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Guidelines for Evaluating Public Investments

Original post made by stephen levy, University South, on Jun 27, 2009

A reader asked me to explain the difference between public spending and public investment from an economist's perspective. I am going to try using two issues often discussed on Town Square: high-speed rail (HSR) and education.

For purposes of this blog I will confine public investment to education and infrastructure and avoid debating whether spending on health care, social services and prisons should be considered an "investment."

One characteristic of investments in education and infrastructure is that they build our stock of human and physical capital. Education increases the skills (and usually the earning power) of people while infrastructure such as roads, energy and water systems and ports provide services that increase the productivity of businesses and lower costs (such as congestion) and improve the quality of life for residents.

Another characteristic of public investments is that they provide a flow of benefits for many years. Education provides benefits to the individual and to the nation over a long period of time. And physical infrastructure is built to last and provide services for decades.

A third characteristic of public investments is that the dollar costs come in the early years and the benefits come more in later years. The distinct difference between the timing of costs and benefits has implications for how public investments are funded.

We normally finance public investments with bonds and taxes like the property taxes that fund local school and library bonds or with fees such as the fees we pay for water and energy usage. The idea is to spread the costs over 20 to 30 years so that the future generations, who are getting much of the benefits, will share in the costs.

Public investments, unlike the private investments that individuals and companies make, have both "private" and "public" benefits. If new transportation investments only made it easier for me to travel, there would be reason to charge me my share of the full cost as a means of funding the investments. We do have many tolls and fees that partially pay for infrastructure such as bridges and water systems. Where possible having people pay for their share of infrastructure costs through user fees improves decision making about using infrastructure and is a good idea if there are no serious equity questions.

But public investments bring benefits to the broader community and nation. Education helps my children become more productive but it also improves the nation's stock of human capital and makes our overall economy more productive and prosperous. Here in Palo Alto and across the nation Americans have a long tradition of investing in the education of future generations of children.

That is why school bonds and parcel taxes pass up and down the state in communities where most voters have no children in school. It explains why voters in Los Angeles last November approved $10 billion in school bonds, funded completely by new property taxes, for children who will primarily be the children and grandchildren of Latino and Asian immigrants.

It is why Californians have passed more than $100 billion in state and local bonds to fund projects such as new roads, water systems and high speed rail that may not be operational in the lifetime or neighborhood of most voters.

But investments are still investments whether they are private or public investments. We invest to make a return on our investment. The accounting is more difficult for public investments compared to buying stock or building a factory, but the standard is still the same.

In comparing the benefits and costs of public investments, we have to agree on how to value benefits that occur in the future. A dollar received twenty years from now is worth less as an investment return than a dollar received next year. And we have to find ways to include the benefits that accrue to the overall economy in addition to those directly received by users. People struggle with this issue in valuing the impact of air quality regulations on the health and quality of life of millions of people in Southern California's smog basin.

But the bottom line is the same. Public investments only make sense when they have a positive return on investment compared with other uses of the funds.

There is a large body of evidence that investing in the education of America's children is generally a good investment on financial grounds without including any social benefits that occur from having a better educated population. The returns to having some post-secondary training, which implies graduation or the equivalent from high school, are high. Each year the Census Bureau Web Link reminds us that our intuition is correct—education pays!!

This is one reason that many people are concerned that California is cutting back on our investment in K-12 and college education as a result of budget pressures. Great companies work hard to maintain their investments in down times. President Obama articulates what is one of America's great bi-partisan agreements—that education is critical for economic competitiveness and our children are our future.

When you view education spending as an investment some of the silliness that gets tossed about related to educating the children of unauthorized immigrants gets turned on its head. Education is either a good investment for society or it is not. Often returns on education investment are highest for the most at-risk kids. But this has nothing to do with whether one or both of their parents came to California through unauthorized immigration.

There is certainly a good case for extra federal aid for communities that have a high share of at-risk children. But there is no evidence or logic that I know of that says it is good to educate children, especially at-risk children, but the economics changes depending on how their parents came to California.

Physical investments like high speed rail are somewhat easier to evaluate. We can measure their impact on travel time and cost, throw in environmental considerations if we like and compare the benefits to the costs of construction and operation, look at alternative uses of the funds for similar purposes and make a reasonable decision as to whether this is a good public investment.

The HSR as currently proposed fails in my opinion, not because as someone recently argued, we are borrowing money in a recession, but because the presumed benefits are likely overstated and cost estimates in public transportation investments has a disappointing history of ending up higher than anticipated.

We should be borrowing money to fund good public investments. The problem with HSR is not that sometime down the road California will sell bonds to finance the investment but that it is a questionable investment in the first place.

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