Are Government Activities Productive? Evidence from a Panel of U.S.

States
Author(s): Paul Evans and Georgios Karras
Source: The Review of Economics and Statistics, Vol. 76, No. 1 (Feb., 1994), pp. 1-11
Published by: The MIT Press
Stable URL: https://www.jstor.org/stable/2109821
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 The Review of Economics and Statistics
VOL. LXXVI FEBRUARY
ARE GOVERNMENT ACTIVITIES PRODUCTIVE?
EVIDENCE FROM A PANEL OF U.S. STATES
Paul Evans and Georgios Karras*
Abstract-Using panel data for the 48 contiguous U.S. states
in each year between 1970 and 1986, this paper investigates
the extent to which government capital and current govern-
ment services contribute to private production. The paper
finds fairly strong evidence that current government educa-
tional services are productive but no evidence that the other
government activities considered are productive. Indeed, gov-
ernment capital often has statistically significant negative pro-
ductivity. The results are robust across the many specifications
considered.
I. Introduction
RUMBLING bridges and potholed roads
C,have made regular appearances on nightly
television news programs and have become a
frequently discussed topic in the press. Many
news commentators and politicians have discov-
ered an "infrastructure crisis," which in their
view has resulted from insufficient government
investment.1 In addition, it is often argued that
the government provides too few current inputs
into private production. In order to assess these
views, this paper empirically investigates the ex-
tent to which government capital and current
government services contribute to private produc-
tion.
For much of the postwar period, economists
virtually ignored the effects of fiscal policies on
aggregate supply. More recently, however, they
have begun to investigate the extent to which
Received for publication December 20, 1991. Revision ac-
cepted for publication October 28, 1993.
* Ohio State University and University of Illinois at Chicago,
respectively.
We are grateful to Mike Simms for his assistance in gather-
ing the government expenditure data. We have received
helpful comments from Alicia Munnell, James Stock, two
anonymous referees, and the participants in the Macroeco-
nomics and International Economics Workshop at the Univer-
sity of Illinois at Chicago.
1 See Szabo (1989), Stix (1990), Friedman (1991), Koretz
(1989), and Kuttner (1991).
Copyright C 1994
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1994 NUMBER 1
government activities are directly productive, sup-
plementing labor and private capital in the aggre-
gate production function. Several of these studies
claim to have established the productivity of gov-
ernment inputs in the aggregate production func-
tion. Ratner (1983) estimated an aggregate Cobb-
Douglas production function for private output as
a function of employment, private capital, and
the government capital stock. He found govern-
ment capital to be productive with an output
elasticity of about 0.06. Aschauer (1989) esti-
mated a similar function but also disaggregated
government capital into military and nonmilitary
capital. In addition, he examined government
spending as a third potential government input.2
His results indicated that government spending
and military capital are not productive but that
nonmilitary government capital is a significant
input in the production function and has the very
high output elasticity of 0.39. His investigation of
total factor productivity gave very similar results.
Following essentially the same methodology,
Munnell (1990a) found the output elasticity of
nonmilitary government capital to be between
0.31 and 0.39. Munnell (1990b) also estimated
Cobb-Douglas and translog aggregate production
functions using data for the 48 contiguous U.S.
states. She again found that government capital is
a statistically significant input in the production
function with an output elasticity ranging from
0.06 to 0.15. Finally, regional studies such as
Helms (1985), da Silva Costa et al. (1987), Deno
(1988), and Aschauer (1990) have presented
2 Barro (1981) had also included current government ser-
vices in an aggregate production function. His empirical work,
however, tested the productivity of government inputs only
indirectly; i.e., without estimating the actual production func-
tion.
[ 1 ]
2 THE REVIEW OF ECONOMICS AND STATISTICS
evidence that government inputs are significantly
productive.'
A common criticism of these papers is that the
correlations they report do not necessarily imply
causality (Hulten and Peterson (1984), Musgrave
(1990), Hulten and Schwab (1991)). According to
this argument, a positive and statistically signifi-
cant coefficient for a government input in an
estimated "production function" may only indi-
cate the degree to which increased income causes
an increased level of government activities. More
recently, however, the very methodology of these
studies has come under attack. Aaron (1990),
Evans and Karras (1993), Hulten and Schwab
(1991), Jorgenson (1991), Rubin (1991), and
Tatom (1991) make essentially the same point:
regressions like the ones estimated by Ratner,
Aschauer, and Munnell are likely to be misspeci-
fied because they are estimated in levels and the
data contain stochastic trends. When Hulten and
Schwab (1991) and Tatom (1991) fit the models to
differenced data, the apparently strong positive
associations between private output and govern-
ment inputs disappear and, in fact, often be-
come negative. Jorgenson's conclusion is that
"the intrusion of macroeconomists armed with
conventional econometric techniques into the in-
frastructure debate has been counterproductive."
Instead, he recommends a microeconomic ap-
proach.4 We share Jorgenson's concern but think
that his assessment of the contribution of
macroeconometrics to the present debate may be
too harsh. We think that preserving the aggregate
perspective is useful and that we can address the
"Jorgenson critique" by improving the empirical
methodology.
In this study, we use panel data for the 48
contiguous U.S. states in each year between 1970
and 1986. After correcting for the obvious mis-
specifications of other studies, we find fairly strong
evidence that current government educational
services are productive but no evidence that the
other government activities considered are pro-
ductive. Indeed, we typically find statistically
significant negative productivity for government
capital. Therefore, we cannot conclude that the
United States suffers from an infrastructure cri-
3Eberts (1990) provides a useful summary of this literature.
unutilized capital. Including U in the regressions reported in
4Gramlich (1991) may be an example of what Jorgenson
this
in mind.
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sis, crumbling bridges and potholed roads
notwithstanding.
After completing the first draft of this paper in
August 1991, we became aware of a study by
Eisner (1991) that uses almost the same data set
and reaches conclusions similar to ours. Since
then, Holtz-Eakin (1994) has applied similar tech-
niques and reached similar conclusions. Our study
is more complete than these studies because we
correct for serial correlation, consider manufac-
turing, examine the effects of current government
services, disaggregate KG and G into several
components, attempt to take endogeneity into
account, and employ an alternative approach that
reduces the problem of endogeneity and allows
for cross-state structural heterogeneity.
The rest of the paper is organized as follows.
Section II discusses our empirical methodology,
section III describes the data, section IV presents
our estimated production functions, section V
formulates and uses an alternative approach, and
section VI concludes.
II. Econometric Issues
In this paper we work with panel data for the
48 contiguous U.S. states in each year between
1970 and 1986. To these data we fit Cobb-Doug-
las and translog aggregate production functions
of the form
ln Yst ao + aI E ln Xlst + a,+jUst + ust
i=l1
and
ln Yst =o + , IE n Xlst + a,+ Ujst
i = 1
I I
+ ,j ln Xist lnXjst + ust
i=1 j=1
j21
(2)
where s and t index states and years, the Y's are
gross state products, the X's are factor inputs, U
is the unemployment rate,' the a's and ,B's are
5We include the unemployment rate in the production
functions to account for cyclical changes in hoarded labor and
haspaper produces highly significant estimates of a1,+ but
essentially no effect on the other estimated coefficients.
 ARE GOVERNMENT ACTIVITIES PRODUCTIVE? 3
parameters, and u is an error term. We consider
several specifications for u. The simplest is that u
is uncorrelated both across states and over time.
We consider this invalid specification primarily in
order to compare the estimates obtained under it
with the estimates obtained under two specifica-
tions that may be valid. These specifications de-
compose u in one of two ways:
ust =/is + At + Est (3)
with
Est = PEst-I + vst, (4)
or
Aust = (t + vst (5)
with
vst= Qvst- + vst (6)
mates turn out not
where p and Q are parameters and to bev
sensitive
is an to how it is
term that is assumed to have a zero mean and to
be uncorrelated both across states and over time.
If firms and governments do not anticipate the
The components ,A and A appear in equation (3)
because climates and topographies differ system-
atically across states (e.g., California vs. North
Dakota) and technologies improve systematically
over time, leading to systematic differences in
total factor productivity across states and over
time. We treat ,A's and A's as fixed effects for
three reasons. First, the ,A's cannot be regarded
as a sample of realizations from a distribution
because we include the entire population of con-
tiguous states in our sample. Second, the A's
cannot be regarded as independent realizations
from a stationary distribution if technology does
indeed improve over time. Third, so long as E is
uncorrelated with the X's, applying generalized
least squares to equations (1) and (2) yields con-
impossible, task. We did, however, perform some
sistent estimates if we treat ,A and A as fixed
effects but must yield inconsistent estimates if we
treat them as random effects or simply ignore
their presence; see Judge et al. (1985). The rea-
son is that profit-maximizing firms with produc-
tion functions of the form (1) or (2) vary the Xs
that they control in response to all predictable
components of u. Moreover, governments proba-
bly also vary their Xs in response to the pre-
dictable components of u.
Differencing u removes all state fixed effects in
the levels. Nonzero state fixed effects in the spec-
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ification (5) would therefore imply that the growth
rate of total factor productivity differs perma-
nently across states and hence that all mobile
factors would eventually end up in the state with
the highest growth rate. The implausibility of this
occurrence leads us to exclude state fixed effects
from the specification (5). The growth rate of
total factor productivity is likely to differ system-
atically over time since technology probably im-
proves more in some years than in others. It is
plausible, however, that these differences are in-
dependent draws from a stationary distribution
and that firms and governments do not anticipate
them when they set the X's. Treating f in the
specification (5) as a random effect may therefore
be appropriate. For this reason, when we fitted
differenced specifications to equations (1) and (2),
we treated f both as a fixed effect and as a
random effect. Because treating it as a fixed ef-
fect is more conservative and because our esti-
error
treated, we report only the estimates obtained by
treating it as a fixed effect.
error term E in setting their inputs, equations
(1) and (2) can be estimated consistently with
generalized least squares since the X's are inde-
pendent of the error term by assumption.6 In
contrast, if either firms or governments anticipate
E in setting their inputs, the X's are correlated
with E. In that case, we can estimate (1) and (2)
consistently only if we instrument for the X's that
are correlated with E. Even though firms and
governments can probably predict E at least to
some extent, we did not instrument for the X's in
obtaining most of the estimates reported in this
paper. The reason is that arriving at a list of
instrumental variables that are a priori more valid
than the Xs themselves is a daunting, if not
instrumental estimation in order to determine
how robust our results are.
In section V, we develop a method for estimat-
ing the productivity of the government inputs
consistently even if the private inputs are corre-
lated with E.
6If specification (5) is used, v/A should replace E in the
statements below.
4 THE REVIEW OF ECONOMICS AND STATISTICS
III. The Data
We use the following data in our empirical
analysis:
Q real gross state product of private
nonagricultural industries;
QM real gross state product in manufac-
turing;
N number of workers employed in pri-
vate nonagricultural industries;
NM number of workers employed in man-
ufacturing;
HM average weekly hours in manufactur-
ing;
KP net stock of private capital used in
private nonagricultural industries;
KM net stock of private capital used in
manufacturing;
U the state unemployment rate for all
civilian workers measured as a frac-
tion;
KHW- net stock of highway capital;
KWS net stock of water and sewer capital;
KOI net stock of other infrastructure capi-
tal;
KG net stock of government capital
(KHW+KWS +KOI);
GED current educational services;
GHW current highway services;
GHH current health and hospital services;
GPF current police and fire services;
GSN current sewer and sanitation services;
G current government services (GED +
GHW+ GHH+ GPF + GSN);
P relative price of gross state product in
private nonagricultural industries;
W real wage in private nonagricultural
industries; and
R real rental rate in private nonagricul-
tural industries.
In most of the estimated production functions
reported in the next section, we let I = 4
with Y= Q, X1 = N, X2 = KP, X3 = KG, and
X4 = G or GED. We also consider I = 10 with
X3 = KHW, X4 = KWS, X5= KOI, X6 = GED,
X7 = GHW, X8 = GHH, Xg = GPT, and X1o =
GSN. In order to check the robustness of our
results, we fit production functions for manufac-
turing. In that case, Y = QM, X1 = NM or NM
HM, and X2 = KM.
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The gross state product data are described in
Renshaw, Trott, and Friedenberg (1988) and were
obtained from a tape provided by the Bureau of
Economic Analysis. The employment and hours
data are described in each issue of Employment
and Earnings and were obtained from a tape
provided by the Bureau of Labor Statistics. They
are averages over calendar years. The capital
stock data are described in Munnell (1991b) and
were generously provided by her.7 They are for
the beginning of the calendar year. Current gov-
ernment services are total expenditures of the
state and local governments less their investment
expenditures divided by the deflator for state and
local government purchases. The expenditure
data come from Governmental Finance, and the
deflator data come from the SAS Citibase tape.
We consider only the categories education, high-
ways, health and hospitals, police and fire protec-
tion, and sewers and sanitation because the other
categories of expenditure contain substantial
amounts of transfer payments. They are for fiscal
years that typically lag calendar years by six
months.8 We exclude federal capital from our
measure of government capital and current fed-
eral services from our measure of current govern-
ment services because allocating them to specific
states is difficult, if not impossible.9
Dividing nominal gross state product by real
gross state product yields the state deflator. P
then results from dividing this deflator by the
deflator for the gross national product. Dividing
nominal labor compensation and nominal capital
charges by N and KP, respectively, and then
dividing by the state deflator generates W and R.
The data on nominal gross state products, nomi-
nal labor compensation, and nominal capital
charges come from the tape provided by the
7We have also used KH, the state capital stock data of
Holtz-Eakin (1993), in lieu of KG. We thank Douglas Holtz-
Eakin for providing his data. Tables of our results are avail-
able upon request. Because virtually every estimated coeffi-
cient on KH is either less positive or more negative than
those on KG, we use KG in order to increase our chances of
finding productive government capital. Nevertheless, we find
no evidence that government capital is productive.
8 We have also used calendar-year measures obtained by
interpolating between adjacent fiscal years. Our empirical
results are not sensitive to which measure we use.
9 In our empirical analysis, we implicitly assume that the
inputs provided by the governments in a given state do not
spill over into other states. We made some efforts to check
this assumption, finding no evidence of spillovers.
 ARE GOVERNMENT ACTIVITIES PRODUCTIVE? 5

TABLE 1.-FOUR-INPUT COBB-DOUGLAS PRODUCTION FUNCTIONS FOR GR

PRODUCT IN ALL PRIVATE NONAGRICULTURAL INDUSTRIES

Equation N KP U KG G or

(a) .541a .386a -.889a .096a .045a

(.022) (.016) (.180) (.021) (.012)

(b) .717a .180a - 544a -.048 .044

(.039) (.043) (.144) (.031) (.035)

(c) .935a .002 -.299a - .110a .064a .865a

(.032) (.020) (.084) (.040) (.021) (.017)

(d) .885a .003 -.236a -.029 .064a

(.035) (.028) (.078) (.046) (.024)

(e) .960a -.039a -.169a -.063 .035a *399a

(.035) (.016) (.069) (.057) (.017) (.036)
Notes. Standard errors appear in parentheses.
(a) OLS on levels with heteroskedasticity-consistent standard errors.
(b) OLS on levels less estimated state and time fixed effects with heteroskedasticity-consistent standard errors.
(c) AR1 on levels less estimated state and time fixed effects.
(d) OLS on differences less estimated time fixed effects with heteroskedasticity-consistent standard errors.
(e) AR1 on differences less estimated time fixed effects.
a Significant at the 0.05 level.

Bureau of Economic Analysis, and the deflator nary least squares to the transformed variables.
for the gross national product comes from the This two-step estimator is asymptotically equiva-
SAS Citibase tape. lent to generalized least squares; see Judge et al.
(1985). On their face, the estimates in row (b)
IV. Empirical Results provide no evidence that government capital and
current government services have positive pro-
We used ordinary least squares to fit equation ductivity. Again, these estimates should not be
(1) for I = 4.10 Our estimates of the a's are taken seriously because the Durbin-Watson
reported in row (a) of table 1. On their face, statistic for the regression is only 0.46.
these estimates would seem to provide consider- Row (c) of table 1 reports the estimates that we
able evidence that government capital and cur- obtained when we specified the error term of
rent government services are productive. The equation (1) to take the form (3) with A and ,A
estimates, however, should not be taken seriously being state and time fixed effects and with E
for two reasons. First, both the regressors and the being the first-order autoregression (4).11 Estima-
error term are likely to have important fixed tion is by a two-step procedure similar to the one
effects in them. The presence of such fixed effects described in the previous paragraph. The esti-
would make the estimates inconsistent and could mates apparently provide strong evidence that
induce large biases. Second, the Durbin-Watson government capital has negative productivity and
statistic for the regression is only 0.19. The re- current government services have positive pro-
ported standard errors are thus inconsistent and ductivity. In addition, the adjustments for first-
biased downward. order autocorrelation in E are important since
Row (b) of table 1 reports the estimates we the estimated p is 0.865.
obtained when we specified the error term of We used the two-step procedure described
equation (1) to take the form (3) with A and above
,A to obtain the estimates reported in rows (d)
being treated as fixed state and time effects. We and (e) of table 1. We specified the error term to
calculated our estimates using the following two- take the form (5) and treated f as a fixed effect.
step procedure. In the first step, we estimate the Row (d) assumes that v is serially uncorrelated,
state and time means and subtract them from
each observation on the dependent and indepen- 11 We also allowed p to vary across the states here and AR1
regressions reported below, obtaining similar results. We do
dent variables. In the second step, we fitted ordi-
not think that this specification is sensible, however, because
16 time-series observations do not suffice for precise estima-
10 We used the regression package RATS for all estimation.
tion of a p for each state.

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 THE REVIEW OF ECONOMICS AND STATISTICS

TABLE 2.-FOUR-INPUT COBB-DOUGLAS PRODUCTION FUNCTIONS

FOR GROSS STATE PRODUCT IN ALL PRIVATE NONAGRICULTURAL INDUSTRIES
FITTED ASSUMING THAT N Is ENDOGENEOUS

Equation N NP U KG G or

(a) 1.441a -.069a .268a -.055 -.022 .916a

(.066) (.024) (.133) (.053) (.206) (.019)
(b) 1.558a -.077a .238a -.088 -.039 .465a
(.072) (.019) (.090) (.077) (.022) (.037)
Notes. Standard errors appear in parentheses.
(a) Fair estlimation on levels less estimated state and time fixed effects. The instrumental variables are In P,
In W, In R, In KP, U, In KG, and In G less their estimated state and time fixed effects; these variables lagged
one year; and In Q and In N lagged one year less their estimated fixed state and time effects.
(b) Fair estimation on differences less estimated time fixed effects. The instrumental variables are A In P,
A In W, A In R, A In KP, AU, A In KG, and A In G less estimated time fixed effects; these variables lagged
one year; and A In Q and A In N lagged one year less their estimated time fixed effects.
Significant at the 0.05 level.

and row (e) assumes that it is a first-order autore-
gression. The estimates in both rows provide no
evidence that government capital has positive
productivity but substantial evidence that current
government services do. Moreover, the autore-
gressive specification appears to be superior.
One problem with the estimates in rows (c)-(e)
is that the estimated coefficient on employment
(private capital) is much larger (smaller) than
labor's (capital's) share in national income. These
results suggest that the estimates in table 1 may
be seriously biased. One likely source of bias is
the simultaneity that would result if firms set
employment in anticipation of E.12 (Firms should
be able to predict E because it is serially corre-
lated.) Because labor demand should be increas-
ing in the anticipated component of E, N should
be positively correlated with E. This positive cor-
relation would typically bias the regression coef-
ficient on N upward and the other regression
coefficients downward, the result that we have
apparently obtained.
Table 2 reports the estimates that we obtained
when we instrumented for N. The specifications
for rows (a) and (b) are the same as those for
rows (c) and (e) Qf table 1. In choosing the
instrumental variables, we assumed that each state
faces an exogenous relative price, real product
wage, and real rental rate in private nonagricul-
tural industries. The assumption that each state is
a price-taker in its product and factor markets is
not especially credible but may be more accurate
than the assumption that firms cannot predict E
when they set N. Fair's (1970) analysis guided our
choice of instrumental variables; see the note to
table 2 for the complete list. Comparing the co-
efficients in rows (a) and (b) with those in rows (c)
and (e) of table 1, we find that instrumenting
raises those on N substantially, reduces those on
KP somewhat, changes the sign of those on U,
leaves those on KG negative, and makes those on
G negative and statistically insignificant. These
estimates are even more difficult to reconcile with
our a priori view that the elasticities of output
with respect to employment and private capital
should be near their shares in national income.
Moreover, U cannot be interpreted as controlling
for cyclical variation in labor hoarding and capital
utilization.
Investment, labor hoarding, and capital utiliza-
tion decisions may also anticipate the error term
E. If so, KP and U may be correlated with E. For
this reason, we also instrumented for KP and U.
The results are not reported here since they do
not solve the problems cited above.
It is well known that using instrumental vari-
ables can produce poor estimates if the instru-
mental variables are not well correlated with the
endogenous right-hand-side variables. We do not
have that problem because the F-ratios of our
first-stage regressions are statistically significant
at 10-8.13 The fairly small standard errors in
table 2 provide further evidence. Nevertheless,
table 2 may not improve on table 1 because P, W,

13 We have F(16,703) = 1020 for the levels regression and

12As in section II, v/I should replace e in the statements
below if specification (5) is used. F(16,655) = 95 for the differenced regression.

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 ARE GOVERNMENT ACTIVITIES PRODUCTIVE? 7

TABLE 3.-A TEN-INPUT COBB-DOUGLAS PRODUCTION FUNCTION FOR GROSS STATE

PRODUCT IN ALL PRIVATE NONAGRICULTURAL INDUSTRIES

N KP U KHW KWS KOI GED GHW GHH GPF GSN e

.941a .004 - .218a - .062 .011 - .061a .057a .003 .009 - .007 .004 .865
(.033) (.020) (.085) (.051) (.021) (.025) (.019) (.007) (.009) (.010) (.003) (.017)

Notes. Standard errors appear in parentheses. AR! is applied to differences less time fixed effects.
a Significant at the 0.05 level.

TABLE 4.-MORE COBB-DOUGLAS PRODUCTION FUNCTIONS FOR GROSS STATE PRODUCT

IN ALL PRIVATE NONAGRICULTURAL INDUSTRIES

Equation N KP U KG GED G-GED e)

(a) .960a - .039a - .169a - .063 .033a .003 .398a

(.035) (.016) (.069) (.057) (.015) (.010) (.036)

(b) .962a - .039a - .169a - .063 .033a .398a

(.035) (.016) (.069) (.057) (.015) (.036)
Notes. Standard errors appear in parentheses. The regressions apply AR1 to differences less estimated time
fixed effects.
a Significant at the 0.05 level.

and R are apparently correlated with E. Two
pieces of evidence support this statement. First,
the estimated coefficients on P, W, and R in the
first-stage regressions are difficult to reconcile
with these regressions' being labor-demand func-
tions as they would be if P, W, and R are really
exogenous. Second, N, KP, and U Granger-cause
P, W, and R. These results suggest that estimat-
ing cost and profit functions is not an attractive
alternative to estimating production functions.
Our estimates may be biased because our mea-
sures of government capital and current govern-
ment services are too aggregated. In order to
evaluate this possibility, we estimated equation
(1) with I = 10. From now on, we report only the
results for the specification (5) and (6) with e # 0
since the significant autoregressive coefficient in
row (e) of table 1 suggests that this specification
is superior to the others. The specification (3) and
(4) with p # 0, however, produces essentially the
same estimates. Table 3 reports our estimates.
On the basis of the estimated coefficients on the
government-capital variables, it would be difficult
to make the case that government capital has
positive productivity.14 The estimated coefficients
on the government-service variables provide fairly
tive. The estimated coefficient on employment
14 We also estimated the equation of table 3 excluding KOI
from the list of explanatory variables. The estimated elastici-
ties of the other inputs did not change noticeably.
strong evidence that current educational services
have positive productivity but no evidence that
the other current government service are produc-
tive. As in tables 1 and 2, the estimated coeffi-
cient on employment remains much greater than
labor's share in national income and that on
private capital remains much less than capital's
share. Therefore, disaggregating the government
variables does not improve the results.
The estimates in table 3 suggest that educa-
tional services are the only productive current
government service. Table 4 investigates this hy-
pothesis further. Clearly, GED is significant in
both regressions and G-GED is not. We there-
fore include only GED in the regressions re-
ported below. The estimated coefficients on the
regressors are not sensitive to whether GED or
G is included in the regressions.
Our estimates may be biased because our mea-
sure of output is too aggregated to have a stable
production function. In order to evaluate this
possibility, we fitted a four-input production func-
tion for manufacturing. Our estimates are re-
ported in row (a) of table 5, which has the same
specification as row (b) of table 4. The principal
difference between the former estimate and the
latter is that GED is no longer significantly posi-
remains much greater than its share in national
income and that on private capital remains much

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8 THE REVIEW OF ECONOMICS AND STATISTICS

TABLE 5.-FOUR-INPUT COBB-DOUGLAS PRODUCTION FUNCTIONS FOR GROSS STATE

PRODUCT IN MANUFACTURING

NM or
Equation NM HM KM U KG GED e

(a) .974a .014 - .254 .001 - .032 .167a

(.044) (.019) (.149) (.096) (.032) (.039)

(b) .775a .032 - .199 .036 - .036 .184a

(.049) (.021) (.189) (.121) (.042) (.045)

Notes. Standard errors appear in parentheses. AR1 is applied to differences less estimated time fixed effects.
Row (a) is for NM, and row (b) is for NM * HM.
a Significant at the 0.05 level.

less than its share. Therefore, fitting production TABLE 6.-A FOUR-INPUT TRANSLOG PRODUCTION FUNCTION
FOR GROSS STATE PRODUCT IN ALL PRIVATE
functions for a less aggregated measure of output NONAGRICULTURAL INDUSTRIES
does not improve the results.'5
Elasticities with Respect to
Employment imperfectly measures labor input.
N KP KG GED U
A potentially better measure, employment times
average weekly hours, is available for manufactur- .945 -.044 -.030 .028 -.190a .414a
ing in 42 states over the period 1972-1986. We (.069) (.037)

therefore fitted Cobb-Douglas production func-
tions to QM, NM HM, KM, U, KG, and GED
over this reduced sample in order to learn whether
our results improve. Row (b) of table 4 reports
estimates that are exact analogues of those re-
ported in row (a). The coefficient on NM HM is
closer to labor's share in national income but the
other coefficients are not much affected. The
estimates continue to indicate that government
capital and current educational services are not
productive.
In obtaining the estimates reported in tables
1-5, we have imposed a rather restrictive func-
tional form on the production function. The re-
strictiveness of the Cobb-Douglas production
function may be responsible for our inability to
find evidence that government capital and cur-
rent government services are productive. In order
to examine this possibility, we estimated the
translog production function (2) with I = 4. We
considered the same four specifications for the
error term as in tabl-e 5. Table 6 reports the
elasticities of output with respect to employment,
private capital, government capital, and current
15 We also estimated production functions for the mining,
construction, transportation, finance, and services industries.
Because the state private capital stocks for these industries
are unavailable, we assumed that the fraction of the nonresi-
dential nonagricultural capital stock for every industry in a
state equals the fraction for the United States as a whole. We
obtained very similar results.
Notes: AR1 is applied to differences less estimated time fixed effects.
a Significant at the 0.05 level.
government services, each evaluated at the sam-
ple means.16 We can make four observations
about these elasticities. First, the output elastici-
ties are about the same for the translog specifica-
tion as for the Cobb-Douglas specification even
though the latter can be rejected in favor of the
former. Second, they provide no evidence that
government capital is productive. Third, they pro-
vide some evidence that current educational ser-
vices may be productive. Fourth, the estimated
elasticity of output with respect to employment
remains much greater than its share in national
income and that with respect to the private capi-
tal stock remains much less than its share. We
conclude that using the translog specification does
not improve our results.'7
Government capital and current educational
services may be sufficiently correlated with each
other that we cannot obtain precise estimates of
their separate effects. If so, it may then be possi-
ble to find significant positive productivities for
each of them if we exclude the other from our
regressions. Table 7 reports the estimates ob-
16 We do not provide standard errors of the estimated
elasticities because they are tedious to calculate and are not
necessary for our observations below.
17 We also estimated equation (2) using the dissagregated
series (I = 10) and manufacturing data. The results are simi-
lar to those reported in tables 3-5.

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 ARE GOVERNMENT ACTIVITIES PRODUCTIVE? 9

TABLE 7.-ABBREVIATED COBB-DOUGLAS PRODUCTION FUNCTIONS FOR GROSS STATE

PRODUCT IN ALL PRIVATE NONAGRICULTURAL INDUSTRIES

Equation N KP U KG GED e

(a) .976 a - .039a -.175 a - .057 .407 a

(.034) (.016) (.088) (.058) (.035)
(b) .962a -.041a - .174a .032a .400a
(.035) (.016) (.069) (.015) (.036)
(c) .571a .396a -.571 .102a
(.014) (.012) (.166) (.018)

Notes. Standard errors appear in parentheses.

(a) AR1 on levels less estimated state and time effects.
(b) Same as (a).
(c) OLS on levels.
a Significant at the 0.05 level.

tained by excluding first current educational ser-
vices and then government capital from our
regressions. The specifications in rows (a) and (b)
are the same as that of row (b) of table 4. These
estimates provide no evidence that government
capital has positive productivity and fairly strong
evidence that current educational services have
positive productivity.
In row (c) of table 7, we show that estimates
similar to Munnell's (199Gb) can be obtained by
not allowing for fixed effects and not taking serial
correlation into account. We learn that one can
estimate a large and statistically significant elas-
ticity of output with respect to government capi-
tal if one does not account for fixed effects. In the
light of our other results, however, we do not
interpret the estimates in row (c) and in Munnell
as evidence that government capital is highly pro-
ductive. Rather, we interpret them as evidence
that state and local governments choose to have
more capital, the larger is output in the state.
V. An Alternative Approach
In this section, we formulate an alternative
approach that we use to investigate whether gov-
ernment capital and current government services
affect productivity. This approach has three ad-
vantages. First, it yields consistent estimates of
the elasticity of output with respect to govern-
ment inputs even if employment and private
capital are correlated with technology shocks.
Second, the parameters of technology can differ
across states. Third, the parametric assumptions
about technology can be greatly relaxed. The
disadvantage is that assumptions must be made
about how factor markets operate.
In our alternative approach, we assume that
output is produced according to the technology
In Qst = In F(Nst, KPst s) + OUst
+ y ln KGst + 8 ln GEDst + ust, (7)
where 0, y, and 8 are parameters and F(Q) is
increasing and twice continuously differentiable
in N and KP and is homogeneous of degree Y7.
Differencing both members of equation (7) and
substituting from equation (5) yields
/v ln Qst = (F1 Nst/F) ln Nst
+ ( F2KPst/F) A ln KPst
+ 0AUst + y/ ln KGst
+ &Xln Gst + (t + Est (8)
to a first approximation. We assume further that
in every year and every state, both private labor
and capital are paid a fixed parameter 'p times
their marginal products. Consequently, WstNstl
Qst = (F,NstJF), RstKst/Qst =cp(F2Kst1F)
and hence
WstNst/(WstNst + RstKst)
- F,Nst/(F,Nst + F2Kst) (9)
and
RstKstl(WstNst + RstKst)
- F2Kst/(F,Nst + F2Kst).* (10)
Substituting equations (9) and (10) into equat
(8) and making use of the fact that F1Ns
18 Similar empirical results to those reported below in ta
8 are obtained if one instead assumes that F(*) is Cobb-
Douglas and that F,NS,/(F,NS, + F2KPS,) equals the mean of
WMt Ntl/Qt.

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 10 THE REVIEW OF ECONOMICS AND STATISTICS

TABLE 8.-SOME MORE THREE-INPUT COBB-DOUGLAS ernment educational services are productive but
PRODUCTION FUNCTIONS FOR GROSS STATE PRODUCT
IN ALL PRIVATE NONAGRICULTURAL INDUSTRIES
no evidence that the other government activities
considered are productive. Indeed, we found that
Z U KG GED e
the productivity of government capital is usually
(a) 0.658a - .554 a _.140a .074a .294a negative and often significantly so. This result is
(.041) (.088) (.067) (.020) (.040) robust across all our specifications, which include
(b) 0.800 - .486a _.160a .065a .242a
(.086) (.064) (.020) (.039)
Cobb-Douglas and translog functional forms, dif-
(c) 1.000 -.372a _.190a .046a .187a ferent degrees of disaggregation for output and
(.090) (.063) (.021) (.039) the government inputs, different assumptions
(d) 1.200 - .244a -.223a .023 .157a
(.097) (.065) (.022) (.039)
about the error term, and the use of instrumental
variables. We believe that these estimates may be
Notes. Standard errors appear in parentheses. ARI is fitted to differences
less estimated time fixed effects. biased since the estimated elasticity of output
a Significant at the 0.05 level.
with respect to employment is typically about one
and the estimated elasticity of output with re-
F2 K, = -7F,19 we have spect to private capital is typically about zero.
A\ In Qst = 7 In Zst + OiU,, + y/ In KG,,The likely source of any such bias is the endo-
+ b/v In Gst + At + Est (11) geneity of the labor and private capital inputs.
where In order to overcome this potential endogene-
ity problem, we then developed an alternative
/InZSt (WstNstA In Nst + Rst Kst A In Kst)
approach with which consistent estimates of the
/( Wst Nst + Rst Kst ) ( 12)
output elasticities of government capital and cur-
The variable /v In Zst is the growth raterent
of government
the services can be obtained under
private inputs into production. On the assump-
weaker assumptions. Using this approach, we
tion that Iln Z, AXU, /v In KG, and A IlnG are
again found no evidence that government capital
uncorrelated with E, the methods of the previous
is productive but fairly strong evidence that
section estimate equation (5) consistently. If
educational services are productive. Indeed, the
/v In Z is correlated with E but AXU, /v In KG, and
productivity of government capital is always sig-
/v In G are not, the parameters 0, y, and 8 can be
nificantly negative. This finding is robust across
estimated consistently if one knows the correct
all specifications tried.
value of -q, the returns to scale for private inputs Although crumbling bridges and potholed roads
of labor and capital.
are easy to find, our results suggest that the
Table 8 reports estimates of equation (5). The
United States as a whole does not suffer from
parameter -7 is unconstrained in the first row underprovision
and of government capital and may
is constrained to be 0.8, 1.0, 1.2 in the other three
well suffer from overprovision. Moreover, current
rows. The estimates of y and 8 provide no evi-
noneducational government services appear not
dence that government capital has positive pro-
to be underprovided. Tables 4 and 6-8 suggest
ductivity but some evidence that current educa-
that the elasticity of gross private nonagricultural
tional services do. This finding is consistent with
product with respect to current educational ser-
the results reported in the previous section.
vices is about 0.04 with a standard error of about
0.02. At the sample means, this elasticity implies
VI. Summary and Conclusions
that each $1 in current educational services in-
In this paper, we investigated how productive creases national income by about $0.85 with a
government activities are. We first estimated ag- standard error of about $0.42. These figures im-
gregate production functions for private nonagri- ply that current educational services may be ei-
cultural gross state product in which we included ther over- or underprovided with some presump-
government capital and current government ser- tion in favor of overprovision.
vices as inputs in addition to labor and private These tentative conclusions need to be quali-
capital. We found fairly strong evidence that gov- fied, however. Even if government activities cost
more than they contribute to private output, they
19 Because F(*) is homogeneous of degree -j in N and KP,may still be underprovided because government
qi/F = FQ/N, qiKP, s) for any positive parameter qi. Differ-
activities may also contribute direct nonmarket
entiating both members with respect to qi and evaluating the
resulting derivatives at qi = 1 results in -qF = F1N + F2KP.consumption services. As Blinder (1991) has ob-

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 ARE GOVERNMENT ACTIVITIES PRODUCTIVE? 11
served, "If my car and my back absorb fewer
shocks from potholes, I am surely better-off; but
GNP may even decline as a result of fewer car
repairs and doctor's bills." Without evidence that
government capital does indeed generate empiri-
cally important direct nonmarket consumption
services, we would agree with Gramlich that im-
proving how existing government activities are
priced and carried out may be more important
than providing more of them.
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