Working Paper: CEPR ID: DP6090
Authors: Roel Beetsma; Frederick van der Ploeg
Abstract: The political distortions in public investment projects are investigated within the context of a bipartisan political economy framework. The role of scrapping and modifying projects of previous governments receives special attention. The party in government has an incentive to overspend on large ideological public investment projects in order to bind the hands of its successor. This leads to a bias for excessive debt, especially if the probability of being removed from office is large. These political distortions have implications for the appropriate format of a fiscal rule. A deficit rule, like the Stability and Growth Pact, mitigates the overspending bias in ideological investment projects and improves social welfare. The optimal second-best restriction on public debt exceeds the level of public debt that would prevail under the socially optimal outcome. Social welfare may be boosted even more by appropriate investment restrictions: with a restriction on (future) investment in ideological projects, the current government perceives a large benefit of a debt reduction. However, debt and investment restrictions are not needed if investment projects only have a financial return.
Keywords: bipartisan; deficit rule; golden rule; ideological projects; investment restriction; market projects; political economy; public investment; scrapping public investment
JEL Codes: E6; H6; H7
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Incumbent government has an incentive to borrow excessively (H74) | Overspending on large public investment projects (H54) |
| Overspending on large public investment projects (H54) | Binding the hands of successor (Y20) |
| Probability of being removed from office is high (J63) | Increased overspending on large public investment projects (H54) |
| Scrap value of public investment is considerable (H54) | Increased overspending on large public investment projects (H54) |
| Overspending on large public investment projects (H54) | Higher overall debt levels (F65) |
| Deficit rule implementation (H62) | Reduced overspending incentive (E62) |
| Reduced overspending incentive (E62) | Improved social welfare (D69) |
| Overspending on large public investment projects (H54) | Lower expected future cost of funds for incumbent (E43) |
| Lower expected future cost of funds for incumbent (E43) | Increased investment in ideologically favored projects (H54) |