Public stimulus for private investment: An extended real options model

The recent global financial crisis and the European sovereign-debt crisis have put financial constraints on governments limiting their capacity to increase public investment and to promote economic growth. Also, in periods of high uncertainty firms tend to postpone the implementation of their projects, which has a negative impact on the economic growth. In this paper, we study different policies that can be set by governments in order to stimulate private investment. We develop an extended real options model that takes into account some relevant macroeconomic factors (namely, different types of taxes, asymmetric investment multipliers, and public inefficiencies) that do not appear in the related literature. The optimal incentives for the different types of stimuli are derived and discussed. We show that the optimal subsidy that prompts the private investment must be subject to a maximum that accounts for the government's incremental tax-related benefits. Additionally, the required optimal subsidy can be reduced if the government acts as a competitor fighting for the project. This would diminish the public spending while achieving the same objectives. We also show that a subsidy policy is always better than tax reductions. Finally, we illustrate the implementation of the model with an example that applies to the Portuguese economy.