Public Investment under Fiscal Constraints

Bacchiocchi E., Borghi E., Missale A.University of Milan

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"Fiscal Policy and Public Investment for Relaunching Potential Growth"EC DG ECFIN, Brussels 24 January 2017

Introduction

Aim Investigate whether fiscal rules or debt sustainability (fiscal

constraints) affect public investment in physical capital and expenditure on education.

Provide evidence on the effect of fiscal constraints and adjustment on the composition of government expenditure, in particular on the share of investment expenditure.

Assess the impact of the Maastricht Treaty and the SGP deficit limit on public investment, by comparing EMU member States to other OECD countries.

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Main Findings3

Empirical Evidence Public investment and education expenditure are significantly

reduced in high-debt countries as the debt ratio increases.

This effect is independent of EMU (or EU) membership and, thus, possibly independent from SGP rules.

Debt sustainability appears the key constraint binding investment decisions.

Tentative Implications for policy High-debt countries may not take full advantage of flexibility.

Promoting investment, with initiatives similar to the Investment Plan for Europe, can be more effective.

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Literature

Balassone and Franco (2000), focusing on 32 episodes of fiscal consolidation in EU-15 countries over the 1980s and 1990s, find that in 25 cases adjustment was achieved through investment cuts.

Investment is easier to cut because of weaker opposition from citizens. Advocates of the "golden rule of public finances" contend that a limit on

overall government deficit, eg the SGP, may lead to underinvestment or distortions in the allocation of public resources. Buiter (1984) Balassone-Franco, 2000; Blanchard-Giavazzi (2004); Easterly-Irwin-Servén (2008).

Galí and Perotti (2003) compare EMU and other OECD economies and conclude that the reduction of public investment was the result of a secular decline affecting all countries more than the effect of the Maastricht Treaty and the SGP.

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Our view: Debt sustainability matters

The idea of the paper is that there are two types of fiscal constraints: i) Fiscal rules, like the SGP, and; ii) debt sustainability.

We cannot simply compare EMU countries to other OECD economies to infer the effect of the SGP on public investment; we must account for the effect of debt sustainability that could also bind investment decisions.

Public investment could be restrained by high public debt because of sustainability concerns; we expect the effect of debt on investment to be non linear.

We distinguish between high- and low-debt countries (unlike Galì-Perotti 2003), besides EMU and other OECD countries.

We also consider government expenditure on education and health.

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Does less investment help sustainability?

Cutting public investment has an uncertain effect on debt sustainability in that a lower stock of public capital decreases output growth and government net wealth.

We investigate the effect of lower investment on debt sustainability in an endogenous growth model where output is produced with both private and public capital, and the government cannot cut consumption or increases taxes, say, because of political opposition.

We show that a reduction in public investment (in spite of decreasing the ratio of public capital to output) allows a higher debt ratio to be sustained unless growth becomes negative.

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Lower investment for Debt sustainability

Debt sustainability depends on output growth, , and on the value of net debt and thus on the difference between gross debt, , and the value of public capital, :

Intuition Lower investment allows to sustain a higher level of gross debt

because it raises the relative return and the price, , of public capital. The value of public capital increases (despite the fall in its stock, ) and more than offsets the effect of lower growth.

This result provides theoretical support to the empirical analyisis.

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Estimation

Panel Estimation – country fixed effects and cluster-robust std errors We consider a panel of OECD countries over the period 1990-2008

and estimate government expenditure reaction functions to public debt and cyclical conditions à la Bohn (1998):

Dependent variable (relative to GDP or total expenditure) Gov't Gross Capital Formation (+ net acquisition non-financial assets) Gov't expenditure on Education or Health (COFOG)

Explanatory variables = Gross financial liabilities relative to GDP (OECD outlook) = GDP growth (or output gap) = Controls (Deficits or government expenditure) Country fixed effects and time trend

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Estimation strategy

We distinguish between countries with low and high debt-to-GDP ratios and between EMU (or EU) States and other OECD countries:

If the SGP had imposed additional constraints than debt sustainability, the reaction of public investment to the debt and deficit ratios should be stronger in EMU (or EU) member States.

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High-debt and Low-debt countries

Distinction is based on debt-to-GDP ratios observed in the first half of sample period, ie in the 1990s.

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Government capital formation - EMU vs OTH11

Debt ratio is significant only in high debt countries (no membership effect)The effect is only slightly stronger in EMU countriesResults are robust to the inclusion of the deficit ratio (next slide)

Government capital formation - EMU vs OTH

The deficit is marginally significant in low-debt EMU countries

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Government capital formation - EU vs OTH

Same result; the effect is even stronger in Other OECD countriesHigh-debt EU countries are Sweden, Denmark, Hungary

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Debt sustainability is the key constraint

Summary At high levels of debt, governments cut public investment, as the debt

increases, independently of SGP rules.

At low levels of debt, the SGP does not appear to have imposed additional restrictions on public investment in EMU or EU States*.

This suggests that investment decisions have been constrained more by debt sustainability than by fiscal rules.

*There is only a marginally significant contraction in the share of public investment as the deficit increases in low-debt EMU countries.

Public investment is also more procyclical in EMU and EU countries.

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Investment in human capital

We consider government expenditure on education, and health, as fiscal adjustment may lead to a reduction of investment in human capital as well as in physical capital.

Same panel estimation of reaction functions

Dependent variables (relative to GDP or total expenditure) Expenditure on Education or Public Health for 1990-2007

Taken from the OECD classification of governement expenditure by functions (COFOG).

Country groups by level of debt and EMU membership.

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Expenditure on Education - EMU vs OTH OECD

The share of education expenditure decreases with debt only in high-debt countries independently of EMU membership.

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Education expenditure decreases with debt

The share of Education expenditure in total expenditure decreases with debt only in high-debt countries and the effect is stronger for countries outside the Euro area.

Education expenditure increases with total expenditure, though at a lower rate, in all countries but in terms of GDP it significantly decreases with the debt ratio only in high-debt countries independently of EMU membership

In high-debt countries, the share of education expenditure decreases with the deficit but the effect is stronger for Non-EMU countries. More importantly, expenditure in terms of GDP significantly increases with the deficit in EMU countries (not shown here).

Debt sustainability (more than SGP rules) has forced highly indebted countries to cut investment in education relative to other expenditures.

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Expenditure on Health - EMU vs OTH OECD

The deficit reduces health expenditure except than in low-debt EMU countries

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Conclusions

At high levels of debt, countries reduces public investment in physical capital and education expenditure as the debt increases while health expenditure decreases with the deficit.

These effects are independent of EMU (or EU) membership and appear to reflect a sub-optimal reaction to rising debt and sustainability concerns rather than the constraints imposed by the Maastricht Treaty and the SGP.

Policy Flexibility within the Pact such as the "investment clause" may not

be enough to free public investment from budget cuts; Promoting investment with specific plans, such as the Investment Plan

for Europe, can be more effective.

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Public Investment percent of GDP – 1995-201520

Thank You!

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