ISAS Working Papers

With economic growth as a priority goal of the state it is a puzzle as to why public investment declined since the mid 1990s despite no significant reduction in fiscal deficits. This paper advances the proposition that public investment affects the returns to the distribution of factor endowments differentially. The rise in inequality then turns the attention of the state towards redistribution. Even when expenditures are financed by borrowing rather than taxation, increased inequality that creates pressures for redistributive transfers, crowds out public investment. Future income generation gets adversely affected by a reversal of public investment which makes creditors impose borrowing constraints on the state. This can take the form of the enactment of fiscal responsibility legislation.