How Public Investment Could Help Improve Iran’s Growth Potential
This article is adapted from a working paper presented at the conference of the International Iranian Economic Association in March 2018. The full paper can be seen here.
Since the early 2000s, growth in Iran has been insufficient to improve real GDP per capita incomes. Sanctions and negative oil price shocks led to budget tightening and a contraction in pro-growth spending. Investment in infrastructure has been cut in half since 2012.
Looking ahead, lower public investment could constrain Iran’s growth potential. On the other hand, it is possible that an increase in government revenue could be followed by an aggressive scaling up of public investment.
In this study, we look at various approaches (gradual, aggressive, and conservative) to scaling up public investment in Iran under different oil price scenarios (baseline and adverse) in order to analyze how Iran can increase its public investment to achieve higher growth while preserving a fiscally sustainable path that avoids explosive and unsustainable debt or excessively tight tax policies that would be impossible for the government to maintain in the long run.
Fundamentally, a relaxation of the fiscal stance to finance a large temporary increase in investment faces two hurdles. First, scaling up too abruptly leads to inefficiencies. For example, selected projects may be of lower quality, making the entire process more inefficient.
Second, increasing investment requires building fiscal buffers so that in case of adverse shocks, such as an unexpected decrease in oil revenue, the investment plan can still be carried out without compromising fiscal stability. Furthermore, scaling up investment may shift financial resources from the private to public sector and have a distortionary effect by increasing interest rates and crowding out private investment.
To that end, we define and examine multiple scenarios for investment scaling-up: (1) a “gradual” scenario, in which investment would increase by 3 percent of GDP over four years and would then remain stable at its 10-year, pre-sanctions (2002-2011) average of 5.2 percent of GDP; (2) a “conservative” scenario, in which the same increase in public investment takes place over eight years instead of four—before it reaches the same long-run level as in the gradual scenario; and (3) an “aggressive” scenario that, in three years, leads to the highest level of public investment in Iran in the past two decades—6.5 percent of GDP—before stabilizing at its long-run level.
We also define two oil price scenarios: In the “baseline” scenario, oil prices are assumed to reach $55 a barrel by 2021, while under the “adverse scenario,” oil prices never exceed $48 a barrel.
We use a dynamic stochastic general equilibrium model that includes a resource fund and a range of fiscal tools. The model also contains developing economy features, such as absorptive capacity constraint and public investment inefficiency, which makes the model suitable to study Iran. The model is calibrated to Iran using annual applications. The baseline calibration reflects the 2002-2011 average.
The simulations show that scaling up investment is viable under all scenarios. However, because gross debt remains on a declining path in the long run and accumulating wealth continues, the costs of an aggressive strategy are considerable in terms of the increased consumption tax rate to finance the investment scaling up and the exchange rate appreciation in the real exchange rate. Furthermore, because of absorptive capacity constraints and investment inefficiencies inherent in oil-exporting developing economies, the growth impact of an aggressive strategy does not significantly differ from a conservative or a gradual design. Meanwhile its costs, in terms of fiscal adjustment, are significantly higher, especially during periods when oil prices are low.
The government is better off with an aggressive investment approach—if it can improve the efficiency of public investment. An aggressive front-loading of public investment results in 0.9 pp of higher growth, relative to the growth that can be achieved under the gradual scenario. However, that comes at the cost of a 1 pp higher consumption tax rate than what would be needed with the gradual approach (2 pp in the adverse scenario) and 4 pp higher accumulation rate of public debt in the short run (10 pp in the adverse scenario). Furthermore, there will be a larger appreciation in the real exchange rate under the aggressive public investment scenario, eroding the competitiveness of the tradeables sector. Structural reforms that improve the efficiency of public investment lead to larger growth margin, due to expansion in public investment: 2.1 pp vs. 1.0 pp in the adverse scenario.
Effective investment means that only a fraction of total public investment turns into productive capital and as public investment increases, the rate of expansion in effective public investment declines. An improvement in investment efficiency has a significant positive impact on growth outcomes and leads to higher private consumption and investment. Rising efficiency, however, does not help with the size of fiscal adjustment required to close the fiscal gap.
Introducing an oil fund, on the other hand, shows that the size of the adjustment needed to finance the scaling up of capital expenditures is smaller if the government fully utilizes its financial assets. The depletion of the oil fund, however, comes with larger appreciation of real exchange rates and deterioration in the current account balance.
Overall, preserving fiscal sustainability in the case of investment scaling-up is a complex task. It puts pressure on government to increase taxes, which can neutralize the impact of fiscal spending on growth. It can also lead to higher debt, which can, through higher interest rates, crowd out the private sector.
To overcome these challenges and ensure that investment spending supports sustainable growth, two policies could be considered. The first is to increase non-oil revenue. This would help build space for development spending while preserving overall fiscal deficit objectives. Furthermore, increasing domestic revenue would help reduce dependency on oil revenue by increasing the share of current expenditure financed by domestic taxes and allowing more oil revenue to fund public investment. The second suggested policy would be to strengthen the government investment framework to improve the efficiency of investment spending. Furthermore, bringing a long-term perspective to fiscal policy formulation, particularly through the adoption of a medium-term fiscal framework, could be very important and helpful in managing oil price shocks.
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