Fiscal rules and the intergenerational welfare effects of public investment

A common argument against balanced-budget fiscal rules has it that the costs of durable public capital fall entirely on current generations while its benefits also accrue to future generations. This paper proposes an additional argument whereby balanced-budget rules imply uneven welfare effects of p...

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Bibliographic Details
Published inEconomic modelling Vol. 81; pp. 455 - 470
Main Author Bom, Pedro R.D.
Format Journal Article
LanguageEnglish
Published Elsevier B.V 01.09.2019
Subjects
Balanced-budget rule
Golden rule
Intergenerational welfare
Public capital
Public investment
E62
Balanced-budget rule
F41
Public capital
Intergenerational welfare
H54
Public investment
Golden rule
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ISSN0264-9993
1873-6122
DOI10.1016/j.econmod.2018.02.002

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Summary:A common argument against balanced-budget fiscal rules has it that the costs of durable public capital fall entirely on current generations while its benefits also accrue to future generations. This paper proposes an additional argument whereby balanced-budget rules imply uneven welfare effects of public investment across generations. Using an overlapping generations model of a small open economy, I show that, when subject to a balanced-budget constraint, public investment causes a negative financial wealth effect on current generations. Numerical simulations of the model show that, in terms of welfare, this negative financial wealth effect more than offsets the productivity gains of higher public investment spending, leaving current generations worse-off. A golden rule exempting net public investment from the balanced-budget requirement overturns this effect and allows for welfare gains to both current and future generations. Allowing for debt-financing may thus be necessary to ensure public support for efficient increases in public investment spending. •I study how fiscal rules affect the welfare effects of public investment across generations.•Balanced-budget rules imply welfare gains to future generations and losses to current ones.•The key mechanism is a negative financial wealth effect on current generations.•A golden rule overturns the financial wealth effect and brings welfare gains to current generations.•The results suggest that public capital spending be exempted from balanced-budget rules.
ISSN:0264-9993
1873-6122
DOI:10.1016/j.econmod.2018.02.002