HYPERBOLIC D ISCOUNTING, P U BLIC DEBT A ND B ALANCED B U DGET R ULES

AbstractThis paper considers a government that chooses its tax and borrowing policy inorder to minimize the present value of the excess burden caused by taxation. Indoing so, the government uses hyperbolic discounting. It turns out that publicdeficits are positive even if public expenditures are constant over time. Withcyclical expenditures, the government chooses an asymmetric debt policy, i.e., inbad times it borrows more than it repays in good times. In contrast to taxsmoothing and political economy theories of public debt, the welfare effects of abalanced budget rule are ambiguous.I IntroductionBalanced budget rules are widespread among US states. According to theNational Association of State Budget Officers (1992), all states but Vermonthave constitutional or statutory rules requiring that the annual budget ofthe 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 otherfederations. For example, in European countries municipalities often face anti-deficit rules or debt controls (Dafflon, 2002). Moreover, also the Stability andGrowth Pact (SGP) of the European Union comprises borrowing rules. A keyelement of this treaty is the excessive deficit procedure which requires that amember state’s annual deficit is not above 3% of GDP. Another importantfeature 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