Capturing Four Budget Deficit Theories in a Simple Graphical Model

Abstract

The phenomenon of chronic, excessive budget deficits in western democracies has brought on many explanations and interpretations in both the empirical and theoretical literature. However, popular political economy and/or public choice textbooks present those explanations not in an integrated framework but are instead focusing on one special motif to create budget deficits at a time. This is probably owed to the fact that the ‘standard’ explanations of budget deficit are based on more or less complex economic models which require intertemporal optimization. The analysis of these models is usually technically demanding which leads to the fact that the basic principles of budget deficits and public debt are by and large taught to graduate students only.

As an alternative approach we propose a simple graphical model which combines four of the most important political-economic explanations of budget deficits. The non-technical and intuitive setup helps to increase the awareness of undergraduate students with basic microeconomic knowledge. The theories which are in the focus of interest in our model are the following: The first one is the theory of government as a ‘Leviathan’ in the sense of Brennan and Buchanan (1980), according to which a government tries to extract an extra rent from its citizens by raising tax revenues and budget deficits in excess of what would be needed in order to finance the provision of public goods. The second and third theories belong to the family of strategic deficit theories and can be distinguished according to the groups at which the strategy is aimed. On the one hand, strategic deficits can be aimed at voters in order to secure electoral victory (second theory) either in the next election (e. g. Lizzeri (1999)) or the one after the next (e. g. Lockwood et al. (1996)). On the other hand, strategic deficits can be used by governments in order to constraint the spending decisions of possible successors (e.g. Tabellini and Alesina (1990) or Persson and Svensson (1989), third theory). The latter authors present the appealing idea of a “stubborn” conservative government (Persson and Svensson 1989, 338) which leaves high deficits in order to constrain the liberal successor’s public spending and apply this to the fiscal policy of the Reagan administration in the US. Unfortunately these game-theoretic models require analytical skills which tend to go beyond the abilities of most undergraduate students. Finally, the fourth theory deals with the phenomenon of tax competition, which prevents governments from rising taxes excessively as this could lead to a capital flight diminishing the overall welfare of an economy (Alesina and Tabellini, (1990)).

We used the model successfully in lectures in macroeconomics in open economies at undergraduate level. Anecdotal evidence from within the lessons suggests that the intuitive way of approaching the deficit topic is not only attractive to the students but also tends to reduce the antipathy against analytically demanding economic models.

Keywords: budget deficit, public debt, teaching, macroeconomics instruction

JEL Classification: H11, H63, H71