Public investment and economic growth

Public investment on infrastructures, education and health are prominently featured in developing country’s fiscal budget. But, how fruitful are these investments? Does increase in public investment leads to growth? The World Bank (2007) argued that public spending on infrastructure, education, and health yields positive effects on growth. Similarly, the Commission on Growth and Development (2008) noted that fast-growing countries are characterized by high public investment, defined as 7 percent of gross domestic product (GDP) or more.

Recently, Arslanalp, Bornhorst and Gupta (2010) studied the impact of public investment on economic growth for 48 advanced and developing economies during 1960–2001. They found that public investment generally has a positive impact on growth. Specifically, on average, GDP grew by 3.4 percent in advanced economies and 4.4 percent—1 percentage point more—in developing economies from 1960 to 2000. Here they summarize the main findings of their paper. They argue that the mixed result is resulting because most of the studies look at investment rate (% of GDP devoted to capital stock). However, the authors argue that the rate of growth of capital stock should be the focus. The capital stock—together with other production factors, such as labor and technology—determines an economy’s production potential. The investment flow in any given period, by contrast, determines how much capital is accumulated and therefore available for production in the subsequent period.

Tackling the issue of depreciation:

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The value of the capital stock is calculated using the perpetual inventory method. In this method, the net capital stock—public and private—is determined by adding gross investment flows from the current period to the depreciated capital stock of the previous period. As a result, the stock data account for the wear and tear on assets.The choice of depreciation rates presents perhaps the biggest challenge to tallying the capital stock data—mainly because country-specific estimates of depreciation rates (how much of the capital stock is used up in a period) are typically not available. Instead of applying a uniform rate to all countries, we differentiate the assumed depreciation by groups of countries reflecting different types of assets typically available in those countries. These assets have different life spans, resulting in different depreciation rates. For example, concrete structures are typically estimated to last longer than assets related to technology, whose investment life may be only a few years. As countries become richer, the share of assets with shorter life spans rises, thereby raising the overall depreciation rate.

The U.S. Bureau of Economic Analysis estimates that overall depreciation rates for public capital in the United States were about 2½ percent per year in 1960 and 4 percent in 2001 (Bureau of Economic Analysis, 2010). We extended this assumption to the public capital stock estimates for all advanced economies in our sample. For middle-income countries, we used a time-varying profile in which the depreciation rate starts at 2½ percent in 1960 and reaches 3½ percent by 2001. We assumed a constant rate of depreciation of 2½ percent for low-income countries throughout the sample period. We confirmed our findings using other plausible depreciation rates.

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The correlation between average public capital growth and average GDP growth is much higher than between the average public investment rate and GDP growth.

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It shows that the public investment rate has been on a downward trend since the early 1970s in advanced economies. In contrast, the public investment rate increased significantly in developing countries in the 1970s, although it returned to its earlier levels in the 1980s. Public capital stock, as a percent of GDP, peaked for advanced economies in 1983 and for developing economies in 1985. The peak levels were 60 percent of GDP for advanced economies and 61 percent of GDP for developing economies.

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How will India’s fiscal budget affect Nepali economy?

The Indian Finance Minister Pranab Mukherjee presented to the Indian parliament a fiscal budget of around US$278.38 billion for the next fiscal yar (April 1, 2011- March 31, 2012). Since Nepal shares an open border with India and has also pegged its currency with Indian rupee, the fiscal policies (both expenditure and tax) of India affect the Nepali economy as well. Here is a list of issues officials at the finance ministry in Nepal will have to grapple with while rolling out next fiscal year’s budget (July 16, 2011-July 15, 2012).

• Inflation in India (expected at 5%) will affect price levels in Nepal. The increase in purchasing power (indirectly) due to subsidies and indexing MGNREGA wages (IRs 100 in real terms) to consumer price index will not help to decrease prices of essential items; it will either maintain status quo or an increase in prices. In real terms, the Indian consumers would not lose that much. But, Nepali consumers will lose (both in real and nominal terms). Also, purchasing power of average families will increase by over IRs 2000 due to upping of personal income tax exemption (at IRS 180,000). The nominal increase in demand will further increase demand in the Indian market. If it affect general prices, then Nepal will also bear the brunt. But, if it increases real expenditure on sectors with idle resources (including travel and recreation), then Nepal might benefit.
• The increase in services tax (hotel, airfares, branded products, etc. of 10 percent) might make Nepali destinations relatively cheaper. However, nothing concrete can be said on this regards as it all depends on relative (cost of production) prices on the sectors concerned between the two countries.
• Indian farm and fertilizer subsides will affect Nepali agricultural prices as Nepal imports a lot of food products from India. Meanwhile, Nepal has agreed to eliminate Agricultural Reform Fee (ARF) for Indian agro-good, making Indian agro products further cheaper in the Nepali market. It might make some agro-products cheaper in the product market. But, it might also erode our agriculture production and employment (especially that of commercial ones).
• The decision to impose higher tariff on gold will further widen gold price differential between Nepal and India. Nepal will have to increase tariff on gold to discourage gold smuggling to India and to not let balance of payments deficit further widen.
• Similarly, prices of fuel have not been revised. So, some price differential on the two sides of the border is very likely, leading siphoning off of fuel from Nepal to India. It will not only affect domestic availability of fuel but also widen trade deficit as Nepal buys fuel at international prices from IOC and sells it in the domestic market at a little deflated price.

I will add more on later posts.

Trade and Labor Market Outcomes

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This paper reviews a new framework for analyzing the interrelationship between inequality, unemployment, labor market frictions, and foreign trade. This framework emphasizes firm heterogeneity and search and matching frictions in labor markets. It implies that the opening of trade may raise inequality and unemployment, but always raises welfare. Unilateral reductions in labor market frictions increase a country's welfare, can raise or reduce its unemployment rate, yet always hurt the country's trade partner. Unemployment benefits can alleviate the distortions in a country's labor market in some cases but not in others, but they can never implement the constrained Pareto optimal allocation. We characterize the set of optimal policies, which require interventions in product and labor markets.

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Full paper by Helpman, Itskhoki, and Redding (2011) here.

Highlights of India’s FY 2011-12 budget

Highlights of budget for next fiscal year (April 1, 2011- March 31,2012) presented by Indian Finance Minister Pranab Mukherjee on Monday to the parliament. Budget summary sourced from Reuters.

At US$ 1= IRs 45.18 exchange rate [100 crore = 1 billion], total estimated expenditure equals to US$ 278.38 billion, total estimated revenue (tax and non-tax) equals to US$ 174.83 billion; and total deficit borrowing (recovery of loans, other receipts and borrowing and other liabilities) equals to US$ 103.54 billion. Total estimated GDP for FY 2011-12 is US$ 1.99 trillion.

BORROWING

• Gross market borrowing for 2011-12 seen at 4.17 trillion rupees
• Net market borrowing for 2011-12 seen at 3.43 trillion rupees
• Revised gross market borrowing for 2010-11 at 4.47 trillion rupees

FISCAL DEFICIT

• Fiscal deficit seen at 5.1 percent of GDP in 2010-11
• Fiscal deficit seen at 4.6 percent of GDP in 2011-12
• Fiscal deficit seen at 4.1 percent of GDP in 2012-13
• Fiscal deficit seen at 3.5 percent of GDP in 2013-14

SPENDING

• Total expenditure in 2011-12 seen at 12.58 trillion rupees
• Plan expenditure seen at 4.41 trillion rupees in 2011-12, up 18.3 percent

REVENUE

• Gross tax receipts seen at 9.32 trillion rupees in 2011-12
• Corporate tax receipts seen at 3.6 trillion rupees in 2011-12
• Tax-to-GDP ratio seen at 10.4 percent in 2011-12; seen at 10.8 percent in 2012-13
• Customs revenue seen at 1.52 trillion rupees in 2011-12
• Factory gate duties seen at 1.64 trillion rupees in 2011-12
• Non-tax revenue seen at 1.25 trillion rupees in 2011-12
• Service tax receipts seen at 820 billion rupees in 2011-12
• Telecoms fees, auction of broadband spectrum to raise 296.5 billion rupees in 2011-12

SUBSIDIES

• Subsidy bill in 2011-12 seen at 1.44 trillion rupees
• Food subsidy bill in 2011-12 seen at 605.7 billion rupees
• Revised food subsidy bill for 2010-11 at 606 billion rupees
• Fertiliser subsidy bill in 2011-12 seen at 500 billion rupees
• Revised fertiliser subsidy bill for 2010-11 at 550 billion rupees
• Petroleum subsidy bill in 2011-12 seen at 236.4 billion rupees
• Revised petroleum subsidy bill in 2010-11 at 384 billion rupees
• State-run oil retailers to be provided with 200 billion rupee cash subsidy in 2011-12

GROWTH, INFLATION EXPECTATIONS

• Inflation seen at 5 percent in 2011-12
• Economy expected to grow at 9 percent in 2012, plus or minus 0.25 percent

TAXES

• Standard rate of excise duty held at 10 percent
• Service tax rate held at 10 percent
• Scope of service tax to be widened
• Minimum alternate tax raised to 18.5 percent from 18 percent
• Iron ore export duty raised to 20 percent
• Personal income tax exemption limit raised to 180,000 rupees

DISINVESTMENT

• Disinvestment in 2011-12 seen at 400 billion rupees

POLICY REFORMS

• Food security bill to be introduced this year
• Foreign direct investment policy to be liberalised further * Infrastructure debt funds to be created
• Infrastructure growth to be boosted with tax-free bonds of 300 billion rupees
• Foreign institutional investor limit in 5-year corporate bonds for investment in infrastructure to be raised by $20 billion
• To permit Securities and Exchange Board of India (SEBI) registered mutual funds to access subscriptions from foreign investments
• Public debt bill to be introduced in parliament soon

SECTOR SPENDING

• Infrastructure allocation increased by 23.3 percent to 2.14 trillion rupees in 2011-12
• To allocate more than 1.64 trillion rupees to defence sector in 2011-12
• Corpus of rural infrastructure development fund raised to 180 billion rupees in 2011-12
• To provide 201.5 billion rupees capital infusion in state-run banks in 2011-12
• To allocate 520.5 billion rupees for the education sector
• To raise health sector allocation to 267.6 billion rupees
• Mahatma Gandhi National Rural Employment Guarantee Scheme wage rates linked to consumer price index; will rise from existing Rs.100 per day.

AGRICULTURE

• To focus on removing supply bottlenecks in the food sector
• To raise credit flow target to agriculture sector to 4.75 trillion rupees
• Give 3 percent interest subsidy to farmers in 2011-12
• Cold storage chains to be given infrastructure status
• To provide 3 billion rupees for 60,000 hectares under palm oil plantation
• Actively considering new fertiliser policy for urea

MAJOR CONCERNS

• Food inflation remains a concern
• Current account deficit situation poses some concern
• Must ensure private investment is sustained
• "Certain events in the past few months may have created an impression of drift in governance and a gap in public accountability ... such an impression is misplaced."
• Corruption is a problem, must fight it collectively

The Service Sector as India's Road to Economic Growth

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While India is distinctive among developing countries for its fast-growing service sector, sceptics have raised doubts about the quality and sustainability of this service-sector growth and its implications for economic development. We show, consistent with the views of the sceptics, that while growth of the sector has been unusually rapid, it started 15 years ago from unusually low levels. That the share of services has now simply converged to the international norm raises questions about whether it will continue growing rapidly. In particular, whether service-sector output and employment continue to grow in excess of international norms will depend on the continued expansion of modern services (business services, communication and banking) but, also, on the application of modern information technology to more traditional services (retail and wholesale trade, transport and storage, public administration and defense ). The second aspect obviously has more positive implications for output than for employment.

We also show that the modern services that are growing most rapidly are now large enough where their future performance could have a significant macroeconomic impact. The expansion of modern service-sector employment is not simply disguised manufacturing activity. Finally, we show that the mix of skilled and unskilled labor in manufacturing and services is increasingly similar. It is no longer obvious therefore that manufacturing is the main destination for the vast majority of Indian labor moving into the modern sector and that modern services are a viable destination only for the highly-skilled few. We conclude that sustaining economic growth and raising living standards will require shifting labor into both manufacturing and services.

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That’s the abstract from Eichergreen and Gupta (2011) paper.

U-curve in economic development

Relative productivity of agriculture exhibits a U-shaped pattern over the course of development, argues Rodrik. Labor productivity first falls and then rises, as countries get richer.

Within countries as well, the trend is consistent.

Why does this happen? Because new, high-productivity activities (typically outside agriculture) are needed for development to happen. Relative productivity in agriculture falls. Labor tends to move from low to high productivity activities as economies grow. The gap between productivity in agriculture and non-agriculture reduces. Diminishing marginal returns (in terms of productivity) gradually kicks in on non-agriculture sector. Relative productivity in agriculture sector again rises and the curve starts to slope outward.

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economic development requires both new activities (diversification) and ongoing transfer of resources from traditional to modern activities. Some countries are stuck with no new industries, so they never grow. Others get a few new industries (e.g. mining and other natural resource-based industries), but these do not expand sufficiently and absorb much labor, so development gets stuck at an intermediate level of income. The real successful countries are those that pull off both tricks.

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Making fiscal policy effective

Abstracts of two latest working papers from the Levy Economics Institute.

Lessons from the Great Recession (Pavlina R. Tcherneva 2011):

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This paper reconsiders fiscal policy effectiveness in light of the recent economic crisis. It examines the fiscal policy approach advocated by the economics profession today and the specific policy actions undertaken by the Bush and Obama administrations. An examination of the labor market renders the contemporary aggregate demand–management approach wholly inadequate for achieving certain macroeconomic objectives, such as the stabilization of investment and investor expectations, the generation and maintenance of full employment, and the equitable distribution of incomes. The paper reconsiders the policy effectiveness of alternative fiscal policy approaches, and argues that a policy that directly targets the labor demand gap (as opposed to the output gap) is far more effective in stabilizing employment, incomes, investment, and balance sheets.

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Why aggregate demand management fails and what to do about it? (Pravlina R. Tcherneva 2011)

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This paper argues for a fundamental reorientation of fiscal policy, from the current aggregate demand management model to a model that explicitly and directly targets the unemployed. Even though aggregate demand management has several important benefits in stabilizing an unstable economy, it also has a number of serious drawbacks that merit its reconsideration. The paper identifies the shortcomings that can be observed during both recessions and economic recoveries, and builds the case for a targeted demand-management approach that can deliver economic stabilization through full employment and better income distribution. This approach is consistent with Keynes’s original policy recommendations, largely neglected or forgotten by economists across the theoretical spectrum, and offers a reinterpretation of his proposal for the modern context that draws on the work of Hyman Minsky.

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