Social Design Engineering Series

SDES-2020-16

Public Investment and Labor Market Flexibility

Chun-Hung Kuo
National Tsing Hua University

Hiroaki Miyamoto
Tokyo Metropolitan UniversityKochi University of Technology

28th December, 2020

School of Economics and Management
Research Institute for Future DesignKochi University of Technology
KUT-SDE working papers are preliminary research documents published by the School of Economics and Management jointly with the ResearchCenter for Social Design Engineering at Kochi University of Technology. To facilitate prompt distribution, they have not been formally reviewedand edited. They are circulated in order to stimulate discussion and critical comment and may be revised. The views and interpretations expressedin these papers are those of the author(s). It is expected that most working papers will be published in some other form.

Public Investment and Labor Market Flexibility
Chun-Hung Kuo

Hiroaki Miyamoto

National Tsing Hua University

Tokyo Metropolitan Universityand
Kochi University of TechnologyAbstract
This paper examines how labor market flexibility affects the output effect of a public investment shock by using a panel data of OECD countries. We identify the public investment shock
as a forecast error of public investment spending and employ the local projection method toestimate its effect on output. Our empirical analysis shows that labor market flexibility affects
the output effect of the public investment shock. While a positive public investment shock
boosts output significantly in economies with flexible labor markets, output responses are notstatistically significant in economies with rigid labor markets.
Keywords: Public investment, fiscal multipliers, labor market flexibility
JEL Classification

Hiroaki Miyamoto (Corresponding author). E-mail: hmiyamoto@tmu.ac.jp. Mailing address: Tokyo Metropolitan
University, 1-1 Minami-Osawa, Hachioji-shi, Tokyo, Japan 192-0397.

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1Introduction

The global economy has been hit hard by the coronavirus pandemic. Governments around theglobe are taking extraordinary measures to respond to the current crisis. Under such circumstances, the role of public investment to recover the economies is drawing attention.1 But, howeffective is public investment? While the size and determinants of government consumption multipliers have been studied2 , those of public investment multipliers have not been fully explored.
The purpose of this paper is to fill this gap by examining how labor market flexibility affects
the effect of public investment to boost an economy. Public investment could create jobs which inturn raises the growth of average living standards. However, job creation depends on the labormarket structure. In a labor market with strict employment protection and regulations, it may
not be profitable for firms to create jobs in response to fiscal stimulus. Thus, the labor market
flexibility could play an important role in determining public investment effects.
This paper estimates the output effects of public investment shocks and examines how labormarket flexibility affects them by using a panel data of OECD countries. The public investment
shock is identified as a forecast error of public investment, as in Auerbach and Gorodnichenko(2012, 2013), and its output effects are estimated by using the local projection method of Jordà(2005).
Labor markets flexibility matters. We find that while in economies with flexible labor markets,
public investment boosts output, the output response to a positive public investment shock arenot statistically significant in economies with rigid labor markets.
Our paper is related to the recent literature of public investment multipliers. Abiad et al.
(2016) find a short- and long-term positive and significant effect of public investment on output
for advanced economies. They also find that output effects of public investment depend on thestate of business cycles and investment efficiency. For developing countries, Furceri and Li (2017)find a positive effect of public investment on output in the short and medium terms. Izquierdo
et al. (2019) also estimate public investment multipliers in developing countries and find that theinitial level of public capital stock affects public investment multipliers. None of them explore
how labor market flexibility affects public investment multipliers.
This paper is most related to Cacciatore et al. (2020). They study both theoretically and empirically how labor market regulations affect fiscal multipliers and find that job protection legislation
has a significant impact on fiscal multipliers. While their study focuses on government spending
1 IMF (2020) argues that increasing public investment could help revive economic activity from the sharpest anddeepest global economic collapse in contemporary history. Low interest rates also support governments to invest inold and new projects as well as infrastructures.
2 IMF (2014) and Ramey (2016) provide broad surveys of the literature estimating fiscal multipliers.

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multipliers, our paper examine how labor market flexibility affects public investment multipliers.
Thus, our paper could be considered as their complement.

2

Methodology and Data

We identify public investment shocks as forecast errors of public investment as in Auerbach andGorodnichenko (2012, 2013) and Abiad et al. (2016).3 Thus,Shock i,t = PIi,tE
PIi,t,

where PIi,t is the actual public investment spending as a share of GDP of country i in year t, andE is the forecast of the public investment spending. Forecasts are taken from the fall issue ofPIi,t

the Economic Outlook issued by the OECD.
The identified public investment shocks are used to examine the output effect of public investment with the local projection method of Jordà (2005). We first estimate the average impactof public investment shocks on output. We then examine how labor market flexibility affects theoutput effect of public investment shocks by allowing the output response to vary with a degreeof labor market flexibility.
The first regression specification is:
Yi,t+hhYi,t 1 = βh Shock i,t + θ h Xi,t + αih + γth + εi,t,(1)where Yi,t is log of the real GDP, α is the country fixed effect, γ is the time fixed effect, Shock is
the identified public investment shock, and X is a set of control variables. We estimate equation(1) for eachh = 0, . . . , 3, where h = 0 is the year when the public investment shock take place.
We compute the impulse response functions of variables of interest with the estimated βh . The
confidence intervals associated with the impulse response functions are obtained by the estimated(clustered robust) standard errors of the coefficient βh .
The second specification allows the response of output to vary with the degree of labor market flexibility. As discussed in Auerbach and Gorodnichenko (2013), the local projection method
can easily adapt nonlinearity and thus estimate a state dependent model. The second regression
model isYi,t+hYi,t 1 = βhR G (zi,t )Shock i,t + βhF (1hG (zi,t )) Shock i,t + θ h Xi,t + αih + γth + εi,t,(2)3 This identification method overcomes two challenges often associated with the estimation of fiscal multipliers,

namely the "fiscal foresight" problem (Leeper et al., 2012; Leeper et al., 2013) and the potential feedback from the stateof the economy to fiscal policy.

3withG ( ai,t ) =exp( δzi,t ), δ > 0,1 + exp( δzi,t )where z is an indicator of the business cycle normalized to have zero mean and unit variance, andG ( ) is the corresponding smooth transition function. As in Abiad et al. (2016) and Miyamoto etal. (2020), we set δ = 1. For the indicator z, we use the hiring and firing practices indicator fromthe World Economic Forum (WEF)’s Global Competitiveness Report. The indicator takes values
between 1 and 7. More flexible the labor market, the higher the score.
We obtain the data used in the analysis from the OECD’s Statistics and Projections Database.
In order to construct public investment shocks, we use the forecast of public investment reported
in the fall issue of the OECD’s Economic Outlook for the same year. Our data set covers anunbalanced sample of 17 countries over the period 1985–2017.

3Results

This section presents our empircal results.4 We first examine the average effect of the public investment shock on output by estimating equation (1). Figure 1 displays the responses of output
to an increase in public investment by 1 percent of GDP. In this and subsequent figures, the horizontal and vertical axes measure the years after the shock and the deviation from pre-shock inpercent for output, respectively. Dashed lines indicate 90% confidence bands.
Positive public investment shocks raise output. A positive public investment shock of 1 percentage point of GDP is associated with an increase in output of about 0.3 percent in the same year
and 1.1 percent three years after the shock. Using the sample average of government investment
as a percentage of output, this implies that investment spending multiplier is about 1.1 in t = 0.
This result is in line with other estimates of the public investment multiplier (see for example,Batini et al., 2014). Moreover, public investment shocks have long-lasting effects on output, inline with the hypothesis that an increase in public investment boosts the productive capacity ofthe economy.
Labor market flexibility affects the output effects of public investment shocks. Figure 2 showsthe estimated output responses to public investment shocks from equation (2). The analysis showsthat in countries with flexible labor markets, a positive investment shock of 1 percentage point of
4 Our results are robust in several directions. Instead of using the forecasts made in October of the same year, weuse the forecasts from October of the previous year to compute the forecast errors of public investment. Oure results
remain broadly unchanged with the alternative shock. We also consider different combinations of control variables(e.g., public sector debt, fiscal variables, revenue shocks, and the interest rate) and lag length. Our main results broadly
unchanged with the regressions suing these variables. To save a space, the results of these robustness checks areavailable upon request.

4GDP increases output by about 0.5 percent in the same year, and by 2.5 percent in the medium
term. In countries with rigid labor markets, the response of output is not statistically significant.
This result suggests that labor market flexibility plays an important role in success of public investment.
We now check our results are sensitive to a measure of labor market flexibility. Instead ofindicators on hiring and firing practices, we use the WEF’s labor market efficiency indicator andOECD’s employment protection legislation indicator as the measure of labor market flexibility
and estimate equation (2). Table 1 reports the results. We find that our main result broadly remainunchanged.

4Conclusions

This paper finds that the effect of public investment to boost an economy depends on the degreeof labor market flexibility. In economies with flexible labor markets, a positive public investment
shock increases output significantly. In contrast, in economies with rigid labor markets, the public
investment shock does not have a statistically significant impact on output. Our finding suggeststhat labor market flexibility plays a crucial role in degerming effectiveness of public investment,
which would be of interest for not only economists but also policy makers.

References[1] Abiad, A., D. Furceri, and P. Topalova. 2016. “The Macroeconomic Effects of Public Investment: Evidence from Advanced Economies.” Journal of Macroeconomics 50: 224–40.
[2] Auerbach, A. J. and Y. Gorodnichenko. 2012. “Measuring the Output Responses to FiscalPolicy.” American Economic Journal: Economic Policy4 (2): 1–27.
[3] Auerbach, A. J. and Y. Gorodnichenko. 2013. "Fiscal multipliers in recession and expansion."
In: A. Alesian and F. Giavazzi (eds.), Fiscal Policy After the Financial Crisis, pp. 63–98. University of Chicago Press.
[4] Batini, N., L. Eyraud and A. Weber. 2014. “A Simple Method to Compute Fiscal Multipliers.”
IMF Working Paper 14/93.
[5] Cacciatore, M., R. Duval, D. Furceri, and A. Zdzienicka. 2020. “Fiscal Multipliers and JobProtection Regulation.” European Economic Review, Forthcoming.

5[6] Furceri, D. and B. G. Li. 2017. “The Macroeconomic (and Distributional) Effects of Public
Investment in Developing Economies.” IMF Working Paper 17/217International MonetaryFund Washington, DC.
[7] International Monetary Fund (IMF). 2014. “Fiscal Multipliers: Size, Determinants, and Usein Macroeconomic Projections,” Technical Notes and Manuals 14/04 .
[8] ______. 2020. Fiscal Monitor, Washington, DC October.
[9] Izquierdo, A., R. Lama, J. P. Medina, J. Puig, D. Riera-Crichton, C. Vegh, and G. Vuletin.
2019. “Is the Public Investment Multiplier Higher in Developing Countries? An Empirical
Exploration,” IMF Working Paper 19/289.
[10] Jordà, Ò. 2005. “Estimation and Inference of Impulse Responses by Local Projections.” American Economic Review95 (1): 161–82.
[11] Leeper, E.M., Richter, A.W., and T.B. Walker. 2012, “Quantitative Effects of Fiscal Foresight,”
American Economic Journal: Economic Policy, 4(2), pp. 115–144.
[12] Leeper, E.M., Walker, T.B., and S.-C.S. Yang. 2013, “Fiscal foresight and Information Flows,”
Econometrica 81(3), pp. 1115–1145.
[13] Miyamoto, H., N. Gueorguiev, J. Honda, A. Baum, and S. Walker. 2020. “Growth Impact ofPublic Investment and the Role of Infrastructure Governance.” In Well Spent: How StrongInfrastructure Governance Can End Waste in Public Investment, edited by G. Schwartz, M.
Fouad, T. Hansen, and G. Verdier. Washington, DC: International Monetary Fund.
[14] Ramey, V. 2016. “Macroeconomic Shocks and Their Propagation,” in the Handbook of Macroeconomics, eds. John B. Taylor and Harald Uhlig, Amsterdam: Elsevier, Vol. 2, pp. 71-162.

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Table 1: Robustness check: the output effects of public investment shocks at time hBaseline

WEF’s Labor market efficiency

OECD’s employment protection legislation

hFlexible

Rigid

Flexible

RigidFlexible

Rigid

0

0.525

-0.3620.715-0.325

0.444

0.072

(0.207)(0.240)(0.180)(0.331)(0.176)(0.438)1.133-0.6101.381-0.834

0.745

0.106

(0.337)(0.477)(0.313)(0.592)(0.389)(0.918)1.836-0.7511.731-0.568

0.712

0.954

(0.477)(0.588)(0.383)(0.626)(0.534)(1.248)2.504-0.8222.100-0.430

0.642

1.773

(0.624)(0.743)(0.449)(0.673)(0.622)(1.460)123

Note: h = 0 is the year of the shock. Standard errors are in parentheses.

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Figure 1. The average output effect of public investment shock

21.8
1.6
1.4
1.2
10.8
0.6
0.4
0.2
0-10
1
2
Years after the shock

3Note: The x-axis indicates the years after the shock, and 𝑡 = 0 represents the year of the shock.
Shock represents an increase of 1 percentage point of GDP in public investment spending.

Figure 2. Effects of Public Investment Shocks: The Role of Labor Market Flexibility
Flexible labor market

Rigid labor market

41

3.5

0.5302.5-0.5

2-1

1.5
1-1.5

0.5

-2

0-10
1
2
Years after the shock

3-2.5

-101
2
Years after the shock

3Note: The x-axis indicates the years after the shock, and 𝑡 = 0 represents the year of the shock.
Shock represents an increase of 1 percentage point of GDP in public investment spending. Flexible(rigid) labor market is defined based on the value of 𝑧 in the transition function.