The Role of Investment in Poverty Reduction

This essay is an attempt to explain the role of investment in poverty reduction. In order to achieve this, an exposition of the theoretical assumptions on the linkages between investment and poverty reduction will be undertaken. In addition, relevant definitions and practical examples will be cited. A conclusion will then be drawn from the discourse.

As is well known, poverty is multi-dimensional. There are several different indicators of well-being (e.g. education, health, nutrition, security), and a minimum level deemed acceptable by society associated with each. Poverty is a complex phenomenon that has attracted numerous definitions that have centered on its characteristics, extent, and measurement. The World Bank (2001) arbitrarily defines it as the inability of people to attain a minimum standard of living. However, this definition raises other question pertaining to what is meant by minimum standard of living, how such a level is measured, and the extent to which a single measure can be sufficient to encompass a phenomenon of a multifaceted immensity.

However, for argument’s sake, this essay will adopt Todaro & Smith’s (2008) definition of poverty as a lack of basic human needs, such as adequate and nutritious food, clothing, housing, clean water, and health services ---these being fundamental for the promotion of human dignity and welfare. Therefore poverty reduction entails pursuing policies that are focused on the general improvement in human welfare.

Anderson et al. (2006:3) define (net) public investment as public expenditure that adds to the public physical capital stock. This would include the building of roads, ports, schools, hospitals etc.

The UN Millennium Project (2005) has re-emphasized the need for a ‘big push’ strategy in public investment to help poor countries break out of their poverty trap. The report argues that, to enable all countries reduce poverty, there should be identification of priority public investments to empower poor people, and these should be built into MDG-based strategies that anchor the scaling-up of public investments, capacity-building, resource mobilization, and official development assistance. Seven main investment-and-policy clusters are identified in the areas of rural development; urban development; health systems; education; gender equality; environment; and science, technology and innovation.

However, the contribution of public investment to growth and poverty reduction has not always been as positive or as significant as one might expect. Despite the development of increasingly sophisticated methods for assessing the desirability of public expenditure during the 1960s and 1970s, large increases in public investment in many developing countries between 1974 and 1982 often yielded few returns (Little and Mirrless, 1990).

There are, of course, many possible reasons for this, including some unconnected with public investments (e.g. declining terms of trade for developing country exports). Nevertheless, there is a possibility that at least one of the reasons was that the methods available to assess the desirability of public investment alternatives were flawed, badly implemented, or ignored.

Looking at methodologies for assisting policy-makers in deciding an optimal investment portfolio is, therefore, fundamental in furthering our understanding of the linkages between public investment, growth and poverty reduction, and of the ways in which economic policy-making can become a better tool for promoting positive development outcomes. In recent years, there has been an increasing interest in Public Expenditure Management (PEM) systems, and the ways these can deliver on a government’s poverty reduction objectives. In the 1980s and 1990s the focus was largely on macroeconomic stability and aggregate fiscal discipline whereas more recently, criteria for resource allocation and issues of efficiency and effectiveness of public spending have come to the fore, highlighting the importance of the role of government in determining the ‘pro-poorness’ of growth paths and public investment policies (Wilhelm and Fiestas, 2005).

The role of investment in reducing poverty can be analyzed on two levels, that is, at the macro (economic-wide) and micro (household) level.

At the macro level, investment has the following functions in poverty reduction. Firstly, it complements private capital. This is justified on the grounds that public and private capital are made up of quite different things, with public capital consisting mainly of public goods (e.g. roads, electricity supply) and private capital consisting of private goods (e.g. buildings, machinery). In this case, the aggregate production function for an economy is of the form: Y = A⋅ f (K,G,N, L), where Y is aggregate output, K is private capital (human and/or physical), G is public capital, N is natural resources, L is the labour force, and A is the level of technology, or total-factor productivity. When modeled in this way, an increase in the public capital stock raises aggregate output and also raises the productivity of all other factors of production, including labour. If labour markets are competitive, and labour supply is inelastic, an increase in the productivity of labour leads to an increase in real wages.

Secondly, owing to the above, when public and private capital are complements, public investment raises the marginal productivity of private capital. This raises the returns to private investment and, if private savings are flexible, the amount of private investment. This ‘crowding-in’ of private investment in turn increases the rate of economic growth.

Thirdly, Fujita et al. (2001), observe that improvements in domestic transport and communications infrastructure can have significant effects on growth. There are two reasons for this. The first is that, by lowering transport costs, firms’ profits are raised, as are (depending on the characteristics of the labour market) the wages paid to labour. This generates a one-off boost to average income. The second is that, by driving a cumulative process by which labour and other resources move to a small number of core regions and/or cities in which (because of increasing returns) levels of labour productivity are higher, an acceleration in a country’s rate of growth is caused, which may well persist over several years if not decades.

Fourthly, according to the Keynesian school of thought, an increase in public investment would have an immediate positive impact on the level of national income, followed by a successively smaller positive impact in a limited number of subsequent years. In countries operating at less than full employment, public investment will tend to increase the level of employment, at least in the short-term, by stimulating aggregate demand.

Another role investment plays is that it increases economic growth simply by raising the rate of national savings. Put simply, a government can, in some circumstances, increase the share of national income that is saved by taxing consumption and investing the revenues this generates. For this particular effect to occur, the rate of private saving must not fall significantly if public investment reduces the returns to private investment. However, whether a government can raise national savings in this way is, of course, contested. Most notable is the argument, referred to as Ricardian equivalence, that current generations will, in response to a tax rise (fall), adjust their own savings downwards (upwards) by an amount that leaves the national savings rate unchanged (Barro, 1974).
Therefore, increased national savings can allow the government to channel resources to poverty reduction projects.

At a micro level, one of the main effects of public investment is to increase the quantity and/or quality of public goods and services. As is well known, the private sector will typically not supply public goods and services, because they cannot charge a price for their use. They must instead be provided by the government, through its ability to raise revenues from domestic taxation or foreign aid. In this case, the amount of the good or service which is provided, and which any one firm or household can use is in effect rationed. Nevertheless, additional investment can increase the quantity and/or quality of this rationed amount, benefiting households and firms in the process.

Therefore, public investments make it possible for the poor to access goods and services that would otherwise be very expensive if controlled by the private sector, at an affordable price. Such goods and services include schools, health centers, security, legal services, water and sanitation services, etcetera.

In a nutshell, investment has an impact on poverty reduction at both a macro and micro level. Some of the roles it plays include complementing private capital, crowding-in private investment, market integration, increasing aggregate demand, increasing national savings, creating employment opportunities, increasing disposable incomes, increasing economic choices and etcetera.

BIBLIOGRAPHY
Anderson, E., de Renzio, P. & Levy, S. (2006). The Role of Public Investment in
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Barro, R. (1974) ‘Are Government Bonds Net Wealth?’, Journal of Political Economy 81: 1095– 117.
Fujita, M., Krugman, P. and Venables, A. (2001). The Spatial Economy: Cities, Regions and International Trade. London: MIT Press.
Pernia, E. (2003). Pro-poor Growth: What is it and how is it Important? ERD Policy Brief 17.Manila: Asian Development Bank.
Thirlwall, A.P. (2011). Economics of Development. 9th Edition. Hampshire: Palgrave Macmillan.
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