Can Budget Deficits Improve Welfare in Both the Short Run and Long Run?

In the neoclassical model of public debt, consumers have finite life spans and budget deficits shift taxes to future generations, reducing savings, raising the interest rate, and reducing the capital stock. In such a setting, budget deficits decrease welfare in the long run. This result also holds in an otherwise Ricardian model subject to distortionary taxation. This paper shows that budget deficits are welfare-improving in the long run if a capital income tax of appropriate magnitude is imposed given a high interest-rate environment, and this welfare improvement does not come at the expense of welfare reduction in the short run. Copyright 1997 by The Economic Society of Australia.