Do States Optimize? Public Capital and Economic Growth

First, there is the question of whether a permanent increase in public investment induces a permanent, or merely a temporary, increase in economic growth. The traditional neoclassical growth model of Solow (1956) predicts that any positive effect of an increase in the national savings and investment rate on economic growth will be transitory; the steady-state growth rate is fully determined by population growth and exogenous technological progress. In the neoclassical setting, an increase in spending on productive public capital will induce a period of temporarily high investment, but the pace of capital accumulation, and of economic growth, will slow over time as the accumulation of capital diminishes the return to capital and the incentive for further investment. In the long run, the level of output will be higher but the growth rate of output will return to the same level as before the public spending initiative. Second, the effect of an increase in public investment on economic growth is likely to depend on the relative marginal productivity of private versus public capital. In the neoclassical setting, an increase in public investment (at the expense of private investment) will raise or lower the economic growth rate depending on whether the marginal product of private capital. This consideration validates the concerns of Aaron and others that the range of empirical estimates of the output elasticity of public capital is too large to be informative to the public policy process; we need to know, rather precisely, not only that public capital is productive but that it is sufficiently productive to be confident of a beneficial effect of increased public investment on economic growth. Third, the effect of public investment on growth is likely to depend on how the increased spending is financed. Empirical studies such as Engen and Skinner (1996) find evidence that increases in tax rates reduce the rate of economic growth. Thus, it is to be expected that an increase in public capital-- which, in most cases, will require a corresponding increase in tax rates--will stimulate economic growth only if the productivity impact of public capital exceeds the adverse tax impact. This paper focuses on some of these considerations by investigating the relationship between public capital, productivity, and economic growth in an endogenous growth setting.