Taxing Deficits to Restrain Government Spending

In a dynamic model of fiscal policy, social polarization provokes a deficit bias. Policy advisors have recently proposed that governments running a deficit should be forced to generate additional tax revenue. We show that this deficit taxation reduces each group's spending bias today because it decreases the fear that the financial resource will not be available tomorrow due to the other groups' spending behavior. This effect adds to the literature as previous findings focused mainly on the fact that deficit taxation reduces excessive spending because it increases the likelihood of politicians being voted out of office as the private sector dislikes taxation. In the present setup, the effect is driven solely by internalizing the externality exerted on tomorrow's spending potential.