Europe and the United States are a story of contrasts these days. While the Obama Administration is pushing for fiscal stimuli at the cost of large deficits, Europe is severely putting the brakes on its public expenses to bring public budget back in order. This is quite ironic, as European governments have in the past used public deficits quite liberally, while the US has always been wary of deficits, and most US states in fact have balanced budget requirements. This makes the proposal that the federal government adopt a balanced budget amendment a hot topic again.
Marina Azzimonti, Marco Battaglini and Stephen Coate use a political economy model to contrast the short time costs of the debt reduction (with lower public services and higher taxes) against the long term benefits of a lower debt burden and the long term cost of higher volatility in tax rates and public services.
In such an analysis, the first order of business is to establish why the Ricardian Equivalence would fail in a quantitatively meaningful way. If it does not, then deficits do not matter as they internalized as future taxes by all agents, and a balanced budget rule has no impact. My reading of the literature is that there certainly no agreement, but overall we are not that far away form the Ricardian Equivalence. Well, let us assume it does not hold, because labor income tax is sufficiently distorting, as Azzimonti, Battaglini and Coate implicitly assume. They also calibrate the model to the US, which is quite tricky as one needs to take a stand on the utility of public goods.
This is where the paper becomes rather strange. At least at the state level, a balanced budget rule is usually thought to be challenging because income and expenses vary with the business cycles. This is not the approach taken here, whereas the fluctuations stem from changes in the taste for public goods. The authors' argument is that one needs to distinguish normal times to unusual times where the government wants to spend massively more, like wars. I do not think this is the real issue. If wars are the problem, then an amendment to the rule can be that properly declared wars can be financed with war bonds.
Well, let us assume this is what we want to care about. The quantitative analysis indicates that a balanced budget rule would indeed be beneficial in the long run, because it imposes lower taxes, and thus less distortions, which are more valuable than the missing public services according to the calibration. But one must point out that there are serious costs in the transition, as one starts with rather high levels of debt. But these transition costs cannot be evaluated with the present model, as it does not feature growth and thus cannot take into account the debt/GDP ratio declines naturally as an economy grows. All in all, I am not sure what we learned with this paper.