“Dwelling on years of research and a wealth of evidence, this new book is a masterful combination of theory, facts, and intuition. It provides a clear, rigorous, and unified perspective on the role of infrastructure in growth and development. That investing in infrastructure may be not only about promoting markets and reducing production costs, but also about achieving health and education outcomes, empowering women, and fostering innovation, is a message that development practitioners and multilateral institutions would do well to heed.”–Otaviano Canuto, vice president, World Bank

Pierre-Richard Agenor is the Hallsworth Professor of International Macroeconomics and Development Economics at the University of Manchester and codirector of the Centre for Growth and Business Cycle Research. He is the coauthor of Development Macroeconomics (Princeton) and author of The Economics of Adjustment and Growth, among other books.

PUBLIC CAPITAL, GROWTH AND WELFARE

ANALYTICAL FOUNDATIONS FOR PUBLIC POLICY By PIERRE-RICHARD AGÉNOR

PRINCETON UNIVERSITY PRESS

Copyright © 2013 Princeton University Press
All right reserved.
ISBN: 978-0-691-15580-7

Contents

Introduction and Overview……………………………………11 | Basic Channels………………………………………….112 | Public Capital and Education……………………………..493 | Public Capital and Health………………………………..724 | Public Capital and Innovation…………………………….1115 | Public Capital and Women’s Time Allocation…………………1326 | Public Capital and Poverty Traps………………………….1747 | Research Perspectives……………………………………192Lessons for Public Policy……………………………………219References…………………………………………………225Index……………………………………………………..247

Chapter One

Basic Channels

Macroeconomists typically emphasize three basic channels through which public capital may affect growth: a direct productivity and cost effect on private production inputs, a complementarity effect on private investment, and a crowding-out effect on private spending through the financial system.

This chapter begins by reviewing the evidence on all three effects. It then presents a basic OLG framework, with full capital depreciation, that accounts for the productivity effect. The equilibrium and the balanced growth path (along which key macroeconomic variables grow at a constant rate) are then derived, and the growth effects of public investment are examined, under alternative assumptions about the importance of the existing public physical assets for the production of new capital. The cost effect of public capital is also discussed, with respect to labor inputs. Optimal fiscal policy is analyzed next. The chapter concludes by discussing various extensions, including indirect taxation, the complementarity effect of public capital on private investment, public capital in the utility function, partial depreciation, and maintenance expenditure.

1| Background

1.1| Productivity and Cost of Private Inputs

The direct productivity and cost effects of infrastructure is the argument that is most commonly referenced to account for a growth effect of public capital. If, as is normally the case, production factors are gross complements, a higher stock of public capital would tend to raise the productivity of other inputs, such as labor and the stock of private capital, thereby reducing unit production costs. Given decreasing returns, the magnitude of this effect would depend, of course, on the initial stock of public capital. In mature economies, marginal productivity effects are likely to be limited; but in low-income countries, where stocks of infrastructure assets are relatively low to begin with, they could be substantial.

Sub-Saharan Africa is a case in point. In most countries of the region, particularly the lower-income ones, infrastructure remains a major constraint on economic activity, depressing firm productivity perhaps by as much 40 percent (Escribano et al. (2008)). For one set of countries power is the most constraining factor by far; a majority of firms cites it as a major business obstacle. Africa’s power infrastructure delivers only a fraction of the services found elsewhere in the developing world (Eberhard et al. (2008)). The 48 countries of sub-Saharan Africa (with a combined population of about 800 million) generate roughly the same amount of power as Spain (with a population of about 45 million). For a second set, inefficient functioning of ports is equally significant. Deficiencies in transport and in information and communication technologies (ICTs) are less prevalent but substantial in some cases.

Africa’s road density is sparse when viewed against the size of the continent and the distribution of its population. In rural areas over 20 percent of the population lives in dispersed settlements, where typical population densities are less than 15 people per square kilometer. Only one-third of the population living in rural areas are within two kilometers of an all season road, compared with two-thirds in other developing regions. In cities, population density is relatively low by global standards and does not benefit from large economies of agglomeration in the provision of infrastructure services. As a result, the costs of providing a basic infrastructure package can easily be twice as much as in other, more densely populated cities in the developing world (Foster and Briceño-Garmendia (2010)). Lack of railways in the region is a key constraint to trade expansion, especially for agriculture and extractive industries.

Estimates by the African Development Bank suggest that in sub-Saharan Africa transport and energy costs, at 16 and 35 percent of total costs, respectively, represent by far the largest share of firms’ indirect costs. A large fraction of these costs is the result of the poor quality of basic infrastructure. For instance, because of inadequate transport facilities and unreliable supply of electricity, firms often incur additional expenses in the form of more expensive transportation means and onerous energy backup systems. Poor quality of electricity provision has a particularly large impact on the poorest countries (Escribano et al. (2010)). In many countries of the region, lack of irrigation also represents a major constraint on agricultural productivity (see Food and Agriculture Organization (2008)). With the availability of fresh water becoming increasingly vulnerable to climate change, in coming years the continent may face severe losses in annual grain production, as well as drastic reductions in energy capacity production.

The productivity and cost effects of public infrastructure may be magnified in the presence of externalities associated with the use of some production factors, such as, for instance, learning-by-doing effects resulting from a high degree of complementarity between physical capital and skilled labor. In addition, independent of its direct effect on the marginal product of factor inputs in the production process (as discussed earlier), public infrastructure may also have an indirect, additional impact on labor productivity. The idea, as suggested for instance by P. Ferreira (1999), is that with better access to roads and other means of public transportation (such as railways), workers can get to their job more easily, therefore spending less time commuting from home or moving across different work locations. This would tend to reduce traffic-related stress, which can be detrimental to concentration on the job. With greater access to electricity and telecommunications, workers can perform a number of tasks more rapidly (such as checking price quotations), as well as additional tasks away from the office (such as checking electronic messages from home). In poor countries, improved access to mobile phones has led to the development of new data services, such as mobile-phone-based agricultural advice, health care, and money transfer, which may all provide significant benefits in terms of productivity. By providing easier access to information, broadband networks may have a large impact on productivity as well. In turn, higher productivity would tend to enhance growth. Czernich et al. (2011), for instance, in a study of OECD countries during the period 1996–2007, found that a 10-percentage-point increase in broadband penetration (measured as the number of broadband subscribers per 100 inhabitants) raises annual per capita growth by 0.9 to 1.5 percentage points.

Another indirect effect of public capital could be through inventories that firms hold. In a study covering 36 major Chinese cities, Li (2010) found that infrastructure investment since the mid-1980s led to a dramatic reduction in inventories, from an inventory/sales ratio of 0.8 to approximately 0.15. Road investments alone reduced raw materials inventories by 25 percent during the period 1998–2007. In fact, one dollar of road spending caused 1 to 2 cents of inventory decline, which is similar in magnitude to the estimates for the United States prior to the 1980s (Henckel and McKibbin (2010)). In a study of India’s Golden Quadrilateral (GQ) Program—a major highway project aimed at improving the quality and width of existing highways connecting the four largest cities of the country—Datta (2011) found that firms in cities affected by the GQ highway project reduced their average stock of input inventories by between 6 and 12 days worth of production. Thus, transport infrastructure investment may contribute to economic efficiency not only by reducing transport costs but also by reducing the need to maintain high (and expensive) inventories.

Of course, the positive effect of public capital on the marginal productivity of private inputs may hold not only for infrastructure but also for other components of public capital—such as in education and health, which may both affect the productivity of labor. Moreover, other components of public spending, related for instance to the enforcement of property rights and maintenance of public order, could also increase productivity, reduce costs, and exert a positive effect on private investment and growth, despite the fact that they may not be considered as being directly “productive.” Improved public safety for instance could reduce the need for firms to spend resources to protect employees and physical assets by hiring guards, building fences, reinforcing doors, and buying security systems. But, as noted earlier, infrastructure capital may have a particularly large effect in countries where initial stocks are low and basic infrastructure services (such as electricity and clean water) are lacking, as is the case in many low-income countries.

1.2| Complementarity Effect on Private Investment

Another channel through which public capital can exert a positive effect on growth is through its effect on private capital formation. As noted earlier, public infrastructure increases the marginal productivity of private inputs. In so doing, it raises the perceived rate of return on, and may increase the demand for, physical capital by the private sector. For instance, the rate of return to building a factory is likely to be higher if the country has already invested in power generation, transportation, and telecommunications.

The complementarity effect has been well documented in the empirical literature on private capital formation in developing countries (see Agénor (2004, chap. 2)). Albala-Bertrand and Mamatzakis (2004) for instance found that in Chile, public infrastructure capital had a significant positive effect on private investment. In Vietnam, the decision to improve National Highway No. 5 and rehabilitate the port of Haiphong in the early 1990s led to a massive increase in investment (much of it foreign) in major industrial zones, spurring growth and employment in the northern part of the country in general (see Mitsui (2004)). The provision of infrastructure services (particularly in the area of telecommunications) has also been shown to be a key determinant of foreign direct investment in a number of other countries (see Vijayakumar and Rao (2009)).

Conversely, the study of Uganda by Reinikka and Svensson (2002) illustrates well how inadequate public infrastructure may adversely affect private investment. A survey of 243 manufacturing firms conducted in 1998 in that country showed that the lack of adequate electricity sources was ranked as the most important constraint to investment. Firms did not receive electricity from the public grid for 89 operating days on average, which led to 77 percent of large firms (in addition to 44 percent of medium and 16 percent of small firms) purchasing generators, representing 25 percent of their total investment in equipment and machinery in 1997. The same survey showed that for a firm without a privately owned generator, a 1 percent increase in the number of days without power resulted in a 0.45 percent reduction in investment. Thus, lack of access to, and poor reliability of, public infrastructure may affect both the level and the composition of private investment, in the latter case by biasing private capital formation toward the accumulation of assets that may alleviate the constraints that firms face in their day-to-day activities.

In the short run, public capital may also affect private capital formation indirectly, through changes in output and relative prices. As noted earlier, improved access to infrastructure may raise the marginal productivity of all factor inputs (capital and labor), thereby lowering marginal production costs and increasing the level of private production. In turn, this scale effect on output may lead, through a standard accelerator effect (or increased expected demand), to higher private investment—thereby raising production capacity over time and making the short-run growth effect more persistent.

Another indirect channel is through the effect of public infrastructure on the price of domestic consumption goods relative to the price of imported goods, that is, the (consumption-based) real exchange rate. An increase, for instance, in public investment in infrastructure would raise aggregate demand and put pressure on domestic prices. If the nominal exchange rate does not depreciate fully to offset the increase in domestic prices, the domestic-currency price of imported consumption goods will fall in relative terms (that is, the real exchange rate will appreciate), thereby stimulating demand for these goods. The net effect on domestic output may be positive or negative, depending on the intratemporal elasticity of substitution between domestic and imported goods. If this elasticity is low (as one would expect in the short run), the net effect may well be positive. Again, through the accelerator effect, private investment may increase, and this may translate into a more permanent growth effect.

At the same time, to the extent that the increase in government spending on infrastructure raises the relative price of domestic capital goods, and the switch in private consumption demand toward imports translates into a nominal appreciation, the domestic-currency price of imported capital goods may fall in relative terms, resulting in a drop in the user cost of capital. If a large fraction of the capital goods used by the private sector is imported (as is often the case for machinery and equipment in developing countries) this may lead to an increase in private investment. The relative price effect is not necessarily only short term in nature; as suggested by the evidence reported in Sala-i-Martin et al. (2004), it may translate into a more persistent growth effect.

1.3| Crowding-Out Effects

In the short term, an increase in the stock of public capital in infrastructure may have an adverse effect on activity, to the extent that it displaces (or crowds out) private investment. This short-run effect may translate into a longer-lasting adverse effect on growth if the drop in private capital formation persists over time.

Crowding-Out effects may take various forms. For instance, if the public sector finances the expansion of public capital through an increase in distortionary taxes, the reduction in the expected net rate of return to private capital may lower the propensity to invest. A similar, and possibly more detrimental, effect on private capital formation may occur if the increase in public infrastructure outlays is paid for by borrowing on domestic financial markets, as a result of either higher domestic interest rates (in countries where market forces are relatively free to operate in the financial system) or a greater incidence of rationing of credit to the private sector. Moreover, if an investment-induced expansion in public borrowing raises concerns about the sustainability of public debt over time and strengthens expectations of a future increase in inflation or explicit taxation, the risk premium embedded in interest rates may increase. By raising the cost of borrowing and negatively affecting expected after-tax rates of return on private capital, an increase in the perceived risk of default on government debt may have a compounding, depressing effect on private capital accumulation.

In principle, crowding-out effects associated with public infrastructure should be short term in nature; to the extent that an increase in the public capital stock raises output growth in the medium and longer term, future government borrowing needs may actually fall as a result of higher tax revenues. In that sense, deficits today may pay for themselves tomorrow, a common logic when discussing tax cuts and increases in productive expenditure in a growth context (see for instance Agénor and Yilmaz (2011)). However, as noted earlier, these effects may also persist beyond the short term, and turn into longer-run (adverse) effects on growth. For instance, if higher (anticipated) tax rates create permanent incentives for tax evasion, lower resources may reduce durably the government’s capacity to invest in infrastructure and other areas in the future, or its ability to ensure adequate maintenance of the public capital stock. If so, then, despite the productivity and complementarity effects mentioned earlier, the net effect of an increase in public spending on infrastructure may well be to hamper, rather than foster, economic growth. Moreover, as discussed in more detail in chapter 7, the crowding-out effect associated with excessive public debt can be a source of instability and prevent the economy from reaching an equilibrium with constant growth.

2| The Economy

To illustrate the link between public capital and productivity highlighted in the foregoing discussion, and its implications for growth, a simple overlapping-generations (OLG) model is presented. A fairly detailed description of the model is given in this chapter because the same fundamental apparatus (with various extensions and modifications) will be used in subsequent chapters.

(Continues…)

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