Tax Austerity: Does it Avert Solvency Crises?

Many high-debt countries are adopting tax austerity, whereby governments raise their tax rate as the debt level rises with the hope to dispel future solvency crisis. This paper investigates the implications of tax austerity on the likelihood of a solvency crisis. A solvency crisis occurs once adverse shocks push the debt level above its effective debt limit, which is the maximum level of debt that the government can repay. We derive the effective debt limit and show that its position depends on tax austerity. We find that high-debt countries like Italy that undergo tax austerity could lower their effective debt limit and induce a solvency crisis in the near future.