Public Infrastructure and Economic Growth A Dynamic General Equilibrium Analysis with Heterogeneous Agents

The relationship between investment in public infrastructure and growth has become a pervasive theme in the theoretical and empirical literatures on economic growth in both developed and developing countries alike. Much of the recent debate on the means to reduce persistent poverty in developing countries and to spur growth in all countries has revolved around the idea of significantly boosting investment in public infrastructure. The rationale behind that idea is the belief that infrastructure services have a strong impact on growth via their positive effects on the productivity of private firms. This paper assesses the growth, sectoral and welfare implications of increased spending on infrastructure using a multisector intertemporal general equilibrium with public capital and heterogeneous agents. The seminal works of Aschauer (1989) and Barro (1990) have paved the way to a substantial volume of studies that aim to provide a better grasp of the contribution of public infrastructure to economic growth. The theoretical literature has mostly focused on modeling public infrastructure as an input in firm technology so as to account for its externality in production. Several studies in the empirical literature on infrastructure and growth have employed a variety of econometric techniques to find support for a positive impact of public infrastructure on growth. Aschauer (1989), Calderon and Serven (2004), and Sahoo and Dash (2009) are few examples among several others. Some of these studies have been heavily criticized for obtaining overly high output elasticities of public investment because of methodological weaknesses[1]. Yet, a good understanding of the multiple linkages through which investment in public infrastructure exerts an impact on economic growth is required. In that respect, econometric regressions do not provide an adequate framework for tracing the transmission mechanisms that we need to understand. In particular, they do not allow for an analysis of important general equilibrium feedback effects of spending on public infrastructures as well as their fiscal implications. These general equilibrium effects of public investment are the more important since their increase needs to be financed somehow by either increasing taxes or foreign aid. The increase in taxation may discourage private investment, and thereby affect economic growth negatively. The overall effects of increasing public investment in infrastructure depend thus on the trade-off between the positive productivity effect of public investment and the distortionary effects of taxes. Most of the existing CGE studies are of a recursive-dynamic nature in the sense that they are simply stacked static models linked by a simple adjustment of the stocks of primary factors from one period to another. Identical to the approach of static models, saving and investment decisions are determined in an ad hoc manner where households and firms are assumed to behave myopically. Yet, saving and investment decisions, which are crucial to the growth process, are purely intertemporal decisions that take into consideration expectations on variables in the future. Intertemporal CGE models, in which firms and households are no longer myopic, are better suited to adequately capture the adjustment, the transmission mechanisms, and the growth and distributive implications of the proposed policy change. In this paper we develop a multisector, intertemporal general equilibrium model with public capital and heterogeneous agents to assess the growth and sectoral implications of increased government spending on infrastructure in a developing country. We use a stock approach to model public capital in firm's technology. The introduction of heterogeneity among agents stems from the desire to take into account a peculiar characteristic of developing countries where a significant proportion of households and firms do not or cannot display forward-looking behavior as they lack access to the credit market. The model considers two categories of households and two categories of firms. It distinguishes on the one hand, between forward-looking and myopic households, and on the other hand, between forward-looking and myopic firms. Previous papers such as Campbell and Mankiw (1989), Carmichael and Samson (1995), McKibbin and Vines (2000) and Berg et al. (2010) have also introduced heterogeneity among households in intertemporal models. Nevertheless, in contrast to those models, which assume that myopic households consume all their one-source income (wages), we assume that myopic households have an additional source of income to their wages, (capital income) as they are the owners of the myopic firms. They do not consume all of their disposable income; they only consume a constant fraction of it (less than one, as in a Solow growth model). It follows that in our model, myopic households do save; their savings are used to fund investment in physical capital made available to myopic firms. In contrast, the savings of forward-looking households are used to fund investment in forward looking firms that they own. Thus, the model establishes an isomorphism between the set of household categories and the set of firm categories as far as the return to capital is concerned. In contrast to forward-looking firms in which managers maximize the discounted sum of dividends, managers of myopic firms maximize their current profits. We elect to use the model to study the growth implications of increased public capital in an African country, Benin, which is a small-open economy of West-Africa where international organizations have started to place a strategic emphasis on public infrastructure as an important means for achieving stronger economic growth and poverty reduction. A recent World Bank assessment of this country (World Bank, 2009) clearly emphasizes the need to raise the level of public infrastructure that is partly responsible for the low levels of private investment and entrepreneurship. See above See above