Tax Policy – Cautionary Notes from CBO on the Effects of Federal Investment
There has been a considerable amount of talk recently from both the White House and Congress on the potential for a major federal infrastructure bill. While there are few details on what such a compromise would entail, the projects could run the gamut from roads and bridges to public schools and VA hospitals.
There seems to be a common belief among lawmakers that the returns to federal investments are significant in terms of higher productivity and GDP, and that this is the kind of spending the government should be making to revive a weak economy. But before lawmakers rush to find consensus on a major infrastructure bill, they would do well to consult the research of the Congressional Budget Office (CBO), which provides some cautionary guidance.
For example, the main findings of CBO’s June 2016 report, The Macroeconomic and Budgetary Effects of Federal Investment, suggest that:
- Encouraging private sector investments would deliver twice the economic bang for the buck compared to federally funded investments.
- Federal investment financed by debt or taxes could do more economic harm than good because federal borrowing and taxes crowd out private investment. To avoid harming the economy, federal investments should be financed by cuts in other discretionary programs.
- A dollar of federal spending results in only $0.67 worth of actual investment because state, local, and private sector entities reduce their spending in response to the federal dollars.
Let’s look at these one by one.
Returns to federal investment are only half the returns to private investment
The CBO reviewed the academic literature on the economic returns to public investments and found that they are relatively modest and about half the returns to private investments.
“CBO estimates that the average rate of return on private sector investment is currently about 10 percent—that is, that a $1 increase in private investment, all else being equal, increases output by 10 cents over a year. As a result, the average rate of return on federal investment in the illustrative policies examined in this report is about 5 percent.”
In other words, a $50 million federal investment would increase GDP by $2.5 million, whereas the same private investment would boost GDP by $5 million.
Moreover, “In CBO’s view, returns on federal investment accrue more slowly than returns on private investment do, on average. That is because most private-sector investment is for physical capital, whereas the majority of federal nondefense investment—56 percent from 1985 through 2012—is for education and R&D.”
So if lawmakers are looking for policies to boost the economy quickly, they should aim to incentivize private investments, not launch new federal projects.
How you finance federal investment matters
There are three basic ways of covering the cost of federal investment: increased borrowing, raising taxes, or reducing other spending in the budget. Of the three options, CBO finds that the only option that does not lead to negative economic consequences is to offset the cost of investment by reducing other noninvestment discretionary spending in the federal budget.
The CBO modeled two investment scenarios funded through increased federal borrowing. The first scenario illustrated a onetime $100 billion increase in federal investment, while the second scenario illustrated a 10-year, $500 billion investment program paid out in $50 billion annual increments.
In both scenarios, the federal investment did increase productivity. However, following an initial boost to GDP, the long-term economic benefits of both investment plans were swamped by the negative effects of the federal borrowing needed to fund the investment. Over the long term, the $100 billion plan resulted in a very small increase in GDP while the $500 billion plan actually reduced the level of GDP because of the harmful economic impact of the federal borrowing.
By contrast, the CBO modeled two identical scenarios but with the assumption that the cost of the new federal investment was offset by cuts in other discretionary spending. Each of these scenarios led to sustained productivity and economic growth because the investment was not encumbered by the higher federal borrowing. Moreover, the higher levels of productivity and economic output resulted in a smaller federal deficit.
With regard to taxpayer financing, the CBO determined that “if an increase in federal investment was financed by an increase in marginal tax rates…people’s after-tax wages would fall, reducing their incentive to work—and thus reducing labor supply and output.”
$1 of federal investment spending nets only $0.67 of actual investment
The CBO’s analysis of the economic literature found that federal investment spending tended to crowd out or disincentivize investment by states, localities, and private entities, which dampens the effect of federal investment. The net effect is “that [a] $1 increase in federal investment reduces investment by states, localities, and private entities by one-third of a dollar.” In other words, when the federal government invests $1, nonfederal sources reduce their investment by $0.33, which leaves a net investment of $0.67, not the full $1.
In a separate analysis of federal highway spending, the CBO found, “For an increase of $1 in federal grants, most estimates suggest, state and local governments would reduce spending on highways from their own funds by between $0.20 and $0.80.”
Based on the CBO’s assessment of the economic and budgetary effects of federal investment, lawmakers should train their energies on spurring private sector investment rather than try to enact a massive federal infrastructure bill. The returns on private investment will be twice what a federal investment would likely deliver. Private investment won’t crowd out state, local, or other private investment, so $1 of private investment won’t shrink by $0.33 as a result. And the economy will respond faster from private investment than it would from public works projects.
Source: Tax Policy – Cautionary Notes from CBO on the Effects of Federal Investment