The rapid decline in investment observed in the heavily indebted countries has been attributed to the investment disincentive effects of an external debt overhang. The notion of a “debt Laffer curve” has been used to argue that these disincentives could potentially be so large that a reduction in the stock of debt could actually increase future repayments. Empirical work, however, has so far been unable to establish a clear relationship between debt and investment in heavily indebted countries.
The paper links fiscal interactions within the debtor country to its debt repayment capacity and highlights the importance of the domestic tax system in determining the effect of a debt overhang on investment. As an illustrative example, a simple taxation scheme is specified, and a country is shown to be on the “wrong side” of its debt Laffer curve only if it is on the wrong side of its tax Laffer curve. The analysis indicates that strong assumptions about the domestic tax system are required to ensure that the investment disincentive effects of debt are so large that a reduction in debt increases repayment.
The model gives rise to the possibility of multiple equilibria, suggesting that the debt Laffer curve may not be a simple functional relationship between the stock of debt and the expected present discounted value of future repayments. Thus, estimation of the debt Laffer curve as a functional relationship could be misleading.
As an extension of the model, the possibility of capital flight is incorporated into the framework. Multiple equilibria are again possible, and, for some levels of debt, capital flight and default obtain in one equilibrium, and full repayment (with no capital flight), in another.