Chen, Ricardo Lagos and Tom Sargent for their constant encouragement, thoughtful advice and insightful

Abstract. I analyze a dynamic optimal taxation problem in a closed economy under in-complete markets allowing for default on the debt. If the government defaults, it will go to temporary financial autarky and it can only exit by paying a given fraction of the defaulted debt. The possibility of paying may not arrive immediately; thus, in the meantime, house-holds trade the defaulted debt in secondary markets. The equilibrium price in this market is used to price the debt during the default period. Households predict the possibility of default, and this generates endogenous debt limits, which hinder the government’s ability to smooth shocks using debt. I characterize the optimal default decision, optimal govern-ment policy, and the set of implementable allocations. Quantitative exercises match various qualitative features observed in the data for emerging economies