## _wp1639

## Source details

**Canonical URL:** [_wp1639](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2016/_wp1639.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2016/_wp1639.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2016/_wp1639.pdf.json)

---

### Introduction
- At 21.8 percent of GDP in 2014, the investment rate in the Philippines is well below regional peers.
- The government plans to increase infrastructure spending from 3 percent of GDP in 2014 to 5 percent by 2016, and to facilitate Public Private Partnership (PPP) projects.
- The paper analyzes macroeconomic implications of improving public infrastructure via an increase in public investment expenditure, considering:
  - Two financing modalities for a permanent increase in public investment of 2 percent of GDP: borrowing (deficit-financing) and higher taxes (tax-financing).
  - Sub-scenarios with and without improvements in public investment efficiency (baseline inefficiency 40 percent; a scenario assumes half of the inefficiency is eliminated in five years).

Key simulation results (GIMF model):
- Improving public infrastructure leads to sustained output increases because of productivity gains that crowd in private investment.
- Real GDP is higher than the steady state by 4.5‒6 percent after 15 years even without an improvement in public investment efficiency.
- Assuming half of the inefficiency is eliminated in five years, the increase in real GDP after 15 years is 9‒11 percent.
- Financing dynamics:
  - Deficit-financing leads to a substantial increase in the public debt-to-GDP ratio; higher borrowing costs constrain investment over time.
  - Tax-financing results in a slight decrease in the public debt-to-GDP ratio; consumption is initially subdued because the increase in the consumption tax lowers households’ disposable income.
  - Output gains are initially higher under deficit-financing but become higher under tax-financing over time due to rising government borrowing costs in the deficit-financed scenarios.
- External and price effects:
  - Public infrastructure improvement worsens the external current account (facilitating external rebalancing).
  - It generates additional domestic demand initially, creating inflationary pressures that subside over time as supply capacity increases.
- Policy guidance highlighted:
  - Given large spending needs and the need to ensure debt sustainability, continued efforts to mobilize revenue are critical.
  - Preferably pursue comprehensive tax reform focusing on broadening the tax base and enact measures to offset revenue-eroding policy changes.

### Literature Review
- Situates the analysis within dynamic general equilibrium (DGE) studies examining public investment scale-ups; extends prior work by allowing dynamic changes in public investment efficiency and interactions with scale-up.
- Builds on IMF (2014) modeling of public investment efficiency.
- Notes extensive but inconclusive empirical literature on public investment and growth due to data, measurement, and reverse-causation issues.
- Historical documentation of weak public infrastructure and low public investment in the Philippines referenced.

### The State of Public Infrastructure in the Philippines
A. Level of Public Capital
- Public investment averaged 2.5 percent of GDP in 2000‒14.
- The public capital stock in the Philippines is around 35 percent of GDP in 2013 compared to the ASEAN average of 72 percent of GDP.

B. Quality of Infrastructure
- World Economic Forum survey-based indicators place the Philippines among the lowest in ASEAN on overall infrastructure and all subcomponents (scale 1–7).

C. Public Investment Efficiency
- Governance and fiscal transparency have improved: World Bank World Governance Indicators ranking improved every year since 2010.
- IMF (2015b) assessed Philippines’ PFM practices and acknowledged reform efforts with broadly favorable conclusions.
- PIMA assessment (15 institutions across planning, allocation, and implementation stages) finds:
  - Stronger institutions in planning and implementation.
  - Weaker institutions in allocation (relative to the average of emerging and developing Asian countries).
  - Relative strengths: national planning, PPP management, project selection.
  - Relative weaknesses: fiscal rules, multiyear budgeting, budget unity.
- IMF technical assistance (2014) priorities for strengthening PIM include:
  - Critical review of development project stock to eliminate duplication and low-priority projects.
  - Anchor planning within a medium term resource framework and improve coordination.
  - Strengthen gate-keeping by budget agencies and departments’ appraisal, prioritization, and multiyear budgeting.
  - The new PFM bill (if passed) would institutionalize reforms and clarify PFM framework elements.
- Outcome-based efficiency metric (PIE-X) findings:
  - The inefficiency gap is 27 percent for EMEs on average.
  - The Philippines’ efficiency gap is substantially larger than the EMEs average.
- Recent implementation measures in 2015 to improve disbursements include: releasing funds early in the year, administrative procurement clearances, and strengthening procurement units, which appear to have improved government disbursements for infrastructure spending.

### GIMF Simulations

#### Model and Calibration
- Model: IMF’s Global Integrated Monetary and Fiscal (GIMF) model (multi-region DGE model with optimizing firms and households, sticky prices and wages, real adjustment costs, a financial accelerator, inflation-forecast-targeting monetary policy, and fiscal policy ensuring debt sustainability).
- Regions: three-region version—Philippines, rest of Asia, rest of the world; focus on the Philippines.
- Calibration targets:
  - Long-run overall fiscal deficit to GDP ratio set to about 2 percent of GDP.
  - Long-run debt-to-GDP ratio set to 45 percent.
- Departures from standard specification:
  - Not all public investment spending contributes to formation of public capital; part of budgeted public investment is reclassified as public consumption (unproductive). The size of reclassification depends on inefficiency.
  - Baseline inefficiency is set as 40 percent; steady state government investment is assumed to be 2 percent of GDP reflecting this assumption.
- Public capital dynamics (notation preserved):
  - Government investment spending augments publicly provided infrastructure capital per capita 1GtK, after rescaling by growth in technology (g) and population (n).
  - 1GtK contributes to production of the private-public composite good DtZ by the specification 1 1() G D A G t t t Y KSZ α =, where AtY is the private final good and S is a technology scaling factor.
- Simulation scenarios:
  - Permanent increase in public investment by 2 percent of GDP financed by borrowing (deficit-financing).
  - Same increase financed by higher taxes (tax-financing).
  - Each scenario with and without improvements in public investment efficiency (baseline inefficiency 40 percent; half of the inefficiency eliminated in five years in the efficiency-improvement case).

#### Assumptions and sovereign risk premium specification
- Premium in the government’s borrowing cost is increasing in the debt-to-GDP ratio, specified following Schule (2010) as:
  - premium_t = β1 + β2 log(B_t / GDP) + β3 (log(1 + B_t / GDP) - lim)
- It is assumed that the premium increases by 3 basis points per increase in the debt-to-GDP ratio in the baseline calibration.
- Changes in the government borrowing cost are translated to the borrowing cost of the private sector in the GIMF model.
- Public investment inefficiency is assumed to be 40 percent in the status-quo case; half of the inefficiency is eliminated gradually over five years in the efficiency-improvement case.
- Two financing regimes modeled:
  - Deficit-financed: a permanent increase in public investment by 2 percent of GDP, financed by borrowing (implies a 2 percent of GDP increase in overall fiscal deficit). The deficit-financed public investment scale up is limited to the first 25 years to ensure all scenarios converge to the same long-run debt-to-GDP ratio.
  - Tax-financed: the same increase in public investment financed by higher consumption taxes (consumption taxes chosen over labor and capital taxes in the baseline).

#### Model features and transmission channels
- Public capital enters the aggregate production function, raising overall productivity and acting akin to an increase in total factor productivity for the private sector.
- Higher public capital increases marginal productivity of capital and labor, crowding in private investment and raising labor demand and household income.
- Increases in the government’s borrowing cost due to a higher risk premium lead to a parallel increase in all domestic interest rates; monetary policy also affects domestic interest rates.
- Additional public infrastructure demand generates inflationary pressures and a positive output gap, inducing higher policy interest rates, which are gradually reversed as supply capacity increases.

#### Baseline results
- Output and growth:
  - Even without improvement in public investment efficiency, the increase in public investment results in a 4.5‒6 percent cumulative increase in real GDP relative to the steady state after 15 years.
  - Improving public investment efficiency to about 80 percent efficiency increases output by 5 percent after 15 years compared with unchanged efficiency scenarios (both tax-financed and deficit-financed).
  - Efficiency arithmetic preserved from source:
    - With 40 percent assumed inefficiency, a 5 percent of GDP public investment results in about 3 percent of GDP contribution to public infrastructure.
    - When inefficiency is improved to 20 percent inefficiency, the same 5 percent of GDP public investment results in over 4 percent of GDP contribution to public infrastructure and a cumulative increase in GDP of 9‒11 percent after 15 years.
- Financing regime comparison:
  - Deficit-financed scenarios show initially higher output gains but over time the tax-financed scenarios deliver larger gains because the deficit-financed scenario experiences a continuous increase in the debt-to-GDP ratio which raises domestic interest rates and negatively affects private investment and consumption.
  - Long-term real interest rates increase on impact for both scenarios, with a larger increase for deficit-financed scenarios due to stronger demand effects and anticipation of a future increase in the risk premium.
- External sector and inflation:
  - The current account exhibits a sustained deterioration, mostly because of higher imports.
  - Exports decline initially due to initial real appreciation associated with policy interest rate increases; exports subsequently increase as investment stimulates production and the initial real appreciation is reversed.
  - The size of the current account deficit increase is roughly proportional to the output increase and reaches 0.7–1.5 percent of GDP after two years.

#### Sensitivity analysis
- Alternative borrowing cost premia:
  - Baseline premium: 3 basis points per unit increase in the debt-to-GDP ratio.
  - Higher premium calibration: 5 basis points per unit increase in the debt-to-GDP ratio (draws on Peiris (2015), which finds 5‒6 basis points).
  - Lower premium calibration: 1 basis point response per unit increase in the debt-to-GDP ratio.
  - Simulation outcome: the higher the borrowing cost increase, the more subdued the effect of public investment scale up on output. Even under the lower premium calibration, real output increase slightly undershoots the tax-financed scenario after 15 years.
- Alternative tax incidence:
  - Baseline revenue mobilization relies solely on consumption tax, implying an increase in the tax rate of around 3 percent.
  - Alternative scenario: revenue mobilization equally distributed to CIT, PIT, and consumption tax.
  - Results: the alternative tax mix causes less negative effect on consumption initially and more negative effect on investment; output growth is lower in this alternative scenario than the baseline.
  - Rationale: indirect taxes are generally superior for growth in the GIMF model because capital and labor taxation are more distortionary for investment and labor supply.
  - Policy note: rationalization of tax incentives could raise revenue without raising statutory rates and mitigate negative effects on private investment (tax exemptions are outside the model in this paper).

### Key policy implications and conclusions
- The Philippines’ public infrastructure is below neighboring countries; persistently low public investment has resulted in a low public capital stock and unfavorable survey-based indicators of infrastructure quality.
- Public investment efficiency has substantial room for improvement; strengthening institutions and governance can raise efficiency.
- Increasing public investment spending can generate sustained output growth; improving public investment efficiency yields substantial additional benefits.
- Deficit-financing and tax-financing produce different macroeconomic dynamics, particularly via their effects on risk premia, domestic interest rates, private investment, and consumption.
- Given large spending needs in other priority areas and the need to ensure debt sustainability, continued efforts to mobilize revenue are critical, preferably through comprehensive tax reform that focuses on broadening the tax base and enacting measures to offset revenue-erosive policy changes.

*Source: _wp1639 - References .............................................................................................................*

### References .............................................................................................................

### _wp1639 - References .............................................................................................................

### Introduction
- At 21.8 percent of GDP in 2014, the investment rate in the Philippines is well below regional peers.
- The government plans to increase infrastructure spending from 3 percent of GDP in 2014 to 5 percent by 2016, and to facilitate Public Private Partnership (PPP) projects.
- The paper analyzes macroeconomic implications of improving public infrastructure via an increase in public investment expenditure, considering:
  - Two financing modalities for a permanent increase in public investment of 2 percent of GDP: borrowing (deficit-financing) and higher taxes (tax-financing).
  - Sub-scenarios with and without improvements in public investment efficiency.

Key simulation results (GIMF model):
- Improving public infrastructure leads to sustained output increases because of productivity gains that crowd in private investment.
- Real GDP is higher than the steady state by 4.5‒6 percent after 15 years even without an improvement in public investment efficiency.
- Assuming half of the inefficiency is eliminated in five years, the increase in real GDP after 15 years is 9‒11 percent.
- Financing dynamics:
  - Deficit-financing leads to a substantial increase in the public debt-to-GDP ratio; higher borrowing costs constrain investment over time.
  - Tax-financing results in a slight decrease in the public debt-to-GDP ratio; consumption is initially subdued because the increase in the consumption tax lowers households’ disposable income.
  - Output gains are initially higher under deficit-financing but become higher under tax-financing over time due to rising government borrowing costs in the deficit-financed scenarios.
- External and price effects:
  - Public infrastructure improvement worsens the external current account (facilitating external rebalancing).
  - It generates additional domestic demand initially, creating inflationary pressures that subside over time as supply capacity increases.

Policy guidance highlighted:
- Given large spending needs and the need to ensure debt sustainability, continued efforts to mobilize revenue are critical.
- Preferably pursue comprehensive tax reform focusing on broadening the tax base and enact measures to offset revenue-eroding policy changes.

### Literature Review
- The paper situates itself within dynamic general equilibrium (DGE) studies examining public investment scale-ups, extending prior work by allowing dynamic changes in public investment efficiency and interactions with scale-up.
- IMF (2014) is noted as an initial effort to model public investment efficiency; this paper builds on that approach.
- Empirical literature on public investment and growth is extensive but inconclusive due to data, measurement, and reverse-causation issues.
- Historical literature documents weak public infrastructure and low public investment in the Philippines through works such as Montes (1986), Dohner and Intal (1989), Rodlauer and others (2000), Bocchi (2008), and Warner (2014).

### The State of Public Infrastructure in the Philippines
A. Level of Public Capital
- Public investment averaged 2.5 percent of GDP in 2000‒14.
- The public capital stock in the Philippines is around 35 percent of GDP in 2013 compared to the ASEAN average of 72 percent of GDP.

B. Quality of Infrastructure
- World Economic Forum survey-based indicators place the Philippines among the lowest in ASEAN on overall infrastructure and all subcomponents (scale 1–7).

C. Public Investment Efficiency
- Governance and fiscal transparency have improved: World Bank World Governance Indicators ranking improved every year since 2010.
- IMF (2015b) assessed Philippines’ PFM practices and acknowledged reform efforts with broadly favorable conclusions.
- PIMA assessment (15 institutions across planning, allocation, and implementation stages) finds:
  - Stronger institutions in planning and implementation.
  - Weaker institutions in allocation (relative to the average of emerging and developing Asian countries).
  - Relative strengths: national planning, PPP management, project selection.
  - Relative weaknesses: fiscal rules, multiyear budgeting, budget unity.
- IMF technical assistance (2014) priorities for strengthening PIM include:
  - Critical review of development project stock to eliminate duplication and low-priority projects.
  - Anchor planning within a medium term resource framework and improve coordination.
  - Strengthen gate-keeping by budget agencies and departments’ appraisal, prioritization, and multiyear budgeting.
  - The new PFM bill (if passed) would institutionalize reforms and clarify PFM framework elements.
- Outcome-based efficiency metric (PIE-X) findings:
  - The inefficiency gap is 27 percent for EMEs on average.
  - The Philippines’ efficiency gap is substantially larger than the EMEs average.
- Recent implementation measures in 2015 to improve disbursements include: releasing funds early in the year, administrative procurement clearances, and strengthening procurement units, which appear to have improved government disbursements for infrastructure spending.

### GIMF Simulations
A. Model and Calibration
- The model used: IMF’s Global Integrated Monetary and Fiscal (GIMF) model (multi-region DGE model with optimizing firms and households, sticky prices and wages, real adjustment costs, a financial accelerator, inflation-forecast-targeting monetary policy, and fiscal policy ensuring debt sustainability).
- The version applied has three regions: the Philippines, rest of Asia, and rest of the world; the paper focuses exclusively on the Philippines.
- Calibration targets:
  - Long-run overall fiscal deficit to GDP ratio set to about 2 percent of GDP (reflecting the current administration’s commitment).
  - Long-run debt-to-GDP ratio set to 45 percent.
- Model departures from standard specification:
  - Not all public investment spending contributes to the formation of public capital; part of budgeted public investment is reclassified as public consumption (unproductive). The size of reclassification depends on inefficiency.
  - Baseline inefficiency is set as 40 percent; steady state government investment is assumed to be 2 percent of GDP reflecting this assumption.
- Public capital dynamics (notation preserved from source):
  - Government investment spending augments publicly provided infrastructure capital per capita 1GtK, after rescaling by growth in technology (g) and population (n).
  - 1GtK contributes to production of the private-public composite good DtZ by the specification 1 1() G D A G t t t Y KSZ α =, where AtY is the private final good and S is a technology scaling factor.
- Simulation scenarios summarized:
  - Permanent increase in public investment by 2 percent of GDP financed by borrowing (deficit-financing).
  - The same increase financed by higher taxes (tax-financing).
  - Each scenario with and without improvements in public investment efficiency (baseline inefficiency 40 percent; a scenario assumes half of the inefficiency is eliminated in five years).

Sensitivity analysis highlights:
- In deficit-financing scenarios, larger sovereign risk premia reduce the size of the increase in output, private investment and consumption, and inflation, and lead to a smaller decrease in the current account.
- In tax-financing scenarios, distributing revenue mobilization equally to corporate income tax (CIT), personal income tax (PIT), and consumption tax results in:
  - Smaller negative effect on consumption initially,
  - Larger negative effect on investment,
  - Lower output relative to the baseline scenario of exclusively consumption tax financing.
- Rationalization of tax incentives could mobilize revenue while mitigating negative effects on growth.

Final simulation implications:
- With low capital stock and a fast-growing young population, scaling up public investment can raise potential growth and reduce poverty and external imbalances.
- Improving public investment efficiency yields substantial additional benefits on top of pure scale-up.
- Fiscal financing choices (deficit vs tax) produce different macroeconomic dynamics; debt sustainability and revenue mobilization are critical considerations.

*Source: _wp1639 - References .............................................................................................................*

### 3.3 percent of GDP on average since 2011 at the general government level.

### _wp1639 - 3.3 percent of GDP on average since 2011 at the general government level.

### Assumptions and sovereign risk premium specification
- Premium in the government’s borrowing cost is increasing in the debt-to-GDP ratio, specified following Schule (2010) as:
  - premium_t = β1 + β2 log(B_t / GDP) + β3 (log(1 + B_t / GDP) - lim)
  - It is assumed that the premium increases by 3 basis points per increase in the debt-to-GDP ratio in the baseline calibration.
- The changes in the government borrowing cost are translated to the borrowing cost of the private sector in the GIMF model.
- Public investment inefficiency is assumed to be 40 percent in the status-quo case; half of the inefficiency is eliminated gradually over five years in the efficiency-improvement case.
- Two financing regimes are modeled:
  - Deficit-financed: a permanent increase in public investment by 2 percent of GDP, financed by borrowing (implies a 2 percent of GDP increase in overall fiscal deficit).
    - The deficit-financed public investment scale up is limited to the first 25 years to ensure all scenarios converge to the same long-run debt-to-GDP ratio.
  - Tax-financed: the same increase in public investment financed by higher consumption taxes (consumption taxes chosen over labor and capital taxes in the baseline).

### Model features and channels
- Public capital enters the aggregate production function, raising overall productivity and acting akin to an increase in total factor productivity for the private sector.
- Higher public capital increases marginal productivity of capital and labor, crowding in private investment and raising labor demand and household income.
- In the GIMF model, an increase in the government’s borrowing cost due to a higher risk premium leads to a parallel increase in all domestic interest rates; monetary policy also affects domestic interest rates.
- Additional public infrastructure demand generates inflationary pressures and a positive output gap, inducing higher policy interest rates, which are gradually reversed as supply capacity increases.

### Baseline results
- Output and growth:
  - Even without improvement in public investment efficiency, the increase in public investment results in a 4.5‒6 percent cumulative increase in real GDP relative to the steady state after 15 years.
  - Improving public investment efficiency to about 80 percent efficiency increases output by 5 percent after 15 years compared with unchanged efficiency scenarios (both tax-financed and deficit-financed).
  - Example efficiency arithmetic preserved from text:
    - With 40 percent assumed inefficiency, a 5 percent of GDP public investment results in about 3 percent of GDP contribution to public infrastructure.
    - When inefficiency is improved to 20 percent inefficiency, the same 5 percent of GDP public investment results in over 4 percent of GDP contribution to public infrastructure and a cumulative increase in GDP of 9‒11 percent after 15 years.
- Financing regime comparison:
  - Deficit-financed scenarios show initially higher output gains but over time the tax-financed scenarios deliver larger gains because the deficit-financed scenario experiences a continuous increase in the debt-to-GDP ratio which raises domestic interest rates and negatively affects private investment and consumption.
  - Long-term real interest rates increase on impact for both scenarios, with a larger increase for deficit-financed scenarios due to stronger demand effects and anticipation of a future increase in the risk premium.
- External sector and inflation:
  - The current account exhibits a sustained deterioration, mostly because of higher imports.
  - Exports decline initially due to initial real appreciation associated with policy interest rate increases; exports subsequently increase as investment stimulates production and the initial real appreciation is reversed.
  - The size of the current account deficit increase is roughly proportional to the output increase and reaches 0.7–1.5 percent of GDP after two years.

### Sensitivity analysis
- Alternative borrowing cost premia:
  - Baseline premium: 3 basis points per unit increase in the debt-to-GDP ratio.
  - Higher premium calibration: 5 basis points per unit increase in the debt-to-GDP ratio (draws on Peiris (2015), which finds 5‒6 basis points).
  - Lower premium calibration: 1 basis point response per unit increase in the debt-to-GDP ratio.
  - Simulation outcome: the higher the borrowing cost increase, the more subdued the effect of public investment scale up on output. Even under the lower premium calibration, real output increase slightly undershoots the tax-financed scenario after 15 years.
- Alternative tax incidence:
  - Baseline revenue mobilization relies solely on consumption tax, implying an increase in the tax rate of around 3 percent.
  - Alternative scenario: revenue mobilization equally distributed to CIT, PIT, and consumption tax.
  - Results: the alternative tax mix causes less negative effect on consumption initially and more negative effect on investment; output growth is lower in this alternative scenario than the baseline.
  - Rationale: indirect taxes are generally superior for growth in the GIMF model because capital and labor taxation are more distortionary for investment and labor supply.
  - Policy note: rationalization of tax incentives could raise revenue without raising statutory rates and mitigate negative effects on private investment (tax exemptions are outside the model in this paper).

### Key policy implications and conclusions
- Philippines’ public infrastructure is below neighboring countries; persistently low public investment has resulted in a low public capital stock and unfavorable survey-based indicators of infrastructure quality.
- Public investment efficiency has substantial room for improvement; strengthening institutions and governance can raise efficiency.
- Increasing public investment spending can generate sustained output growth; improving public investment efficiency yields substantial additional benefits.
- Deficit-financing and tax-financing produce different macroeconomic dynamics, particularly via their effects on risk premia, domestic interest rates, private investment, and consumption.
- Given large spending needs in other priority areas and the need to ensure debt sustainability, continued efforts to mobilize revenue are critical, preferably through comprehensive tax reform that focuses on broadening the tax base and enacting measures to offset revenue-erosive policy changes.

*Source: IMF working paper content (provided content unit)._wp1639 - 3.3 percent of GDP on average since 2011 at the general government level.*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2016/_wp1639.pdf_