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1 February 2016 CFA Institute Journal Review

How Does Fiscal Policy Affect Investment? Evidence from a Large Panel (Digest Summary)

  1. Peter Eickelberg, CFA

Using a panel analysis of 95 developed and emerging economies, the authors study the budgetary determinants of public and private investment. They find that government consumption and expenditures tend to negatively affect private investment but may boost public investment, public health spending boosts private investment, population growth boosts public and private investment, but debt service and subsidies drag both down.

What’s Inside?

Data from a panel of 95 countries indicate potential determinants of public and private investment levels. The authors find that population growth positively affects private and public investment. Several types of taxes and entitlement payments inhibit private investment, although they positively affect public investment in some regions—particularly given a high dependency ratio. The magnitude of this effect can depend on existing debt and deficit ratios. In addition, good fiscal rules (such as in the EU) should limit excess spending but also limit investment. Government expenditures appear to affect future investment more than government revenues.

How Is This Research Useful to Practitioners?

The authors’ findings apply primarily to policymakers who want to stimulate investment within a country or to analysts and economists who could examine the data for the clearest indicators of future investment and perhaps use that information in forecasts. It is important to understand what drives private versus public investment in such cases. For example, by knowing that a higher age dependency ratio inhibits private but not public investment, an analyst would thus expect demographic headwinds to private sector growth in the future. A policymaker considering how population growth boosts both public and private investment might feel more confident about an increase in government spending when demographic trends point to growth. Legislators imposing rules on government spending could reflect on how Economic and Monetary Union rules historically have affected investment in member countries.

The authors also focus on how individual budgetary components may affect private and public investment; intuition is not always accurate in this area. When entered into the regressions individually, government revenue components do not significantly influence either type of investment in OECD countries. Income and investment taxes, as well as social security contributions, seem to have a positive effect on public investment for non-OECD countries. Interest payments and subsidies negatively affect investment, influencing emerging markets (which often have high debt) more than other sample markets. Another interesting finding is that government health spending may correlate with higher public and private investment, perhaps because productivity gains result from a healthy population.

How Did the Authors Conduct This Research?

Examining data on 95 countries over the period 1970–2008, the authors use five-year averages in factor formulas for public and private investment levels. The formulas contain terms for starting GDP per capita at the beginning of each five-year period; a vector of control variables (to help deal with endogeneity and simultaneity); a vector of budgetary components; and variables for labor force participation rate, population growth, and age dependency. The authors attempt to control for known biases and to overcome the usual drawbacks of time-series regressions by using system-generalized methods of moments, which they describe.

The fiscal variables are drawn from the World Bank’s World Development Indicators, the International Monetary Fund’s international financial statistics, and Easterly’s (Journal of Economic Growth 2001) data. Revenue and expenditure budgetary components are expressed as a percentage of GDP. Revenues include taxes on goods and services, payroll, income, profits/capital gains, and property. There is also an input for social security contributions. Expenditures include employee compensation; interest payments; subsidies; public final consumption expenditure; and spending on education, health, social security, and welfare.

Abstractor’s Viewpoint

In economic theory, investment levels greatly affect future economic growth. Investment should be directed to the appropriate areas, and government spending is not always optimal for future growth because it can crowd out productive investment and lead to the kind of investments that the authors demonstrate have detrimental effects on investment conditions (e.g., high debt/debt service payments and high deficits). If the results of the study are valid, policymakers should consider what sort of fiscal and growth environments they are facing when determining types and levels of public investment as well as any proposed controls on the same.

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