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Abstract

The budget deficit bias is modeled as the result of a domestic common pool problem and of an international externality. Deficits can be used to finance both unproductive and productive public spending. An optimally set supranational deficit ceiling is examined and welfare is compared to the unconstrained outcome and to the case of nationally set deficit ceilings.The supranational deficit ceiling is found to be welfare improving relative to similar national arrangements, but does not fully eliminate the deficit bias unless combined with a domestic fiscal institution allowing for precommitment to productive public spending.

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