Partisan Public Investment and Debt: The Case for Fiscal Restrictions

Abstract

The political distortions in public investment projects are investigated within a bipartisan framework. The role of scrapping and modifying projects of previous governments receives special attention. The ruling party overspends on large ideological public investment projects and accumulates too much debt to bind the hands of its successor, especially if the probability of being removed from office is large and the possibility of scrapping is not ruled out. 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 socially optimal level of public debt. Social welfare is boosted more by investment restrictions on ideological projects. The government then perceives a larger benefit of debt reduction. In fact, if scrapping is forbidden, optimal investment restrictions can yields the socially optimal outcome. Finally, debt and investment restrictions are not needed if investment projects only have a financial return.