Optimal Public Investment in Resource-Rich Low-Income Countries

Abstract

Recent studies have found that resource-rich low-income countries are better off investing their resource revenues domestically rather than saving them abroad in a sovereign wealth fund (SWF). This paper finds an optimal rule-based policy of accumulating public capital and its associated public investment path in a perfect foresight general equilibrium model. The model has several specific features different from the existing frameworks: the policy rule for public capital is introduced. Public investment is inefficient and has its absorptive capacity constraint costs. External savings clear the government budget. There is a variable share of resource revenues to accumulate the SWF, and the natural resource sector is assumed to be capital-intensive with its foreign direct investment shock. Based on calibration for African countries, the study finds that the front-loaded public investment path is optimal given an initial one-period resource windfall, public investment inefficiency and absorptive capacity constraints in the economies. This result also holds under less productive public capital and more patient households, while a scenario of no resource windfall produces the welfare loss due to a steady increase in consumption tax to finance public investment.