The Impact of Public Investment on Private Investment: Evidence from India

Abstract

Executive Summary This paper estimates the impact of public investment on private investment in India during 1970-2013 using ARDL procedure developed by Pesaran and Shin (1999) and Pesaran, Shin, and Smith (2001) by incorporating endogenously determined structural break in the model. The base line result implies that a 1 per cent increase in public investment as a ratio to GDP leads to 0.81 per cent and 0.53 per cent decrease in private investment as a ratio to GDP in the long run (about 4 to 5 years) and short run (about 2 to 3 years), respectively, after controlling for economic conditions. To address the concern that the results may be driven by government consumption expenditure, fiscal deficit, or inadequate infrastructure, the analysis was repeated by estimating the investment function after including these variables and similar results were obtained. The investment regression was also estimated for a shorter sample period (1978–2013) to get the same result. It is observed that the crowding out effect of public investment on private investment has dampened during the post-liberalization period. The results also reveal that a “market friendly” incumbent and an increase in foreign direct investment dampen the magnitude of the crowding out effect of public investment. Formal tests were conducted to examine whether the crowding out effect was driven by political uncertainty and political business cycle channels but no evidence for the same is found. The results also reveal that public infrastructure (represented by kms of roads per capita) has a positive effect on private investment in the short run. This is similar to the findings by Blejer and Khan (1984) that while public infrastructure investment is complementary to private investment, other kinds of public investment lead to crowding out of private investment. This suggests that public investment should be more focused on goods and services which are enjoyed or consumed by many consumers simultaneously and non-excludable in nature with significant positive externalities. In this model, a single endogenously determined structural break was included and the possibility of multiple breaks was excluded. There is a scope to increase multiple structural breaks and re-investigate the impact of public investment on private investment in India in future studies.