Work

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

Year: 2026

Type: article

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. However, this also reduces the government’s long-term 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 inefficiently low public investment and public deficit. Second, 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 deficit rules: a balanced budget rule, the absence of a rule, and a benchmark deficit rule that limits deficits to the level chosen by the social planner. For moderate present bias, the absence of a deficit rule yields higher welfare than a balanced budget, but it is consistently dominated by the benchmark rule. However, with substantial present bias the balanced budget rule delivers higher welfare than the other rules.

Source: European Journal of Political Economy

DOI: 10.1016/j.ejpoleco.2026.102852

Authors: Tobias Bergmann, Nikolaj Moretti

Institutions: Technische Universität Berlin, Potsdam Institute for Climate Impact Research, University of Potsdam

Language: English

Topic: Fiscal Policies and Political Economy

Subfield: Economics and Econometrics

Field: Economics, Econometrics and Finance

Domain: Social Sciences

Open Access status: hybrid

Estimated APC paid: $3,650

Funders: Deutsche Bundesstiftung Umwelt, Heinrich Böll Stiftung