Investment scaling up and the role of government

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.