Public infrastructure investment, output dynamics, and balanced budget fiscal rules

We study the dynamic macroeconomic effects of public infrastructure investment under a balanced budget fiscal rule, using an overlapping generations model of a small open economy. The government finances public investment by employing distortionary labor taxes. The balanced budget rule implies a negative short-run output multiplier that exceeds (in absolute terms) the positive long-run output multiplier. Larger public capital spillovers sharpen the intertemporal output tradeoff. In contrast to conventional results regarding public investment shocks, we obtain dampened cyclical responses for plausible parameter values. The cyclical dynamics arise from the interaction between the labor tax rate, the tax base, and the intergenerational spillover effects. We show that financing scenarios involving public debt creation can substantially reduce the short-run output contraction and the transitional macroeconomic fluctuations induced by public investment.