Université de Toulouse I – Sciences Sociales Midi-Pyrénées Sciences Economiques

Thèse pour le doctorat en Sciences Economiques Infrastructure and the Marginal Cost of Public Funds

Présentée et soutenue le xx décembre 2004 par Michael WARLTERS sous la direction de Mme. Emmanuelle AURIOL

Membres du jury

Infrastructure and the Marginal Cost of Public Funds Michael Warlters

L’Université n’entend ni approuver, ni désapprouver les opinions particulières du candidat.

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Thanks I would like to thank my thesis and DEA supervisor, Mme. Emmanuelle Auriol, for her assistance throughout the course of the past four years. Her gentle direction has greatly improved the thesis, she was always available for discussion, and it was always a pleasure. I couldn’t have asked for more. I wish also to thank M. Devarajan and M. ?? for accepting to be rapporteurs for the thesis. I appreciate the time and effort that has gone into their comments. My thanks are also due to M. ,M. and M. for their participation on the jury. I am very grateful for comments received from Stéphane Straub on Chapters 2 and 3 and Bertrand Villeneuve on Chapter 4. Australians aren’t renowned for great expressions of sentiment, and I’m no exception. To some extent I don’t understand why people feel the need to thank their friends for what is merely one piece of work among many others in a professional career. Nevertheless a doctorate is perhaps a little more than just a standard work product. It is also a very clearly defined period with a beginning and an end, and it’s difficult to think of any other period that provides such freedom and wealth, both intellectually and socially. For those who became my French teachers, for those who invited me to their dinners, their parties and their weddings, for those who holidayed with me, for those who invited me to rugby matches and those who viewed my interest in cricket with amusement, for my fellow orienteers, and for all the other friends who helped to make my time in Toulouse unforgettable, I thank you.

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Contents 1 Introduction 1.1 Infrastructure, Growth and Poverty . . . . . . . . . . . . . . . 1.1.1 Productivity Effects of Infrastructure Investment . . . 1.1.2 Poverty and Inequality . . . . . . . . . . . . . . . . . . 1.1.3 Assessing the Adequacy of Infrastructure . . . . . . . . 1.2 The Marginal Cost of Public Funds . . . . . . . . . . . . . . . 1.3 Content of the Thesis . . . . . . . . . . . . . . . . . . . . . . . 1.3.1 The Marginal Cost of Public Funds in Africa . . . . . . 1.3.2 Infrastructure Privatization and the Marginal Cost of Public Funds . . . . . . . . . . . . . . . . . . . . . . . 1.3.3 Regulating Natural Gas Transportation as an Exhaustible Resource . . . . . . . . . . . . . . . . . . . . . . . . . . 1.3.4 Nonlinear Pricing and the Rate of Extraction of an Exhaustible Resource . . . . . . . . . . . . . . . . . . .

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1 2 3 7 8 9 12 12 15 17 19

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CONTENTS

Chapter 1 Introduction This thesis concerns aspects of the delivery of infrastructure services: the cost-benefit analysis of public projects; when privatization is desirable; and potential improvements in the regulation of infrastructure services. The thesis also concerns the marginal cost of public funds which is of fundamental importance in any cost-benefit appraisal of public projects, and, it will be argued, an important determinant of the efficiency of infrastructure privatization. The emphasis of the thesis is on developing countries, but there is much that is relevant in rich countries as well. The 1994 World Development Report (World Bank 1994) reported that developing countries invested around $200 billion a year in infrastructure such as water, electricity, and natural gas transmission and distribution networks, telecommunications networks, ports, roads and railways. Around 90% of this was financed by government or foreign aid intermediated by governments. Foreign aid funded nearly $24 billion of infrastructure investment. Private investment accounted for the residual. On average, half of government investment spending went to infrastructure, while maintenance and operating expenditures represented large proportions of governments’ current expenditures. These figures on high finance and ostensible government concern with the provision of infrastructure services stand in stark contrast with the reality of service provision. In 2004, 1.1 billion people lack access to safe drinking water, 2.4 billion do not have adequate sanitation, 1.4 billion do not have access to electricity. Poor transport infrastructure in developing countries is a brake on growth and represents opportunities forgone for the alleviation of poverty. So the stylized facts motivating this thesis are: (i) lots of money is spent on infrastructure; (ii) lots of people do not receive adequate infrastructure services; and (iii) governments remain responsible for the majority of infras1

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CHAPTER 1. INTRODUCTION

tructure investment and service provision. The first two stylized facts suggest that either more money should be spent on infrastructure, or that existing expenditure is wastefully employed, or both. The third fact indicates that expenditures should be subject to public sector cost-benefit appraisal: that is marginal expenditures should yield returns at least as large as the marginal cost of public funds. Inherent in this analysis is a supposition that the services received in developing countries are less than ‘adequate.’ This supposition is examined in the next section, where the linkages between infrastructure, poverty and growth are reviewed. The following section presents the concept of the MCF and its use in public sector cost-benefit analysis. The final section introduces the articles that constitute the substance of the thesis, placing them in a broader context and discussing areas where further work is required.

1.1

Infrastructure, Growth and Poverty

In a prize-winning essay in the Economist (2002), Robert Guest described the development costs of poor roads (and corruption) in Cameroon. A voyage to deliver a lorry-load of Guinness a few hundred kilometres, that should ordinarily have taken one day, took four days because of washed-out roads, accidents and predatory police road blocks. The price of a bottle of beer was 50% higher in rural villages than at the point of bottling. This is a case where high returns can be imagined for investment in improved roads. In China, rapid output growth has outstripped investment in electricity production in recent years, resulting in impending capacity constraints. High returns for investment in electricity production and transmission could be imagined here. In contrast, in the Kyrgyz Republic, the electricity network was expanded to ensure almost universal coverage during the Soviet era, to the point of connections even for shepherds living at the top of remote mountains. The subsequent decline in national output and subsidies from the rest of the Soviet Union has left the network possibly over-sized given the current means of the population. Here, investment in network expansion may well be wasteful, although returns to maintenance are probably high as the network is deteriorating. These examples illustrate that the returns to infrastructure investment are very much case dependent. In some cases demand for infrastructure services exceeds existing capacity, so the returns to marginal projects are high. In other cases, existing capacity is sufficient, and the returns to investment are low. There can be no substitute for individual project cost benefit analysis. As an example of such analyses, the average rate of social return on

1.1. INFRASTRUCTURE, GROWTH AND POVERTY

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World Bank projects during 1983-1992 was 11% for electricity projects, and 29% for road building (World Bank 1994). Such rates suggest that on average the investments were worthwhile, but do not suggest great infrastructure shortages.

1.1.1

Productivity Effects of Infrastructure Investment

But there are problems with cost benefit analyses. Even if performed correctly, they are likely to miss certain externalities. Canning & Bennathan (2000) note, for example, that transport infrastructure may have an effect on market size, the ability to exploit economies of scale, the degree of competition, or the diffusion of knowledge and technology. The public provision of risky, large scale infrastructure used to provide energy services may provide a trigger for private sector investment, important in ‘big push’ models of development. In an effort to take account of such externalities, a small econometric industry has emerged measuring the consequences of infrastructure investment using macroeconomic data. Four methodologies have been used: aggregate production functions; cost or profit functions; regressions of the growth of output; and vector autoregressions (VARs), which avoid imposing assumptions about the direction of causality. Production Function Methodology The paper that launched the industry was that of Aschauer (1989), who sought to estimate the output effect of public investment in the United States. The basic idea is to estimate a Cobb-Douglas production function, of the form: ln(Y ) = ln(A) + a ln(K) + b ln(L) + c ln(G)

(1.1)

where Y is output, A is total factor productivity, K is private capital, L is the labour force and G is the government capital stock. Using time-series data, the estimated coefficient c, the elasticity of output with respect to government capital, had a value of 0.39. The marginal product of a unit of = c YG . Gramlich (1994) calculates that public capital can be estimated as dY dG in the United States in 1991, G was $1938 billion and Y was $4800 billion, implying a marginal product of almost one unit of output.1 The implication 1

A problem with this methodology is that it is very sensitive to the ratio Y/G, and the accuracy of measures of the capital stock. Moreover, when the capital stock is a small fraction of GDP (for example, the value of fixed telephone lines) the multiplier becomes huge, implying very high rates of return.

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CHAPTER 1. INTRODUCTION

from the time series data is that one unit of public capital pays for itself in one year. Many commentators found such rates of return implausibly high. Similar studies using different data sets found the output elasticity of public capital to be in the range 34-39% at the national level, 15-20% at the regional level and 3-8% at the metropolitan level (Munnell 1992). Some critics thought the range of estimates suggested fragile empirical linkages. But it can be argued that they simply show that as the geographic focus narrows, macroeconomic externalities are not captured. Another critique of Aschauer’s methodology was that reverse causation – higher output may lead to higher demand for infrastructure – could bias the results upward. Canning & Bennathan (2000) estimate a translog production function with panel data across countries, using econometric techniques to correct for the problem of reverse causality. For most countries they find rates of return to infrastructure that are similar to, or even below, the returns on other forms of physical capital. But for a group of middle income countries they find acute shortages of sealed roads: the ratios of the rate of return for paved roads to the rate of return for general capital was 37.09 in Bolivia, 17.53 in Colombia, 36.95 in South Korea and 17.99 in the Philippines. For a group of lower and lower-middle income countries they find evidence of high rates of return to electricity generating capacity: the ratio of returns on electricity to returns on general capital was 6.63 for Kenya, 4.74 for Bolivia, 4.58 for Congo, and 4.49 for Gambia. The results suggest there may be large macro-economic effects not detected by micro-economic cost benefit studies, but their existence depends on country and sector specific characteristics. An alternative interpretation of the production function approach is given by Caldéron & Servén (2003). They find that the difference in infrastructure levels between Latin American countries and East Asian countries accounts for about one third of the gap in output per worker between these regions. Cost Function Methodology An alternative empirical approach is to use firm cost functions. Morrison & Schwartz (1996) estimate the potential cost savings from a decline in variable inputs required to produce a unit of output when infrastructure investment occurs. They use data for the 48 contiguous states of the United States for 1970–1987. The measure of public capital includes highways, water and sewer capital. Focusing on results for 1982, they find that a $1 million investment in infrastructure results in approximately $160,000-$180,000 cost saving for manufacturing firms in most regions, but almost twice that in southern states. It is not clear that additions to water or sewer capital would usually have major productivity effects for most manufacturing firms, so much of these

1.1. INFRASTRUCTURE, GROWTH AND POVERTY

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effects may come from transport investments. Growth Regressions Methodology Another strand of literature has used economic growth as the dependent variable, with infrastructure indicators on the right-hand side of a reduced form model. Barro & Sala-i-Martin (1995) perform one such analysis, with results suggesting that there is no significant difference in rates of return on public and private investment (i.e., rates of change of capital stocks). Similarly, Levine & Renelt (1992) performed regressions with a long list of variables potentially influencing growth rates, finding that the level of government capital stock never has significantly positive coefficients. Devarajan, Swaroop & Zou (1996) examine the determinants of growth of per capita real GDP in developing countries. Controlling for the level of total public expenditure, they find that the standard candidates for productive public expenditure – capital, transport and communication, health, and education – had either a negative or insignificant relationship with economic growth. The only broad category associated with higher economic growth was current expenditure. Performing similar regressions for rich countries they find opposite results, that increased capital expenditure is associated with higher growth. The results suggest that capital expenditures may have been excessive in developing countries, rendering them unproductive at the margin. Components of current expenditure such as operations and maintenance may have higher returns than capital expenditure. La Ferrara & Marcellino (2000) present a variant on the growth regressions using data on manufacturing output in regions of Italy in 1970-1994. They calculate the growth of total factor productivity (TFP) using a standard growth accounting framework, and then investigate the impact of the growth of capital, labour and public capital on the growth of TFP. They compare the results using this model with results obtained using the production function and the cost function methodologies. The growth accounting methodology suggested a significant elasticity of output with respect to public capital of 0.47. In contrast, using the production function technique, the elasticity is negative and significant. Using the cost function technique, increased public investment slightly increases firm costs, though the effect is close to zero. Esfahani & Ramírez (2003) develop a structural growth model that helps discern the mutual effects of infrastructure and the rest of the economy on each other, distinguishing how different policies and institutions affect steadystates and rates of convergence across countries. They find the elasticity of output with respect to the stock of telecommunications capital to be 0.08 and

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CHAPTER 1. INTRODUCTION

with respect to the stock of electricity capital to be 0.13. These estimates imply that if the growth rate of telephones per capita rose from about 5% as in Africa, to about 10% per year as in East Asia, the annual growth rate of GDP per capita would rise by about 0.4 percentage points. If the growth rate of electricity production increased from 2% in Africa, to 6% as in East Asia, annual GDP growth would increase by a further 0.5%.2 VAR Methodology A final technique for investigating the relationship between output and infrastructure investment is presented by Sturm, Jacobs & Groote (1999), using data on the Dutch economy in the 19th century. A Vector Auto-Regression (VAR) model seeks to explain a limited number of variables by their own lags and lags of the other variables. Infrastructure investment is said to ‘Grangercause’ an increase in GDP if the time-series prediction of GDP from its own past improves when lags of infrastructure investment are added to the equation. Using lags of GDP and investment in infrastructure and private capital, the authors find that infrastructure significantly Granger causes GDP to increase, while GDP growth has a significant, but lesser, negative effect on infrastructure investment. An advantage of this methodology is that it lets the data speak for themselves, without imposing assumptions of particular models. A disadvantage is that it cannot discriminate between infrastructure investments causing GDP to rise and infrastructure rising in anticipation of future GDP growth. Summary of Productivity Impact Estimates The different studies cited suggest ambiguous effects of infrastructure investment on output. Production function techniques commonly, but not always, give high estimates, at least at the national level. The cost function approach also gives significant and positive estimates although, in the paper cited, the rates of return are similar to the marginal cost of public funds, yielding a net return on investment that is close to zero. The growth regression technique gives widely diverging results, ranging from highly positive to negative effects of public infrastructure investment. The VAR technique suggests that in the Netherlands in the 19th century, infrastructure investment induced higher growth. 2

The authors do not report the implied marginal productivity of infrastructure investment. If we value Tanzania’s 862 MW of installed electricity capacity at $862 million, the ratio Y/G=26, so the implied marginal productivity of investment in electricity is 339%.

1.1. INFRASTRUCTURE, GROWTH AND POVERTY

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Part of the reasons for these different results is surely related to the estimation methodologies employed, as highlighted by La Ferrara & Marcellino (2000) who find different results using the same data but different methodologies. But part of the variation is probably also due to the fact that the productivity of infrastructure investment, even taking account of macroeconomic externalities, is likely to depend on whether the existing infrastructure is in short or excess supply. In interpreting the results of these macroeconomic studies it is also useful to bear in mind the standard warning message associated with all investment: past returns offer no guarantee of future performance. For example, construction of new infrastructure systems, such as railways in the 19th century or the US or European highway networks built in the 1950s to 1970s, may have had high returns. Extensions to the networks might have much lower returns. In developing countries, where the coverage of infrastructure networks is low, there are reasons to believe that investment in network expansion could have high returns, but if Devarajan et al. (1996) are right, maintenance of existing networks could have even higher returns.

1.1.2

Poverty and Inequality

Even if infrastructure investment does not yield output returns greater than other forms of physical capital, additional investment may be justified if it reduces poverty or inequality. Some of the strongest poverty links are found with investments in water services and rural roads. Access to clean water and adequate sanitation play an important role in health, one of the most important indicators of well-being. For example, Jalan & Ravallion (2000) find that the prevalence and duration of diarrhea for children under five in India is significantly lower for families with piped water than for equivalent families without access to piped water. Galiani, Gertler & Schargrodsky (2004) find that privatization of water services in Argentina led to increased connections to water and sanitation services for the poor, and higher quality services. As a result, child mortality fell by 8% on average in the areas that privatized their water services, and the effect was greatest (26%) in the poorest areas. Leipziger, Fay, Woden & Yepes (2003) find that a quarter of the difference in infant mortality between the rich and the poor is explained by their respective access to water services. Rural roads provide cheaper access to markets for agricultural outputs and for modern inputs, as well as improving the quality of life through improved access to modern consumer goods. They can thus lift the incomes of rural farmers. Jacoby (2000) finds that rural roads in Nepal substantially diminish rural poverty, but have only a limited effect on inequality within

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CHAPTER 1. INTRODUCTION

rural areas because the benefits tend to accrue more to landowners, who are not generally among the very poor. Other forms of infrastructure typically have an effect on poverty through their effects on output. But more direct effects are possible. For example, electricity allows more time for study (because of cheap lighting at night) and the use of computers, and so has an impact on educational attainment. Electric lighting can also have an effect on health, when it replaces kerosene lamps. Access to telecommunications services can lift incomes for rural farmers, by giving them better information about market prices, and so squeezing the margins of middle-men. A recent attempt to measure the effect of infrastructure provision on inequality found that income inequality declines with higher infrastructure quantity and quality. Calderón & Servén (2004) obtain this result with a database encompassing over 100 countries and covering 1960-2000, using the Gini coefficient as the dependent variable. A variety of tests supports the proposition that causation does indeed run from infrastructure to reduced inequality. Much of the interest in infrastructure’s effect on inequality has focused on the effects of privatization. Newly privatized firms may cut employment, but the impact on inequality depends on the income distribution of dismissed workers prior to being laid off, the monetary compensation they receive, and their probability of being re-employed. In some cases, notably telecommunications, privatization has been associated with reforms increasing competition, and an increase in total employment in the industry. The distributive impact of privatization can also depend on how transaction revenues are used. Privatization is often associated with pricing reforms, including the elimination of subsidies, which may limit affordability for low income groups. Overall, it seems that the effect of privatization on income distribution is very much a product of how the reforms are designed. Any adverse effects on inequality can be minimized by establishing a regulatory environment restraining prices and with obligations for increased service coverage for the poor; by cushioning the employment impact with adequate severance and retraining packages; and by using revenues for pro-poor expenditures.

1.1.3

Assessing the Adequacy of Infrastructure

On poverty or inequality grounds it can be argued that access to certain infrastructure services is a basic need, regardless of the cost. For example, the South African government has made it a priority to ensure that all households have access to safe water within 500 metres of the house. Such a policy automatically places high value on the benefits of water provision, and

1.2. THE MARGINAL COST OF PUBLIC FUNDS

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does away with the need for comparison of costs and benefits. (The policy does not, however, extinguish the need for comparison of least-cost means of providing safe water.) But outside such special cases there is a need for micro-economic cost benefit analyses. There is no blanket rule that infrastructure investment always has a high return. Since the returns to infrastructure investment are project specific, it is important that governments implement systems that ensure appropriate methodologies for decision-making. As argued in the next section, estimates of the benefits of public projects should be compared against the marginal cost of public funds. Privatization perhaps provides stronger incentives to make correct investment decisions (or at least to make the decisions more quickly)3 , but only to the extent that market demands reflect social benefits. It is likely that the wider economic benefits will not always be fully captured by micro-economic studies. The papers cited suggest that, at least in some cases, infrastructure investments can have important macroeconomic externalities, even to the point of lifting the rate of economic growth. When such externalities exist, there is a case for public subsidy. But it is not clear exactly how to identify the circumstances in which these external effects occur. It seems possible that a precondition for such externalities is an excess of private demand compared with infrastructure capacity. If so, standard cost-benefit studies should indicate high rates of return, sufficient to justify investment, any time when there are additional externalities. To avoid the possibility of white elephants built on the imagined possibility of great externalities, the safest course seems to be to rely on thorough cost-benefit analysis, comparing measurable benefits with the marginal cost of public funds.

1.2

The Marginal Cost of Public Funds

The marginal cost of one dollar of public funds is typically greater than one, because of the welfare costs induced by distortionary taxes. A commonly cited estimate of the MCF for the United States is 1.33, indicating that raising $1 by taxation induces a 33 cent welfare cost (Ballard, Shoven & Whalley 1985). In an efficient economy there is a single MCF, since the welfare cost of all tax instruments should be equalized at the margin. Moreover, in an efficient economy the MCF is equal to the marginal benefit of public funds (MBF). As illustrated in Figure 1.1, the intersection of the MCF and 3

Esfahani & Ramírez (2003) find that the rate of convergence to the steady state growth rate is higher when infrastructure is privatized.

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CHAPTER 1. INTRODUCTION

MCF

a MBF 1

b

Revenue/GDP

Figure 1.1: MCF and the Optimal Size of Government MBF functions determines the optimal MCF (a) and the efficient size of government (b). If a new public infrastructure project is proposed, it should have a return at least equal to the optimal MCF. This neat theoretical framework is disturbed by several considerations. In the first place there are multiple tax instruments, and in practice governments do not equate the MCF for different taxes. Thus, there are multiple MCFs, and in a non-optimized economy, it is not possible to draw a nice diagram such as Figure 1.1. Many practitioners side-step this problem by talking of a revenue-weighted average of MCFs for all tax instruments, supposing that governments needing additional revenue will increase all taxes proportionately. But the true marginal cost of funds will depend on which taxes are actually involved when governments marginally alter their revenues. It is thus important to know the marginal costs of each tax instrument. This is the subject of Chapter 2. Secondly, governments can raise funds by borrowing rather than by increasing taxation. Measures of the interest rate associated with government borrowing are frequently used in practical cost benefit analysis for public projects. But if the true cost of debt were the interest rate, and if the in-

1.2. THE MARGINAL COST OF PUBLIC FUNDS

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terest rate were lower than the MCF of taxation, then governments should indeed increase debt. But there are various limits to the amount of debt governments can incur, and when these limits are reached any additional revenue must be raised by taxation. Moreover, the true cost of debt is not just the interest rate. In a draft paper, Dahlby (2004) uses a simple AK endogenous growth model to examine the relation between public debt, distortionary taxation and the growth rate. The net savings rate (public plus private savings) determines the growth rate. An increase in public debt of itself lowers the growth rate. But it also has an effect on private savings. Distortionary taxes must increase to meet the interest payments, reducing the return on saving, and so reducing private savings. And in a Ricardian equivalence effect, households anticipate higher taxes and so increase their savings. The Ricardian equivalence effect exactly offsets the decrease in public saving, so net savings decline because of the distortionary tax effect, resulting in lower growth, and thus lower welfare. Calibrating his model to the Canadian economy, Dahlby finds that government bonds with an interest rate of 8% have a marginal cost of public funds of 1.15.4 If the Ricardian equivalence effect is muted, the welfare cost of debt is higher. Finally, governments can fund marginal expenditure by cutting existing programs. The neat MBF function of Figure 1.1 implicitly supposes that governments analyze the returns on all their potential projects, and then perform the projects in descending order of return, until such a point that the revenue requirement increases the MCF to equate the MBF. In this setting, the MBF of a marginal project, would be equal to the MCF of raising funds through increased taxation. Cutting any other project would have a higher MCF than an increase in taxes. Thus, if governments make mistakes about the project with the lowest marginal benefit when choosing a program to be cut, the MCF of funds obtained by cutting an existing program will on average be higher than the MCF of funds obtained by increased taxes. In practice, there are likely to be implemented projects that yield marginal benefits less than the MCF, and the MCF of funds obtained by cutting existing programs will be program specific. But if governments have some tendencies towards choosing projects efficiently, the MCF of cutting programs should tend on average to be close to, but higher than the MCF of increased taxation. To summarize, governments can raise funds by different tax instruments, by borrowing, or by cutting existing programs. There is likely to be a different 4

The 8% interest rate is not mentioned by Dahlby (2004), but can be derived from his calibration figures.

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CHAPTER 1. INTRODUCTION

MCF associated with each of these mechanisms. The threshold rate of return to be used in public cost benefit analysis is different depending on how the government intends to raise the funds. Nevertheless, the argument that there are limits to borrowing suggests that, ultimately, if governments wish to increase total spending (i.e., without sacrificing existing programs) it must be paid for by increased taxes. Accordingly, the MCF associated with taxation is probably the best candidate as a threshold rate of return for public projects.

1.3 1.3.1

Content of the Thesis The Marginal Cost of Public Funds in Africa

Despite the obvious importance of measures of the MCF for the cost-benefit appraisal of public infrastructure projects, in practice the MCF is rarely used. One of the principal reasons for this is that very few estimates exist, particularly in Africa. There is a need for a practical way to estimate the MCF of different taxes. The challenge taken up in Chapter 2 is to develop a means of estimating MCFs for the main classes of taxes, using data that is readily available. The paper uses a simple general equilibrium model, written in GAMS MPSGE, to estimate the MCFs of taxes on domestic goods, capital, labour, exports and imports in 38 sub-Saharan countries. The basic model is derived from the ‘1-2-3 model’ of Devarajan, Go, Lewis, Robinson, & Sinko (1994), a model that can be calibrated with little more than national accounts data. The basic 1-2-3 model has one country with two producing sectors and three goods: a domestic good, exports and imports. This model is extended to include production of an informal good, and four factors of production: formal capital, informal capital, formal labour and informal labour. The definition of an informal good or factor is simply one on which no tax is paid. The paper uses a very simple calibration method for calculating the size of informal parts of the economy. For example, the size of the formal domestic sector is calculated as VAT revenue divided by the VAT rate. Excluding export production, the residual part of GDP is the informal economy. Although crude, this methodology gives roughly the same estimates of the informal economy as are found for the two African countries mentioned by Schneider & Enste (2000) in their survey of informal economy estimates. The general equilibrium model is sufficiently simple that most of the results are entirely intuitive. But the estimates suggest an average African MCF of 1.17. This is lower than most estimates for rich countries, and runs counter to intuition for many people, who consider that inefficient taxation

1.3. CONTENT OF THE THESIS

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MCF

MCF’

MBF’ a MBF

1

b

Revenue/GDP

Figure 1.2: MCFs in Rich and Poor Countries systems in poor countries should result in high MCFs. An inefficient tax system results in a higher MCF function. But it is also a fact that rich countries tax a larger proportion of GDP (25% to 50% in rich countries, compared with around 20% in Africa). So the apparent conundrum of a higher MCF function in poor countries, a higher observed MCF value and higher tax revenue in rich countries could be resolved by supposing that the MBF function is higher in rich countries. Thus, in Figure 1.2, rich countries are represented by MCF’ and MBF’, and the equilibrium MCF value is higher. In fact, it is not clear that the MCF function is higher in poor countries (when the MCF function is calculated as a revenue-weighted average of the MCFs of individual taxes). Chapter 2 suggests that the MCF function tends to be higher with greater reliance on capital, labour, or export taxes, and with higher administrative costs of collecting taxes or larger informal sectors. Rich countries tend to rely more on capital and labour taxes than poor countries, while poor countries tend to rely more on export taxes, have higher administrative costs and larger informal sectors. Where these effects balance is an empirical question that requires estimates of the MCFs for rich countries using a comparable model.

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CHAPTER 1. INTRODUCTION

In the context of this thesis, the motivation for estimating MCFs is their use in infrastructure project appraisal. Using MCF estimates for cost-benefit analysis there is often a question whether the benefit side has been measured in a way that is appropriate given the MCF measurement methodology. In particular, benefits are often measured using consumer prices as the numeraire, while MCFs are often measured using producer prices as the numeraire. Such differences in methodology can render cost-benefit comparisons meaningless, since estimates of both MCFs and MBFs depend on the numeraire (Triest 1990). This may be further explanation for why MCF estimates are rarely used in cost-benefit analysis. MCF estimates requiring returns of between 17% and 30% sound like prohibitively high thresholds for analysts used to using thresholds such as an 8% rate of interest to justify public investment. But it seems possible that if benefits were measured in a fashion consistent with MCF estimates, the resulting rates of return on infrastructure would indeed be consistent with the high MCF thresholds. This is a case where greater theoretical work is required concerning the appropriate way to measure the marginal benefit of public expenditure. A more direct use of the MCF estimates generated by the paper is in tax reform. If the MCF of two taxes differ, welfare can be improved holding government revenue constant by lowering the tax with a high MCF and increasing the tax with a low MCF. Thus directions for partial tax reform can be derived from the MCF estimates, without any doubt about whether the estimates have been prepared using consistent methodologies. Much of the paper interprets the MCF estimates in terms of their implications for tax reform. For example, the paper suggests that taxes on factors and on exports are particularly costly, and suggests that greater reliance on VATs and imports taxes would improve welfare. Another of the findings of Chapter 2 is that the magnitude of the informal sector is an important determinant of the level of the MCF. At least for the African countries studied, the informal sector size seems to be more important than differences in tax structure. Auriol & Warlters (2004) suggest that developing country governments have a revenue incentive to limit the size of the formal sector, at least in the short term. Governments wish to create market power by limiting entry into the formal sector, in order to confiscate the rents. Barriers to entry are created using entry fees and other red tape obstructions. Reading the two papers together, governments that can reduce market entry fees are likely to enlarge their formal sectors, and thus increase their tax bases and tax revenue in the long term, and simultaneously reduce the marginal cost of public funds. As with many applied general equilibrium models, the results depend on

1.3. CONTENT OF THE THESIS

15

assumed elasticities. For the base case estimates all production and consumption elasticities of substitution are assumed to be Cobb-Douglas. For many of the elasticities this is a reasonable assumption. In any case, the ordering of results (important for tax reform) is little affected in sensitivity testing. Among the unknown elasticities, the results are most sensitive to the consumers’ elasticity of demand substitution between the informal good and the taxed domestic good. To tighten up the robustness of the model, empirical work to measure this elasticity would be particularly useful.

1.3.2

Infrastructure Privatization and the Marginal Cost of Public Funds

Since the 1980s governments have increasingly turned to the private sector to manage and to invest in infrastructure. There seem to have been two principal motivations for privatization. One is the conversion of a future flow of revenues into a capital sum, that can be used to resolve immediate cash flow difficulties. The other is a belief in the greater efficiency of the private sector. Chapter 3 examines the revenue and efficiency effects of privatization, finding that the benefits and costs vary with the MCF. Two forces operate: the private sector has stronger incentives to reduce costs, but also earns higher information rents under regulation than a public firm. When the cost of raising public funds through taxation is low, the welfare cost of paying information rents is low, and public sector managers have weak incentives to reduce costs because they know the government will bail them out in the event of a loss. When the MCF is high, the government can use a public firm as a low welfare cost source of funds, the welfare cost of a private firm’s information rents is high, and public sector managers have stronger incentives to reduce costs because bailouts are less likely. The paper supposes that the government is a welfare-maximizer. Whatever governments’ true motivations, privatization is presumably politically easier to implement if it enhances welfare, so that privatization is more likely to occur. Using the introduction of a VAT as a proxy for a reduction in the MCF (more efficient taxation lowers the MCF), the theory is empirically supported by data on infrastructure privatizations in developing countries. Various other arguments have been raised, for and against infrastructure privatization. Some politicians have mistakenly believed that privatization is a means of having the private sector fund infrastructure investment. Of course, private investors require a return on their investment, which must be achieved either through government payments or user fees. Citizens ulti-

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mately pay for the services they receive, either as tax payers or as consumers. Privatization offers no free lunch. An argument opposing privatization is that governments have a lower cost of capital than private investors, so that it is cheaper for governments to finance investment. The interest rate on government borrowing is indeed typically lower than the rate offered to private firms in the same market. But Klein (1997) notes that this is because governments can have recourse to taxation to repay their debts in the event of project failure, so that taxpayers provide an unremunerated form of credit insurance or callable capital. If the insurance or callable capital were properly priced at the true cost to society, the government’s ostensible capital cost advantage would disappear. In any case, as argued above, the cost of government debt is not simply the interest rate, but also the additional distortionary cost of taxes necessary to meet the debt repayments. The theoretical section of Chapter 3 focuses on government motivations for privatization. It supposes that governments are able to obtain the full value of the privatized firm, by means of a competitive auction. But there have been many cases of governments that have sought to privatize but have been unable to find investors. In many cases this may be due to unrealistic expectations on the part of governments. A minimum requirement for profitability is that tariffs cover costs, but even this may not be possible when the population served is very poor. If the government is truly committed to providing infrastructure services to such a poor population, this problem can be overcome by so-called ‘negative concessions’, where the right to operate the business is auctioned to the private firm requiring the least subsidy. But such a mechanism requires investor confidence that the government will indeed pay the subsidy. Even when demand is sufficiently high to meet cost-covering tariffs, investors require credible government commitments concerning the durability of such tariffs. Governments face strong political pressures to reduce tariffs. Once investors have sunk their investments, governments can renege on commitments to keep prices sufficiently high to cover those fixed costs. Provided the regulated price covers marginal costs, the private operator could still be induced to continue operations. But investors know all this, so they will not invest unless the government can give credible commitments concerning the future trajectory of regulated prices. In many countries with weak governments it is simply impossible to give credible commitments. Private investors can compensate for some level of country risk by increasing the premium they require, but this has the effect of increasing consumer tariffs, and rendering the whole package even more unstable. It is for reasons such as these that infrastructure privatization practition-

1.3. CONTENT OF THE THESIS

17

ers have placed much emphasis on mechanisms which would help to increase the credibility of government commitments to cost-covering tariffs. Such mechanisms include the establishment of independent regulatory agencies with statutory duties to ensure cost-covering tariffs; transparent procedures for privatization transactions, to reduce the risk of subsequent legal challenges which would provide an excuse to subsequent governments to renege on the privatization contract; or the involvement of local investors in the privatization transaction to provide more effective political resistance to any subsequent government attempt to renege on privatization commitments. The empirical section of Chapter 3 finds that certain aspects of country risk do indeed have an effect on the probability of infrastructure privatization. For all these reasons, there is a need to supplement Chapter 3’s theory for when governments wish to privatize, with an additional theory of the conditions under which investors wish to participate in privatization transactions, and what proportion of the risk-free value of the transaction they are willing to pay.

1.3.3

Regulating Natural Gas Transportation as an Exhaustible Resource

A further possible critique of the analysis of Chapter 3 is that it supposes that infrastructure firms are regulated by classic mechanisms of the sort propounded by Baron & Myerson (1982) or Laffont & Tirole (1998), where the problem is to limit the market power of infrastructure monopolies. Historically, the problems of public infrastructure service provision in developing countries have frequently been low prices rather than monopoly prices. To curry political favour, politicians in many countries have resisted price increases or even the enforcement of consumer bills, resulting in the worst cases in inadequate firm revenues, and thus non-existent network expansion, inadequate maintenance and deteriorating services. Furthermore, the classic regulatory mechanisms have typically supposed strong institutions, including the ability to enforce contracts, assumptions that are not always relevant in developing countries. Accordingly, there is a developing literature on the adaptation of classic regulatory mechanisms to the constraints of developing countries. For example, Laffont (2004) examines how the choice between price cap and cost of service regulation is affected by developing country characteristics, and develops a theory of regulation with limited enforcement. Much work on regulation in developing countries addresses the incentives created by institutional arrangements.

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Despite these advances there is still room for improvement in the classic forms of regulation developed for rich countries. Chapter 4 suggests a potential improvement in the way that natural gas pipelines are regulated. The name of the paper arises from the fact that pipelines are rendered useless when the gas resource is exhausted, so that pipelines are themselves exhaustible resources. The basic idea is that under Hotelling’s Rule for the optimal extraction of an exhaustible resource, prices on the welfare maximizing path should rise over time at a rate that ensures that marginal welfare rents (the difference between the price and the marginal cost of delivered gas) rise at the rate of interest. The existence of these positive rents means that regulators of the transportation price could cover the fixed costs of pipeline construction without any distortion of the first-best price path for delivered gas. In comparison, standard methods of regulation achieve at best an approximation of the optimal price path. The standard method of regulation is characterized in the paper as a fixed markup on the price of transportation over the marginal cost of transportation. The markup is designed to cover the fixed cost of pipeline construction. The markup could be determined by means such as cost of service or price cap regulation. The important point is that it stays fixed over time, so that marginal welfare rents do not rise over time as required by Hotelling’s Rule. If production is competitive, such a regulatory strategy would result in prices for delivered gas which are a little worse than optimal. If production is monopolized, the strategy would result in prices that are a little worse than an unregulated monopoly. Chapter 4 has obvious relevance in developing countries with natural gas resources. Pipelines already exist between and within Chile and Argentina; Bolivia and Brazil; Uzbekhistan, Kyrgyz Republic and Kazakhstan; Russia and Europe; North Africa and Europe; within Bangladesh; and a pipeline is planned along the coast of West Africa to take natural gas from Nigeria to the neighbouring countries as far as Côte d’Ivoire. The paper is useful for intra-country regulation, within the country of gas production. But one message of the paper is that access regulation is of little use for importing countries. Faced with a monopoly supplier of gas, regulation of the price of transportation can indeed achieve the optimal price of delivered gas, but only at the expense of very high rents being transferred to the supplier. To resolve such questions of market power, importing countries must participate in the larger game which is not addressed in the analysis of Chapter 4: the game in which the market structure is established. In this game, a natural gas pipeline is constructed only if the present value of the cost of delivered energy is less than the cost of energy delivered by other means – gas pipelines from other countries, or production of electricity by other means.

1.3. CONTENT OF THE THESIS

19

At the time of constructing the pipeline, the gas producer’s market power is constrained by the possibility of alternative energy sources. The importing country typically signs a contract to ensure that these constraints continue to operate over a long term, fixing the final consumer price for delivered gas, rather than just fixing the transportation price.

1.3.4

Nonlinear Pricing and the Rate of Extraction of an Exhaustible Resource

Chapter 5 presents a short technical note on nonlinear pricing, closely related to the analysis in Chapter 4. Existing analyses of extraction of exhaustible resources have entirely considered linear pricing. This is natural, since for the majority of exhaustible resources, of which oil is no doubt the most significant, the possibility of resale between consumers rules out the possibility of nonlinear prices. For natural gas, it is physically possible to liquefy natural gas and to resell it, but this is uneconomic for small quantities or for delivery distances shorter than about 3000 kilometres. For natural gas delivered by pipelines nonlinear prices are clearly feasible and indeed commonly observed: most consumers pay a fixed monthly fee and a per unit tariff. Hotelling’s Rule governs the optimal extraction of gas, fixing the quantities of gas to be extracted in each period. To maximize welfare, linear prices should be used in intra-period pricing, since this is the optimal fashion to ration a fixed quantity across heterogeneous consumers. But a monopolist, under the assumptions of the paper, would choose a price schedule that gives a lower marginal price to consumers who consume greater quantities of gas. In standard textbook expositions, where monopolists are constrained to use linear prices, monopolists extract gas too slowly, relative to the welfare maximizing rate. Allowing for the possibility of nonlinear prices, a monopolist extracts gas too slowly at periods far from the final exhaustion date, and too quickly at dates close to exhaustion.

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