Empirical Economics (1995) 20:331-359

Short Paper
Public Capital Stock and State Productivity Growth:
Further Evidence from an Error Components Model

B A D I H . BALTAGI AND N A T P I N N O I '

Texas A&M University, Department of Economics, College Station, TX 77843-4228, USA

Abstract: The contribution of different types of public infrastructure on private production is

investigated using time-series of cross-section data for the 48 contiguous states over the period
1970-1986. A Cobb-Douglas production function is estimated with unobserved state-specific
effects. Measurement errors in public capital stock and its components are detected and rectified.

JEL Classification System-Numbers: C23

1 Introduction

The relationship between public infrastructure and private economic perfor-

mance isfinallyreceiving some long overdue attention from economists. A typ-
ical approach is to estimate a Cobb-Douglas production function by a simple
regression including public capital stock. Public capital is commonly found to
be a productive factor in private production. However, the magnitude of con-
tribution varies according to the level of aggregation. A large contribution is
found using national time-series data (Aschauer (1989a,b) and Munnell (1990a));
whereas a much smaller contribution is obtained from a panel of selected
urban areas (Eberts (1986)). State-wide panel data (Munnell (1990b) and Garcia-
Milla and McGuire (1992)) provide estimates in between. This evidence may
suggest that one can capture more and more of the spill-over effects of public
capital as one moves up the aggregation level. This result has been challenged
more recently by Holtz-Eakin (1994) who found that after controlling for state-
specific characteristics, the public-sector capital has no role in affecting private
sector productivity. Additionally, Holtz-Eakin showed that aggregating from
states to regions yields the same result.

' We would like to thank Baldev Raj and an anonymous referee for helpful comments. Also,
Timothy J. Gronberg and Kay McAllister who thoroughly read the earlier draft and offered many
constructive suggestions. We are, however, solely responsible for any remaining errors. The data
set used in this research was generously provided by Alicia H. Munnell and Leah Cook of the
Federal Reserve Bank of Boston. Nat Pinnoi acknowledges the research support provided by the
Texas Transportation Institute.

0377 - 7332/95/2/351 - 359 $2.50 © 1995 Physica-Verlag, Heidelberg

352 B. H. Baltagi and N. Pinnoi

Measurement error may also contribute to such varying estimates. It is

difficult to directly observe and quantify the price of and service provided by
investment goods. This is even more so for services from public infrastructure.
For example, consider the case of measuring the stock of highways available to
a firm. How can we separate which highways are of some use to the firm? How
can we aggregate highways that have different quality (e.g., 4-lane, 6-lane, di-
vided, undivided, etc.)? Therefore, with unobservables, we should not preclude
measurement errors. More importantly, the results of conventional econometric
procedures may not be consistent in the presence of measurement errors. The
remainder of the paper is organized as follows: Section 2 describes the model
and the data. Section 3 gives the empirical results while section 4 provides
some concluding remarks.

2 Model and Data

The panel data set used in this research covers the 48 contiguous states for the
period of 1970-1986. Gross State Products, Y, are employed as the private
business output. Labor input, L, is measured by the employment in nonagri-
cultural payrolls. State unemployment rate, Unemp, is included in the empiri-
cal model to capture the business cycle in a given state. Private capital stock,
K, is computed by apportioning Bureau of Economic Analysis (BEA) national
stock estimates. Finally, public capital, KG, and its components highways and
streets, KH, water and sewer facilities, KW, and other public buildings and
structures, KO, are calculated based on BEA national series. A perpetual in-
ventory method is used with BEA assumptions of service life and straight-line
depreciation. These two crucial assumptions deserve further discussion. A study
sponsored by the U.S. Department of Transportation (See Jack Faucett Asso-
ciates, Inc. (1972)), estimates service lives for various type of highways and
streets to be between 33 to 42 years; whereas BEA assumes 60 year service life
for the same structure (as well as water supply and sewer system facilities). All
other public buildings are assumed (BEA) to last SO years. Statistics Canada
(1986) conducted a survey of fixed assets in 1984 and reported information on
service life of several groups of privately owned structures and equipments.
Total expected useful lives for office buildings, roads, and water and sewage
are 42, 20, and 32 years, respectively. Furthermore, the straight-line deprecia-
tion employed by BEA implies that value of capital declines by a fixed amount
each year of its useful life. However, with obsolescence and declining services
from the capital stock, this may not be the case. Boskin, Robinson, and Huber
(1987) construct alternative measures of public capital and its component. High-
ways and streets are assumed to last 40 years instead of 60 years (BEA). For all
other public structures, the service life assumptions of BEA are utilized. Fur-
Public Capital Stock and State Productivity Growth 353

thermore, the stock of public capital is assumed to depreciate geometrically.

Boskin, Robinson, and Huber (1987) conclude that BEA underestimates the
stock of public capital by as much as 17% (total stock in 1985). Therefore, the
estimates of public capital stock are likely to contain measurement error.
The following log-linear Cobb-Douglas specifications are estimated. All vari-
ables are in the natural logarithm except for Unemp.

Model 1: Yi, = a -\- bjK;, -I- ^2^11 +

i = l , . . . , 4 8 , t = 1970,..., 1986.
Model 2: Yi, = a-\- b^Ki, H- bj^d + b^KGi, H- b^Unempi, -(- u,,
Model 3: Yi, = a-\- b^K^ -»- b^Lf, + b^KH^ + b^KWi, -t-

The disturbances are assumed to follow a one-way error component model,

see Baltagi and Raj (1992) for a recent survey. In this case, MJ, = /i; -t- v,-,, where
Hi is a state-specific effect and V;, is a classical random disturbance, /i,- can be
modelled as either fixed or random. Examples of such state-speciiic effects are
the endowment of natural resources, the quality of public infrastructure, physi-
cal characteristics of a state (e.g., landlocked state), the ability to attract and
utilize foreign investment, and the network effects. Furthermore, the spillover
effects of infrastructure improvement from other states could be included in
the state-specific effects.

3 Empirical Results

Before the time-series and cross-section data are combined, a poolability test is
carded out. The results of the Chow (1960) test are reported in the last row of
Table 1. Based on the central F distribution, the null hypothesis that the data
can be pooled is rejected at the 1% level. However, if we are willing to trade
some bias for a reduction in variance, some weaker criteria can be used. The
second weak Mean Square Error (MSE) criteria of Wallace (1972) is adopted
in this research. The null hypothesis is that the restricted model (the pooled
model) is better than the unrestricted model (individual state regressions) based
on the trade-off between bias and variance. Bias is introduced by imposing an
incorrect restriction and reduction in variance results whenever a restriction is
imposed. Using this criteria, the restricted model is preferred to the unrestricted
model because of lower MSE. Consequently, the individual state time-series
data will be pooled and analyzed through out this research.
The results shown in the first three columns of Table 1 are similar to those
of Munnell's (1990b). Public capital stock has been shown to have positive and
354 B. H. Baltagi and N. Pinnoi

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Public Capital Stock and State Productivity Growth 355

significant effects upon private output. It should be noted that the f-statistics
are highly significant. Because state-specific effects are ignored, the standard
errors computed by OLS can be severely biased, (see Moulton (1986)). Follow-
ing Moulton (1986), a simple F-test is constructed to test the significance of
state-specific effects. The values of f-tests are 83.03, 74.14, and 75.01 for models
1, 2, and 3, respectively. Therefore, we can easily reject the null hypothesis that
state-specific effects are insignificant. We also performed a test for the signifi-
cance of time-effects given the existence of state specific effects. These turn out
to be insignificant at the 5% level. Additionally, an F-test for the null hypothe-
sis of constant retums to scale for all inputs yields a value of 270.9 for model 2
and is therefore soundly rejected.
The results of the Between regression are tabulated in the next three columns
of Table 1. These results suggest that, in the long run, public capital is a pro-
ductive input in the private business production function. The estimated coeffi-
cient (Model 2) of total public capital (0.39) is statistically significant at the 1%
level. In contrast, the short run estimate, from the Within regression, of output
elasticity with respect to aggregate public capital stock is negative and statisti-
cally insignificant. Accordingly, the benefits from investment in public infra-
structure would be realized after the business sector has time to adjust to and
absorb such benefits. These long-run effects are consistent with the argument
raised by Hulten (1990).
Next, the results of Model 3, with three components of public infrastructure
stock, confirm that highways and streets, as well as water and sewer stocks do
have short run effects on private production. Adding more of such public infra-
structures creates additional demand for private commodities, services and con-
struction employment. Deno and Eberts (1991) show that a 1% increase in
public expenditures for infrastructure construction leads to a 1.1% increase in
personal income. These effects fade soon after the completion of the project,
however. The private output elasticities with respect to KH and KW are 8%
each in the short run compared to long run estimates of 16% and 19%, respec-
tively. However, within the category of all other public structures and build-
ings, the short run effects are negative (—11%) and the long run effects are
positive, but insignificant. This may be explained by the law of diminishing
marginal retums. The majority of other public buildings are public school build-
ings. A closer examination of public schools and their enrollment between 1970-
1986 may prove helpful. Clearly, the "baby boomers" and their children were
responsible for the high enrollments during the first half of the 197O's. The
level of enrollment reached almost 54 million pupils in 1975. Enrollment in
public schools declined steadily from these high levels until 1984. An excess
capacity of school buildings is not implausible. Therefore, adding more to the
stock of these public buildings may reduce available resources for other viable
altematives. Finally, private output may be lower. This is not to say that pub-
licly provided education and health care have no influence on private produc-
tivity. Instead, the KO variable used may not be the best index of education
and health services.
356 B. H. Baltagi and N. Pinnoi

So far, we assume that state-specific effects are fixed. Alternatively, state-

specific effects can be treated as random. Then Feasible Generalized Least
Squares (FGLS) will be more efiicient than Within regression (if the random
effects are not correlated with other regressors). The FGLS results given in
the last three columns of Table 1, do not vary much from the Within results.
Honda's (1985) test for the existence of random state-specific effects is carried
out. The null hypothesis of no random state-specific effects is rejected for each
model. This result reenforces that state-specific effects are important and should
be included in the specification of the empirical model, see also Holtz-Eakin
(1994).
Hausman-Taylor's (1981) orthogonal test was calculated based on the differ-
ence between the within and the between regressions. The test results shown in
Table 1 reveal that the error terms are correlated with the regressors only when
public capital stock and its components are included in the production func-
tion. As a result, FGLS estimates will not be consistent, whereas the Within
estimates remain consistent. One source of correlation may be due to measure-
ment error in the public capital stock and its components. To test for measure-
ment error, Griliches and Hausman (1986) suggest that we should compare
regression estimates of differenced variables (of different lengths), see Table 2. If
the estimated parameters differ significantly, then measurement error may be
present in the variables of our empirical model. Results of these tests show that
the estimated coefficients significantly diverge from one another, especially when
the first-difference and the fourth-difference were compared (xl = 43.27 and
xl = 42.65 for models 2 and 3, respectively). Thus, we have reason to believe
that public capital stock is measured with error. Consequently, the results from
OLS, Within, and FGLS techniques would all be inconsistent. Moreover, the
results of prior research, which do not take measurement error into account,
may not be consistent as weU.
Following Hsiao (1986), it is assimied that the measurement errors are inde-
pendently and identically distributed across time and state. Let x^ be the inde-
pendent variable believed to have errors in measurement; the public capital
stock in this case. Then, x,_,_2 or (x; ,_2 — x,_,_3) can be used as Instrumental
Variables (IVs) for (x^, — x,_,_i). We further assume that x,., is serially corre-
lated. These IV results for models 2 and 3 are furnished in the last two columns
of Table 2. The results reveal that the relationship between aggregate public
capital stock and aggregate private output is not as robust as reported else-
where. Public capital's effect is positive (0.02) but insignificant. This is in agree-
ment with the results of Holtz-Eakin (1994).
However, one should not disregard the importance of public infrastructure
based exclusively on this evidence. More insight can be gained by examining
the results of disaggregating the model. When total public capital stock is de-
composed into its three major components (e.g., highways and streets, water
and sewer facilities, and others), water and sewer stock have consistently re-
turned positive and significant effects on private production. This result implies
that an increase in the stock of water and sewer facilities (KW) would have
Public Capital Stock and State Productivity Growth 357

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358 B. H. Baltagi and N. Pinnoi

positive effects on private output. Elasticities of the KW range from as low as

8% (Within and FGLS) to as high as 22% (IV) if we account for measurement
error. Highways and streets always yield a positive effect on private output
ranging from 6% for OLS and FGLS to 16% for the Between estimate. How-
ever, after accounting for measurement error, its effect becomes insignificant
Our study also show that all other public capital {KO) are highly sensitive to
measurement error with estimates ranging from positive and insignificant to
negative and significant.
In summary, once we control for measurement error and state effects, total
public infrastructure capital has an insignificant impact on private production,
(see the results of model 2). However, when we disaggregate total public capital
into its components a different picture emerges, (see the results of' model 3). In
fact, model 2 restricts the output elasticities of the disaggregate public capital
stock to be equal, whereas model 3 allow these estimates to vary. This aggre-
gation restriction can be easily tested using an f-test. The resulting values of
the f-test are 83.24, 67, and 60.45 for pooled OLS, Within regression, and
FGLS, respectively. Therefore, we can safely reject the null hypothesis that the
sum of the coefficients of the disaggregate public capital equals the coefficient
of the aggregate public capital stock.

4 Concluding Remarks

This research provides further insight into the relationship between public infra-
structure and private economic perfonnance. We have illustrated that conven-
tional methods suffer from some serious drawbacks: exclusion of unobservable
state-specific effects and measurement errors. The result of a series of misspeci-
fication tests reveals that OLS without state effects is not a correct specifica-
tion for this data set, see also Holtz-Eakin (1994). We also detected measure-
ment error in public infrastructure and its components. Therefore, OLS results
that do not take into account this measurement error are inconsistent. An IV
method is employed to obtain consistent estimates, see Griliches and Hausman
(t986). Some of the main findings of this study are the following: The contribu-
tion of total public infrastructure capital stock becomes insignificant when state
effects and measurement error are considered. However, when total public cap-
ital is disaggregated into its components and their separate effects are freely
estimated without imposing the aggregation restriction a different picture
emerges. In fact, water and sewer capital consistently provide productive con-
tributions to private productivity. On the other hand, highways and streets
effects are insignificant and other public buildings yield a negative impact on
aggregate output.
Public Capital Stock and State Productivity Growth 359

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First version received: October 1994

Final version received: January 1995