Productiveness and welfare implications of public infrastructure: a dynamic two-sector general equilibrium analysis

Abstract

This paper develops a dynamic general equilibrium model that provides an internally consistent micro-foundations framework where various effects of infrastructure policy changes can be studied. Devoting additional resources to infrastructure investment can payoff in terms of sizable increases in GDP and private investment. In addition to this, the model also makes predictions concerning changes in the welfare of agents resulting from additional infrastructure investment. Specific policy recommendations that attain highest welfare gains are computed. The recommendation is that on average an additional 4% of GDP per year should be devoted to public investment in the Latin American countries in the sample.

Introduction

Despite common wisdom about its benefits, the importance of publicly provided airports, highways, streets, and water systems for the economic growth of a country is not well understood. Most economists believe that investment in such public infrastructure contributes to output growth since it increases productivity and decreases costs for the private sector. Increased attention to this topic can be found in recent issues of such publications like The Economist, as well as some academic journals (e.g., Morrison and Schwartz, 1996). Consider the following two examples.

⋅ Seven South-American countries that comprise the common market MERCOSUR which was formed in 1991 have liberalized trade, fostering increased growth. To fully integrate this market, however, transport links like ports, roads, e.g., an unfinished key section of highway in Bolivia that would finally connect the continent's east and west coasts, and railways, need improvement. The Inter-American Development Bank IDB estimates that if these economies grow at 5%, their investment in infrastructure improving transport links needs to increase significantly.

⋅ The former U.S. Navy base in Subic Bay, Philippines was closed in 1992. An organized effort from neighboring-town Olongapo's mayor to preserve the abandoned infrastructure, i.e., port facilities, a runaway capable of handling Jumbo-jet airplanes, and buildings successfully turned the base into a port. This attracted private investment of 200 companies worth US$1.2 billion. This was one of the factors contributing to the increase of Philippine GDP from about 0% in 1992 to about 6% in 1995.¹

Both articles suggest that more infrastructure investment is needed in these countries.² Low levels of investment in infrastructure have been observed in recent years in regions like East Asia (about 5% of GDP), Latin America (about 6% of GDP), and even the U.S. (about 1% of GDP). In Latin America fiscal restraint in the mid-1980s (called for by stabilization plans) was in part responsible for the decline in public investment that has not yet recovered 1970s levels. Continuing low levels of public investment could stall economic growth.³ This paper develops a general equilibrium model that can offer guidelines for infrastructure policy. In addition to studying the overall productiveness of infrastructure, this paper studies its effects on private investment. That is, is private business investment encouraged or deterred with additional public investment, and in what proportion? Furthermore, this paper studies how additional public infrastructure investment affects the population's welfare. A majority of previous studies of infrastructure have only focused on the implications for output. This paper attempts to quantify policy recommendations for public investment guided by potential welfare gains for the citizenry. Specific quantitative policy recommendations concerning additions to infrastructure that result in the largest welfare gains to the population are computed.

In order to address the questions above, a dynamic two-sector general equilibrium model is solved and its quantitative predictions examined. Most types of infrastructures can potentially become congested with usage. The model in this paper accounts for that by using an `effective' stock measure so different degrees of non-rivalry for the public input are possible. Equilibrium in the model is characterized by a system of difference equations which is solved using numerical techniques. The benchmark model is solved for an average of parameters estimated for a sample of seven Latin American countries (Argentina, Brasil, Chile, Colombia, Mexico, Peru, and Venezuela). Some of these parameter estimates come from Elias (1992) (a thorough growth accounting study of the seven countries) and Easterly and Rebelo (1993) (who construct series of infrastructure measures for a worldwide sample).

Empirical testing of the significance of public investment has been conducted among others by Aschauer (1989) (using U.S. states data), Canning and Fay (1993) (using data from 95 developing countries), Ford and Poret (1991) (using cross-section of OECD countries), and Hulten (1996) (using data from 42 low and middle-income countries), all of which find infrastructure important.⁴ Most of the papers cited above use regression analysis of either `growth accounting' or of steady-state equations. Unfortunately, this methodology does not allow for important general equilibrium feedback effects among variables.⁵ That is, they are not fully articulated frameworks that can be used for policy analysis. A dynamic general equilibrium model that is explicitly solved, such as the one described in Section 2, provides such an internally consistent micro-foundations framework for policy analysis as suggested by Lucas (1987). The model is grounded in the equilibrium theoretical literature of Uzawa (1974), Barro (1990), and Glomm and Ravikumar (1994). However, their models are not quantitatively solved and do not emphasize effects on welfare and private investment. In this paper, measures of government investment in infrastructure are obtained from actual data from these seven countries and used as a benchmark. Experiments deviating from this benchmark are then undertaken studying long-run and short-run effects on output, welfare, and other macroeconomic variables. It is found that infrastructure (even if funded by taxation) has sizable positive effects on GDP and private investment. For the countries studied, maximum welfare gains can be achieved by raising public investment by about 4% of GDP above present averages. Welfare–infrastructure trade-offs are also found; too much infrastructure investment is shown to be detrimental.

The paper proceeds as follows. The economic environment is specified in Section 2, and the recursive competitive equilibrium is characterized. Section 3describes the solution procedure, while Section 4discusses parameterization issues to be used in the solution. Section 5describes the results, and Section 6makes concluding remarks.