Fiscal Policy, Infrastructure Expenditure and Growth: Sharing experience from Latin America

1. Fiscal Policy, Infrastructure Expenditure and Growth: Sharing experience from Latin America Luis Serven, Research Manager, DEC Workshop: Modeling Fiscal Policy, Public Expenditure and Growth linkages, June 14-15, 2006

2. Background • Work focused on Latin America • Motivation: perception that fiscal adjustment has led to a steep decline in productive public expenditure – specifically infrastructure. • Private sector entry insufficient to offset the decline, hence potentially adverse growth effects. • Concern with myopic fiscal rules targeting liquidity and ignoring intertemporal dimension of solvency • Research program including • Analytical papers • Empirical cross-country work • Country studies (Brazil, Colombia…)

3. Selective summary • Assembling infrastructure spending data • From expenditure flows to asset stocks • The output contribution of infrastructure • Country simulation models

4. Infrastructure expenditure • Very limited data availability: only Central Gov expenditure from GFS – unreliable because of (i) decentralization and (ii) PEs. • Collect data from national sources for 7 countries (ARG, BRA, BOL, CHL, COL, MEX, PER), 1980-2000. • 4 different sectors: roads, railways (if applicable), power, telecommunications. • public and private investment • No luck with O&M

5. Infrastructure expenditure • A casualty of fiscal adjustment Latin America

6. Infrastructure expenditure Brazil

7. Infrastructure expenditure Latin America Total (public +private) investment in Infrastructure (weighted average of 7 countries, percent of GDP)

9. Expenditure flows and asset stocks • What matters is the availability / quality of services, not (necessarily) the volume of expenditure. • Their trends may be very different -- due to changing efficiency, corruption, waste…(Pritchett, Tanzi etc)

10. Expenditure flows and asset stocks Brazil: the power sector Investment Capacity change

11. Expenditure flows and asset stocks • Easterly and Servén (2003): regression approach relating the trajectory of infrastructure asset stocks to investment flows. • Simple-minded ARDL models (to allow time-to-build) • Kt = {power generation capacity in Gw; Km of roads (+railways); # of phone lines} • It = total investment (also private and public separately) • Panel data for 8 countries / 20 years; fixed effects (+time effects)

12. Expenditure flows and asset stocks • Results: can explain very well telecom (R2 = .7-.8), fairly well roads / rail (R2 = .4-.6), power not so well (R2 = .2-.3). • For roads, some evidence that private investment makes a bigger contribution to stocks (= lower unit cost) • Other regressions relating measures of service quality (e.g., phone faults, power losses…) to private sector participation – with mixed results: positive for telecom, negative for power… • Heterogeneity of assets potentially a big problem here (e.g., private sector only does “easy” roads)

13. Expenditure flows and asset stocks • Ferreira (2005) does similar exercises for Brazil. He gets very close tracking for telecom, fair for power, poor for roads. • Unresolved major question: how does the stock / flow link depend on governance and fiscal institutions – or other country features ? • One way to address this would be through country-specific (rather than pooled) estimates -- e.g., a RCM. But that requires broader cross-country data coverage...

14. The output contribution Standard Cobb-Douglas specification imposing CRS: Panel data for 90+ countries, 1960s-1990s h = years of secondary schooling (other measures also) z = physical infrastructure measures (km of roads, phone lines, power generation capacity Gw) Endogeneity a major problem. 2 empirical approaches: -- GMM (large N asymptotics: Arellano-Bond etc) with internal instruments as well as demographic instruments -- Panel time-series approach (large N and T: Mark-Sul, Philips-Moon) w/ unrestricted cross-country heterogeneity

15. The output contribution

16. The output contribution

17. The output contribution Significant contributions of infrastructure in both cases – but smaller coefficients (as much as 50%) in the panel time-series approach. Tests of country-specific vs pooled estimates do not show much evidence of cross-country parameter heterogeneity – in general, null of homogeneity cannot be rejected…

18. Simulation models • Focus on assessing alternative fiscal strategies / fiscal rules • 2 applications: Brazil & Colombia • Brazil (Ferreira and Gonçalves 2005): main concern is the interplay of fiscal rules, investment and growth. • Colombia (Suescún 2005): upcoming fiscal correction to accommodate pension deficit. • Models of intertemporally-optimizing infinitely-lived agents, with endogenous labor supply. • …but model details differ.

19. Brazil model

22. Brazil model • Questions: • Would it make sense to raise public infrastructure investment ? • If so, what form of financing should be used ? Cuts in other expenditure, taxes or debt ? • Main conclusion from simulations: the best strategy for growth and welfare is an investment increase financed by reducing public consumption.

23. Colombia model • Three reproducible factors: infrastructure capital, business capital and human capital • Infrastructure capital can be supplied by the government or the private sector (imperfect substitutes) • Market-determined user fees on infrastructure services (infrastructure expansion may cost revenues ! [Uruguay]) • Public consumption does not yield utility • Learning-by-doing human capital externality • Solvency assured by tax rates that depend on public debt

24. Colombia model Question: should the adjustment be financed via tax hikes or infrastructure investment cuts ? Simulations show investment cuts yield lower growth in long run (about 1% less per annum ) – i.e., the cost of lower public capital outweighs the gain from lower real interest rates allowed by reduced indebtedness. The less easily substitutable public infrastructure, the deeper the slowdown.

25. End

26. When can public investment pay for itself ? The marginal impact on net worth of a deficit-financed rise in the public investment ratio: Tax ratio User charge on public services Unit maintenance cost Purchase cost of capital (including corruption, waste etc…) Marginal cost of borrowing Marginal product of public capital

27. When can public investment pay for itself ? Perotti (2004): In most industrial countries, no – marginal return is too low. But marginal return should be higher with lower stocks. Ferreira (2005): In Brazil, yes – depending on slope of cost of borrowing. Estache (2005): In many African countries, yes.