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ESSAYS ON ISSUES THE FEDERAL RESERVE BANK OF CHICAGO JU LY 1992 N U M B E R 59 Chicago Fed Letter ■ ■ ■ ■ ■ ■ ■ ■ I■ • I Buy now, invest later: state and local governm ent spending strategies Economists often call for an increase in public spending in order to spur economic growth. For example, de spite the yawning federal budget defi cit, 100 economists, including six No bel laureates, recently proposed that federal spending on education and infrastructure be increased in order to stimulate growth in the economy. Proposals such as this one favor invest ment oriented government spending over consumption oriented spending. While both types of spending—con sumption or investment—may be helpful in boosting short run aggre gate spending during an economic downturn, investment spending carries the added benefit of stimulating long er term welfare, growth, and interna tional competitiveness. Programs such as public aid, prisons, and government administration tend to have benefits which are immediately consumed. Other expenditures such as education and infrastructure development are investment oriented, producing re turns to society years after the initial expenditure. Traditionally, the use of spending as an agent of economic growth has been primarily a concern of the federal government. However, during the 1980s, many program responsibilities fell upon state and local governments as federal support was withdrawn. Left to fend for themselves, state and local governments have shown more inter est in using fiscal policy to help their economies grow. The question is: have state and local governments been adopting investment oriented spend ing strategies by boosting expenditures on education, infrastructure and the like? In this Chicago Fed Letter, I look at the implications of the choice of con sumption versus investment strategies by state and local governments, both nationally and within the five Seventh District states of Illinois, Indiana, Iowa, Michigan, and Wisconsin. The evidence In order to examine the mix of state and local expenditures, it is first neces sary to divide the various categories of expenditures into investment and consumption components. Statistics covering government spending are not typically reported as consumption or investment so the data must be reassigned. This assignment is far from an exact science since most if not all programs have elements of both consumption and investment.1 In this article, state and local government spending which is investment oriented will include all capital outlays (spend ing on buildings, roads, equipment, school buildings, and other infrastruc ture) as well as all noncapital educa tion and noncapital health and hospi tal spending. (For the purposes of this article, health and hospital expendi tures will not include Medicaid expen ditures. When Medicaid is included, health related expenditures grow at a faster rate.) Spending on infrastructure is perhaps the most obvious investment by gov ernment. A bridge or building will provide a benefit to future taxpayers who will utilize and benefit from the physical structure years after it is com pleted. However, spending designed to enhance human rather than physi cal capital is increasingly being consid ered investment spending. Many pub licly funded programs within the areas of education and health care fit such a definition. Spending on education provides a future return to society in the form of more productive workers as well as citizens who are better able to participate in the democratic deci sion making process. Spending on health reduces the threat of conta gious disease and improves worker productivity since healthy workers are likely to be more productive workers. Of course, future returns need not appear as part of the economic statis tics in order to qualify as returns to investment. For example, greater longevity or a greater sense of physical well being are no less important as returns to public investment. In using these three types of spending as a proxy for government investment in physical and human capital, the remainder of government expendi tures (spending on corrections, public welfare, and government administra tion) are considered consumption oriented spending. Figure 1 illustrates the estimated trend in investment versus consumption spending for all state and local governments and for the five Seventh District states by in dexing the per capita relative real growth rates in the four expenditure types since 1968. As the Figure showrs, consumption expenditures have grown much faster than investment expenditures over this 21 year period. The growth in consumption expendi tures over this period was over 140% while the growth in the three invest ment oriented spending categories ranged from 52% for health and 27% for education to an 11 % decline in capital outlays. (If Medicaid spending is included in health expenditures, the growth rate is slightly over 80% for the category.) Figure 1 also demonstrates the pattern of consumption versus investment expenditure growth for the Seventh L Indexed real per capita growth rates for state and local expenditures 0i I 1969 I i i I 73 I i i i ’7 7 i ............................. ’81 l i ’8 5 i i ’8 9 |_J__ I__I__I__I__l_ l__L-J__I__I__L_l__L_J__L-J__I__I__L J 1969 73 ’7 7 ’81 ’8 5 ’8 9 I I 1969 i I I I 73 i I i I ’7 7 ................... .... ’81 i l ’85 i l l l 0 ’89 SOURCE: U.S. Department of Commerce, Bureau of the Census Government Finances, various years, author’s calculations. District states. While their experiences differ, the growth in consumption expenditures outpaced the growth rate in the three investment spending cate gories in all five states. Within the investment area, Indiana, Iowa, and Michigan all mirrored the national trend with noncapital health and hos pital spending growing the fastest, followed by noncapital education and capital outlays. Illinois and Wisconsin differed in that education spending was the fastest growing investment component, followed by health and capital outlays. Why has the mix o f investment and consumption changed? Numerous studies have pointed out the benefits and economic returns on various types of investment goods provided by state and local govern ments. These studies range from those that have found a significant relationship between state infrastruc ture spending and productivity growth to studies focusing on education spending and its positive relationship to employment and industrial growth.2 One recent study even found that the negative effect of higher business taxes can be overcome when the revenue raised is used to fund spending on education, highways, public health, and safety.3 Owing to the apparent consensus on the benefits of these investments, it is difficult to under stand the lag in investment oriented spending by the state and local sector during the 1980s. Several explanations may be helpful. First, dwindling state and local resourc es would seem to explain part of the story. The flattening of the growth rates in the three investment oriented categories and the growth in the con sumption oriented spending coincides with the reduction in federal grants to the states during the 1980s. Federal aid to the states reached its zenith in 1978. Since then, declining levels of support have forced states to fund programs out of their own resources. During this era of increasing responsi bilities and dwindling resources, in vestment spending gave way. More recently, strained state and local budgets have exacerbated the prob lem. Just as a household with a tight budget will put off investments in favor of putting food on the table, state and local governments are emphasizing keeping up with current operating expenses rather than spending on investments. The most recent Nation al Income and Product Account data illustrates this. In the recessionary year of 1991, spending on consumption oriented transfer payments grew by 14% while expenditures for the invest ment oriented purchase of structures fell by 1.3%. A second explanation concerns the effect of political behavior on spend ing patterns. Given the limited term of office of many policymakers and barring the very close interest and scrutiny of an informed public, those policies that produce immediate and visible results are likely to be favored over long term investments that may not demonstrate results for many years. For example, the bulk of the return from increased investment in elementary and secondary education will not be realized until the individual receiving the education is an adult. As such, the political benefit to the policy maker is less than in the case of a pro gram which provides an immediate and visible benefit to constituents (such as building a park). Similarly, the perceived returns from educating a younger generation may seem dis tant to portions of the voting popula tion or even be perceived as risky due to outmigration of the young from declining regions. Third, it may be the case that current forms of government accounting and reporting fail to accurately portray the distinction between consumption and investment. If so, policymakers may be unaware of the shift toward con sumption spending within their states. For this reason, it may be wise for state and local governments to devise invest ment budgets, in which the programs within these categories can be classi fied as investments or consumption. For example, a report was issued by the Michigan House Fiscal Agency urging the development of an invest ment budget.4 In Wisconsin, a contro versial new welfare proposal attempts to recognize explicitly the investment oriented aspects of the state’s welfare program by rewarding education, training, and employment of welfare recipients. Finally, the demand for these four types of spending has also changed over this period of time. For example, in the area of infrastructure spending, Seventh District states, which can be characterized as having a more mature economic base, developed much of their infrastructure earlier than other regions of the country. While pressure for maintaining the existing infrastruc ture exists, the demand for new infra structure is less intense than in rapidly growing regions. This may explain why capital outlays in the five District states declined faster than was the case for the nation as a whole. In the case of the U.S., the decline in school en rollments in the 1980s lessened the demand for rapid growth in school budgets, helping to explain the initial decline in the growth rate in school expenditures in the 1980s. By the end of the decade, the growth rate was beginning to rise, reflecting the growth in school enrollments expect ed to continue through the mid-1990s. Implications State and local governments are charged with a broad range of func tions. Clearly, no state or local govern ment should ignore the immediate needs of its constituents in order to increase investment. However, the work of several economists has focused on whether the slowdown in public capital outlays has hindered economic and productivity growth.5 If estimates of returns from physical capital invest ment are correct, the fact that state and local governments are devoting a smaller share of their available re sources to these expenditure areas may indicate a less productive use of state and local resources. If a similar return can be established for pro grams geared to human capital invest ments, policymakers may be missing an opportunity to expand their econo mies by not taking a more aggressive position in supporting investment oriented expenditures. With a need to rebuild crumbling infrastructure and provide education to a growing school aged population, the demand for these investment ori ented expenditures is likely to grow. However, increasing investments in other, less tangible, programs, such as maintaining the local sewer system or targeted education and health pro grams, may be more difficult to justify unless a clearer distinction between consumption and investment spend ing is made in government accounts. As the proposal from the 100 econo mists favoring increased federal spend ing pointed out, wise investments in education and infrastructure are a very different avenue from merely increas ing the level of government expendi ture or running an operating deficit. — R ichard H. M attoon T o r ex am p le, in this analysis, public w elfare pay m en ts a re assum ed to be c o n su m p tio n sp en d in g . H ow ever in som e states, tra in in g p ro g ra m s are in clu d ed in pub lic w elfare p ro g ra m s a n d these w ould certainly re p re s e n t investm ents. 2See T.R. P lau t a n d J.E. Pluta, “Business clim ate, taxes a n d e x p e n d itu re s a n d state in d u strial grow th in th e U .S.,” Southern EconomicJournal, V olum e 50, N o. 1, 1983, pp. 99-119, a n d M ichael W asylenko a n d T h e re se M cG uire, ‘Jo b s a n d taxes: th e effect o f business clim ate o n states’ em p lo y m en t grow th ra te s,” National Tax Journal, V olum e 38, 1985, pp. 497-511. 3Jay H elm s, “T h e effect o f state a n d local taxes o n e co n o m ic grow th: a tim e series cross-section a p p ro a c h ,” The Review o f Economics and Statistics, V olum e 67, 1985, pp. 574-582. 4See W arren G regory, Investment Budgeting: M oving Back to M ichigan’s Future, M ichigan H o u se Fiscal Agency, A ugust 1991. T o r m o re o n th e re tu rn to public infra stru c tu re in v estm en t see David A lan Asc h a u e r, “G o v e rn m e n t sp e n d in g a n d th e ‘falling ra te o f p ro fit,’ ” Economic Perspec tives, F ed eral Reserve B ank o f C hicago, M a y /Ju n e 1988, pp. 11-17; also A schauer, “Is p ublic e x p e n d itu re p ro d u ctiv e?,"Jour nal o f Monetary Economics, V olum e 23, 1989, pp. 177-200; a n d Alicia M unnell, “H ow d o es pub lic in fra stru ctu re affect reg io n al e co n o m ic p e rfo rm a n c e ? ,” Is There a Shortfall in Public Capital Investment ? F ed eral Reserve B ank o f B oston, C o n fer en c e Series No. 34, 1990. Karl A. S cheld, S en io r Vice P re sid en t an d D irecto r o f R esearch; David R. A llardice, Vice P re sid en t a n d Assistant D irecto r o f R esearch; Carolyn M cM ullen, E ditor. Chicago Fed Letter is p u b lish ed m o n th ly by th e R esearch D e p a rtm e n t o f th e F ed eral Reserve Bank o f Chicago. T h e views ex p ressed are the a u th o rs ’ a n d are n o t necessarily th o se o f th e F ederal Reserve B ank o f C hicago o r th e F ederal Reserve System. A rticles m ay b e re p rin te d if th e source is c re d ite d a n d th e R esearch D e p a rtm e n t is p ro v id ed with copies o f th e rep rin ts. Chicago Fed letter is available w ith o u t ch arg e from th e Public In fo rm atio n C e n te r, F ederal Reserve B ank o f C hicago, P.O. Box 834, C hicago, Illinois, 60690, (312) 322-5111. ISSN 0895-0164 Tracking Midwest manufacturing activity Purchasing Managers’ Survey-production index Manufacturing output index April Month ago Year ago MMI 138.3 138.2 134.2 USMI 133.2 133.5 131.1 U .S . 60 M id w e s t Motor vehicle production (millions, saar) May Month ago Year ago Autos 6.2 5.9 5.3 Light trucks 3.7 3.8 3.4 Purchasing managers’ association: production index May Month ago Year ago MW 60.3 57.7 48.1 U.S. 63.0 56.9 48.1 50 40 30 _i— i—i—i—i_i— _l__I__I__I__I__I__L_ 1991 Manufacturing activity in the Midwest, as measured by a weighted average of the production indexes of the Chicago, Detroit, and Milwaukee Purchasing Manag ers’ Surveys, expanded in May for the fourth consecutive month. The composite index equaled its previous peak in August of 1991. (An index level of 60 indi cates that 60% of the responses reported expanding production and 40% report ed contraction.) The Midwest has generally followed the national pattern, but showed a deeper contraction in the fall of last year and slightly slower expansion than the nation since January, largely because of weakness in the Detroit economy. Chicago and Milwaukee showed expansion equal to or stronger than the nation as a whole. 1992 SOURCES: T h e M idwest M an u factu rin g In d ex (MMI) is a com posite in d ex o f 17 in d u stries based on m o n th h o u rs w orked a n d kilowatt hours. IP rep re se n ts th e FRBB indu strial p ro d u c tio n in d ex for th e U.S. m a n u factu rin g sector. A utos a n d light trucks are m easu red in an n u alized physical units, using seasonal adjust m en ts d ev elo p ed by th e F ederal Reserve Board. T h e PMA survey for th e U.S. is th e p ro d u c tio n c o m p o n e n ts o f th e NPMA survey a n d fo r th e M idwest is a w eighted average o f th e p ro d u c tion c o m p o n e n ts o f th e C hicago, D etroit, an d M ilwaukee PMA survey. 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