Policy Watch: Infrastructure Investment and Economic Growth
Author(s): Alicia H. Munnell
Source: The Journal of Economic Perspectives, Vol. 6, No. 4, (Autumn, 1992), pp. 189-198
Published by: American Economic Association
Stable URL: http://www.jstor.org/stable/2138275
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Perspectives- Volume Number4-Fall 1992-Pages 189-198
Journal of Economic 6,
Infrastructure Investment and
Alicia H. Munnell
P ublic policies are often made without much reliance on economic
reasoning. Economists are often unaware of what is happening in the
world of public affairs. As a result, both the quality of public decision-
making and the role that economists play in it are less than optimal. This
feature contains short articles on topics that are currently on the agendas of
policymakers, thus illustrating the role of economic analysis in current debates.
Suggestions for future columns and comments on past ones should be sent to
Isabel V. Sawhill, c/o Journal of Economic Perspectives, The Urban Institute,
2100 M Street N.W., Washington, D.C. 20037.
The stock of public capital in the United States is very large, $2.7 trillion in
1991 or about one-half the size of the private capital stock, according to data
from the U.S. Bureau of Economic Analysis.' About $2.2 trillion of that
IThe capital stock figures are calculated from historical investment figures revalued to current cost
that are then cumulated and depreciated using a perpetual inventory method.
*Alicia H. Munnell is Senior VicePresidentand Directorof Research,Federal Reserve
Bank of Boston, Boston, Massachusetts.
190 Journal of Economic Perspectives
Nonmilitary Nonresidential Net Public Capital Stock by Type of Asset, 1991
Public Billions of Percent of
Capital Stock Dollars Total
Highwaysand Streets $722.0 32
Waterand Sewer Systems 306.3 14
Buildingsand Other Structures
Schools, Hospitals,and Other Buildings 665.4 30
Conservationand DevelopmentStructures 177.6 8
Electricand Gas Facilities,
Systems,Airfields,etc. 163.6 7
Equipment 209.7 9
Total $2,250.5 100
Source:U.S. Bureau of EconomicAnalysis,unpublisheddata.
public capital stock is nonmilitary, with $1.9 billion held by state and local
governments. Table 1 presents a breakdown. Despite its magnitude, public
capital had been virtually ignored by the economics profession until the late
1980s. At that time, David Aschauer (1989) triggered a long overdue dialogue
among economists and political leaders when he published a study arguing that
much of the decline in U.S. productivity that occurred in the 1970s was
precipitated by declining rates of public capital investment. My own work
confirmed these results (Munnell, 1990a).
Spending advocates seized on these findings as support for increased
public investment. Transportation Secretary Samuel Skinner and New Jersey
Governor James Florio joined traditional interest groups to argue that more
public investment in infrastructure would help the economy. Prominent
economists signed a national petition for increased infrastructure spending.
Several congressional committees held hearings on this topic. The U.S. Council
of Mayors (1992) called for stimulative infrastructure spending earlier this year,
and Governor Clinton has made infrastructure spending a major part of his
economic plan. Felix Rohatyn (1992) argued for very large increases in infra-
structure investment in a recent article in New YorkReview of Books.
The enthusiasm among policymakers for the early Aschauer results was
matched, if not surpassed, by skepticism on the part of many economists.
Critics of these studies charged that the methodology was flawed, that the
direction of causation between public investment and output growth is unclear
and that, even if the historical empirical relationships were estimated correctly,
they provide no clear indications for current policy.
Who's right? What do we know and not know about the link between
public infrastructure and productivity? And what are the implications of these
results for policy?
Alicia H. Munnell 191
Public Capital and the Production Process
Everyone agrees that public capital investment can expand the productive
capacity of an area, both by increasing resources and by enhancing the produc-
tivity of existing resources. A well-constructed highway allows a truck driver to
avoid circuitous back roads and to transport goods to market in less time. The
reduction in required time means that the producer pays the driver lower
wages and the truck experiences less wear and tear. Hence, public investment
in a highway enables private companies to produce their products at lower total
cost. The condition of the highway, of course, is just as important as its
existence. Similar stories can be told for mass transit, water and sewer systems,
and other components of public capital.
Beginning with Aschauer's work, a number of studies have estimated
regressions where the dependent variable is output within some area, and the
independent variables are private capital, labor, public capital, and a constant
for the level of technology.2 In such regressions, the levels of public capital are
generally significant, and the consensus is that Aschauer made a significant
contribution by drawing attention to the importance of public infrastructure
and by adding public capital to the conventional production function. The
controversy arises about the method of estimating this expanded function and
about the interpretation of the results.
Aschauer's original aggregate time series estimates (1989), my reestimates
(1990a), and earlier work by Holz-Eakin (1988) suggest that the impact of
aggregate public capital on private sector output and productivity is very large.
My own equations indicate that a 1 percent increase in the stock of public
capital would increase output by .34 percent. Given the size of the public capital
stock and output, these figures imply a marginal productivity of public capital
of roughly 60 percent; that is, a $1 increase in the public capital stock would
raise output by $.60. The marginal productivity of private capital estimated
from these equations is about 30 percent. Looking at similar numbers,
Aschauer (1990, p. 16) concludes that "increases in GNP resulting from in-
creased public infrastructure spending are estimated to exceed those from
private investment by a factor of between two and five."
In my view, the implied impact of public infrastructure investment on
private sector output emerging from the aggregate time series studies is too
large to be credible. It does not make sense for public capital investment to
2Treating public capital as an input whose services enhance the productivity of both capital and
labor yields the equation Q = (MFP)*f(K, L, G), where Q is output, MFP is the level of technol-
ogy, K is the private capital stock, L is labor, and G is the stock of public capital. Assuming a
generalized Cobb-Douglas form of technology yields a more specific relationship between inputs
and outputs: Q = MFP*KaLbGC. Translating this equation into logarithms produces a linear
function that can be estimated: ln Q = ln MFP + a ln K + b ln L + c ln G. The coefficients a, b, and
c are the output elasticities of factor inputs. In other words, the coefficients indicate the percentage
change in output for a given percentage change in factor input.
192 Journal of EconomicPerspectives
have a substantially greater impact on private sector output than private capital
investment, particularly considering that so much public investment goes for
improving the environment and other goals that are not captured in national
To obtain more evidence, I looked at the relationship between public
capital and measures of economic activity at the state level (Munnell, 1990b).
Since no data on state-level public or private capital stocks were available, the
first step was to construct stock estimates; these estimates were then used in
three separate exercises. The first, parallel to the national work, estimated
production functions for states and found that public capital had a significant,
positive impact on output, although the output elasticity was roughly one-half
the size of the national estimate.
The second analysis examined the relationship between public and private
investment, which is characterized by two opposing forces. On one hand, public
capital enhances the productivity of private capital, raising its rate of return
and encouraging more investment. On the other hand, from the investor's
perspective, public capital acts as a substitute for private capital and "crowds
out" private investment. The estimated equations confirmed both forces
but suggested that, on balance, public capital investment stimulates private
The third exercise used a business location model to explore the relation-
ship between public capital and employment growth. Here the average annual
change in employment was estimated as a function of variables reflecting input
costs (labor, energy, land), market size, tax burden, and public capital stock.
The results showed that, after accounting for all the other factors that affect
employment, public capital had a positive, statistically significant effect on
Taken together, these three analyses indicate that public capital has a
positive impact on several measures of state-level economic activity: output,
investment, and employment growth. The magnitudes of these effects are
considerably smaller than those found at the national level; for instance, the
elasticity of public capital with respect to output was .15, roughly half the
estimate at the national level. These estimates are consistent with the estimates
of other researchers working at the state level (Mera, 1973; Costa, Ellson, and
Martin, 1987; Garcia-Mila and McGuire, 1992).
Enter the Critics
Critics have leveled three major changes at the results emerging from
estimated production functions. First, they contend that common trends in the
output and public infrastructure data have led to a spurious correlation.
Second, they argue that the wide range of estimates emerging from the various
3This estimated effect on state employment may overestimate the national impact if employment is
merely diverted from one area to another.
Policy Watch 193
studies renders the coefficients suspect. Finally, they suggest that causation
runs not from public capital to output, but rather in the other direction.
The most vociferous critics, concerned about the seemingly clarion call for
dramatically increased public investment, focus mainly on the aggregate time
series; they argue essentially that the equations should be estimated in the form
of first differences (Aaron, 1990; Hulten and Schwab, 1991; Jorgenson, 1991;
Tatom, 1991). Specifically, they contend that the data are not stationary but
tend to drift over time, and that it is necessary to remove this trend to eliminate
spurious correlations and determine the true relationship between the two
variables. This means specifying the relationship in terms of first differences,
which often yields results showing that public capital's effect is quite small,
sometimes negative, and generally not statistically significant.
The first-differencing specification has its problems, however. After all, no
one would expect the growth in the capital stock, whether private or public, in
one year to be correlated with the growth in output in that same year. In fact,
equations estimated in this form often yield implausible coefficients for labor
and private capital as well as for public capital (Evans and Karras, 1991; Hulten
and Schwab, 1991; Tatom, 1991). However, researchers do not conclude from
these misspecified equations that private capital and labor do not contribute to
private sector output.
In addition, first-differencing destroys any long-term relationship in the
data, which is exactly what one is trying to estimate. Instead of just first-dif-
ferencing, the variables should be tested for co-integration, adjusted, and
estimated accordingly. That is, researchers should examine not just whether
the variables grow over time, that is, the extent to which they are non-
stationary, but also whether they grow together over time and converge to their
long-run relationship, that is, the extent to which they are co-integrated.4
The second broad criticism is that the wide range of estimates of public
capital's impact on output makes the empirical linkages fragile at best. In my
view, the critics are seriously misreading the evidence. In almost all cases the
impact of public capital on private sector output and productivity has been
positive and statistically significant. This finding is amazing, given that much
public capital spending is designed to alleviate environmental problems or
enhance the quality of life, and therefore contributes little to national output as
Furthermore, the coefficients at each level of government tend to be very
similar across studies, as shown in Table 2. The variation between estimates
occurs as the unit of observation moves from the nation to states to cities. As the
geographic focus narrows, the estimated impact of public capital becomes
smaller. The most obvious explanation is that, because of leakages, one cannot
4 ratom (1991) adjusts for co-integration by including in the equation all significant leads and lags
of the independent variables and finds public capital's effect to be negative and insignificant.
However, Tatom's effort has been criticized for including the price of energy in an equation with
the quantities of other factor inputs. Clearly, more work is needed, and it should focus on adjusting
for co-integration rather than mechanically first-differencing all variables.
194 Journal of Economic Perspectives
Production Function Estimates of the Output Elasticity
of Public Capital by Level of Geographic Aggregation
Level of Elasticityof
Author Aggregation Specification Public Capital
Aschauer (1989) National Cobb-Douglas; Log levels .39
Holz-Eakin (1988) National Cobb-Douglas; Log levels .39
Munnell (1990a) National Cobb-Douglas; Log levels .34
Martin (1987) States Translog; Levels .20
Eisner (1991) States Cobb-Douglas; Log levels .17
Mera (1973) Japanese regions Cobb-Douglas; Log levels .20
Munnell (1990b) States Cobb-Douglas; Log levels .15
Eberts (1989)a Metropolitan areas Log levels .08
Eberts (1986, 1990) Metropolitan areas Translog; Levels .03
Note: Results from the first-difference model used by Aaron (1990), Hulten and Schwab (1991), and
other critics are not included because they yielded implausible coefficients on the private inputs.
aThe authors do not estimate a production function, but instead use personal income as the
capture all of the payoff to an infrastructure investment by looking at a small
The third major criticism is that the direction of causation may run from
high levels of output to greater public capital investment, rather than the other
way around. The criticism is legitimate. Capital investment, private as well as
public, goes hand in hand with economic activity. However, this mutual
influence can exist without necessarily tainting the coefficient on public capital,
or, for that matter, private capital in estimated production functions.
Eberts and Fogarty (1987) examined the question of causality by looking at
public and private investment data from 1904 to 1978 for 40 metropolitan
areas. They found causation running in both directions. Their analysis indi-
cated that public investment led private investment in cities that experienced
most of their growth before the 1950s, while the reverse was true for southern
cities and cities that grew faster since 1950.
To examine the simultaneity issue, I reestimated some equations using the
state data, but included only the value of public capital at the beginning of the
period, which foreclosed the possibility of any feedback effect of output growth
on public capital investment. Nonetheless, public capital continued to exhibit a
large, positive, statistically significant effect on output. This small exercise does
not put the question to rest, but does suggest that the coefficient of public
capital is not seriously tainted by the simultaneity problem.
Other critics have suggested that the production function framework is
inadequate, both because it omits input prices (which affect factor utilization
Alicia H. Munnell 195
and bias the estimated coefficients) and also because it places too many restric-
tions on firms' technology and behavior (Friedlaender, 1990; Morrison and
Schwartz, 1992). They believe that researchers should instead estimate cost
functions, which allow one to disentangle the effects of infrastructure, scale
economies, and fixed effects on costs and the cost-output relationship.
Dalenberg and Eberts (1992), Morrison and Schwartz (1992), and Nadiri and
Mamuneas (1992) all adopt the cost-function approach and find that public
capital significantly reduces the costs of private production.
In summary, the critics are correct that the numbers emerging from the
aggregate time series studies are not credible, and that more evidence is
needed on the causation issue. But the tendency to throw the baby out with the
bathwater should be resisted. At this point, an even-handed reading of the
evidence-including the growing body of cross-sectional results-suggests that
public infrastructure is a productive input which may have large payoffs.
Does the Nation Need More Public Investment?
If infrastructure has substantial payoffs, does this imply that public capital
is undersupplied and higher levels of investment are warranted? At this time,
production function estimates provide little guidance on this point, but some
other evidence seems to support the notion that profitable public investment
For example, cost-benefit studies reported by the Congressional Budget
Office (1988) indicate that the return to projects designed to maintain the
average condition on the federal highway system could be as high as 30 to 40
percent. The CBO (1991) also suggests the likelihood of substantial bene-
fits from increased outlays for both air traffic control and airport capacity
Another piece of evidence comes from the work of George Peterson (1990,
1991). He explored voters' preferences for public capital investment as ex-
pressed in bond elections and other referenda. If public officials were trying to
satisfy the median voter, as theory suggests, they would submit frequent bond
proposals for consideration to assess voter demand. As a result, bond elections
should be closely contested with bond approval rates and margins close to 50
percent. Instead, Peterson found that 80 percent of infrastructure bond pro-
posals were approved between 1984 and 1989, and that the margin exceeded
66 percent on average.5 Although only 25 percent of capital spending passes
through the referendum process, this experience suggests that voters are
willing to pay for more infrastructure spending.
5Aaron (1991) offers a note of caution concerning Peterson's work. Specifically, he points out that
elected officials control the supply of proposals and it is very difficult to make any determinations
about voters' demands for infrastructure without analyzing changes in supply. Aaron concludes,
however, that he would not be surprised if Peterson's claims are entirely correct, but does not feel
that the case has been proven yet.
196 Journal of EconomicPerspectives
Despite such findings, several voices urge caution when considering in-
creased spending for public infrastructure. For example, Clifford Winston and
his colleagues contend that the condition of the nation's highways could be
improved and congestion reduced with the same or less investment by making
three changes (Winston, 1990, 1991; Small, Winston, and Evans, 1989). First,
building roads thicker than prevailing engineering standards would produce
great savings. Second, shifting from a tax on the number of truck axles to one
on weight per axle would greatly encourage efficient use of highways and
minimize damage. Third, increasing the use of congestion taxes would reduce
peak-period congestion and increase the services provided by existing capacity.
Others point to inefficiencies in our federal grant programs, where matching
rates are probably much higher than can be justified on the basis of interjuris-
dictional spillovers (Gramlich, 1990, 1991). As a result, many states pay as little
as 10 cents on the dollar for new highways, giving little reason to believe that
they will make economically sensible decisions about infrastructure investment.
Those who worry about the incentives to spend, the efficiency of design,
and the appropriateness of the prices charged tend -to believe that infrastruc-
ture policy should focus on eliminating current distortions and inefficiencies.
They seem to believe that once the perversities in the existing system are
removed, the present stock of infrastructure can meet most of the nation's
needs. Additional investment at this time will divert attention and alleviate the
pressure to make needed pricing reforms. Although these concerns about
pricing and grant programs should be addressed, my hunch is that these
reforms will be slow in coming and the country will still need more spending to
repair roads and bridges, treat wastewater, dispose of trash, and improve the
quality of the nation's lakes and rivers.
Some proponents of expanded infrastructure investment are truly inter-
ested in the effect that additional spending will have on economic activity;
others are at least as interested in the potential or lucrative contracts coming
their way. The immediacy of policy implications places great demands on
economists, both not to oversell preliminary results and not to dismiss a
growing body of evidence. It has proved a difficult environment in which to
make a calm assessment of the evidence.
That said, my views are as follows. This is an area ripe for research that
could have important policy implications. Researchers should focus on explain-
ing the variations in the coefficients by level of government, disentangling the
causation question, and examining the cointegration issue. Aggregate results,
however, cannot be used to guide actual investment spending. Only cost-benefit
studies can determine which projects should be implemented. Finally, while
reforms to grant programs and pricing should occur, it is probably neither
realistic nor desirable to hold off on infrastructure investment until such
Policy Watch 197
reforms are adopted. For the evidence suggests that, in addition to providing
immediate economic stimulus, public infrastructure investment has a signifi-
cant, positive effect on output and growth.
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