Public Investment and Fiscal Policy

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Public Investment and Fiscal PolicyTeresa Ter-Minassian Director, Fiscal Affairs Department International Monetary Fund January 24, 2005

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Outline of the presentationPublic investment trends during 1970-2000 Choice of indicators/targets for fiscal policy and its impact on public investment A strengthened approach to safeguarding public investment The role of PPPs Preliminary results of pilot projects

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Public Investment Trends, 1970-2000Significant variation of trends in public investment (as a share of GDP) across countries and regions over the last three decades Fell to historically low levels in a number of OECD and Latin American countries Also, high degree of volatility in Latin America Declining public investment has been offset only in part by private investment

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Public Investment Trends in Advanced OECD Countries and Selected Latin American Countries, 1970-2000

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Why have we seen a declining trend in public investment?Short-term fluctuations mainly reflect comparative ease of cutting investment in a context of fiscal retrenchment. Long-term trends may also reflect: Changes in preferences about the size of public sector; and Data coverage changes, in particular due to privatization.

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Impact of Decline in Public Investment on Growth and Social IndicatorsEmpirical evidence on the long-term relation between public investment and growth is inconclusive. This likely reflects a number of factors: Public investments that do not directly boost a country’s productive potential. Current spending on social programs (such as education and health) may, in certain circumstances, be equally or more effective in removing impediments to growth. Not all public investment is of high quality.

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Impact of Decline in Public Investment on Growth and Social Indicators (continued)Evidence on impact of infrastructure compression on growth is more robust: Calderón, Easterly, and Servén (2003) study for Latin American countries. Other recent World Bank studies focusing on links between infrastructure and MDGs. The World Bank is stepping up efforts to assess infrastructure gaps in various regions (REDIs)

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Possible Fiscal Roots of Declines in Public Investment Concerns that focus on the overall fiscal balance and the gross public debt may unduly constrain scope to finance public investment in infrastructure. Alternative suggested approach: target current fiscal balance, excluding investment

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Pros and Cons of Targeting the Current Fiscal BalanceAdvantages: Would promote intergenerational equity, by spreading the costs of public investment over time. Would recognize that productive public investment adds to the stock of capital and, therefore, does not reduce the net worth of the government. Disadvantages: Does not recognize possible short-term financing constraints May conflict with need to curb excess demand Does not take into account the quality of public investment projects May encourage creative accounting May detract attention from other budgetary priorities May create a bias against private involvement in infrastructure

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Safeguarding Government Investment: A Strengthened ApproachGiven the significant risks entailed by a shift to a current balance approach, and its avoidance of real trade-offs between investment and other budget priorities, it is preferable to continue targeting the overall balance and the gross public debt. However, steps can and should be taken by governments to safeguard productive public investment, including during fiscal retrenchment periods.

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Safeguarding Government Investment: A Strengthened Approach (continued)Such steps could include: Improve assessments of impact of proposed new government investment projects on growth and the public finances in the short to medium term Increase focus on trends in the current fiscal balance and government’s net worth; when appropriate, use the current fiscal balance as a supplementary fiscal policy target. Make greater use of mechanisms aimed at reducing the volatility and procyclicality of fiscal policy, including when appropriate, the adoption of structural (cyclically adjusted) budget targets. Improve the productivity and cost-effectiveness of government investment.

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The Role of PPPs in Stepping up Infrastructure InvestmentPPPs should be preferred to direct public investment if they lead to efficiency gains. Key considerations in this area include: The standard of services to be provided by PPPs can be adequately specified in the contract There is an appropriate sharing of risks between the public and the private sector The intervention of a private partner can help mobilize resources There is adequate competition in the bidding process, and in the subsequent provision of services, or an appropriate regulatory framework for the latter A robust institutional framework is in place The fiscal implications of PPPs are appropriately disclosed and accounted for.

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What can the Fund do to Assist Countries in Safeguarding Quality Public InvestmentFocus more systematically in surveillance on the quality of fiscal adjustment; in particular on trends and policies to support high quality public investment. Ensure that additional financing for high quality infrastructure investment is accommodated in fiscal targets of Fund-supported programs, when consistent with macro-stability and debt sustainability. Assist countries in: designing mechanisms to reduce volatility and procyclicality of their fiscal policies implementing the GFSM 2001, to facilitate the compilation and analysis of statistics on the public sector’s current balance and net worth

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Testing the Proposed ApproachGiven, in particular, the significant resource costs involved in some of these steps, it was decided to undertake, in cooperation with the World Bank and other MDBs, some pilot studies to implement the steps outlined above. To ensure representativeness of these studies, an effort was made to span different regions and levels of development. Brazil, Colombia, Chile, Peru Ethiopia, Ghana India, Jordan Romania, Spain

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Pilot studies: direct public investmentThe full extent and impact of the decline in public investment is hard to gauge in some countries: Effect of privatization (Peru, Brazil) Issues of coverage of statistics and definitions (Colombia) Impact of efforts to improve the screening of projects In some cases (e.g., Peru) declining public savings, rather than adjustment, have squeezed the room for investment

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Pilot studies: some policy dilemmasClear evidence of significant infrastructure gaps but difficult quantification Constraints imposed by high public debt levels Other potential problems: currency mismatches divergence between social and economic rates of return Further work is needed to better understand relationship between public investment and growth

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Pilot studies: quality as well as quantityProject evaluation and selection systems need improvement Inadequate funding of budgeted projects, excessive delays in execution, and increased costs Poor planning and execution capacity of subnational governments Poor ex-post quality control of projects Failure to properly maintain projects after they are finished

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Pilot studies: PPPsVariety of experiences and degrees of sophistication Brazil—recent legislation Colombia—simulation of costs of contingent liabilities Peru—no registry of contingent liabilities Some common problems Costly, frequent contract renegotiation Too often, subsidy-dependent projects are structured as PPPs—often to bypass fiscal ceilings Scope for learning from leaders (Chile, Colombia) Careful contract design, effective regulation and careful assessment and disclosure of fiscal risks are key.

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