## wp18129

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---

### I. Introduction — context and motivation
- 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 (Figure 1).
- Lower public investment could constrain Iran’s growth potential, though an increase in government revenue could be followed by an aggressive scaling up of public investment.
- Two principal hurdles to scaling up public investment:
  - Abrupt scaling up can lead to inefficiencies and lower-quality projects (citations: Pritchett, 2000; Dabla-Norris et al., 2012; Gupta et al., 2014; Qu et al., 2014).
  - Building fiscal buffers is required to preserve investment plans under adverse shocks (for example, unexpected decreases in oil revenue).
- Additional consideration: scaling up public investment may crowd out private investment by shifting financial resources and increasing interest rates.

### Investment scaling-up scenarios analyzed
- “Gradual” scenario:
  - Investment increases by 3 percent of GDP over four years.
  - Then remains stable at its 10-year, pre-sanctions (2002-2011) average of 5.2 percent of GDP.
- “Conservative” scenario:
  - Same total increase in public investment but phased over eight years before reaching the 5.2 percent of GDP long-run level.
- “Aggressive” scenario:
  - In three years, leads to the highest level of public investment in Iran in two decades.
  - Then stabilizes at the long-run level of 5.2 percent of GDP.
- Oil price scenarios:
  - “Baseline”: oil prices are assumed to reach $55 a barrel by 2021.
  - “Adverse”: oil prices never exceed $48 a barrel.
- Additional scenarios:
  - “Efficient” scenario: larger share of nominal investment turns into productive capital (to study structural reforms improving public investment efficiency when oil prices are low).
  - “Oil fund” scenario: government has an oil fund and can deplete it completely to finance investment scaling-up; baseline model assumes government must maintain a minimum of 10 percent of GDP in the oil fund.

### Key quantitative findings and trade-offs
- Viability:
  - Scaling up investment is viable under all modeled scenarios because gross debt remains on a declining path in the long run and accumulating wealth continues.
- Costs of aggressive frontloading (relative to gradual scenario):
  - 0.9 percentage points (pp) of higher growth.
  - 1 pp higher consumption tax rate required (2 pp in the adverse scenario).
  - 4 pp higher accumulation rate of public debt in the short run (10 pp in the adverse scenario).
  - Larger appreciation in the real exchange rate, eroding tradables sector competitiveness.
- When aggressive public investment coincides with persistently low oil prices (adverse scenario):
  - Costs are higher; however, if public investment efficiency doubles, the growth margin from public investment expansion is larger: 2.1 pp vs. 1.0 pp in the adverse scenario.
  - Rising efficiency does not reduce the size of fiscal adjustment required to close the fiscal gap.
- Using the oil fund (full depletion allowed) to finance scaling-up:
  - Increase in the consumption tax rate needed to close the fiscal gap will be less than 0.3 pp (compared to 2 pp in the adverse scenario).
  - Gross debt will increase by only 1 pp (compared to 10 pp in the adverse scenario).
  - However, depletion of the oil fund leads to large appreciation of the real exchange rate, a current account deficit, greater vulnerability to exogenous oil price shocks, and compromised macroeconomic stability in the medium and long run.
  - An oil fund is necessary to smooth government consumption and shield the economy from volatility in global oil prices, especially when access to international debt markets is limited (van der Ploeg, 2011).

### Fiscal policy instruments and modeling choices
- Fiscal instruments considered for financing capital expenditure expansion include:
  - Raising consumption or labor income taxes.
  - Cutting spending.
  - Cutting household transfers.
  - Combination of the above.
  - Borrowing domestically, internationally, or concessional loans (not modeled as debt financing is not considered due to Iran’s limited access to international financial markets).
- For this paper, only the consumption tax is used for fiscal adjustment because differences in impact on key endogenous variables (specifically growth) across financing methods are limited in the model.

### Model pedigree and organization
- The model has been previously applied to:
  - Mozambique (Melina and Xiong, 2013), Kazakhstan (Minasyan and Yang, 2013), Chad (IMF, 2014), and Côte d’Ivoire, Guinea, Liberia, and Sierra Leone (Deléchat et al., 2015).
  - A similar model applied to Mongolia (Li et al., 2017).
- Paper structure:
  - Section II: introduces the model and explains features important for analyzing growth and capital expenditure dynamics in Iran.
  - Section III: discusses calibration issues.
  - Section IV: reports results.
  - Section V concludes the paper.

### Main conclusion (Section V)
- Scaling up public investment in Iran is viable under the baseline and adverse oil price scenarios, but an aggressive frontloading strategy entails considerable costs.

### Broader fiscal implications and risks
- Preserving fiscal sustainability during investment scaling-up is complex:
  - Pressure to increase taxes can neutralize the stimulative impact of fiscal spending on growth.
  - Higher debt can raise interest rates and crowd out the private sector.
  - Frontloaded investment can cause larger appreciation of the real exchange rate and harm tradables.

### Policy recommendations
- Increase non-oil revenue to:
  - Build space for development spending while preserving overall fiscal deficit objectives.
  - 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.
- Strengthen the government investment framework to improve the efficiency of investment spending.
- Adopt a long-term perspective to fiscal policy formulation, particularly through the adoption of a medium-term fiscal framework, to better manage oil price shocks.

*Source: wp18129*

### References ________________________________________________________________22

### References ________________________________________________________________22

### Figures and Tables (inventory)
- Figures:
  - Figure 1. Weak Growth and Low Public Investment
  - Figure 2. Baseline vs. adverse scenario. Y-axis is in percent deviation from the steady-state path unless stated otherwise.
  - Figure 3. Baseline vs. adverse scenario (continued). Y-axis is in percent deviation from the steady-state path unless stated otherwise.
  - Figure 4. Aggressive investment scheme and baseline oil price scenario. Y-axis is in percent deviation from the steady-state path unless stated otherwise.
- Tables:
  - Table 1. Calibration of Key Parameters for Iran

### I. Introduction — context and motivation
- 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 (Figure 1).
- Lower public investment could constrain Iran’s growth potential, though an increase in government revenue could be followed by an aggressive scaling up of public investment.
- Two principal hurdles to scaling up public investment:
  - Abrupt scaling up can lead to inefficiencies and lower-quality projects (citations: Pritchett, 2000; Dabla-Norris et al., 2012; Gupta et al., 2014; Qu et al., 2014).
  - Building fiscal buffers is required to preserve investment plans under adverse shocks (for example, unexpected decreases in oil revenue).
- Additional consideration: scaling up public investment may crowd out private investment by shifting financial resources and increasing interest rates.

### Investment scaling-up scenarios analyzed
- “Gradual” scenario:
  - Investment increases by 3 percent of GDP over four years.
  - Then remains stable at its 10-year, pre-sanctions (2002-2011) average of 5.2 percent of GDP.
- “Conservative” scenario:
  - Same total increase in public investment but phased over eight years before reaching the 5.2 percent of GDP long-run level.
- “Aggressive” scenario:
  - In three years, leads to the highest level of public investment in Iran in two decades.
  - Then stabilizes at the long-run level of 5.2 percent of GDP.
- Oil price scenarios:
  - “Baseline”: oil prices are assumed to reach $55 a barrel by 2021.
  - “Adverse”: oil prices never exceed $48 a barrel.
- Additional scenarios:
  - “Efficient” scenario: larger share of nominal investment turns into productive capital (to study structural reforms improving public investment efficiency when oil prices are low).
  - “Oil fund” scenario: government has an oil fund and can deplete it completely to finance investment scaling-up; baseline model assumes government must maintain a minimum of 10 percent of GDP in the oil fund.

### Key quantitative findings and trade-offs
- Viability:
  - Scaling up investment is viable under all modeled scenarios because gross debt remains on a declining path in the long run and accumulating wealth continues.
- Costs of aggressive frontloading (relative to gradual scenario):
  - 0.9 percentage points (pp) of higher growth.
  - 1 pp higher consumption tax rate required (2 pp in the adverse scenario).
  - 4 pp higher accumulation rate of public debt in the short run (10 pp in the adverse scenario).
  - Larger appreciation in the real exchange rate, eroding tradables sector competitiveness.
- When aggressive public investment coincides with persistently low oil prices (adverse scenario):
  - Costs are higher; however, if public investment efficiency doubles, the growth margin from public investment expansion is larger: 2.1 pp vs. 1.0 pp in the adverse scenario.
  - Rising efficiency does not reduce the size of fiscal adjustment required to close the fiscal gap.
- Using the oil fund (full depletion allowed) to finance scaling-up:
  - Increase in the consumption tax rate needed to close the fiscal gap will be less than 0.3 pp (compared to 2 pp in the adverse scenario).
  - Gross debt will increase by only 1 pp (compared to 10 pp in the adverse scenario).
  - However, depletion of the oil fund leads to large appreciation of the real exchange rate, a current account deficit, greater vulnerability to exogenous oil price shocks, and compromised macroeconomic stability in the medium and long run.
  - An oil fund is necessary to smooth government consumption and shield the economy from volatility in global oil prices, especially when access to international debt markets is limited (van der Ploeg, 2011).

### Fiscal policy instruments and modeling choices
- Fiscal instruments considered for financing capital expenditure expansion include:
  - Raising consumption or labor income taxes.
  - Cutting spending.
  - Cutting household transfers.
  - Combination of the above.
  - Borrowing domestically, internationally, or concessional loans (not modeled as debt financing is not considered due to Iran’s limited access to international financial markets).
- For this paper, only the consumption tax is used for fiscal adjustment because differences in impact on key endogenous variables (specifically growth) across financing methods are limited in the model.

### Model pedigree and organization
- The model has been previously applied to:
  - Mozambique (Melina and Xiong, 2013), Kazakhstan (Minasyan and Yang, 2013), Chad (IMF, 2014), and Côte d’Ivoire, Guinea, Liberia, and Sierra Leone (Deléchat et al., 2015).
  - A similar model applied to Mongolia (Li et al., 2017).
- Paper structure:
  - Section II: introduces the model and explains features important for analyzing growth and capital expenditure dynamics in Iran.
  - Section III: discusses calibration issues.
  - Section IV: reports results.

*Source: wp18129 - References ________________________________________________________________22*

### Section V concludes the paper.

### Section V concludes the paper.

### Main conclusion
- Scaling up public investment in Iran is viable under the baseline and adverse oil price scenarios, but an aggressive frontloading strategy entails considerable costs.

### Quantified trade-offs of an aggressive frontloading (relative to a gradual approach)
- Growth: aggressive frontloading results in 0.9 pp of higher growth (relative to the growth under the gradual scenario).
- Consumption tax: requires a 1 pp higher consumption tax rate than the gradual approach (2 pp higher in the adverse scenario).
- Public debt: leads to a 4 pp higher accumulation rate of public debt in the short run (10 pp in the adverse scenario).
- Competitiveness: causes a larger appreciation in the real exchange rate, eroding the competitiveness of the tradables sector.

### Role of public investment efficiency
- Improved efficiency raises the growth payoff from public investment: 2.1 pp vs. 1.0 pp in the adverse scenario.
- Efficiency improvements do not reduce the size of the fiscal adjustment required to close the fiscal gap.
- Recommendation: strengthen government investment framework and “invest in investment” (building capacity to manage and absorb investment).

### Role of the oil fund
- Full depletion of the oil fund substantially reduces necessary fiscal adjustments:
  - Increase in the consumption tax rate needed to close the fiscal gap would be less than 0.3 pp (compared to 2 pp in the adverse scenario).
  - Gross debt would increase by only 1 pp (compared to 10 pp in the adverse scenario).
- Cost of depletion: compromises macroeconomic stability by making the economy more vulnerable to oil price shocks, worsening current account and real exchange rate outcomes, and contributing to Dutch disease.

### Broader fiscal implications and risks
- Preserving fiscal sustainability during investment scaling-up is complex:
  - Pressure to increase taxes can neutralize the stimulative impact of fiscal spending on growth.
  - Higher debt can raise interest rates and crowd out the private sector.
  - Frontloaded investment can cause larger appreciation of the real exchange rate and harm tradables.

### Policy recommendations
- Increase non-oil revenue to:
  - Build space for development spending while preserving overall fiscal deficit objectives.
  - 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.
- Strengthen the government investment framework to improve the efficiency of investment spending.
- Adopt a long-term perspective to fiscal policy formulation, particularly through the adoption of a medium-term fiscal framework, to better manage oil price shocks.

*Source: wp18129 - Section V concludes the paper.*

### REFERENCES

### wp18129 - REFERENCES

### Resource rents, windfalls, and state stability
- Arezki, R., and M., Bruckner, 2011, “Oil Rents, Corruption, and State Stability: Evidence From Panel Data Regressions,” European Economic Review, Vol. 55, No. 7, pp. 955–63. 
- Arezki, R., Hamilton, K., and K., Kazimov, 2011, “Resource Windfalls, Macroeconomic Stability and Economic Growth,” IMF Working Paper No. 11/142 (Washington: International Monetary Fund). Available via the Internet: www.imf.org/external/pubs/ft/wp/2011/wp11142.pdf
- Arezki, Rabah and Kareem Ismail, (2010), “Fiscal Policy Responses of Oil Producing Countries to the Recent Oil Price Cycle,” IMF Working Paper No.10/28, (International Monetary Fund: Washington).
- Van der Ploeg, Frederick, 2011, “Natural Resources: Curse or Blessing?” Journal of Economic Literature, Vol. 49, No. 2, pp. 366–420.
- ——— and Anthony J. Venables, 2011, “Harnessing Windfall Revenues: Optimal Policies for Resource-Rich Developing Economies,” The Economic Journal, Vol. 121, pp. 1–30.
- Sachs, J., and A., Warner, 1999, “The Big Push, Natural Resource Booms and Growth,” Journal of Development Economics, Vol. 59, pp. 43–76.

### Public investment, growth, debt sustainability, and infrastructure
- Berg, A., Portillo, R., Yang, S., and L.-F. Zanna, 2013, “Public Investment in Resource Abundant Developing Countries” IMF Economic Review. Vol. 61, No. 1, pp. 92-129.  
- Buffie, E.F., Berg, A., Pattillo, C., Portillo, R., Zanna, L.F., 2012, “Public investment, growth, and debt sustainability: putting together the pieces,” IMF Working Paper 12/144. International Monetary Fund, Washington, D.C. 
- Dabla-Norris, E., Brumby, J., Kyobe, A., Mills, Z., and C., Papageorgiou, 2012, “Investing in Public Investment: An Index of Public Investment Efficiency” Journal of Economic Growth, Vol. 17(3), pp. 235–66.
- Esfahani, H.S., Ramirez, M.T., 2003, “Institutions, infrastructure, and economic growth.” Journal of Development Economics,” Vol 70, pp. 443–477.
- Melina, G., S. S. Yang, and L. Zanna. 2016. “Debt Sustainability, Public Investment, and Natural Resources in Developing Countries: the DIGNAR Model,” Economic Modelling, Volume 52, Part B, Pages 630-649.  
- Melina, G., and Y. Xiong, 2013, “Natural Gas, Public Investment and Debt Sustainability in Mozambique,” IMF Working Paper No. 13/261.
- Qu, Haonan, Martin Sommer, and SeokHyun Yoon, 2014, “Public Infrastructure Investment in the MENAP and CCA Regions,” Middle East and Central Asia: Regional Economic Outlook (Washington: International Monetary Fund, April).

### Fiscal frameworks, rules, and policy responses
- Baunsgaard, T., M., Villafuerte, M., Poplawski-Ribeiro, and C. Richmond, 2012, “Fiscal Frameworks for Resource Rich Developing Countries,” IMF Staff Discussion Note SDN/12/04. Available via the Internet: http://www.imf.org/external/pubs/ft/sdn/2012/sdn1204.pdf  
- Gupta, S., Segura-Ubiergo, A., and E., Flores, 2014, “Direct Distribution of Resource Revenues: Worth Considering?” IMF Staff Discussion Note SDN14/05 (Washington: International Monetary Fund). Available via the Internet: http://www.imf.org/external/pubs/ft/sdn/2014/sdn1405.pdf  
- Ilzetzki, Ethan and Carlos Vegh, (2008), “Procyclical Fiscal Policies in Developing Countries: Truth of Fiction?”, NBER Working Paper 14,191, (National Bureau of Economic Research: Cambridge, Massachusetts).
- IMF, 2005, Fiscal Responsibility Laws (Washington: International Monetary Fund).
- IMF, 2009, Fiscal Rules—Anchoring Expectations for Sustainable Public Finances (Washington: International Monetary Fund). Available via the Internet: www.imf.org/external/np/pp/eng/2009/121609.pdf
- IMF, 2010, Strategies for Fiscal Consolidation in the Post-Crisis World (Washington: International Monetary Fund). Available via the Internet: www.imf.org/external/np/pp/eng/2010/020410a.pdf
- Villafuerte, M. and P. Lopez-Murphy, (2010), “Fiscal Policy Responses of Oil Producing Countries to the Recent Oil Price Cycle”, IMF Working Paper No.10/28, (International Monetary Fund: Washington).

### Country and regional case studies, applications, and fragility
- Deléchat, C., S. Yang, W. Clark, P. Gupta, M. Kabedi-Mbuyi, M. Koulet-Vickot, C. Macario, T. Orav, M. Rosales, R. Tapsoba and D. Zhdankin, 2015, “Harnessing Resource Wealth for Inclusive Growth in Fragile States,” IMF Working Paper No. 15/25.
- Minasyan, G. and Yang, S.C. S., 2013, “Leveraging Oil Wealth for Development in Kazakhstan: Opportunities and Challenges,” Selected Issues, IMF Country Report No. 13/291, International Monetary Fund, Washington, D.C.
- IMF, 2014, “Chad—2013 Article IV Consultation and Assessment of Performance under the Staff-Monitored Program—Staff Report” (Washington: International Monetary Fund).
- Bin Grace Li, Pranav Gupta, Jiangyan Yu, From natural resource boom to sustainable economic growth: Lessons from Mongolia, In International Economics, Volume 151, 2017, Pages 7-25, ISSN 2110-7017, https://doi.org/10.1016/j.inteco.2017.03.001.

### Monetary policy, multipliers, and model closure
- Belinga, Vincent and Constant Lonkeng Ngouana, 2015, “(Not) Dancing Together: Monetary Policy Stance and the Government Spending Multiplier,” IMF Working Paper 15/114. International Monetary Fund, Washington, D.C.
- Ilzetzki, Ethan and Carlos Vegh, (2008), “Procyclical Fiscal Policies in Developing Countries: Truth of Fiction?”, NBER Working Paper 14,191, (National Bureau of Economic Research: Cambridge, Massachusetts).
- Schmitt-Grohe, S. and M. Uribe, 2003, “Closing Small Open Economy Models,” Journal of International Economics, vol. 61(1), pp. 163-185.
- Pritchett, L., 2000, “The Tyranny of Concepts: CUDIE (Cumulated, Depreciated, Investment Effort) Is Not Capital” Journal of Economic Growth, Vol (5): pp. 361–84. Available via the Internet: http://piketty.pse.ens.fr/files/Pritchett00.pdf   

*Source: wp18129 - REFERENCES*

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_Source: https://www.imf.org/-/media/files/publications/wp/2018/wp18129.pdf_