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036 Chap 1 Pakistan Asia-Pacific Development Journal Vol. 23, No. 1, June 2016 PUBLIC SPENDING ON HUMAN CAPITAL FORMATION AND ECONOMIC GROWTH IN PAKISTAN Syed Ammad Ali, Qazi Masood Ahmed and Lubna Naz* This present paper captures the growth effects of public physical and human capital investment, which highlights the relative efficacy of these types of investments on sectoral and aggregate output, employment and private investment, and indicates which sector of the economy of Pakistan is benefiting the most from these investments. It uses the production function approach based on the Mankiw, Romer and Weil (1992) growth models and applied the Fully Modified Ordinary Least Square (FM-OLS) technique using data from the Pakistan economy during the period 1964-2013. The results show that human capital investment in the public sector has a positive significant effect in all models. The coefficient indicates that a 1 per cent change in human capital investment will increase the output of the manufacturing sector by 0.44 per cent; the output of the services sector by 0.15 per cent; the output of agriculture sector by 0.094 per cent; and the aggregate output by 0.027 per cent. The public physical investment has the highest impact on manufacturing sector output (0.084 per cent) followed by aggregate output (0.034 per cent). The estimated elasticities indicate that at the sectoral level, public human capital investment has a greater output effect than the public physical investment, while at the aggregate level, the public-physical- investment effect dominates. JEL classification: O40, O53, E62, H40. Keywords: Economic growth, physical capital, human capital, Pakistan. * Syed Ammad Ali, PhD, Research Fellow, Department of Economics University of Karachi (e-mail: [email protected]); Qazi Masood Ahmed, PhD, Director, Centre for Business & Economics Research, Institute of Business Administration, Karachi (e-mail: [email protected]), and Lubna Naz, PhD, Assistant Professor, Department of Economics, University of Karachi (e-mail: lubnanaz@uok. edu.pk). We acknowledge the reviewers for their valuable comments and suggestions. 1 Asia-Pacific Development Journal Vol. 23, No. 1, June 2016 I. INTRODUCTION The differences in growth among the countries initially mainly considered the availability of physical capital stock. However, after the seminal work of Lucas (1988), Romer (1990) and Mankiw, Romer and Weil (1992), the role of human capital in economic growth has become widely accepted, along with the physical capital stock. Human capital stock is determined through education, health, research and development, and training. However, it is still being debated as to which factor is most efficient and effective with regard to human capital accumulation. Another burning issue pertains to the role of public investment. The effectiveness of public investment on private investment and consequently on growth is widely discussed in economic literature. The classical school of thought is of the view that increments in public spending reduces economic growth by crowding out private investment, as higher spending requires higher taxes at individual and corporate levels, which create a distortion in the choice of economic agents. The Keynesians, on the other hand, consider government spending as a key variable for economic growth. They argue that government development expenditures on health, education, and infrastructure increase labour productivity and reduce the cost of conducting business, which spurs gross private domestic investment. In Pakistan, the public sector is intended to play an effective and efficient role with regard to economic growth and the welfare of the society. In pursuance of these objectives, the Government is trying to improve infrastructure and energy generation and distribution, and promote the establishment of health and education facilities. However, the data trend, as depicted in figure 1, indicates that the ratio of physical investment, the sum of public investment in electricity and gas distribution, and in the transport, storage and communication sector to GDP, and the ratio of human capital investment, the sum of the development expenditures in the health and education sectors to GDP are falling. The broad objectives of the present study are to test the relative effects of public physical investment and of public human capital investment on economic growth. The effects of public investment are evaluated in three major sectors of the economy, namely the agriculture, manufacturing, and services sectors. This study used the Fully Modified Ordinary Least Square (FM-OLS) technique to measure the long-term relationship between public physical and human capital and economic growth at aggregate and sectoral levels. FM-OLS has several advantages over the previously applied vector error correction model (VECM), ordinary least square (OLS), and autoregressive distributed lag (ARDL) techniques. This study is among a pool very few undertaken in the developing countries that capture the growth effects of public physical and human capital investment. It highlights, in particular, the size of 2 Asia-Pacific Development Journal Vol. 23, No. 1, June 2016 Figure 1. Public physical and human capital investment to GDP ratio in Pakistan 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 FY64 FY78 FY82 FY84 FY90 FY94 FY98 FY00 FY02 FY06 FY08 FY10 FY66 FY68 FY72 FY80 FY86 FY88 FY92 FY96 FY04 FY70 FY74 FY76 FY11-12 Physical investment to GDP Human capital investment to GDP Source: Authors’ own estimation based on the data series used for analysis. the impact of these investments on sectoral and aggregate output growth. Notably, it has some unique features; the definition of human capital for the study as the sum of government health and education development expenditures has never been used before and the definition of physical capital as public investment in the electricity generation and distribution and gas generation and distribution sector plus public investment in the transport, storage and communication sector is also being used for the first time. Furthermore, no other study has examined the relative efficacy of public physical and human capital investment jointly, with exception of one conducted by Khan and Sasaki (2001). However, that study used different proxies for human and physical capital. This study also indicates which sector of the economy of Pakistan is benefiting the most from these investments. All and all, the study provides useful information for policymakers. The remaining section of the study is organized as follows: section II contains a review of past literature, section III provides an explanation of the methodological framework, section IV gives data and a diagnostic test, section V provides the basis for the empirical results and finally the conclusion and policy implications is discussed in section VI. 3 Asia-Pacific Development Journal Vol. 23, No. 1, June 2016 II. REVIEW OF LITERATURE The empirical literature related to the research for this study can be divided into three parts: (a) studies on the role of human capital in economic growth; (b) studies on the role of physical investment on economic growth: and (c) research work that explores the comparative effectiveness of physical and human capital. Schultz (1961) stressed the importance of human capital as a major determinant of economic growth. Many studies that followed then examined the role of public investment in human capital in the form of health and education on the economic situation. A cross-country study by Maitra and Mukhopadhyay (2012) explored the impact of public health and education expenditures on economic growth through a vector autoregressive/vector error correction model (VAR/VECM) for 12 countries, namely Bangladesh, Fiji, Kiribati, Malaysia, Maldives, Nepal, the Philippines, the Republic of Korea, Singapore, Sri Lanka, Tonga and Vanuatu, based on annual time series data from 1981 to 2011. The results of those studies showed that public education spending had a significant positive impact on economic growth in Bangladesh, Fiji, Kiribati, Maldives, Nepal, Singapore, Sri Lanka, Tonga and Vanuatu and a significant negative effect in Malaysia, the Philippines and the Republic of Korea. Meanwhile, health expenditures had a significant positive growth effect in Bangladesh, Nepal, the Philippines, Singapore and Sri Lanka, a significant negative growth effect in Kiribati, Malaysia, Maldives, the Republic of Korea and Vanuatu, and no effect in Fiji and Tonga. Khan (2005) analysed the impact of human capital on economic growth by applying a cross-sectional regression for 72 low and middle-income countries, including Pakistan, and using the mean value of all selected variables for the period 1980-2002. Another variable used by Khan was average years of schooling, literacy rate, school enrolment and life expectancy at birth, as a proxy for human capital. The results show that the educational and health indicators have a significant positive effect on real per-capita growth. More specifically, in the case of Pakistan, Khan noted that even though human capital investment has been very low compared to other economies in Asia, it has had a significant effect on the country’s economic growth rate, which can further be accelerated by increasing the quality of human capital. Tamang (2011) investigated the impact of education expenditures on GDP growth in India through Johansen cointegration on an annual data set covering the period 1980-2008. He found that a 1 per cent increase in public education expenditure per worker will lead to 0.11 per cent increase in GDP per worker. Ogungbenle, Olawumi and Obasuyi (2013) estimated the link among life expectancy, public health spending and economic growth in Nigeria using annual time series data for the period 1977-2008 through a VAR model and found a bi-directional causality between public 4 Asia-Pacific Development Journal Vol. 23, No. 1, June 2016 health spending and economic growth. Hussin, Muhammad and Razak (2012) examined the impact of education expenditures on economic growth in Malaysia using a VECM model with the following variables: GDP; fixed capital formation; labour force participation; and public education expenditures.
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