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
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The Review of Economics and Statistics
VOL. LXXVI FEBRUARY 1994 NUMBER 1

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 government activities are directly productive, sup-
in each year between 1970 and 1986, this paper investigates
the extent to which government capital and current govern- plementing labor and private capital in the aggre-
ment services contribute to private production. The paper gate production function. Several of these studies
finds fairly strong evidence that current government educa- claim to have established the productivity of gov-
tional services are productive but no evidence that the other
government activities considered are productive. Indeed, gov- ernment inputs in the aggregate production func-
ernment capital often has statistically significant negative pro-tion. Ratner (1983) estimated an aggregate Cobb-
ductivity. The results are robust across the many specifications Douglas production function for private output as
considered.
a function of employment, private capital, and
the government capital stock. He found govern-
I. Introduction
ment capital to be productive with an output
RUMBLING bridges and potholed roads elasticity of about 0.06. Aschauer (1989) esti-
C,havemade regular appearanceson nightly mated a similar function but also disaggregated
television news programs and have become a government capital into military and nonmilitary
frequently discussed topic in the press. Many capital. In addition, he examined government
news commentators and politicians have discov- spending as a third potential government input.2
ered an "infrastructure crisis," which in their His results indicated that government spending
view has resulted from insufficient government and military capital are not productive but that
investment.1 In addition, it is often argued that nonmilitary government capital is a significant
the government provides too few current inputs input in the production function and has the very
into private production. In order to assess these high output elasticity of 0.39. His investigation of
views, this paper empirically investigates the ex- total factor productivity gave very similar results.
tent to which government capital and current Following essentially the same methodology,
government services contribute to private produc- Munnell (1990a) found the output elasticity of
tion. nonmilitary government capital to be between
For much of the postwar period, economists 0.31 and 0.39. Munnell (1990b) also estimated
virtually ignored the effects of fiscal policies on Cobb-Douglas and translog aggregate production
aggregate supply. More recently, however, they functions using data for the 48 contiguous U.S.
have begun to investigate the extent to which states. She again found that government capital is
a statistically significant input in the production
Received for publication December 20, 1991. Revision ac- function with an output elasticity ranging from
cepted for publication October 28, 1993.
* Ohio State University and University of Illinois at Chicago, 0.06 to 0.15. Finally, regional studies such as
respectively. Helms (1985), da Silva Costa et al. (1987), Deno
We are grateful to Mike Simms for his assistance in gather- (1988), and Aschauer (1990) have presented
ing the government expenditure data. We have received
helpful comments from Alicia Munnell, James Stock, two
2
anonymous referees, and the participants in the Macroeco- Barro (1981) had also included current government ser-
nomics and International Economics Workshop at the Univer- vices in an aggregate production function. His empirical work,
sity of Illinois at Chicago. however, tested the productivity of government inputs only
1 See Szabo (1989), Stix (1990), Friedman (1991), Koretz indirectly; i.e., without estimating the actual production func-
(1989), and Kuttner (1991). tion.

Copyright C 1994 [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.
4Gramlich (1991) may be an example of what Jorgenson has
in mind.
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 + E aI ln Xlst + a,+jUst + ust
i=l1
and
ln Yst=o + , n Xlst + a,+ Ujst
IE
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
unutilized capital. Including U in the regressions reported in
this paper produces highly significant estimates of a1,+ but
essentially no effect on the other estimated coefficients.
 ARE GOVERNMENT ACTIVITIES PRODUCTIVE?
parameters,and u is an error term. We consider
severalspecificationsfor u. The simplestis that u
is uncorrelatedboth across states and over time.
We considerthis invalidspecificationprimarilyin
order to comparethe estimatesobtainedunder it
with the estimates obtained under two specifica-
tions that may be valid. These specificationsde-
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
vst= Qvst- (6)
where p and Q are parametersand v is an error
term that is assumedto have a zero mean and to
be uncorrelatedboth acrossstates and over time.
The components ,A and A appear in equation (3)
because climates and topographiesdiffer system-
atically across states (e.g., Californiavs. North
Dakota) and technologies improvesystematically
over time, leading to systematic differences in
total factor productivityacross states and over
time. We treat ,A's and A's as fixed effects for
three reasons. First, the ,A'scannot be regarded
as a sample of realizations from a distribution
because we include the entire populationof con-
tiguous states in our sample. Second, the A's
cannot be regarded as independent realizations
from a stationarydistributionif technologydoes
indeed improveover time. Third, so long as E is
uncorrelatedwith the X's, applyinggeneralized
least squaresto equations(1) and (2) yields con-
sistent estimates if we treat ,A and A as fixed
effects but must yield inconsistentestimatesif we
treat them as random effects or simply ignore
their presence; see Judge et al. (1985). The rea-
son is that profit-maximizingfirms with produc-
tion functionsof the form (1) or (2) vary the Xs
that they control in response to all predictable lated with E.
componentsof u. Moreover,governmentsproba-
bly also vary their Xs in response to the pre-
dictablecomponentsof u.
Differencingu removesall state fixed effects in
the levels. Nonzero state fixed effects in the spec- statements below.
3
ification(5) would thereforeimplythat the growth
rate of total factor productivitydiffers perma-
nently across states and hence that all mobile
factorswould eventuallyend up in the state with
the highest growthrate. The implausibilityof this
occurrenceleads us to exclude state fixed effects
from the specification (5). The growth rate of
total factor productivityis likely to differ system-
atically over time since technologyprobablyim-
proves more in some years than in others. It is
plausible, however,that these differencesare in-
dependent draws from a stationarydistribution
and that firmsand governmentsdo not anticipate
them when they set the X's. Treating f in the
specification(5) as a randomeffect may therefore
be appropriate.For this reason, when we fitted
differencedspecificationsto 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 conservativeand because our esti-
mates turn out not to be sensitive to how it is
treated,we report only the estimatesobtainedby
treatingit as a fixed effect.
If firmsand governmentsdo not anticipatethe
error term E in setting their inputs, equations
(1) and (2) can be estimated consistently with
generalizedleast squaressince the X's are inde-
pendent of the error term by assumption.6In
contrast,if either firmsor governmentsanticipate
E in setting their inputs, the X's are correlated
with E. In that case, we can estimate (1) and (2)
consistentlyonly if we instrumentfor the X's that
are correlated with E. Even though firms and
governmentscan probablypredict E at least to
some extent,we did not instrumentfor the X's in
obtainingmost of the estimates reported in this
paper. The reason is that arrivingat a list of
instrumentalvariablesthat are a priorimore valid
than the Xs themselves is a daunting, if not
impossible,task. We did, however,performsome
instrumental estimation in order to determine
how robustour results are.
In section V, we develop a method for estimat-
ing the productivityof the government inputs
consistentlyeven if the private inputs are corre-
6If specification (5) is used, v/A should replace E in the
4 THE REVIEW OF ECONOMICS AND STATISTICS

III. The Data The gross state product data are described in
Renshaw,Trott,and Friedenberg(1988)andwere
We use the following data in our empirical
obtained from a tape providedby the Bureau of
analysis:
Economic Analysis. The employmentand hours
Q real gross state product of private data are describedin each issue of Employment
nonagricultural industries; and Earnings and were obtained from a tape
QM real gross state product in manufac- provided by the Bureau of Labor Statistics.They
turing; are averages over calendar years. The capital
N number of workers employed in pri- stock data are describedin Munnell (1991b) and
vate nonagricultural industries; were generously providedby her.7 They are for
NM number of workers employed in man- the beginning of the calendaryear. Currentgov-
ufacturing; ernment services are total expenditures of the
HM average weekly hours in manufactur- state and local governments less their investment
ing; expenditures divided by the deflatorfor state and
KP net stock of private capital used in local government purchases. The expenditure
private nonagricultural industries; data come from Governmental Finance, and the
KM net stock of private capital used in deflator data come from the SAS Citibase tape.
manufacturing; We consider only the categorieseducation,high-
U the state unemployment rate for all ways, health and hospitals,police and fire protec-
civilian workers measured as a frac- tion, and sewers and sanitationbecause the other
tion; categories of expenditure contain substantial
KHW- net stock of highway capital; amountsof transferpayments.They are for fiscal
KWS net stock of water and sewer capital; years that typically lag calendar years by six
KOI net stock of other infrastructure capi- months.8 We exclude federal capital from our
tal; measure of governmentcapital and currentfed-
KG net stock of government capital eral servicesfrom our measureof currentgovern-
(KHW+KWS +KOI); ment servicesbecause allocatingthem to specific
GED current educational services; states is difficult,if not impossible.9
GHW current highway services; Dividing nominal gross state product by real
GHH current health and hospital services; gross state product yields the state deflator. P
GPF current police and fire services; then results from dividing this deflator by the
GSN current sewer and sanitation services; deflator for the gross national product. Dividing
G current government services (GED + nominal labor compensationand nominalcapital
GHW+ GHH+ GPF + GSN); charges by N and KP, respectively, and then
P relative price of gross state product in dividingby the state deflatorgeneratesW and R.
private nonagricultural industries; The data on nominal gross state products,nomi-
W real wage in private nonagricultural nal labor compensation, and nominal capital
industries; and charges come from the tape provided by the
R real rental rate in private nonagricul-
tural industries. 7We have also used KH, the state capital stock data of
Holtz-Eakin (1993), in lieu of KG. We thank Douglas Holtz-
In most of the estimated production functions Eakin for providing his data. Tables of our results are avail-
reported in the next section, we let I = 4 able upon request. Because virtually every estimated coeffi-
cient on KH is either less positive or more negative than
with Y= Q, X1 = N, X2 = KP, X3 = KG, and those on KG, we use KG in order to increase our chances of
X4 G or GED. We also consider I = 10 with
= finding productive government capital. Nevertheless, we find
X3 = KHW, X4 = KWS, X5= KOI, X6 = GED, no evidence that government capital is productive.
8 We have also used calendar-year measures obtained by
X7 = GHW, X8 = GHH, Xg = GPT, and X1o = interpolating between adjacent fiscal years. Our empirical
GSN. In order to check the robustness of our results are not sensitive to which measure we use.
9 In our empirical analysis, we implicitly assume that the
results, we fit production functions for manufac-
inputs provided by the governments in a given state do not
turing. In that case, Y = QM, X1 = NM or NM spill over into other states. We made some efforts to check
HM, and X2 = KM. this assumption, finding no evidence of spillovers.
 ARE GOVERNMENT ACTIVITIES PRODUCTIVE? 5

TABLE 1.-FOUR-INPUT COBB-DOUGLAS PRODUCTION FUNCTIONS FOR GROSS STATE

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 transformedvariables.
for the gross national product comes from the This two-step estimatoris asymptoticallyequiva-
SAS Citibasetape. lent to generalizedleast squares;see Judge et al.
(1985). On their face, the estimates in row (b)
IV. Empirical Results provideno evidence that governmentcapital 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, statisticfor the regressionis only 0.46.
these estimateswould seem to provide consider- Row (c) of table 1 reportsthe estimatesthat we
able evidence that governmentcapital 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 regressorsand the being the first-order autoregression (4).11 Estima-
error term are likely to have important fixed tion is by a two-stepproceduresimilarto the one
effects in them. The presence of such fixed effects described in the previous paragraph.The esti-
would make the estimates inconsistentand could mates apparently provide strong evidence that
induce large biases. Second, the Durbin-Watson governmentcapital has negativeproductivityand
statistic for the regression is only 0.19. The re- current government services have positive pro-
ported standarderrors are thus inconsistentand ductivity.In addition, the adjustmentsfor first-
biased downward. order autocorrelationin 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 ,A above to obtainthe estimatesreportedin rows(d)
being treated as fixed state and time effects. We and (e) of table 1. We specifiedthe errorterm to
calculatedour estimatesusing the followingtwo- 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 seriallyuncorrelated,
state and time means and subtract them from
each observationon the dependent and indepen- 11 We also allowed p to vary across the states here and AR1
We do
dent variables.In the second step, we fitted ordi- regressions reported below, obtaining similar results.because
not think that this specification is sensible, however,
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.
 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) assumesthat it is a first-orderautore-
gression. The estimates in both rows provide no
evidence that government capital has positive
productivitybut substantialevidence that current
governmentservices do. Moreover, the autore-
gressivespecificationappearsto be superior.
One problemwith the estimatesin rows(c)-(e)
is that the estimated coefficient on employment
(private capital) is much larger (smaller) than
labor's(capital's)share in nationalincome. These
results suggest that the estimates in table 1 may
be seriouslybiased. One likely source of bias is
the simultaneity that would result if firms set
employmentin anticipationof E.12 (Firmsshould
be able to predict E because it is serially corre-
lated.) Because labor demand should be increas-
ing in the anticipatedcomponentof E, N should
be positivelycorrelatedwith E.This positive cor-
relation would typicallybias the regressioncoef-
ficient on N upward and the other regression
coefficients downward,the result that we have
apparentlyobtained.
Table 2 reportsthe estimatesthat we obtained
when we instrumentedfor N. The specifications
for rows (a) and (b) are the same as those for
rows (c) and (e) Qf table 1. In choosing the
instrumentalvariables,we assumedthat each state
faces an exogenous relative price, real product
wage, and real rental rate in private nonagricul-
turalindustries.The assumptionthat each state is
a price-takerin its product and factor marketsis
not especiallycrediblebut may be more accurate
than the assumptionthat firms cannot predict E
when they set N. Fair's(1970) analysisguidedour
choice of instrumentalvariables;see the note to
table 2 for the complete list. Comparingthe co-
efficientsin 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 makesthose on
G negative and statisticallyinsignificant.These
estimatesare even more difficultto reconcilewith
our a priori view that the elasticities of output
with respect to employmentand private capital
should be near their shares in national income.
Moreover,U cannot be interpretedas controlling
for cyclicalvariationin laborhoardingand capital
utilization.
Investment,labor hoarding,and capitalutiliza-
tion decisions may also anticipatethe error term
E. If so, KP and U may be correlated with E. For
this reason, we also instrumentedfor KP and U.
The results are not reported here since they do
not solve the problemscited above.
It is well known that using instrumentalvari-
ables can produce poor estimates if the instru-
mental variablesare not well correlatedwith the
endogenousright-hand-sidevariables.We do not
have that problem because the F-ratios of our
first-stage regressions are statisticallysignificant
at 10-8.13 The fairly small standard errors in
table 2 provide further evidence. Nevertheless,
table 2 maynot improveon table 1 because P, W,

13
12As in section II, v/I should replace e in the statements We have F(16,703)= 1020 for the levels regressionand
below if specification(5) is used. F(16,655) = 95 for the differenced regression.
 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 estimatedcoefficientson P, W, and R in the
first-stage regressions are difficult to reconcile
with these regressions'being labor-demandfunc-
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
alternativeto estimatingproductionfunctions.
Our estimatesmaybe biased because our mea-
sures of governmentcapital and currentgovern-
ment services are too aggregated. In order to
evaluate this possibility,we estimated equation
(1) with I = 10. From now on, we reportonly the
resultsfor the specification(5) and (6) with e # 0
since the significantautoregressivecoefficient in
row (e) of table 1 suggests that this specification
is superiorto the others.The specification(3) and
(4) with p # 0, however,producesessentiallythe
same estimates. Table 3 reports our estimates.
On the basis of the estimated coefficientson the
government-capital variables,it would be difficult
to make the case that government capital has
positiveproductivity.14The estimatedcoefficients
on the government-service variablesprovidefairly
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 currenteducationalservices
have positive productivitybut no evidence that
the other currentgovernmentservice are produc-
tive. As in tables 1 and 2, the estimated coeffi-
cient on employmentremainsmuch greaterthan
labor's share in national income and that on
private capital remains much less than capital's
share. Therefore, disaggregatingthe government
variablesdoes not improvethe results.
The estimates in table 3 suggest that educa-
tional services are the only productive current
governmentservice. Table 4 investigatesthis hy-
pothesis further. Clearly, GED is significantin
both regressionsand G-GED is not. We there-
fore include only GED in the regressions re-
ported below. The estimated coefficientson the
regressorsare not sensitive to whether GED or
G is includedin the regressions.
Our estimatesmay be biased because our mea-
sure of output is too aggregatedto have a stable
production function. In order to evaluate this
possibility,we fitted a four-inputproductionfunc-
tion for manufacturing.Our estimates are re-
ported in row (a) of table 5, which has the same
specificationas row (b) of table 4. The principal
difference between the former estimate and the
latter is that GED is no longer significantlyposi-
tive. The estimated coefficient on employment
remains much greater than its share in national
income and that on privatecapital remainsmuch
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
functionsfor a less aggregatedmeasureof output
does not improvethe results.'5
Employmentimperfectlymeasureslabor input.
A potentiallybetter measure, employmenttimes
averageweeklyhours,is availablefor manufactur-
ing in 42 states over the period 1972-1986. We
therefore fitted Cobb-Douglasproduction func-
tions to QM, NM HM, KM, U, KG, and GED
overthis reducedsamplein orderto learnwhether
our results improve. Row (b) of table 4 reports
estimates that are exact analogues of those re-
ported in row (a). The coefficienton NM HM is
closer to labor'sshare in nationalincome 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 restrictivefunc-
tional form on the productionfunction. The re-
strictiveness of the Cobb-Douglas production
function may be responsible for our inabilityto
find evidence that governmentcapital and cur-
rent governmentservicesare productive.In order
to examine this possibility, we estimated the
translogproductionfunction (2) with I = 4. We
considered the same four specificationsfor the
error term as in tabl-e 5. Table 6 reports the
elasticitiesof output with respect to employment,
private capital, governmentcapital, 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.
TABLE 6.-A FOUR-INPUT TRANSLOG PRODUCTION FUNCTION
FOR GROSS STATE PRODUCT IN ALL PRIVATE
NONAGRICULTURAL INDUSTRIES
Elasticities with Respect to
N KP KG GED U
.945 -.044 -.030 .028 -.190a .414a
(.069) (.037)
Notes: AR1 is applied to differences less estimated time fixed effects.
a Significant at the 0.05 level.
governmentservices, 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 translogspecifica-
tion as for the Cobb-Douglasspecificationeven
though the latter can be rejected in favor of the
former. Second, they provide no evidence that
governmentcapitalis productive.Third,they pro-
vide some evidence that currenteducationalser-
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 privatecapi-
tal stock remains much less than its share. We
concludethat usingthe translogspecificationdoes
not improveour results.'7
Government capital and current educational
services may be sufficientlycorrelatedwith each
other that we cannot obtain precise estimates of
their separateeffects. If so, it may then be possi-
ble to find significantpositive productivitiesfor
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.
 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 excludingfirst currenteducationalser- In our alternative approach,we assume that

vices and then government capital from our output is producedaccordingto the technology
regressions.The specificationsin rows (a) and (b)
are the same as that of row (b) of table 4. These In Qst = In F(Nst, KPst s) + OUst
estimates provide no evidence that government + y ln KGst + 8 ln GEDst + ust, (7)
capital has positive productivityand fairly strong
evidence that current educational services have where 0, y, and 8 are parametersand F(Q) is
positiveproductivity. increasing and twice continuouslydifferentiable
In row (c) of table 7, we show that estimates in N and KP and is homogeneousof degree Y7.
similar to Munnell's(199Gb)can be obtained by Differencingboth members of equation (7) and
not allowingfor fixed effects and not takingserial substitutingfrom equation(5) yields
correlationinto account. We learn that one can /vln Qst = (F1 Nst/F) ln Nst
estimate a large and statisticallysignificantelas-
ticity of output with respect to governmentcapi- + ( F2KPst/F) A ln KPst
tal if one does not accountfor fixed effects. In the + 0AUst + y/ ln KGst
light of our other results, however, we do not + &XlnGst+ (t + Est (8)
interpretthe estimatesin row (c) and in Munnell
as evidence that governmentcapitalis highlypro- to a first approximation.We assume furtherthat
ductive. Rather, we interpret them as evidence in every year and every state, both private labor
that state and local governmentschoose to have and capital are paid a fixed parameter 'p times
more capital,the largeris output in the state. their marginalproducts. Consequently,WstNstl
Qst = (F,NstJF), RstKst/Qst =cp(F2Kst1F)
and hence
V. An Alternative Approach
WstNst/(WstNst + RstKst)
In this section, we formulate an alternative
approachthat we use to investigatewhether gov- F,Nst/(F,Nst + F2Kst)
- (9)
ernmentcapital and currentgovernmentservices and
affect productivity.This approachhas three ad-
vantages. First, it yields consistent estimates of RstKstl(WstNst + RstKst)
the elasticity of output with respect to govern- + F2Kst).*
F2Kst/(F,Nst -
(10)
ment inputs even if employment and private
capital are correlated with technology shocks. Substitutingequations(9) and (10) into equation
Second, the parametersof technologycan differ (8) and making use of the fact that F1Nst +
across states. Third, the parametricassumptions 18
about technology can be greatly relaxed. The Similar empirical results to those reported below in table
8 are obtained if one instead assumes that F(*) is Cobb-
disadvantageis that assumptionsmust be made Douglas and that
F,NS,/(F,NS, + F2KPS,) equals the mean of
about how factor marketsoperate. WMtNtl/Qt.
10 THE REVIEW OF ECONOMICS AND STATISTICS

TABLE 8.-SOME MORE THREE-INPUT COBB-DOUGLAS ernment educationalservices are productivebut

PRODUCTION FUNCTIONS FOR GROSS STATE PRODUCT
IN ALL PRIVATE NONAGRICULTURAL INDUSTRIES
no evidence that the other governmentactivities
consideredare productive.Indeed, we found that
Z U KG GED e
the productivityof governmentcapital is usually
(a) 0.658a - .554a _.140a .074a .294a negative and often significantlyso. This result is
(.041) (.088) (.067) (.020) (.040) robustacross all our specifications,which include
(b) 0.800 - .486a _.160a .065a .242a
(.086) (.064) (.020) (.039) Cobb-Douglasand translogfunctionalforms, dif-
(c) 1.000 -.372a _.190a .046a .187a ferent degrees of disaggregationfor output and
(.090) (.063) (.021) (.039) the government inputs, different assumptions
(d) 1.200 - .244a -.223a .023 .157a
(.097) (.065) (.022) (.039) about the errorterm, and the use of instrumental
Notes. Standard errors appear in parentheses. ARI is fitted to differences
variables.We believe that these estimatesmay be
less estimated time fixed effects.
a Significant at the 0.05 level.
biased since the estimated elasticity of output
with respect to employmentis typicallyabout one
and the estimated elasticity of output with re-
F2K, = -7F,19we 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/vInGst+ At+ Est (11) geneity of the labor and privatecapital inputs.
where In order to overcomethis potential endogene-
ity problem, we then developed an alternative
/InZSt (WstNstA In Nst + Rst KstA In Kst)
approachwith which consistent estimates of the
/( WstNst + RstKst) ( 12)
output elasticitiesof governmentcapital and cur-
The variable /v In Zst is the growth rate of the rent governmentservices can be obtained under
private inputs into production.On the assump- weaker assumptions. Using this approach, we
tion that IlnZ, AXU,/v In KG, and A IlnG are again found no evidence that governmentcapital
uncorrelatedwith 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 correlatedwith E but AXU,/v In KG, and productivityof governmentcapital is alwayssig-
/v In G are not, the parameters0, y, and 8 can be nificantlynegative. This finding is robust across
estimated consistently if one knows the correct all specificationstried.
value of -q,the returnsto scale for privateinputs Althoughcrumblingbridgesand potholedroads
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 unconstrainedin the first row and underprovisionof government capital and may
is constrainedto be 0.8, 1.0, 1.2 in the other three well sufferfrom overprovision.Moreover,current
rows. The estimates of y and 8 provide no evi- noneducationalgovernmentservices appear not
dence that governmentcapital has positive pro- to be underprovided.Tables 4 and 6-8 suggest
ductivitybut some evidence that current educa- that the elasticityof gross privatenonagricultural
tional services do. This findingis consistentwith product with respect to current educationalser-
the results reportedin the previoussection. vices is about 0.04 with a standarderrorof about
0.02. At the sample means, this elasticityimplies
VI. Summary and Conclusions
that each $1 in current educational services in-
In this paper, we investigatedhow productive creases national income by about $0.85 with a
governmentactivitiesare. We first estimated ag- standarderror of about $0.42. These figures im-
gregate productionfunctionsfor privatenonagri- ply that current educational services may be ei-
culturalgross state productin which we included ther over- or underprovidedwith some presump-
governmentcapital and current governmentser- tion in favorof overprovision.
vices as inputs in addition to labor and private These tentative conclusions need to be quali-
capital.We found fairlystrongevidence that gov- fied, however. Even if governmentactivitiescost
more than they contributeto privateoutput, they
19Because F(*) is homogeneous of degree -j in N and KP,
may still be underprovidedbecause government
qi/F = FQ/N, qiKP, s) for any positive parameter qi. Differ-
entiating both members with respect to qi and evaluating the activities may also contribute direct nonmarket
resulting derivatives at qi = 1 results in -qF = F1N + F2KP. consumptionservices.As Blinder (1991) has ob-
 ARE GOVERNMENT ACTIVITIES PRODUCTIVE?
served, "If my car and my back absorb fewer
shocks from potholes, I am surelybetter-off;but
GNP may even decline as a result of fewer car
repairsand doctor'sbills."Withoutevidence that
governmentcapital does indeed generate empiri-
cally important direct nonmarket consumption
services,we would agree with Gramlichthat im-
proving how existing government activities are
priced and carried out may be more important
than providingmore of them.
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