Myopic Governments and Welfare enhancing Debt Limits

This paper studies myopic fiscal policy in an incomplete mar-ket setting. A shortsighted, but otherwise benevolent, fiscal pol-icy maker who has a smaller discount factor than society runs deficits which in turn lead to a high stock of government debt in the long run. The high level of debt reduces welfare because distortionary labour income taxes have to be raised to finance the permanently higher interest payments. In two related set-tings, an economy without capital and one with capital, the pa-per shows how the introduction of a fee on excessive debt can almost completely restore the allocation of optimal policy under commitment. Thus, the paper demonstrates how the addition of a legal restriction to the policy maker’s problem can improve welfare