A3 Fiscal Policy and the Optimal Size of Public Investment

The optimal size of public investment depends upon the way in which countercyclical fiscal policy is needed and its effect. Since the benefit of counter-cyclical fiscal measures has been limited recently in Japan, we must pay more attention to the supply side of public investment than the demand side. With severe fiscal constraints, Japan’s public investment policy must be reformed so as to attain sustainability.

In order to attain a sustainable public investment policy, it may also be useful to impose the stable public investment policy rule. For example, we may impose an institutional setting on both counter-cyclical fiscal policy and pro-cyclical public investment management. In the standard budgetary system, built-in stabilizers have been imposed such that social welfare spending is automatically raised and taxes are automatically reduced in a recession as a result of progressive income tax, the social welfare system, unemployment benefits, and so on.

Automatic built-in stabilizers usually improve the macroeconomic situation. In addition, the government may impose automatic public investment expenditure stabilizers on the budgetary system. Namely, even if fiscal conditions worsen, the budgetary system may automatically maintain the predetermined level of public investment expenditure over time by raising taxes or issuing debt. At the same time, this rule implies that the government should not heavily use public investment as a Keynesian discretionary fiscal measure.

However, automatic public investment stabilizers are fiscal rules that must be utilized over time as commitments, such as to maintain the optimal size of public investment even under a recession, which are built into the budgetary system. Such commitments are effective for stable public capital accumulation in a political economy. If the size of public works is predetermined automatically and the interest groups can anticipate this rule in advance, they have no incentives to demand further public investment.

Further, even when public investment is raised because of inefficient cost factors, the tax burden will automatically be increased further in the near future so as to meet the sustainable government budget. Hence, interest groups should recognize the cost of public investment; consequently, they have an incentive to cooperate immediately with the government’s efforts for efficient and effective public investment reforms.

In order to attain stable public investment for sustainability, public investment management is necessary from the long-run perspective. An ex ante public investment stabilization rule is a more feasible and credible method for stimulating aggregate demand than discretionary measures such as an ex post public investment increase. Moreover, the former is more effective for reducing the cost of public works and attaining fiscal sustainability than the latter in a political economy.

Questions

  • 2.1 The multiplier of raising public investment is always greater than that of reducing taxes. However, many voters tend to support tax reduction more than an increase in public investment. Why?
  • 2.2 Many countries ask other countries to conduct more expansionary fiscal measures but they would not like to do so by themselves. Why?
  • 2.3 In the simple Keynesian model, assume that the consumption function is given by

Investment is 100 and government spending and taxes increase by both 100. What is the fiscal multiplier?

 
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