Trading deficits for investment: Optimal deficit rules for present-biased governments

Tobias Bergmann () and Nikolaj Moretti ()
Additional contact information
Tobias Bergmann: PIK Potsdam, Technical University Berlin
Nikolaj Moretti: PIK Potsdam, University of Potsdam, CEPA

No 85, CEPA Discussion Papers from Center for Economic Policy Analysis

Abstract: We develop a simple two-period principal-agent model in which a present-biased government, the agent, chooses public investment levels given a deficit rule imposed by the principal. The principal sets a deficit cap to curb current debt-financed consumption. In doing so, it also reduces long-term government investment. We characterize the optimal deficit rule that balances these opposing effects. Our analysis yields three key insights. First, a deficit rule is always a second-best instrument resulting in nonzero deficits and inefficiently low public investment. Second, while identifying the optimal deficit rule is challenging in practice, we demonstrate that under general conditions, shocks to the productivity of public investment entail an increase in the optimal deficit cap. Third, we compare the welfare effects of three fiscal rules: a balanced budget rule, the absence of any deficit rule, and a benchmark deficit rule. The benchmark deficit rule limits the agent’s deficit to the level incurred by an agent without present bias. For moderate levels of present bias, the absence of a deficit rule leads to higher welfare than the balanced budget rule. The absence of a rule is consistently welfare-dominated by the benchmark deficit rule. Only in cases of substantial present bias does the balanced budget rule result in higher welfare than the benchmark deficit rule.

Keywords: public debt; fiscal rules; present bias; principal-agent; public investment (search for similar items in EconPapers)
JEL-codes: D82 E62 H30 H63 (search for similar items in EconPapers)
Date: 2025-01
New Economics Papers: this item is included in nep-cta and nep-pbe
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
https://doi.org/10.25932/publishup-67027 (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:pot:cepadp:85

Access Statistics for this paper

More papers in CEPA Discussion Papers from Center for Economic Policy Analysis Contact information at EDIRC.
Bibliographic data for series maintained by Marco Winkler ().