about 15% of GDP in response to a permanent 1% of GDP increase in public investment. In building up the stock of public capital, public debt increases somewhat, pushing a subsequent increase in tax rates to ensure the sustainability of the experiment. If the automatic tax response is shut down, tax revenue increases remain high at 0.86% of GDP while the fall in user charges remains relatively unchanged.

On the other hand, an increase in current expenditures has an almost negligible effect on user charges while it raises tax revenue by 0.69% of GDP if tax rates are allowed to vary. But at unchanged tax rates no additional tax revenue is generated. The results are robust to a series of parameter sensitivity tests except when public and private capital stocks are = − highly substitutable (ν<sup>s</sup> 0.75) . In this case the accumulation of public capital raises both tax revenue and user charges, thus rendering capital spending self-amortizing.

**The Permanent Balance Rule** . The permanent balance rule (Buiter and Grafe, 2004) is based on a strong form of tax smoothing. It says that once an economy reaches its ‘permanent tax rate’ (the constant GDP share of taxes that ensures government solvency), that is, once government solvency is guaranteed, temporary spending increases (not only including temporary increases in capital spending) should be financed by issuing debt.

The rule increases budget flexibility by allowing for borrowing to fund temporary increases in expenditures with the proviso that default is ruled out. Otherwise, the rule does not make sense in the long run. Again, the adoption of a permanent balance rule is not relevant at this juncture. The tax rate in the Colombian economy is not ensuring public sector solvency either now or in the future. As shown by the simulation results, substantial tax increases are required in the future to ensure sustainability.

However, aside from the countercyclical management of public spending where no deterioration of the government’s finances is expected if spending is allowed to increase in contractionary phases of the business cycle and then reduced sufficiently during the next upswing, there is still an open question: the long-run budgetary consequences of a temporary increase in capital expenditures to assess whether a temporary increase pays for itself in the long run or if it ends up deteriorating the fiscal position and eventually violating the government’s transversality condition.

The dynamic behavior of the economy is studied using impulse response analysis. Impulse response functions generated by the model trace the response of the economy over time to a 1% of GDP innovation in capital spending carried out by the central government. The experiment assumes that the economy starts from the initial steady state<sup>15</sup> . Once the economy’s transition path has been computed it is possible to estimate additional user charges and tax collections. Their present value figures are computed over a truncated horizon of 1200 periods. Given the nature of the experiment - i.e., a temporary capital outlay leading to a temporary increase in the public capital stock - additional depreciation charges may be used to pay for investment spending in absence of a maintenance obligation.

> 15 A description of the methodology can be found in King, Plosser and Rebelo (2002).

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