Growth-friendly fiscal rules? Safeguarding public investment from budget cuts through fiscal rule design

Abstract

We study patterns of public investment behavior during fiscal consolidations in seventy-five advanced and emerging economies during 1990–2018 and find that results differ significantly depending on fiscal rule design. Fiscal rules can be flexible, meaning that they include mechanisms to accommodate exogenous shocks (e.g., cyclically adjusted fiscal targets, well-defined escape clauses, and differential treatment of investment expenditures) or rigid, meaning they establish 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 an average 10 percent reduction in public investment. Instead, in countries with flexible fiscal rules, the negative effect of fiscal adjustments on public investment vanishes, which implies that flexible rules protect public investment during consolidation episodes. The corollary is that the design of fiscal rules can add a growth-friendliness dimension to the fiscal sustainability objective that has typically been the focus of fiscal rules in the past, provided public investment is productive.