Public investment in infrastructure attracts private investment and fuels economic growth, which in turn generates extra public revenue to spend on more and better infrastructure.
There is no doubt that investing in infrastructure is good for economic development. Indeed, two of the main goals of the quality infrastructure investment initiative that is currently being mainstreamed through the G20 process are to maximize the economic impact of infrastructure and create a "virtuous circle" of economic activities stemming from infrastructure.
A virtuous circle in economic theory occurs when there are positive and mutually reinforcing interactions between public investment and economic development. When one increases, so does the other.
In a fiscal model, public investment leads to economic growth, which strengthens tax bases and increases revenue, which in turn creates fiscal space for more investment. In a trade model, public investment in connectivity increases trade, which induces private investment by reducing transaction costs, which leads to more trade. In a socioeconomic model, public investment raises the productivity of private capital and improves services and the environment, then direct and induced feedback loops attract firms and workers, leading to more growth and investment. These are in fact different windows on a common set of factors.
It has long been common economic wisdom that public investment in infrastructure attracts private investment, which in turn leads to economic growth.
Going back to the early 1900s, economists understood that firms choose least-cost locations, and their decisions could be affected by providing better transportation facilities. Growth was a simple outcome of building to attract more businesses to a city or region.
To the extent that economists thought about other benefits like better infrastructure services or an improved environment, those were likely seen as consumption benefits. And financing infrastructure was generally regarded as a public responsibility in any case, so the potential increase in tax revenues was not a prime motivation. The circle was not yet complete.
Gradually, economists began to understand that economic development progresses more organically as public investment allows firms and households to make more efficient use of their labor, capital, and natural resources. These benefits attract more private investment from firms and households, and their increased output grows the tax base and increases revenues, allowing a new round of public investment.
The virtuous circle of quality infrastructure investment thus relies essentially on increasing economic efficiency by complementing private capital and labor. There are many ways that public infrastructure development can help increase the return on investment for private capital.
Quality infrastructure lowers production costs and increases returns to investment. It increases business efficiency by saving time, improving reliability, and providing higher quality services and thus supporting economies of scale and making agglomerations of economic activity more productive. Quality infrastructure also helps labor markets to become more efficient and flexible, and spurs competition and trade by opening up markets and cutting costs.
These benefits in turn attract more private investment and workers. Think of the decades-long boom in aerospace and high tech sectors as people fled the declining Rust Belt for the suburbs and freeways and universities in the new American west. (There is also a cautionary tale in this example – it should also be noted that vicious circles of economic decline can be created through under-investment and deferred maintenance.)
If we think of public infrastructure as only an input to production, constructing it creates a direct demand stimulus. But when it complements and raises the productivity of the other two inputs of private capital and labor, public infrastructure does much more – it lowers costs and augments the output.
To the extent that public infrastructure resolves this equation successfully, it increases returns to capital and thus induces further private investment and attracts more labor through both higher wages and lower prices. In other words, the consumption benefits of better services and environments are not just amenities, they also catalysts for productivity.
Recent evidence from the IMF, mainly from OECD countries, provides evidence for these effects.
First, a 1% increase in public infrastructure investment can augment GDP by an average 0.4% in the same year and 1.5% over 4 years. Second, public investment does not substitute for private investment but rather crowds it in. Third, employment increases by up to 0.3% for the same level of investment. And fourth, in well governed cities and regions, that investment can reduce public sector debt-to-GDP by up to 4% in the first four years. The evidence from developing economies tells a similar story, but is much more variable than in advanced economies, with estimates tending to be lower.
That last point is very important, as it suggests that economies grow more than the level of spending required to increase the output, and possibly also that governments use their increased tax revenues to pay down existing debt. The implications for tax growth and tax revenue are thus likely to be positive for debt sustainability in developing economies.
There is a very rich literature on these questions, with varying estimates of impact, but a general consensus has emerged that virtuous circles exist and can be supported through public investment policy. The supporting roles played in infrastructure planning, financing, and governance are thus crucial determinants of the economic development path.