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posted on 27 June 2016

Economic And Budgetary Effects Of Federal Investment

from the Congressional Budget Office

Federal investment in physical capital, education, and research and development boosts private-sector productivity gradually. The overall macroeconomic and budgetary effects of federal investment depend on how that spending is financed.

The federal government buys many goods and services that are expected to increase private-sector productivity - that is, the ability of the private-sector workforce, using the stock of capital, to produce goods and services. Such purchases by the federal government are called investment. In an earlier report, CBO examined various aspects of federal investment itself, such as its composition and the way it had changed over time. Building on that analysis, this report explains how CBO, when analyzing proposals that would change the amount of federal investment, determines their effects on the economy and on the federal budget.

What Is Federal Investment?

The federal government invests in three broad areas for nondefense purposes:

  • Physical capital, mostly for transportation, which contributes to the functioning of the economy;

  • Education and training, which helps produce a skilled, capable workforce; and

  • Research and development (R&D), which encompasses a wide variety of work in government laboratories, universities, and the private sector.

In 2015, the federal government spent $293 billion on investment for nondefense purposes, which represented 1.6 percent of gross domestic product (GDP) and 8 percent of federal spending. (Federal investment for defense purposes primarily affects national security rather than productivity, so this report does not focus on it.)

In some cases, it is difficult to determine what increases productivity and thus qualifies as federal investment. For example, CBO's interpretation of empirical research suggests that spending on instruction and on the construction of school buildings affects future productivity; the agency therefore regards such spending as investment. But the empirical link between increases in federal spending on health care and greater private-sector productivity is relatively tenuous, so CBO does not currently regard federal spending on health care as investment.

How Does Federal Investment Affect the Economy?

The increase in productivity that results from federal investment boosts economic output - but only gradually. For instance, this report examines four illustrative policies that would change federal investment (see figure below); in each of those policies, of every $1 billion increase in federal investment in 2016, CBO estimates, only $50 million would affect productivity in that year. In 2017, an additional $200 million of the $1 billion investment would begin to affect productivity, for a total of $250 million of productive investment. Each year, a greater share of the $1 billion would become productive, and the full amount would have made contributions to productivity after 20 years, CBO projects.

The Effects of the Illustrative Policies on Output and the Deficit

CBO further estimates that productive federal investment has an average annual rate of return of about 5 percent, or half of the agency's estimate of the average rate of return on private investment. Therefore, the boost in productivity from that $50 million of productive investment in 2016 would raise private-sector output by about $2.5 million in that year. In 2017, the addition of $250 million to productive investment would boost output by an estimated $12.5 million, and so on.

The macroeconomic effects of an increase in federal investment would depend on how that spending was financed. Although spending can be financed in a number of ways, this report examines just two - reducing other spending and increasing federal borrowing. If an increase in investment was financed by an offsetting reduction in other spending, the effect would be relatively straightforward: a boost in productivity that would increase GDP over the next decade. For example, one of the illustrative policies presented in this report, called Policy 2, would increase funding for federal investment by $50 billion per year for 10 years, starting in fiscal year 2016, and decrease funding for other spending by offsetting amounts. That policy would make productivity slightly higher than it would have been otherwise, CBO estimates; as a result, over the 2016 - 2025 period, GDP would be $33 billion higher.

But if the increase in investment spending was financed by added federal borrowing, three factors would influence the economy. First, productivity would rise, increasing GDP over time, as in the previous case. Second, the increase in federal borrowing would reduce the amount of money available for private investment, damping GDP in later years. And third, because there would be no offsetting reductions in spending, total federal spending would increase, boosting overall demand and GDP during the first several years. Another illustrative policy in this report, Policy 4, would likewise increase funding for federal investment by $50 billion per year for 10 years, starting in fiscal year 2016, but it would finance the investment by an increase in borrowing. Over the 2016 - 2025 period, that policy would make GDP $15 billion higher, CBO estimates.

How Does Federal Investment Affect the Federal Budget?

An increase in federal investment would affect the budget in a number of ways. Because the resulting improvement in productivity would, on its own, increase GDP, the amount of taxable income would rise. Therefore, federal revenues would increase, and the deficit would shrink (provided that the increase in investment was not financed by added federal borrowing). But the higher productivity would also raise the return on capital, boosting interest rates and the cost to the federal government of servicing its debt. Reflecting those effects on tax revenues and interest costs, Policy 2 would shrink federal budget deficits by a total of $4 billion over the 2016 - 2025 period.

If the increase in investment was financed by an increase in federal borrowing, not by reductions in other spending, it would have additional effects on the deficit. The resulting increase in total federal spending would increase the deficit directly. Moreover, CBO estimates that interest rates would rise, increasing the federal government's interest payments, not only because of higher productivity but also for two more reasons. First, the increased government spending would raise overall demand, and the Federal Reserve, in CBO's view, would respond by raising short-term interest rates to prevent inflation from rising above the central bank's longer-term goal. Second, the increased borrowing would reduce the amount of money available for private investment, thereby heightening competition for investors' money. All told, Policy 4 would increase deficits by a total of $424 billion over 10 years.

What Are Some Limitations of CBO's Methods of Estimating Those Effects?

The findings in this report are CBO's best estimates of the macroeconomic and budgetary effects of the illustrative policies analyzed. However, those findings should not be used to directly infer the effects of particular investment proposals. That is the case for three main reasons:

  • Some investments start improving productivity soon after they are made, whereas others take much longer.

  • Similarly, some investments have stronger effects on productivity than others do.

  • The way that states, local governments, and private entities adjust their own investment spending in response to changes in federal investment can also vary, depending on the proposal.

In this report, CBO used an overall average for each of those factors. The agency continues to examine how they vary as groundwork for analyses of future proposals.

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