Central Bank of Luxembourg publishes study on how public infrastructure investment shapes fiscal competition and convergence

The Central Bank of Luxembourg has published Working Paper 204, “Public capital stocks in dynamic fiscal competition”, presenting a theoretical framework for how countries compete for internationally mobile private capital using corporate taxation and strategic public investment that builds a stock of public capital such as infrastructure, networks, administrative capacity, and legal and regulatory institutions. The paper examines whether such investment policies reduce technological gaps between countries or instead entrench and widen them. The model’s results indicate that convergence is not assured. Convergence is more likely when infrastructure depreciates quickly, when infrastructure-related advantages diffuse faster across borders, or when there are adjustment costs to public investment, while persistent divergence can arise when governments are patient, when infrastructure strongly raises private-sector productivity, or when public investment efficiently increases the infrastructure stock. Outcomes also depend on initial conditions: with a moderate initial infrastructure gap both governments invest, but with a large gap the technologically lagging country may rationally delay investment until diffusion erodes the leader’s advantage. The paper also finds that significant frictions in adjusting public investment can lead governments to abandon an infrastructure “investment race” in favour of purely tax-based competition, and that an infrastructure-rich country may sustain a higher corporate tax rate even with a mobile tax base. The Central Bank of Luxembourg notes that the study reflects the authors’ views and not necessarily those of the bank or the Eurosystem.