Debt Limits and Endogenous Growth

Sustainability of fiscal policies is one of the major issues in macroeconomics. Recently, in the United States, both Congress and Administration have proposed budgets designed to reduce the deficit and reach a zero debt target by the years 2002 and 2015, respectively. At the same time, European Monetary Union (EMU) countries are trying to meet the fiscal constraints imposed by the Maastricht Treaty in 1991. Mainly, this Treaty required a slow-downing trend in debt and deficit flows with a maximum debt-to-GDP ratio of 60% and a deficit of no more than 3% of GDP. This implies for most of the EMU countries an austerity regime that will have effects on growth rates, output and unemployment. This paper studies the consequences of imposing debt-limits on the government budget constraint. The economy is modeled in two endogenous growth models. In the first model analyzed, productive government spending is introduced so as to enhance both capital and labor productivity and endogenous growth is achieved via productive public capital. In the second case, government spending enters the household's utility function and private capital induces endogenous growth. Due to the introduction of labor-leisure choice, no closed-form analytical solution is available then we recur to numerical solutions for the competitive equilibrium. We show that relaxing debt and time schedule criteria reduces the economy's growth rate in both models, but with a stronger impact on the government in the production function model, even though consumption-to-output ratio and leisure increase. Thus, a strict and rigid interpretation of debt-limit criteria is recommended. We conclude that both capital tax rates increases and rising debt-limits reduce financial needs, but have different effects on growth.