The macroeconomic effects of closing the public sector capital gap in Malta

Pressures on Malta’s public infrastructure have increased significantly in recent years. Indeed, public capital stock-to-GDP ratio is estimated to stand below that in the EU. This note studies the impact of government investment using a New Keynesian general equilibrium model. Such models are especially useful in capturing both direct and indirect effects of government investment under different financing alternatives. Results indicate that in the short-to-medium run, debt-financed investment shocks are consistent with the highest effects on output. Financing public investment using taxes on returns to factors of production is consistent with the largest output loss. On the other hand, financing through consumption tax increases or cuts in government recurrent expenditure is the least distortionary. Results indicate that a sustained increase in government investment that bridges Malta’s public sector capital gap with the rest of the EU could increase long run output by between 6% and 11%. Results depend significantly on the financing option utilised to stabilise public debt-toGDP, with the smallest output gains achieved under a strategy that seeks to fund outlays by increasing the tax rate on the return to capital or labour. Financing through EU structural or sovereign wealth funds can significantly minimise tax-induced output losses.