The paper uses a bi-regional CGE model to assess the potential impacts of an alternative rural development policy design, which is more targeted to public sector investments on the economic activity of a lagging region of Latvia. The results show the distribution of effects between the rural and urban areas within the lagging region as well as differences in the impacts between the two policy scenarios that are explored. A specially constructed bi-regional SAM (Social Accounting Matrix), that refl ects the specifi c characteristics of Latgale region, was used to calibrate the bi-regional CGE model; and two policy scenarios are explored. The two scenarios, “Enhanced Financial Envelope” and “Investment in Public Sector” are defi ned in terms of allocation volume and reallocation of funding among RDP measures and area payments. This represents the most radical kind of reallocation that is possible within the CAP, between Pillar 1 and 2 and within the Axes and Measures of RDP; and it completely removes the sectoral aspect of the support. The fi rst scenario is based on current implementation plans but with enhanced funding for the lagging region of Latgale, and the second on the complete shift of these funds to public goods fi nancing. Results show that both scenarios generate positive effects in terms of macroeconomic indicators (GDP and employment levels) and sectoral effects (factor income and household income expenditure). However, the effects from the “Investment in Public Sector” are stronger showing that the allocation of funds towards the public sector, which has the stronger links in the regional economy, has the highest positive effects for both rural and urban parts of region Latgale. Also, both scenarios have the ability to increase more the economic activity of the rural area while positive effects are diffused towards the urban area.