey’s taxation property holds, that is, tax rates are higher for markets with lower price elasticity in the social optimal allocation. Additionally, we show that a central planner optimal strategy based only on a partial default on interest payments implements the former goods allocation with taxation. Therefore, an increment on public expenditure due to a public health crisis such as the COVID-19 cannot be financed by a partial default on the public debt. Indeed, it overburdens agents who consume larger amount of inelastic goods, that is, those with lower income. We conclude that an emergency expenditure must be financed through an increase of Value-Added taxes, precautionary savings, or income taxes who do not participate directly on the emergency planning of a public health crisis.