Crowding Out Physical Capital Investment

When government conducts an expansionary fiscal policy (i.e. increases in government spending or decreases in tax rate) it may run afoul of the crowding out effect. Expansionary fiscal policy means an increase in the budget deficit. The government is spending more money than it has in income. Where does government obtain the necessary funds to cover it’s increased deficit? The answer is borrowing.

A larger budget deficit will increase demand for financial capital. The supply of funds in financial markets is the sum of private saving, government saving, and net investment by foreigners into domestic financial markets. If private saving and net foreign investment 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 (i.e. increased budget deficit means a reduction in government saving), the result is crowding out.

The Interest Rate Connection

Let’s look at the details of how crowding out occurs. A larger federal budget deficit requires increased government borrowing in financial markets. How will this affect interest rates in financial markets? In Figure 1, 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.

Figure 1. 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.

Higher interest rates tend to reduce private investment in physical capital. The new factory that made sense when a company could borrow the necessary funding at 5%, no longer makes sense at an interest rate of 6%.

A key question then is how much crowding out occurs. The answer is it depends. Crowding out seems to occur less during recession since banks have savings to lend, but limited borrowers.

Public Investment in Physical Capital

All government spending does not cause crowding out. Public infrastructure spending on physical capital can enhance private investment. Public infrastructure spending in investment in roads and bridges; water supply and sewers; seaports and airports; schools and hospitals; plants that generate electricity, like hydroelectric dams or windmills; telecommunications facilities; just to name a few. New highways (or other transportation networks) can raise the rate of return on private investment by making it easier to transport products to market. As a result, infrastructure investments can result in increased private investment too. Part of the reason for the booming U.S. economy during the 1960s may have been the completion of the interstate highway system.

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 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.

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.

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, both K12 and higher education. Education conveys positive externalities–while individuals gain from an education, so does society at large. Educated citizens are more thoughtful voters. 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. Of course, spending more dollars on education is no guarantee that students will learn more. Despite significant increases over the last several decades in U.S. education spending per pupil, standardized test scores like the SAT have failed to increase significantly. Still, in this day and age it’s hard to argue that education isn’t important.

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 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 people invent and implement new technologies.