Public Investment and EU Funds in a Small Open Economy Integrated in the Euro Area

Abstract

Small open economies within the European Union can be extensively influenced by the utilization of the structural and investment EU funds. Even more so if they are eligible to draw from the Cohesion Fund targeted at the less developed EU countries. In many of these countries, we observe an EU-funds cycle that causes spikes in total investment as the programming period draws near to its end, and a decline after the new programming period begins. As the share of EU-funded public investment and the public investment financed from domestic sources varies highly over time, we decided to explore the differences in the transmission of these two types of public investment shocks into the real economy. We use a version of the EAGLE model calibrated for the Slovak economy integrated in the euro area and extended with EU funds mechanisms. We find that if the part of the total investment that is funded from domestic sources comes from an increase in taxes, the EU-funded investment delivers larger improvement in real GDP. The difference is especially striking for investment funded by an increase of social security contributions paid by firms. Debt-financed public investment delivers virtually the same results irrespective of whether it is co-financed from EU funds or not.