As COVID-19 struck in early 2020, governments across Latin America and the Caribbean moved decisively through transfers, credits and other means to shore up their economies and support families and firms. That swift governmental action did much to alleviate suffering. But in the midst of falling revenues, fiscal deficits increased substantially, rising on average from 3.4% of GDP immediately before the pandemic to 7.5% of GDP in 2020 and 5.8% in 2021. As a result, debt-to-GDP ratios also gained altitude, climbing from 58% to 72% of GDP during the 2019-to-2021 period, raising concerns about the sustainability of debt and the possibility of fiscal crisis.
Fiscal consolidation—the process by which deficits and debts are reduced—is now urgently needed to protect the long-term health of the region’s economies. But the means by which that is achieved makes all the difference. It is crucial to determining whether deficit reduction leads to reduced output and worsening inequality or whether those effects can be mitigated or even reversed. In that respect, the form of that consolidation may be more important than the amount of deficit reduction.
The Temptation to Cut Public Investment
When they slash budget deficits, governments attune to political sensitivities typically find it easier to cut public investment—like that in infrastructure—more dramatically than public consumption, like public sector wages. But evidence shows that the multiplier effect of capital expenditure is typically larger than that for public consumption. This implies that, on average, for example, a peso that is cut from a productive investment project has a larger negative rippling effect on the economy than a peso that is cut from the purchase of government goods and services. Of course, not all public investments are equally productive, and not all public consumption is wasteful. There is a lot of variation across countries and time on these and other relevant dimensions. So, it is worth scrutinizing the evidence carefully.
In a recent IDB study, we evaluated the implications of different forms of consolidation on economic growth. Specifically, we looked at a sample of 26 advanced and 44 developing countries from 1980 to 2019 to examine diverse fiscal consolidations and their short- and medium-term effects on economic activity. We found that when the share of public investment declines relative to public consumption, deep and prolonged economic contractions can result. Indeed, a consolidation of 1% of GDP reduces output by about 0.5% during the fiscal consolidation. That rises through accumulation to 0.7% within three years of the consolidation’s onset. By contrast, protecting public investment from budget cuts can mitigate contractions in the short run. It can even lead to economic expansion in the medium term, as capital spending stimulates private investment.
Public Investment and Higher Growth
Why might protecting public investment during fiscal consolidations result in higher growth? Results from our paper suggest that protecting public investment during fiscal consolidations creates incentives for expanding private investment. When public investment is protected, and thus its share in public expenditures increases, a consolidation of 1% of GDP leads to an increase in private investment of 3.6% within three years, on average, instead of a 1.8% decrease when the share of public investment in total spending declines. There are various reasons why this may be so. Productive public investment directly improves the productive capacity of the economy by increasing the productivity of capital and labor. This generates a crowding-in effect on private investment. Moreover, to the extent that the increase in the share of public investment reflects a relatively larger contribution of public consumption items to total adjustment, the credibility of fiscal adjustment can be greater. That, in turn, could translate into higher private investment levels.
A Broad Research Agenda
We have documented in the past how reductions in fiscal deficits that hurt investment in roads, energy systems, and water and sanitation hurt growth while enhanced public investment in those areas can boost private investment and contribute to prosperity in high productivity sectors like manufacturing. We have also examined, among many other issues, how spending composition affects fiscal multipliers, and the role of fiscal rules in protecting productive public investments during fiscal consolidations.
Our findings in the current study fit into that wider research agenda on public investment, an area of great concern given its low levels in many developing economies. They show how essential productive capital spending is to private investment, to growth, and to medium- and long-term economic health. They also underscore the importance of establishing institutional mechanisms, for example, well-designed fiscal rules, to ensure predictable and consistent capital spending over time.
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