Financing government investment and the implications for public capital: A small open economy perspective

Abstract Expenditure reductions played a key role in many small open economies during fiscal consolidation, with large declines in public investment. This led to a reduction in public capital stock and affected the competitiveness of these economies. After the crisis, the governments that consider increasing investment to replenish the public capital stock have limited fiscal space and have to avoid external imbalances. We show that using budget-neutral investment spending can generate long-term benefits of higher public capital stock while at the same time limiting negative consequences for public finances and trade balance. The best way of financing government investment, which preserves fiscal and trade balance, and increases welfare, is by reducing other government spending. The second-best is financing investment with value-added tax. Financing with debt worsens fiscal and trade balances, while using distortionary labour taxes reduces labour supply, increases wage costs and worsens the trade deficit in the short run.