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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: it reduces public deficits but also inefficiently suppresses public investment. Second, a decrease in the government’s present bias and an increase in 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.