Public investment: Crowding-in or crowding-out?

Mustafa K. Mujeri   | Published: September 12, 2018 21:42:35 | Updated: September 17, 2018 21:53:40

While there is a general consensus that investment is the key to economic growth, relative importance of public and private investments is often debated. This means that it is not just the total investment that matters to the policymakers, but also its composition in terms of public and private investments.

The relationship between public and private investments has been a focus of attention among the policymakers at least since the early 1980s; and it is still a subject of considerable controversy. The main question is: whether public and private investments have a different impact on economic growth. On theoretical grounds, there is no clear reason why the institutional source of investment should matter. However, if there are inefficiencies or distortions associated with public investment that are absent in the case of private investment, then the difference would indeed matter. For example, if the government carries out inefficient public investments or undertakes costly 'prestige' projects, then private investment may have a larger direct effect on growth than public investment. Further, complementarities may arise in the case of public investment in infrastructure, which increases the marginal product of private capital. However, public investment in infrastructure may not automatically have a beneficial impact on private investment and growth. This might be the case, for example, when public infrastructure projects are of dubious quality. 

The relative importance of public and private investments rests on two distinct but related issues: (i) differential impact of public and private investments on economic growth; and (ii) whether public investment substitutes or complements private investment, that is, whether public investment crowds-out or crowds-in private investment in the country's economic growth process. For example, public investment in infrastructure such as education, power generation and transmission, highways, roads, water supply and sewerage systems increases the marginal productivity of private capital. The availability of these core infrastructures reduces the cost facing the private sector and creates an enabling environment for higher private investment and output growth.

Public investment can also act as a barrier to private investment growth when: (i) it is debt-financed which increases the cost of capital and reduces the expected after-tax rate of return on private capital; (ii) it produces goods and services that compete with the private sector; and (iii) it is focused on industries that are highly subsidised, yet inefficient. On balance, while there is no clear-cut theoretical relationship between public and private investment and economic growth, the net effect of the two components remains an empirical issue. If the substitution effect of public investment on private investment outweighs the complementarity effect, adverse impact will be the result. On the other hand, if the complementarity effect is greater than the substitution effect, economic growth will be positively impacted. One study on the effect of public and private investments on economic growth for the Bangladesh economy shows that both public and private investments impact positively; but private investment is more significant than public investment in the economic growth process.

It is indeed important to recognise that the public-investment-driven growth paradigm - often known as 'capital fundamentalism'- runs in contrast to the present-day philosophy of de-emphasising public sector, physical capital, and infrastructure, and prioritising private market, human capital (skills and training), and reforms in governance and institutions. But, probably now is the time to re-think the philosophy. At present, many of the countries that, despite strengthening global economic headwinds, are growing rapidly are those where public investment is playing a big role.

Bangladesh is one of the present-day success stories where annual gross domestic product (GDP) growth rate has exceeded 7.0 per cent in recent years, which has been translated into significant poverty reduction and improved social outcomes. Rapid growth has been supported by a significant increase in public investment, from less than 5.0 per cent of GDP in 2010 to more than 7.0 per cent in 2017. The growth is also underpinned by a substantial increase in overall investment, which now stands at close to one-third of GDP. The government invested in building roads, railways, power plants, other infrastructure and the rural economy that significantly enhanced productivity in the rural areas, where most of the poor reside. To a large extent, public infrastructure investment is helping Bangladesh to maintain its recent growth momentum. As long as public investment serves to accumulate assets, and the return on these assets exceeds the cost of funds, public investment would strengthen the government's balance sheet.

However, if the distinction between the institutional sources of investment matters for productivity and growth, then it is important to understand the linkages between public and private investments. If public investment crowds-in private investment (for example, construction of roads or ports may allow private firms to have broader access to markets), then the relevant question for social welfare would be how to raise productivity of public capital such as through reducing distortions or prioritising public investment into sectors where productivity is higher. But if the distortions are too severe such that public investment crowds-out private investment, then the country would face a twofold problem: first, when public investment increases, average productivity falls because public investment in less productive than private investment; and second, total productivity falls because there is crowding-out of private investment. The relevant policy issue is to implement measures such that the crowding-out effect disappears and the country can reap the benefits from higher public investments.

Although private investment may be more productive, and hence more growth enhancing than public investment, this does not necessarily imply that all forms of public investment are equally productive, nor that investment in public infrastructure is necessarily better for growth than other forms of public expenditures.

Recent literature also focuses on the issue of efficiency of public investment and the role of good governance as a key determinant of its productivity. For example, empirical studies on effect of public health and education spending on outcomes (e.g. child mortality and educational failure rate) show positive and significant effects only in countries with good governance. Further, public investment is observed significantly higher in countries with bad institutions, which is a reflection of the enhanced rent-seeking incentives of governments in environments where property rights are less secure. Further, predatory behaviour by corrupt politicians distorts the composition of government expenditure. In particular, education spending is adversely affected by corruption.

The bottom line is that the determinants and also the consequences of public investment decisions are tied to a country's institutional factors relating to good governance. Further, empirical evidence shows that high public investments (e.g. as a share of total government expenditure and as a percentage of GDP) are significantly associated with weak institutions. Thus, good governance is a key factor mediating the relationship between public and private investment.

The real issue is to acknowledge that there are potentially important complementarities between an adequate public infrastructure and private capital; and not that public and private capital are substitutes in the aggregate. There can be a strong positive role for non-military public capital stock in determining the rate of return to private capital, consistent with the hypothesis that public and private capital stocks are complementary inputs to private production technology.

Similarly, improving infrastructure has a positive impact on output. As might be expected, the greatest returns are in the early stages of development, when existing infrastructure is poor. For example, the availability of paved roads can have a strong positive effect on private investment.

The important point is to recognise that building public capital requires investment, but there might be distortions associated with the public investment process that crowd-out private investment. In countries with poor institutions like Bangladesh, there may be various origins of such distortions such as binding financing constraints, insufficient integration into the global capital market, and low openness to the global economy. Furthermore, in the case of impact on GDP growth, as long as there is no complete crowding-out, public investment would have a positive impact on growth, although it may not represent a socially optimal use of resources.

The economic justification for certain level of public investment is also well recognised. Some public services enjoy a substantial public good component, indicating that their production and provision has externalities, and thus the private sector would provide suboptimal amounts. But if the public sector extends itself into areas where the public good component is nonexistent or the private sector can provide these services more effectively, then it may supplant private investments and may become counterproductive. Thus, it is not the quantity of public investment that matters, rather its quality. In other words, not only must more money be spent on building public capital, but it must be spent wisely, effectively, and in right areas.

Public investments should ideally be focused on increasing productivity and competitiveness, searching for areas where social returns are highest and externalities and spillover effects are significant. The most important concern when it comes to infrastructure investment, for example, is project selection. Selecting projects with the greatest impact is critical; thus, it is crucial to strengthen institutions capable of doing adequate planning, cost-benefit analysis and ongoing monitoring and evaluation. If instead, the focus is on quantity, then it is more likely that higher levels of public investment will have undesirable collateral effects such as crowding-out private investments with little productivity gains for the economy. What is important is to ensure that public investment is productivity enhancing and there are no distortions associated with the public investment process.

Dr. Mustafa Kamal Mujeri is Executive Director, Institute for Inclusive Finance and Development (InM).





Share if you like