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Public Capital and Private Investment, a Real Option Approach

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  • Bruno de Oliveira Cruz
  • Aude Pommeret

Abstract

In this paper, we extend the usual models of irreversible investment underuncertainty by introducing the stock of public capital as an input for the privatesector. Public investment takes place in a stochastic environment. Public capital thenincreases the productivity of private capital which is assumed to be fully irreversible.In our model, the government has an intertemporal budget constraint, i.e. taxes arecollected each period to fund the public debt. We provide a partial equilibriumanalysis, as it is standard in models of irreversible investment under uncertainty. Evenunder uncertainty, the optimal tax rate is then constant and does not depend on thesize of uncertainty, it is exactly the same as the one that would prevail in adeterministic world. We show that the government has an insurance role since itremoves part of the uncertainty faced by the firm.

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Bibliographic Info

Paper provided by Instituto de Pesquisa Econômica Aplicada - IPEA in its series Discussion Papers with number 1177.

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Length: 27 pages
Date of creation: Apr 2006
Date of revision:
Handle: RePEc:ipe:ipetds:1177

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  1. Jones, Larry E. & Manuelli, Rodolfo E. & Rossi, Peter E., 1997. "On the Optimal Taxation of Capital Income," Journal of Economic Theory, Elsevier, vol. 73(1), pages 93-117, March.
  2. Bajo-Rubio, Oscar, 2000. "A further generalization of the Solow growth model: the role of the public sector," Economics Letters, Elsevier, vol. 68(1), pages 79-84, July.
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  5. Simon Grant & John Quiggin, 2003. "Public Investment and the Risk Premium for Equity," Economica, London School of Economics and Political Science, vol. 70(277), pages 1-18, February.
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  7. Paul Cashin, 1994. "Government Spending, Taxes, and Economic Growth," IMF Working Papers 94/92, International Monetary Fund.
  8. Stephen Turnovsky, 1998. "Productive Government Expenditure in a Stochastically Growing Economy," Working Papers 0056, University of Washington, Department of Economics.
  9. S. Rao Aiyagari & Albert Marcet & Thomas J. Sargent & Juha Seppala, 2002. "Optimal Taxation without State-Contingent Debt," Journal of Political Economy, University of Chicago Press, vol. 110(6), pages 1220-1254, December.
  10. Burguet, Roberto & Fernandez-Ruiz, Jorge, 1998. "Growth through taxes or borrowing? A model of development traps with public capital," European Journal of Political Economy, Elsevier, vol. 14(2), pages 327-344, May.
  11. Robert J. Barro, 1991. "Government Spending in a Simple Model of Endogenous Growth," NBER Working Papers 2588, National Bureau of Economic Research, Inc.
  12. Kenneth L. Judd, 1997. "The Optimal Tax Rate for Capital Income is Negative," NBER Working Papers 6004, National Bureau of Economic Research, Inc.
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  15. Arrow, Kenneth J & Lind, Robert C, 1970. "Uncertainty and the Evaluation of Public Investment Decisions," American Economic Review, American Economic Association, vol. 60(3), pages 364-78, June.
  16. David Aschauer, 1988. "Is public expenditure productive?," Staff Memoranda 88-7, Federal Reserve Bank of Chicago.
  17. Pennings, Enrico, 2000. "Taxes and stimuli of investment under uncertainty," European Economic Review, Elsevier, vol. 44(2), pages 383-391, February.
  18. Gramlich, Edward M, 1994. "Infrastructure Investment: A Review Essay," Journal of Economic Literature, American Economic Association, vol. 32(3), pages 1176-96, September.
  19. Barrios, Salvador & Bertinelli, Luisito & Strobl, Eric, 2003. "Dry Times in Africa: Rainfall and Africa's Growth Performance," MPRA Paper 5705, University Library of Munich, Germany.
  20. Eberly, Janice C. & Van Mieghem, Jan A., 1997. "Multi-factor Dynamic Investment under Uncertainty," Journal of Economic Theory, Elsevier, vol. 75(2), pages 345-387, August.
  21. Bentolila, Samuel & Bertola, Giuseppe, 1990. "Firing Costs and Labour Demand: How Bad Is Eurosclerosis?," Review of Economic Studies, Wiley Blackwell, vol. 57(3), pages 381-402, July.
  22. Kevin J. Lansing, 1998. "Optimal Fiscal Policy in a Business Cycle Model with Public Capital," Canadian Journal of Economics, Canadian Economics Association, vol. 31(2), pages 337-364, May.
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