HYPERBOLIC DISCOUNTING, PUBLIC DEBT AND BALANCED BUDGET RULES
| Author | Bernd Huber,Marco Runkel |
| DOI | http://doi.org/10.1111/j.1467-9485.2008.00465.x |
| Date | 01 November 2008 |
| Published date | 01 November 2008 |
HYPERBOLIC DISCOUNTING, PUBLIC
DEBT AND BALANCED BUDGET RULES
Bernd Huber
n
and Marco Runkel
nn
Abstract
This paper considers a government that chooses its tax and borrowing policy in
order to minimize the present value of the excess burden caused by taxation. In
doing so, the government uses hyperbolic discounting. It turns out that public
deficits are positive even if public expenditures are constant over time. With
cyclical expenditures, the government chooses an asymmetric debt policy, i.e., in
bad times it borrows more than it repays in good times. In contrast to tax
smoothing and political economy theories of public debt, the welfare effects of a
balanced budget rule are ambiguous.
I Intro ductio n
Balanced budget rules are widespread among US states. According to the
National Association of State Budget Officers (1992), all states but Vermont
have constitutional or statutory rules requiring that the annual budget of
the state is in balance, i.e. public expenditures are covered by tax revenues.
1
Similar budget institutions can be found on the state or local level in other
federations. For example, in European countries municipalities often face anti-
deficit rules or debt controls (Dafflon, 2002). Moreover, also the Stability and
Growth Pact (SGP) of the European Union comprises borrowing rules. A key
element of this treaty is the excessive deficit procedure which requires that a
member state’s annual deficit is not above 3% of GDP. Another important
feature of the SGP is the early warning procedure which imposes the medium-
term objective that the member countries have a balanced budget (e.g. Calmfors,
2005).
Whether balanced budget rules are beneficial from a welfare point of view,
depends on the underlying theory of public debt. According to the tax
n
University of Munich and CESifo
nn
University of Magdeburg and CESifo
1
It should be noted that the stringency of the rules varies among states. For example, while in
some states the government only has to submit a balanced budget plan, in other states the
balanced plan has to pass the parliament and in a third group of states the budget has to be
balanced at the end of the fiscal year. For an index measuring the budget stringency see von
Hagen (1991). A theoretical argument in favor of different stringencies is developed by Huber
and Runkel (2008).
Scottish Journal of Political Economy, Vol. 55, No. 5, November 2008
r2008 The Authors
Journal compilation r2008 Scottish Economic Society. Published by Blackwell Publishing Ltd,
9600 Garsington Road, Oxford, OX4 2DQ, UK and 350 Main St, Malden, MA, 02148, USA
543
smoothing approach developed by Barro (1979), a benevolent government
chooses constant tax rates to minimize the excess burden of taxation. In case
of cyclical public expenditures, this tax policy is supported by public deficits in
bad times with high public expenditures and public surpluses in good times with
low public expenditures. A balanced budget rule reduces welfare as it prevents
the necessary flexibility of the borrowing policy. In contrast, the political
economy literature provides arguments in favor of anti-deficit rules. For
example, Persson and Svensson (1989) argue that political instability induces a
conservative government to run a deficit because this deficit forces subsequent
governments to reduce their public spending. A similar argument is developed
by Tabellini and Alesina (1990) within a median voter approach where a deficit
allows the current majority to manipulate the composition of public
expenditures chosen by the future majority. As the deficit is ex ante inefficient
in all these political economy approaches, a balanced budget rule improves
welfare.
This paper contributes to the discussion on public debt and balanced budget
rules. As in Barro (1979), we consider a government which chooses its tax
and borrowing policy in order to minimize th e present value of the excess
burden caused by taxation. The main differ ence to Barro (1979) is that we
suppose the government to use hyperbolic inst ead of exponential discounting.
While under the latter the government disc ounts the excess burden of future
periods by a constant rate, under the for mer discount rates are declining
over time. Intuitively, with declining di scount rates the government is more
impatient in the short run than in the long run. This le ads to a commitment
problem as the government prefers a larger bu dget deficit in the current period
than it would have agreed to in previous pe riods. Taking the commitment
problem into account, we show that the time consistent policy of the
government implies an increasing time path of tax es, in contrast to the tax
smoothing result of Barro (1979). As a conseq uence, the government issues
debt even if public expenditures are constan t over time. With cyclical
expenditures, the government pur sues an asymmetric debt policy. In bad tim es
it borrows more than it repays in good times. Hence, hy perbolic discounting
leads to accumulation of public debt unde r both constant and cyclical public
spending.
Many authors conjecture that a balanced budget rule is able to prevent the
commitment problem and the accompanying debt accumulation caused by
hyperbolic discounting. For example, van Ewijk (2001) argues that borrowing
rules like those contained in the European SGP may ‘. . . strengthen national
governments to overcome time-inconsistencies in individual behavior due to
hyperbolic discounting’ (p. 520). Similarly, Poterba (1997) concludes that in the
presence of a hyperbolic time preference anti-deficit rules may serve as a form of
self-control which ‘. . . may provide a mechanism for constraining the discretion
of future budget deliberators’ (p. 58). We investigate the effects of a balanced
budget rule in our model with hyperbolic discounting. It is hardly surprising
that, by definition, the rule prevents public deficits and debt accumulation.
However, we also show that the welfare effects of a balanced budget rule are
BERND HUBER AND MARCO RUNKEL544
r2008 The Authors
Journal compilation r2008 Scottish Economic Society
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