Growth-Friendly Fiscal Rules?: Safeguarding Public Investment from Budget Cuts through Fiscal Rule Design

Jul 2019
Fiscal adjustment episodes tend to be accompanied by large public investment cuts, contributing to the well-documented pro-cyclical bias in public capital expenditures. We study patterns of public investment behavior during fiscal consolidations in a sample of 75 advanced and emerging economies during 1990-2018 and find that results differ significantly depending on fiscal rule design. Fiscal rules can be "flexible," which are rules that include mechanisms to accommodate exogenous shocks (e.g., cyclically adjusted fiscal targets, well-defined escape clauses, and differential treatment of investment expenditures) or "rigid"--i.e., establishing numerical limits on fiscal targets without taking into account flexible features. We find that in countries with either no fiscal rule, or with a rigid fiscal rule, a fiscal consolidation of at least 2 percent of GDP is associated with a 9 percent cut in public investment, on average. In countries with flexible fiscal rules, however, the decline in public investment is less than 2 percent on average. The results hold after controlling for possible endogeneity bias in the estimations. We show that by reducing pro-cyclical biases in public investment spending, flexible fiscal rules can add a growth-enhancing dimension to the fiscal sustainability concerns that have been the focus of fiscal rules to date.