Investment scaling up and the role of government

ABSTRACT

This article studies the fiscal and welfare implications of a scaling up of public investment when the government is subject to inefficiencies on the spending and on the tax collection side. In our simulations, the scaling up of public investments results in higher long-run output and consumption levels but requires a fiscal stabilization package in order to preserve fiscal sustainability. The effects on consumers’ welfare after the fiscal adjustment are nontrivial. Our welfare analysis shows that consumers’ welfare is increased when the government smooths the fiscal adjustment via higher borrowing and not through an increase in taxation. Moreover, the comparison between several stabilization packages via tax adjustment shows that higher welfare is achieved when the government relies mostly on taxation of capital as this allows higher levels of consumption. Lower fiscal costs that do not undermine fiscal sustainability can however be achieved if the government manages to reduce inefficiency in tax collection. Finally, we consider a change in the trade regime that causes a decline in revenues. We find that the higher fiscal burden required to preserve fiscal sustainability would completely wipe out the welfare gain of higher public investments.

KEYWORDS:

• Public investment
• government inefficiencies
• debt sustainability
• fiscal policy
• infrastructure

JEL CLASSIFICATION:

• E62
• F34
• H54
• H63
• O43

Acknowledgements

We would like to thank two anonymous referees for their insightful comments. Furthermore, we are grateful Karim Barhoumi, Christine Dietrich and Felipe Zanna for useful comments. The views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board or its management.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ See Romp and De Haan (2005) for a critical survey.

² International Monetary Fund (2012) presents an overview of the concept of absorptive capacity.

³ The sample covers SSA countries for which tax revenue to GDP is available for the 2010–2013 period.

⁴ For an empirical investigation of this issue, see Eduardo and Daude (2011).

⁵ See also Adam and Bevan (2006) and Torvik (2001).

⁶ This can be thought as the actual level of infrastructures at a certain date.

⁷ All quantity variables except labour are detrended by ${\left(1+g\right)}^t$. In the long run all the variables, including real GDP, grow at the same rate g. However, in the short run, the growth rate of the economy can go above g as a result of scaling up of public investment.

⁸ Calibrating the parameter of credit constrained agents with a higher value does not qualitatively affect the results.

⁹ This is a simplification which does not affect the dynamics of the model.

¹⁰ See Schmitt-Grohe and Uribe (2007) for a detailed discussion of the methodology.

¹¹ This assumption not only is more realistic than assuming a declining capital stock, but also allows us to consider the fiscal implications of sustaining the higher stock of public capital.

¹² We conducted sensitivity analysis for different values of the parameter η_g and the results show that higher sensitivity of interest rates to the stock of debt cause higher debt levels and require slightly higher increases in tax rates. The fiscal sustainability is however preserved. Results are available upon request.

¹³ Customs level data at the six-digit level of the harmonized system (HS6).