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Principles of Economics 2e

31.4 Fiscal Policy, Investment, and Economic Growth

Principles of Economics 2e31.4 Fiscal Policy, Investment, and Economic Growth
  1. Preface
  2. 1 Welcome to Economics!
    1. Introduction
    2. 1.1 What Is Economics, and Why Is It Important?
    3. 1.2 Microeconomics and Macroeconomics
    4. 1.3 How Economists Use Theories and Models to Understand Economic Issues
    5. 1.4 How To Organize Economies: An Overview of Economic Systems
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
  3. 2 Choice in a World of Scarcity
    1. Introduction to Choice in a World of Scarcity
    2. 2.1 How Individuals Make Choices Based on Their Budget Constraint
    3. 2.2 The Production Possibilities Frontier and Social Choices
    4. 2.3 Confronting Objections to the Economic Approach
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  4. 3 Demand and Supply
    1. Introduction to Demand and Supply
    2. 3.1 Demand, Supply, and Equilibrium in Markets for Goods and Services
    3. 3.2 Shifts in Demand and Supply for Goods and Services
    4. 3.3 Changes in Equilibrium Price and Quantity: The Four-Step Process
    5. 3.4 Price Ceilings and Price Floors
    6. 3.5 Demand, Supply, and Efficiency
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  5. 4 Labor and Financial Markets
    1. Introduction to Labor and Financial Markets
    2. 4.1 Demand and Supply at Work in Labor Markets
    3. 4.2 Demand and Supply in Financial Markets
    4. 4.3 The Market System as an Efficient Mechanism for Information
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  6. 5 Elasticity
    1. Introduction to Elasticity
    2. 5.1 Price Elasticity of Demand and Price Elasticity of Supply
    3. 5.2 Polar Cases of Elasticity and Constant Elasticity
    4. 5.3 Elasticity and Pricing
    5. 5.4 Elasticity in Areas Other Than Price
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  7. 6 Consumer Choices
    1. Introduction to Consumer Choices
    2. 6.1 Consumption Choices
    3. 6.2 How Changes in Income and Prices Affect Consumption Choices
    4. 6.3 Behavioral Economics: An Alternative Framework for Consumer Choice
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  8. 7 Production, Costs, and Industry Structure
    1. Introduction to Production, Costs, and Industry Structure
    2. 7.1 Explicit and Implicit Costs, and Accounting and Economic Profit
    3. 7.2 Production in the Short Run
    4. 7.3 Costs in the Short Run
    5. 7.4 Production in the Long Run
    6. 7.5 Costs in the Long Run
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  9. 8 Perfect Competition
    1. Introduction to Perfect Competition
    2. 8.1 Perfect Competition and Why It Matters
    3. 8.2 How Perfectly Competitive Firms Make Output Decisions
    4. 8.3 Entry and Exit Decisions in the Long Run
    5. 8.4 Efficiency in Perfectly Competitive Markets
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  10. 9 Monopoly
    1. Introduction to a Monopoly
    2. 9.1 How Monopolies Form: Barriers to Entry
    3. 9.2 How a Profit-Maximizing Monopoly Chooses Output and Price
    4. Key Terms
    5. Key Concepts and Summary
    6. Self-Check Questions
    7. Review Questions
    8. Critical Thinking Questions
    9. Problems
  11. 10 Monopolistic Competition and Oligopoly
    1. Introduction to Monopolistic Competition and Oligopoly
    2. 10.1 Monopolistic Competition
    3. 10.2 Oligopoly
    4. Key Terms
    5. Key Concepts and Summary
    6. Self-Check Questions
    7. Review Questions
    8. Critical Thinking Questions
    9. Problems
  12. 11 Monopoly and Antitrust Policy
    1. Introduction to Monopoly and Antitrust Policy
    2. 11.1 Corporate Mergers
    3. 11.2 Regulating Anticompetitive Behavior
    4. 11.3 Regulating Natural Monopolies
    5. 11.4 The Great Deregulation Experiment
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  13. 12 Environmental Protection and Negative Externalities
    1. Introduction to Environmental Protection and Negative Externalities
    2. 12.1 The Economics of Pollution
    3. 12.2 Command-and-Control Regulation
    4. 12.3 Market-Oriented Environmental Tools
    5. 12.4 The Benefits and Costs of U.S. Environmental Laws
    6. 12.5 International Environmental Issues
    7. 12.6 The Tradeoff between Economic Output and Environmental Protection
    8. Key Terms
    9. Key Concepts and Summary
    10. Self-Check Questions
    11. Review Questions
    12. Critical Thinking Questions
    13. Problems
  14. 13 Positive Externalities and Public Goods
    1. Introduction to Positive Externalities and Public Goods
    2. 13.1 Why the Private Sector Underinvests in Innovation
    3. 13.2 How Governments Can Encourage Innovation
    4. 13.3 Public Goods
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  15. 14 Labor Markets and Income
    1. Introduction to Labor Markets and Income
    2. 14.1 The Theory of Labor Markets
    3. 14.2 Wages and Employment in an Imperfectly Competitive Labor Market
    4. 14.3 Market Power on the Supply Side of Labor Markets: Unions
    5. 14.4 Bilateral Monopoly
    6. 14.5 Employment Discrimination
    7. 14.6 Immigration
    8. Key Terms
    9. Key Concepts and Summary
    10. Self-Check Questions
    11. Review Questions
    12. Critical Thinking Questions
  16. 15 Poverty and Economic Inequality
    1. Introduction to Poverty and Economic Inequality
    2. 15.1 Drawing the Poverty Line
    3. 15.2 The Poverty Trap
    4. 15.3 The Safety Net
    5. 15.4 Income Inequality: Measurement and Causes
    6. 15.5 Government Policies to Reduce Income Inequality
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  17. 16 Information, Risk, and Insurance
    1. Introduction to Information, Risk, and Insurance
    2. 16.1 The Problem of Imperfect Information and Asymmetric Information
    3. 16.2 Insurance and Imperfect Information
    4. Key Terms
    5. Key Concepts and Summary
    6. Self-Check Questions
    7. Review Questions
    8. Critical Thinking Questions
    9. Problems
  18. 17 Financial Markets
    1. Introduction to Financial Markets
    2. 17.1 How Businesses Raise Financial Capital
    3. 17.2 How Households Supply Financial Capital
    4. 17.3 How to Accumulate Personal Wealth
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  19. 18 Public Economy
    1. Introduction to Public Economy
    2. 18.1 Voter Participation and Costs of Elections
    3. 18.2 Special Interest Politics
    4. 18.3 Flaws in the Democratic System of Government
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  20. 19 The Macroeconomic Perspective
    1. Introduction to the Macroeconomic Perspective
    2. 19.1 Measuring the Size of the Economy: Gross Domestic Product
    3. 19.2 Adjusting Nominal Values to Real Values
    4. 19.3 Tracking Real GDP over Time
    5. 19.4 Comparing GDP among Countries
    6. 19.5 How Well GDP Measures the Well-Being of Society
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  21. 20 Economic Growth
    1. Introduction to Economic Growth
    2. 20.1 The Relatively Recent Arrival of Economic Growth
    3. 20.2 Labor Productivity and Economic Growth
    4. 20.3 Components of Economic Growth
    5. 20.4 Economic Convergence
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  22. 21 Unemployment
    1. Introduction to Unemployment
    2. 21.1 How Economists Define and Compute Unemployment Rate
    3. 21.2 Patterns of Unemployment
    4. 21.3 What Causes Changes in Unemployment over the Short Run
    5. 21.4 What Causes Changes in Unemployment over the Long Run
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  23. 22 Inflation
    1. Introduction to Inflation
    2. 22.1 Tracking Inflation
    3. 22.2 How to Measure Changes in the Cost of Living
    4. 22.3 How the U.S. and Other Countries Experience Inflation
    5. 22.4 The Confusion Over Inflation
    6. 22.5 Indexing and Its Limitations
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  24. 23 The International Trade and Capital Flows
    1. Introduction to the International Trade and Capital Flows
    2. 23.1 Measuring Trade Balances
    3. 23.2 Trade Balances in Historical and International Context
    4. 23.3 Trade Balances and Flows of Financial Capital
    5. 23.4 The National Saving and Investment Identity
    6. 23.5 The Pros and Cons of Trade Deficits and Surpluses
    7. 23.6 The Difference between Level of Trade and the Trade Balance
    8. Key Terms
    9. Key Concepts and Summary
    10. Self-Check Questions
    11. Review Questions
    12. Critical Thinking Questions
    13. Problems
  25. 24 The Aggregate Demand/Aggregate Supply Model
    1. Introduction to the Aggregate Supply–Aggregate Demand Model
    2. 24.1 Macroeconomic Perspectives on Demand and Supply
    3. 24.2 Building a Model of Aggregate Demand and Aggregate Supply
    4. 24.3 Shifts in Aggregate Supply
    5. 24.4 Shifts in Aggregate Demand
    6. 24.5 How the AD/AS Model Incorporates Growth, Unemployment, and Inflation
    7. 24.6 Keynes’ Law and Say’s Law in the AD/AS Model
    8. Key Terms
    9. Key Concepts and Summary
    10. Self-Check Questions
    11. Review Questions
    12. Critical Thinking Questions
    13. Problems
  26. 25 The Keynesian Perspective
    1. Introduction to the Keynesian Perspective
    2. 25.1 Aggregate Demand in Keynesian Analysis
    3. 25.2 The Building Blocks of Keynesian Analysis
    4. 25.3 The Phillips Curve
    5. 25.4 The Keynesian Perspective on Market Forces
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
  27. 26 The Neoclassical Perspective
    1. Introduction to the Neoclassical Perspective
    2. 26.1 The Building Blocks of Neoclassical Analysis
    3. 26.2 The Policy Implications of the Neoclassical Perspective
    4. 26.3 Balancing Keynesian and Neoclassical Models
    5. Key Terms
    6. Key Concepts and Summary
    7. Self-Check Questions
    8. Review Questions
    9. Critical Thinking Questions
    10. Problems
  28. 27 Money and Banking
    1. Introduction to Money and Banking
    2. 27.1 Defining Money by Its Functions
    3. 27.2 Measuring Money: Currency, M1, and M2
    4. 27.3 The Role of Banks
    5. 27.4 How Banks Create Money
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  29. 28 Monetary Policy and Bank Regulation
    1. Introduction to Monetary Policy and Bank Regulation
    2. 28.1 The Federal Reserve Banking System and Central Banks
    3. 28.2 Bank Regulation
    4. 28.3 How a Central Bank Executes Monetary Policy
    5. 28.4 Monetary Policy and Economic Outcomes
    6. 28.5 Pitfalls for Monetary Policy
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  30. 29 Exchange Rates and International Capital Flows
    1. Introduction to Exchange Rates and International Capital Flows
    2. 29.1 How the Foreign Exchange Market Works
    3. 29.2 Demand and Supply Shifts in Foreign Exchange Markets
    4. 29.3 Macroeconomic Effects of Exchange Rates
    5. 29.4 Exchange Rate Policies
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  31. 30 Government Budgets and Fiscal Policy
    1. Introduction to Government Budgets and Fiscal Policy
    2. 30.1 Government Spending
    3. 30.2 Taxation
    4. 30.3 Federal Deficits and the National Debt
    5. 30.4 Using Fiscal Policy to Fight Recession, Unemployment, and Inflation
    6. 30.5 Automatic Stabilizers
    7. 30.6 Practical Problems with Discretionary Fiscal Policy
    8. 30.7 The Question of a Balanced Budget
    9. Key Terms
    10. Key Concepts and Summary
    11. Self-Check Questions
    12. Review Questions
    13. Critical Thinking Questions
    14. Problems
  32. 31 The Impacts of Government Borrowing
    1. Introduction to the Impacts of Government Borrowing
    2. 31.1 How Government Borrowing Affects Investment and the Trade Balance
    3. 31.2 Fiscal Policy and the Trade Balance
    4. 31.3 How Government Borrowing Affects Private Saving
    5. 31.4 Fiscal Policy, Investment, and Economic Growth
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  33. 32 Macroeconomic Policy Around the World
    1. Introduction to Macroeconomic Policy around the World
    2. 32.1 The Diversity of Countries and Economies across the World
    3. 32.2 Improving Countries’ Standards of Living
    4. 32.3 Causes of Unemployment around the World
    5. 32.4 Causes of Inflation in Various Countries and Regions
    6. 32.5 Balance of Trade Concerns
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  34. 33 International Trade
    1. Introduction to International Trade
    2. 33.1 Absolute and Comparative Advantage
    3. 33.2 What Happens When a Country Has an Absolute Advantage in All Goods
    4. 33.3 Intra-industry Trade between Similar Economies
    5. 33.4 The Benefits of Reducing Barriers to International Trade
    6. Key Terms
    7. Key Concepts and Summary
    8. Self-Check Questions
    9. Review Questions
    10. Critical Thinking Questions
    11. Problems
  35. 34 Globalization and Protectionism
    1. Introduction to Globalization and Protectionism
    2. 34.1 Protectionism: An Indirect Subsidy from Consumers to Producers
    3. 34.2 International Trade and Its Effects on Jobs, Wages, and Working Conditions
    4. 34.3 Arguments in Support of Restricting Imports
    5. 34.4 How Governments Enact Trade Policy: Globally, Regionally, and Nationally
    6. 34.5 The Tradeoffs of Trade Policy
    7. Key Terms
    8. Key Concepts and Summary
    9. Self-Check Questions
    10. Review Questions
    11. Critical Thinking Questions
    12. Problems
  36. A | The Use of Mathematics in Principles of Economics
  37. B | Indifference Curves
  38. C | Present Discounted Value
  39. D | The Expenditure-Output Model
  40. Answer Key
    1. Chapter 1
    2. Chapter 2
    3. Chapter 3
    4. Chapter 4
    5. Chapter 5
    6. Chapter 6
    7. Chapter 7
    8. Chapter 8
    9. Chapter 9
    10. Chapter 10
    11. Chapter 11
    12. Chapter 12
    13. Chapter 13
    14. Chapter 14
    15. Chapter 15
    16. Chapter 16
    17. Chapter 17
    18. Chapter 18
    19. Chapter 19
    20. Chapter 20
    21. Chapter 21
    22. Chapter 22
    23. Chapter 23
    24. Chapter 24
    25. Chapter 25
    26. Chapter 26
    27. Chapter 27
    28. Chapter 28
    29. Chapter 29
    30. Chapter 30
    31. Chapter 31
    32. Chapter 32
    33. Chapter 33
    34. Chapter 34
  41. References
  42. Index

By the end of this section, you will be able to:

  • Explain crowding out and its effect on physical capital investment
  • Explain the relationship between budget deficits and interest rates
  • Identify why economic growth is tied to investments in physical capital, human capital, and technology

The underpinnings of economic growth are investments in physical capital, human capital, and technology, all set in an economic environment where firms and individuals can react to the incentives provided by well-functioning markets and flexible prices. Government borrowing can reduce the financial capital available for private firms to invest in physical capital. However, government spending can also encourage certain elements of long-term growth, such as spending on roads or water systems, on education, or on research and development that creates new technology.

Crowding Out Physical Capital Investment

A larger budget deficit will increase demand for financial capital. If private saving and the trade balance remain the same, then less financial capital will be available for private investment in physical capital. When government borrowing soaks up available financial capital and leaves less for private investment in physical capital, economists call the result crowding out.

To understand the potential impact of crowding out, consider the U.S. economy's situation before the exceptional circumstances of the recession that started in late 2007. In 2005, for example, the budget deficit was roughly 4% of GDP. Private investment by firms in the U.S. economy has hovered in the range of 14% to 18% of GDP in recent decades. However, in any given year, roughly half of U.S. investment in physical capital just replaces machinery and equipment that has worn out or become technologically obsolete. Only about half represents an increase in the total quantity of physical capital in the economy. Investment in new physical capital in any year is about 7% to 9% of GDP. In this situation, even U.S. budget deficits in the range of 4% of GDP can potentially crowd out a substantial share of new investment spending. Conversely, a smaller budget deficit (or an increased budget surplus) increases the pool of financial capital available for private investment.

Link It Up

Visit this website to view the “U.S. Debt Clock.”

Figure 31.7 shows the patterns of U.S. budget deficits and private investment since 1980. If greater government deficits lead to less private investment in physical capital, and reduced government deficits or budget surpluses lead to more investment in physical capital, these two lines should move up and down simultaneously. This pattern occurred in the late 1990s and early 2000s. The U.S. federal budget went from a deficit of 2.2% of GDP in 1995 to a budget surplus of 2.4% of GDP in 2000—a swing of 4.6% of GDP. From 1995 to 2000, private investment in physical capital rose from 15% to 18% of GDP—a rise of 3% of GDP. Then, when the U.S. government again started running budget deficits in the early 2000s, less financial capital became available for private investment, and the rate of private investment fell back to about 15% of GDP by 2003.

The graph shows that in the case of the United States, since 1980 government borrowing and private investment have often risen and fallen in tandem. The y-axis shows U.S. government deficits/surpluses and private investment as a portion of GDP. The x-axis plots years from 1980 to 2014. It suggests that reduced government borrowing can free up capital for private investment.
Figure 31.7 U.S. Budget Deficits/Surpluses and Private Investment The connection between private savings and flows of international capital plays a role in budget deficits and surpluses. Consequently, government borrowing and private investment sometimes rise and fall together. For example, the 1990s show a pattern in which reduced government borrowing helped to reduce crowding out so that more funds were available for private investment.

This argument does not claim that a government's budget deficits will exactly shadow its national rate of private investment; after all, we must account for private saving and inflows of foreign financial investment. In the mid-1980s, for example, government budget deficits increased substantially without a corresponding drop off in private investment. In 2009, nonresidential private fixed investment dropped by $300 billion from its previous level of $1,941 billion in 2008, primarily because, during a recession, firms lack both the funds and the incentive to invest. Investment growth between 2009 and 2014 averaged approximately 5.9% to $2,210.5 billion—only slightly above its 2008 level, according to the Bureau of Economic Analysis. During that same period, interest rates dropped from 3.94% to less than a quarter percent as the Federal Reserve took dramatic action to prevent a depression by increasing the money supply through lowering short-term interest rates. The "crowding out" of private investment due to government borrowing to finance expenditures appears to have been suspended during the Great Recession. However, as the economy improves and interest rates rise, government borrowing may potentially create pressure on interest rates.

The Interest Rate Connection

Assume that government borrowing of substantial amounts will have an effect on the quantity of private investment. How will this affect interest rates in financial markets? In Figure 31.8, the original equilibrium (E0) where the demand curve (D0) for financial capital intersects with the supply curve (S0) occurs at an interest rate of 5% and an equilibrium quantity equal to 20% of GDP. However, as the government budget deficit increases, the demand curve for financial capital shifts from D0 to D1. The new equilibrium (E1) occurs at an interest rate of 6% and an equilibrium quantity of 21% of GDP.

The graph plots the downward-sloping demand and upward-sloping supply of financial capital. The y-axis is the interest rate (also known as the “price” of financial capital) and the x-axis shows the quantity of financial capital as a percentage of GDP. An increase in government borrowing increases the quantity of financial capital demanded at all interest rates. This is a rightward shift in the demand for financial capital. The graph shows that the equilibrium interest rate will rise.
Figure 31.8 Budget Deficits and Interest Rates In the financial market, an increase in government borrowing can shift the demand curve for financial capital to the right from D0 to D1. As the equilibrium interest rate shifts from E0 to E1, the interest rate rises from 5% to 6% in this example. The higher interest rate is one economic mechanism by which government borrowing can crowd out private investment.

A survey of economic studies on the connection between government borrowing and interest rates in the U.S. economy suggests that an increase of 1% in the budget deficit will lead to a rise in interest rates of between 0.5 and 1.0%, other factors held equal. In turn, a higher interest rate tends to discourage firms from making physical capital investments. One reason government budget deficits crowd out private investment, therefore, is the increase in interest rates. There are, however, economic studies that show a limited connection between the two (at least in the United States), but as the budget deficit grows, the dangers of rising interest rates become more real.

At this point, you may wonder about the Federal Reserve. After all, can the Federal Reserve not use expansionary monetary policy to reduce interest rates, or in this case, to prevent interest rates from rising? This useful question emphasizes the importance of considering how fiscal and monetary policies work in relation to each other. Imagine a central bank faced with a government that is running large budget deficits, causing a rise in interest rates and crowding out private investment. If the budget deficits are increasing aggregate demand when the economy is already producing near potential GDP, threatening an inflationary increase in price levels, the central bank may react with a contractionary monetary policy. In this situation, the higher interest rates from the government borrowing would be made even higher by contractionary monetary policy, and the government borrowing might crowd out a great deal of private investment.

Alternatively, if the budget deficits are increasing aggregate demand when the economy is producing substantially less than potential GDP, an inflationary increase in the price level is not much of a danger and the central bank might react with expansionary monetary policy. In this situation, higher interest rates from government borrowing would be largely offset by lower interest rates from expansionary monetary policy, and there would be little crowding out of private investment.

However, even a central bank cannot erase the overall message of the national savings and investment identity. If government borrowing rises, then private investment must fall, or private saving must rise, or the trade deficit must rise. By reacting with contractionary or expansionary monetary policy, the central bank can only help to determine which of these outcomes is likely.

Public Investment in Physical Capital

Government can invest in physical capital directly: roads and bridges; water supply and sewers; seaports and airports; schools and hospitals; plants that generate electricity, like hydroelectric dams or windmills; telecommunications facilities; and military weapons. In 2014, the U.S. federal government budget for Fiscal Year 2014 shows that the United States spent about $92 billion on transportation, including highways, mass transit, and airports. Table 31.1 shows the federal government's total outlay for 2014 for major public physical capital investment in the United States. We have omitted physical capital related to the military or to residences where people live from this table, because the focus here is on public investments that have a direct effect on raising output in the private sector.

Type of Public Physical Capital Federal Outlays 2014 ($ millions)
Transportation $91,915
Community and regional development $20,670
Natural resources and the environment $36,171
Education, training, employment, and social services $90,615
Other $37,282
Total $276,653
Table 31.1 Grants for Major Physical Capital Investment, 2014

Public physical capital investment of this sort can increase the economy's output and productivity. An economy with reliable roads and electricity will be able to produce more. However, it is hard to quantify how much government investment in physical capital will benefit the economy, because government responds to political as well as economic incentives. When a firm makes an investment in physical capital, it is subject to the discipline of the market: If it does not receive a positive return on investment, the firm may lose money or even go out of business.

In some cases, lawmakers make investments in physical capital as a way of spending money in key politicians' districts. The result may be unnecessary roads or office buildings. Even if a project is useful and necessary, it might be done in a way that is excessively costly, because local contractors who make campaign contributions to politicians appreciate the extra business. Alternatively, governments sometimes do not make the investments they should because a decision to spend on infrastructure does not need to just make economic sense. It must be politically popular as well. Managing public investment cost-effectively can be difficult.

If a government decides to finance an investment in public physical capital with higher taxes or lower government spending in other areas, it need not worry that it is directly crowding out private investment. Indirectly however, higher household taxes could cut down on the level of private savings available and have a similar effect. If a government decides to finance an investment in public physical capital by borrowing, it may end up increasing the quantity of public physical capital at the cost of crowding out investment in private physical capital, which could be more beneficial to the economy.

Public Investment in Human Capital

In most countries, the government plays a large role in society's investment in human capital through the education system. A highly educated and skilled workforce contributes to a higher rate of economic growth. For the low-income nations of the world, additional investment in human capital seems likely to increase productivity and growth. For the United States, critics have raised tough questions about how much increases in government spending on education will improve the actual level of education.

Among economists, discussions of education reform often begin with some uncomfortable facts. As Figure 31.9 shows, spending per student for kindergarten through grade 12 (K–12) increased substantially in real dollars through 2010. The U.S. Census Bureau reports that current spending per pupil for elementary and secondary education rose from $5,001 in 1998 to $10,608 in 2012. However, as measured by standardized tests like the SAT, the level of student academic achievement has barely budged in recent decades. On international tests, U.S. students lag behind students from many other countries. (Of course, test scores are an imperfect measure of education for a variety of reasons. It would be difficult, however, to argue that there are not real problems in the U.S. education system and that the tests are just inaccurate.)

The line graph shows that government spending on education has continually increased from 1998 up until 2006, where it leveled off. In 2008, it increased dramatically from $35 to over $70 million. Since 2010, spending has steadily decreased to a little over $40 million in 2014.
Figure 31.9 Total Spending for Elementary, Secondary, and Vocational Education (1998–2014) in the United States The graph shows that government spending on education was continually increasing up until 2006 where it leveled off until 2008 when it increased dramatically. Since 2010, spending has steadily decreased. (Source: Office of Management and Budget)

The fact that increased financial resources have not brought greater measurable gains in student performance has led some education experts to question whether the problems may be due to structure, not just to the resources spent.

Other government programs seek to increase human capital either before or after the K–12 education system. Programs for early childhood education, like the federal Head Start program, are directed at families where the parents may have limited educational and financial resources. Government also offers substantial support for universities and colleges. For example, in the United States about 60% of students take at least a few college or university classes beyond the high school level. In Germany and Japan, about half of all students take classes beyond the comparable high school level. In the countries of Latin America, only about one student in four takes classes beyond the high school level, and in the nations of sub-Saharan Africa, only about one student in 20.

Not all spending on educational human capital needs to happen through the government: many college students in the United States pay a substantial share of the cost of their education. If low-income countries of the world are going to experience a widespread increase in their education levels for grade-school children, government spending seems likely to play a substantial role. For the U.S. economy, and for other high-income countries, the primary focus at this time is more on how to get a bigger return from existing spending on education and how to improve the performance of the average high school graduate, rather than dramatic increases in education spending.

How Fiscal Policy Can Improve Technology

Research and development (R&D) efforts are the lifeblood of new technology. According to the National Science Foundation, federal outlays for research, development, and physical plant improvements to various governmental agencies have remained at an average of 8.8% of GDP. About one-fifth of U.S. R&D spending goes to defense and space-oriented research. Although defense-oriented R&D spending may sometimes produce consumer-oriented spinoffs, R&D that is aimed at producing new weapons is less likely to benefit the civilian economy than direct civilian R&D spending.

Fiscal policy can encourage R&D using either direct spending or tax policy. Government could spend more on the R&D that it carries out in government laboratories, as well as expanding federal R&D grants to universities and colleges, nonprofit organizations, and the private sector. By 2014, the federal share of R&D outlays totaled $135.5 billion, or about 4% of the federal government's total budget outlays, according to data from the National Science Foundation. Fiscal policy can also support R&D through tax incentives, which allow firms to reduce their tax bill as they increase spending on research and development.

Summary of Fiscal Policy, Investment, and Economic Growth

Investment in physical capital, human capital, and new technology is essential for long-term economic growth, as Table 31.2 summarizes. In a market-oriented economy, private firms will undertake most of the investment in physical capital, and fiscal policy should seek to avoid a long series of outsized budget deficits that might crowd out such investment. We will see the effects of many growth-oriented policies very gradually over time, as students are better educated, we make physical capital investments, and man invents and implements new technologies.

Physical Capital Human Capital New Technology
Private Sector New investment in property and equipment On-the-job training Research and development
Public Sector Public infrastructure Public education Job training Research and development encouraged through private sector incentives and direct spending.
Table 31.2 Investment Role of Public and Private Sector in a Market Economy

Bring It Home

Financing Higher Education

Between 1982 and 2012, the increases in the cost of a college education had far outpaced that of the income of the typical American family. According to President Obama’s research staff, the cost of education at a four-year public college increased by 257% compared to an increase in family incomes of only 16% over the prior 30 years. The ongoing debate over a balanced budget and proposed cutbacks accentuated the need to increase investment in human capital to grow the economy versus deepening the already significant debt levels of the U.S. government. In summer 2013, President Obama presented a plan to make college more affordable that included increasing Pell Grant awards and the number of recipients, caps on interest rates for student loans, and providing education tax credits. In addition, the plan includes an accountability method for institutions of higher education that focuses on completion rates and creates a College Scorecard. Whether or not all these initiatives come to fruition remains to be seen, but they are indicative of creative approaches that government can take to meet its obligation from both a public and fiscal policy perspective.

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