Effects on Economic Growth of Federal Investment and Reductions in Federal Deficits and Debt

Posted by Doug Elmendorf on
June 20, 2014

As I mentioned in Wednesday’s blog post, we think that some of our answers to follow-up questions from Congressional hearings may be of general interest, so we’re posting them.

Following a hearing on the budget and economic outlook, a Member of Congress asked whether federal investment or reductions in federal deficits and debt would be better for achieving economic growth. Below is our answer (provided as part of a set of answers to questions for the record):

Both sound federal investment and reductions in federal deficits and debt can boost economic growth in the long term. Their relative effectiveness in achieving that goal would depend on the specifics of the federal investments or deficit-reducing policy changes that were adopted. In the short term, reducing federal deficits and debt would tend to lower economic growth, whereas increasing federal investment would tend to raise it.

Most federal investment for nondefense purposes contributes to the economy in the long term by improving the private sector’s ability to invent, produce, and distribute goods and services. In contrast, federal investment for defense purposes contributes to the production of weapon systems and other defense goods but does not typically contribute to future nondefense output because much of it is narrowly focused on defense; the exception is the small portion of defense investment that funds basic and applied research.

Federal nondefense investment, done wisely, can contribute to private-sector productivity in various ways. Without public highways, for example, the cost to the trucking industry of delivering goods would be much higher; without government research and development (R&D), the Internet and whole segments of the economy would not exist; if not for receiving a public education (funded in part by federal spending), many workers would earn lower wages. In the view of the Congressional Budget Office, the government has made higher productivity possible in all of those cases by making investments that the private sector would not have made on its own or would have made in smaller amounts than their broad public benefits would justify.

The result of that higher productivity is a larger economy in the long term, all else being equal. However, the magnitude of the increase in economic output that would result from an increase in federal investment is highly uncertain. Moreover, the factors that contribute to the uncertainty present important considerations for policymakers who face decisions about how—and how much—the federal government should invest.

One factor contributing to that uncertainty is that federal investments differ greatly. The return on investments in transportation infrastructure, education, or research may be quite different, and the returns on investments of varied sorts within those broad categories may be quite different as well. Estimating those returns is difficult because it is challenging to ascribe particular outcomes to specific investments. Scientific and technological discoveries often build on past R&D, so it is difficult to determine what proportion of a new product results from any given investment. Similarly, workers’ skills are the product of education funded not only by the federal government but also by state and local governments, the private sector, and the workers and their families. Moreover, realizing the benefits of federal investment may take many years, and the timing varies for different types of investment. A new highway can improve transportation as soon as it is built, but realizing the benefits of basic research or elementary education can take far longer, thus complicating the task of identifying those benefits.

In addition, the benefits of federal investment are unlikely to be distributed evenly. A business that is near a highway will probably enjoy greater returns from that highway than will a business that is farther away. Recipients of federal grants for R&D may acquire patents on their work, and although products and innovations based on those patents may benefit consumers, they also may earn returns for the patent owners that are not shared with the country as a whole.

Federal investment can have some negative effects as well. It can discourage investment by private entities or by state and local governments if it raises the price of investment goods. If that happens, and if the discouraged investment would have had positive economic returns, then the overall returns on the federal investment are lower. Furthermore, state and local governments may use federal funding for investments that they would otherwise have paid for with their own funds. (In some cases, however, federal investment can increase state and local investment, because some federal grant programs require investment by state and local governments as well.)

Reductions in federal deficits and debt will tend to increase output in the long term but decrease it in the short term, especially under current economic conditions. In the short term, policy changes that decreased federal spending or raised taxes (and thus decreased budget deficits) would generally reduce demand, thereby lowering output and employment relative to what would occur otherwise. That effect would tend to be especially strong under conditions such as those currently prevailing in the United States, with output so far below its potential (maximum sustainable) level that the Federal Reserve is keeping short-term interest rates near zero and would not be expected to adjust those rates to offset the effects of changes in federal spending and taxes.

By contrast, in the long term, policy changes that decreased budget deficits would generally increase national saving and investment, thereby raising output and income relative to what would occur otherwise. However, the economic effects would depend on the specific changes in tax and spending policies as well as on the magnitude of the change in deficits. In particular, the effects of policy changes on people’s incentives to work and save and on federal investment could affect the economic consequences of any given change in deficits.

Thus, in the short term, economic output is likely to be higher if federal investment is increased than if total federal spending is reduced. The relative effects on output of those two approaches in the long term would depend on the specifics of the policies.

Policy changes that differ over time are possible, as are combinations of policies. For example, if policymakers wanted to raise gross domestic product both in the near term and in later years relative to projections under current law, they could devise a combination of policies that increased deficits during the first few years and decreased them by a greater cumulative amount thereafter (ultimately leading to less debt than would occur under current law).