The Implications of Public Investment for Debt Sustainability

Gergő Motyovszki, Philipp Pfeiffer and Jan in 't Veld

No 204, European Economy - Discussion Papers from Directorate General Economic and Financial Affairs (DG ECFIN), European Commission

Abstract: Rising public investment needs raise the issue of debt sustainability. This paper analyses the implications of public investments for debt dynamics using quantitative model simulations. Without offsetting fiscal adjustments via the primary balance, a temporary increase in public investment implies a lasting increase in the debt-to-GDP ratio. While a significant boost to real GDP can create some backing for the additional public debt, the direct budgetary costs of the stimulus outweigh this denominator effect. In the medium and long run, as these endogenous effects fade, debt dynamics becomes increasingly driven by the longterm r−g differential, which is assumed to be positive in our central scenario, putting debt-to-GDP on an increasing trajectory. In contrast, negative r − g could ensure that debt-to-GDP eventually reverts to its baseline level, even without budgetary adjustments. Alternatively, letting the primary balance adjust beyond the impact of the fiscal shock can provide another mechanism for debt stabilisation. In particular, if non-stimulus spending is fixed in real terms while taxes increase in line with expanding output, debt-toGDP falls below its baseline in the medium run, even in an economy with positive r−g. However, this constitutes a quasi-consolidation where the resulting higher primary balances reflect the inherent fiscal costs, underlining that public investment is not a “free lunch”. Nonetheless, the need for debt-financed public investments to be eventually paid for (in a narrow fiscal sense) does not preclude their potential to be welfare-improving for society, especially if they facilitate the climate transition – a channel our model does not explicitly consider.

JEL-codes: E62 E63 H62 H63 (search for similar items in EconPapers)
Pages: 40 pages
Date: 2024-06
New Economics Papers: this item is included in nep-dge and nep-fdg
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Persistent link: https://EconPapers.repec.org/RePEc:euf:dispap:204

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