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

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.