What Are the Costs of Excessive Deficits?

This paper addresses the question of whether or not a period of large government budget deficits, such as that experienced by the United States in the 1980s, is likely to be highly costly to the economy. It finds that if present and future taxpayers are less than perfectly linked, and if the capital stock is too low, then redistributions of wealth from future to present generations—which would result from a policy of temporarily low taxes and high deficits—directly reduce social welfare. The welfare costs of deficits created in this way are likely to be large even if the links between present and future generations are nearly perfect. By contrast, other commonly emphasized costs of deficits, in particular costs through the crowding out of capital (because of either imperfect links between generations or liquidity constraints) or through an irregular pattern of taxes, appear to be of moderate size for plausible parameter values.