CAN BUDGET DEFICITS IMPROVE WELFARE IN BOTH THE SHORT-RUN AND LONG-RUN

In the Neoclassical model of public debt, consumers have finite life s pans, 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 distorti onary taxation. This paper shows that budget deficits are welfare-impr oving in the long run ifa capital income tax of appropriate magnitude is imposed given a high interest-rate environment, and this welfare im provement does not come at the expense of welfare reduction in the sho rt run.