Human Capital Formation and Public Debt: Growth and Welfare Effects of Three Different Deficit Policies

Abstract

In this paper we analyze an endogeneous growth model with human capital that results from public educational spending. We allow for public debt and analyze three different debt policies: a balanced government budget, a slight deficit policy where debt grows but less than GDP, and a strong deficit policy where debt grows at the same rate as GDP. We find that the balanced budget policy and the policy with a slightly growing public debt are equivalent as concerns long-run economic growth. Further, those two rules yield higher growth than a debt policy where public debt grows at the same rate as GDP, unless the government is a creditor. As concerns welfare, it can be demonstrated that a strong deficit policy yields lower welfare than a balanced budget and a slight deficit, unless initial debt ratios are low and the intertemporal elasticity of substitution is high. Finally, it is demonstrated that there may exist an inverted U-shaped relation between welfare and deficit financed educational spending.