Lorenzo Germinetti
Published in post

A framework to evaluate the recent increase in public investment in the UK

In the Chancellor’s 2017 Autumn Budget, he announced that a “balanced approach to managing the public finances” would have been maintained. However, the Government has decided to be somewhat ambitious in devoting resources to public investment. In fact, following the decision, by 2020-21 public investment as a percentage of GDP is going to be at its highest level in 30 years (considering the period immediately after the financial crisis as exceptional). A relevant role will be played by the recently created National Productivity and Investment Fund (NPFI), which the budget extends to 2022-23. The fund will be provided with a constantly increasing amount of money (from £1.6 billion in 2017-28 to £7 billion in 2020-21) to be spent on housing, transport, R&D and communications.

The motive lies perhaps in the slowdown of productivity, illustrated by the Office for Budget Responsibility (OBR)’s revision of its forecast downward in its review of the Budget (figure 1). The Government is now devoted to the idea of helping productivity getting back on track. In its thinking, an increase in public investment would at the same time support demand in the short-run and increase the overall productivity in the long run. The question is thus: will this effort be fit for purpose?

Figure 1 – Productivity growth (output per hour) in the UK, forecasts and outturns.

Source: OBR Economic and Fiscal Outlook, November 2017.

The issue needs to be evaluated carefully. First, it is necessary to recognise that low productivity is being caused by a set of diverse circumstances. Any statement regarding the necessity of raising public investment needs to address the policy mix. In addition, it is worth considering factors that will determine the effectiveness of such a move, such as the way in which the additional spending is financed. Also, it is necessary to evaluate whether a boost to productivity would be better pursued by incentives to private investments.

In what follows, after proceeding through all the steps of this framework, it is concluded the the positive impact of the Government’s decision is likely to be modest, if present at all.

A report written by the Treasury Committee outlines a number of possible reasons why productivity growth has failed to return to pre-crisis levels. First, the recent increase in employment made use of spare labour inputs in low-productivity sectors. Second, the critical conditions of some financial institutions have put some obstacles in the way of the reallocation of capital to the most productive activities. Third, the exceptionally accomodative monetary policy that characterised the post-crisis period has made it possible for firms with low levels of productivity to survive. Lastly, capital formation in the UK, which has been low compared to other developed countries since the 1990’s, failed to come back at pre-crisis levels after the 2007-2008 financial crash (figure 2). This, in turn, has probably been caused by the regulatory context in general, by the uncertainty related to Brexit and by the surge in government spending during the financial crisis itself, which is likely to have had a negative impact on private investment (see Blanchard and Perotti, 1999).

Figure 2 – Gross fixed capital formation (% of GDP) in selected economies.

Source: World Bank national accounts data, and OECD National Accounts data files.

The Government intervention addresses this last cause by increasing its share of investment in the economy. The economic reasoning that links the level of capital to productivity is essentially correct. Theoretically, in the medium and longer term, public investment leads to the optimal level of growth if (1) the return from investment to the general public is higher than the one to the private investor and (2) investment decisions are taken according to the criterion of productive efficiency (see Barro, 1990). In particular, good infrastructure can increase the productive potential of the economy (Bourne and Zuluaga, 2016).

However, the linkages between public investment and the growth rate of output is hotly debated in the empirical literature. De Jong et al. (2017) provide a useful summary of 68 papers published between 1983 and 2008 that made use of the production function approach, concluding that the values of public capital output elasticities range from -1.7 to 2.04, with an average of 0.106. In other words, it has been found that, on average, a 1% increase in public capital leads to a 0.106% increase in output. Looking at these figures, it is fair to conclude that there is mixed evidence of the effectiveness of public investment in raising output.

In contrast, a certain agreement can be reached when considering what kind of financing makes public investment more effective in increasing output. There are, to put it simply, three ways in which resources could be found to increase public investment: issue more debt, impose higher taxes, or forgo government consumption and prioritize investment (see, for instance, Abiad et al., 2015). The Government has decided to proceed with the latter alternative. Fortunately, this means that higher taxes, as well as an increase in the public deficit, are not to be expected. The distortive character of taxation would act against the intent of the measure itself, slowing down GDP growth. In addition, a further increase in inflation and debt, which would occur in the case of a debt-financed measure, will be avoided (see De Jong et al. (2017), p. 27).

Turning to the opportunity cost of the increase in public investment, it is necessary to consider if a rise in the level of capital formation would not have been obtained more swiftly by a decrease in taxation for companies that engage in investment projects. Indeed, the corporate tax rate in the UK is the lowest among G20 members, it has been cut by 1% between 2016 and 2017, and it now lies at 19% (KPMG). Also, the R&D expenditure credit has been increased to 12% (from 11%) and the Annual Investment Allowance (AIA) remained fixed at £200.000. Of course, more radical tax cuts could have been achieved by forgoing the increase in public investment. This would have been particularly attractive, as the ability of the private sector to deliver investment projects cannot be matched by the Government. Bourne and Zuluaga (2016) provide a clear explanation for this. Public investment is subject to flaws that pertain to its political nature. The decision making process hinders the responsiveness of projects, which are not well suited to manage demand in the short term. More importantly for the argument above, public endeavours are often chosen by measuring their electoral advantage, disregarding the cost-benefit ratio. As a result, the opportunity cost of any Government project can be considered high, as private investment is forgone and taxes are not cut.

To conclude, the Government decision to increase its spending on public capital is based on sound economic reasoning, to a certain extent. Public capital can be a key factor in the determination of the potential output of an economy and public investment projects are theoretically desirable when the return to society is greater than the one to private agents. However, there is mixed evidence regarding the linkages between a rise in public capital and the growth rate of output. Other factors will play a relevant role in determining the future rates of productivity growth. Among these, it is worth mentioning the degree of uncertainty caused by Brexit and the state of the financial sector. In general, it is not recommended to have great confidence in the effectiveness of public projects. Public enterprises are often undertaken disregarding their opportunity cost, which is likely to be relevant given the intrinsic differences between private and public decision making. As a consequence, the recent increase in public investment is not likely to deliver on its promise.

Lorenzo Germinetti

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